As I write, representatives from the French and Belgian governments are reaching a deal to break up Dexia SA (OTCPK:DXBGY), a retail and municipal lender with over 500 billion euros in assets, and, apparently, the first major bank to go under in the eurozone crisis.
The overleveraged bank currently faces a short-term funding shortfall of nearly 100 billion euros, and a deteriorating asset base, due in part to significant exposure to troubled debt in Italy and Greece. The bank's failure comes just three years after an initial bailout during the 2008 financial crisis, in which the governments of Belgium, France, and Luxembourg contributed nearly 7 billion euros in capital and another 150 billion euros in guarantees. (The division of responsibility for these guarantees has been a sticking point in this weekend's negotiations.)
Investors should realize that the Dexia dissolution is a major, market-changing event. Up until now, I have been moderately bullish on US equities for most of the difficult summer, while trying to maintain a long-term view. In early August I argued that 2011 was not 2008, and recommended that long-term investors keep their wits and look for bargains; I also advised investors to take advantage of volatility through the use of hedged strategies such as cash-secured puts. In the two months since, the spike in the VIX and a flat, if volatile, market have made those predictions reasonably correct:
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S&P 500 year-to-date chart, courtesy Yahoo! Finance
Overall, I felt, as did many bulls, that the European crisis could be contained; that strong corporate earnings would lift US equities; and that exposure to emerging markets (46% of sales for the S&P 500 are international) could overcome weakness in Western economies.
I've changed my mind. The seriouness of the situation became clear with one quote, at the end of an article on CNBC.com:
Societe Generale Chief Executive Frederic Oudea told Reuters in an interview on Friday that Dexia's circumstances were specific to itself, and "people should not expect further problems with the system".
I recall hearing that sentiment often in 2008, after Bear Stearns -- to whom Dexia has been compared -- after Lehman Brothers, and after AIG. It was wrong then, and it is wrong now. Dexia's "circumstances" are hardly unique; its collapse has been caused by markdowns on sovereign debt combined with an overleveraged asset base that never truly recovered from the 2008-2009 crisis. This is not an unforeseen occurrence, or a situation caused by mistakes specific to Dexia's leadership. Banks across the continent -- and across the world -- face the same dire straits. It may not be Oudea's SocGen (OTCPK:SCGLY) that goes down next; it may not be Greece, at least not immediately; but Dexia will not be the only victim. The fact that Dexia passed European Banking Authority stress tests just three months ago now casts a cloud over the entire European banking community, destroying confidence, and increasing the possibility of another bank run. Arguing that Dexia is somehow an isolated case is delusional.
There is simply no longer any way to deny the extent of the troubles in Europe, no matter how its leaders and bankers try to assuage investor fears. The much-lauded European Financial Stability Facility, intended to suppress the contagion of financial troubles across the continent, offers 440 billion euros in capital. Guarantees from France and Belgium for the Dexia dissolution may reach as high as 200 billion euros, nearly half of amount authorized for the EFSF fund (if that fund is not blocked by the Slovak parliament). Can anyone truly believe that Dexia will be the only casualty, or that a 440-billion euro fund can restore investor confidence across the continent when it so clearly has the possibility to be overwhelmed by a small number of similar collapses?
Furthermore, the political bickering accompanying the potential dissolution proves that the leaders of the Continent still don't understand the severity of the situation. Slovakia is holding up the EFSF; France and Belgium are arguing over guarantees of Dexia's liabilities. Belgian regional governments in Flanders and Wallonia are against the Dexia bailout, wishing to protect their investment and avoid foreign ownership, as if such an outcome is remotely possible. After Dexia, European bondholders and taxpayers face a long-term fight over the tab for Greek (and possibly Italian, and Spanish) default, while Northern European populaces in Germany and France point their fingers at lazy, greedy (and darker-skinned) Greeks and Italians.
It is extremely likely, if not certain, that another shock is coming down the pike. The oft-discussed Greek default -- whose stops and starts have contributed to the past months' volatility -- is the least of investors' concerns. That default is a foregone conclusion, and likely priced into the market for Western equities. The next shock will come out of nowhere, and if it's a name like SocGen, or a further downgrade of sovereign debt beyond the PIGS, the market will take a tumble. The range-bound volatility of the last two months has been a battle of hope versus fear. The Dexia collapse shows that, in the short-term, fear will win out, and the market will have at least one more leg down, perhaps similar to the 15% drop seen in late July, to a new, lower, volatile range.
Investors who are still bullish long-term on US equities should at the least look to hedge existing positions with covered calls, and consider initiating new trades with cash-secured puts. The likely spike in market fear should give gold new life, through ETFs GLD, GDX, and GDXJ, as I believe its bull run is far from over. More aggressive traders can look to short index ETFs such as the SPDR S&P 500 (SPY), or buy puts in anticipation of a downturn. A good example is the SPY December 108 put, asked at $4.10, requiring a 10% drop over the next two-plus months for a profitable trade.
There is an old dark joke in standup comedy, which likely dates back to the days of Milton Berle (and Uncle Miltie, a well-known joke thief, probably stole it from someone else). "If I'd just killed her," the comic sorrowfully grunts about his wife, "I'd be out of jail by now."
If Europe had just killed off its debt, it would be out of by jail now. Instead, it's stuck in a bitter marriage between public and private, Northern and Southern. In the long-term, this crisis will end, whether in divorce, reconciliation, or violence. In the meantime, it will continue to create fear, hostility, and market instability. The reluctance of European leadership to face the crisis head-on will result in the continuation of hastily arranged, insufficient stopgap measures, which will not compensate for the market shocks caused by the next victims of European debt. There will be relief rallies, as political and financial institutions create new agencies, new funds, and new proposals to battle the crisis; as leaders claim that the most recent collapse is really the last one; and as market participants continue to look for "the bottom". But the trend will be downward, as each new victim sparks a new selloff. The bullish hopes for "containment" should be dashed by the Dexia collapse. It is the first sign of a new crisis, or perhaps just the most recent sign that the old crisis never really moved out of the house.