By Simon Lack
A perverse but totally understandable consequence of the current crisis is that even though it was an excess of debt that got us here, the cost of borrowing is about as low as it could get - at least in the U.S., thanks to the Fed's confiscatory monetary policy. But in Europe, the cost of borrowing is rapidly reflecting the unfortunate reality that there's just been altogether too much of it.
On Tuesday, the FT ran an op-ed piece by Jim Millstein, "Europe's largest banks have become too big to save." I can't stop thinking about it. He makes the point that Europe's biggest banks and governments are now so intertwined that one cannot fail without the other. Europe's banking system is much larger relative to its economies than in the U.S., in part because European corporate debt markets are far less developed. Banks are also loaded with government bonds, an unfortunate consequence of the old BIS capital rules assigning no risk weighting to sovereign debt of any developed country. Bankers loaded up on peripheral European debt because it yielded more than German and French bonds but owning it didn't require any greater capital. This is really the cause of today's problems; the common currency simply eliminated the foreign exchange risk, but the capital rules made the buildup of risk virtually free and bankers suspended critical judgment.
So what we have today is a symbiotic relationship. Europe's governments sell bonds to their banks. Those banks, now sagging under the weight of mark to market losses on bonds are having to raise capital at a time of depressed equity prices. This creates the potential for Europe's governments to need to support their own banks because they already own too much of their government's debts. It's a spiral, and the standard austerity prescription from the Germans may be starting to wear thin. The New York Times notes this in an article and wonders whether, as rising bond yields spread to northern Europe (France's 10 year yields are currently 3.76%), the focus on deficit reduction may lose support. “All this underscores the ongoing nervousness about Europe generally and the banking sector specifically,” says my friend Barry Knapp from Barclays.
It's not clear where it ends, and Jim Millstein's piece leads quite logically to just about the worst outcome. So what's an investor to do?
Well, as dire as things seem, timing equity markets is never easy and although the U.S. will inevitably be dragged down by Europe's travails there is a world outside the eurozone and many stocks provide attractive return potential. We continue to be short the € in our hedge fund.
Within our Deep Value Equity Strategy we don't invest in banks (too much leverage for my taste) and natural gas E&P names are no doubt cyclically exposed although it's hard to see how much lower the price of domestic gas can drop than the $3.40 per MCF it's at currently. Among the large E&P names we like Devon Energy, which is all domestic, has an attractive exposure to liquids and trades close to the value of its proved reserves. McMoran Exploration (NYSE:MMR) is a smaller and highly speculative position that will likely resolve itself by the end of the year when it gets results from its Davy Jones Flow Test. MMR had some mildly positive news earlier in the week from their Lafitte Ultra-Deep Exploration Well but this company's future will likely be driven by Davy Jones. MMR will move up and down with the European debt crisis but its value really has absolutely nothing to do with the price of Italian bonds.
We're avoiding obvious risks such as financials, and using bottom-up analysis to manage top-down risks.