Last week we had a moment of clarity, to borrow a line from Pulp Fiction. Like most such moments, it came about in the process of trying to do something else. In our case, we were trying to sketch out a European debt reform project that would not only pass the market smell-test, but really work. We’ve been saying for some time now that the only real way out for Europe is to write down its bad debt and recapitalize its banking system.
It may seem more than a little obvious to say that the devil is in the details, but never has that been more true for the health of the Western financial system. As recent developments have shown in the European sovereign debt markets, the debt problem extends well beyond Greece, whose importance lies not in the size of its economy but in being the most vulnerable part of a foundering system.
In this way Greece might be thought of as Europe’s Bear Stearns rather than its Lehman Brothers. It isn’t because the Greek economy has the heft or reach that either investment firm once possessed, but in being the first part of the archipelago to disappear under a tsunami of bad debt. We know that many Americans are puzzled and tired about why a relatively small country like Greece seems to dominate the headlines, but it’s the tidal wave and protection system that is at stake. If Greece can’t be protected, which other members of the archipelago will be next to go?
The salient weakness of the Greek situation is that the country borrowed too much money relative to its true GDP and fudged accounts of both. That problem is easy to see now, and therein lies the conundrum for our would-be solution and the financial markets. The rest of Europe’s debt isn’t so easy to see, and in this respect again recalls the time of the Bear Stearns collapse. At that time, the common lament was the lack of transparency about the many forms of debt the banks were carrying on and off their books. The irony is that had we really known the full extent of the rot in our system, asset prices would have collapsed much faster than they did.
The centers of the European housing bubble - yes, besides the junk we sold them, they had one too - were in Ireland, Portugal and in particular Spain. The Irish situation is well known because the government effectively nationalized the banks a couple of years ago, but much of the Spanish debt is being held at cost in private banks in Spain and throughout Europe. The market began to turn its attention back to this problem last week, but the true gravity of the situation has been off the screen. It isn’t clear either how much of the bad U.S. paper has been sold off or written down to fair value.
And therein lies the rub. Our attempt to conjure a reasonable approach to Europe’s predicament included recognition that a much bigger piece of the debt needs to be written off than a few hundred billion euros of Greek sovereign bonds. Portugal and Ireland owe more money than they can pay back in a lifetime of austerity, and any forgiveness of Greek debt will find both countries moving up immediately in the queue. The Spanish debt can’t hide or escape notice for much longer. Italy isn’t quite as badly placed as the headlines make it out to be: The scary part is how quickly the contagion infected its bond auctions.
Our moment of clarity: It’s the very absence of the concrete plan that the markets have been demanding that has paradoxically supported asset prices. It’s a bit like that funny noise coming from under the hood of your car: so long as you don’t know what it is, you can hope that it’s just a loose something-or-other. The bill shock comes later.
A program that could genuinely stand the market test for more than a day or two of short-squeezing is well beyond where the Europeans, in particular the Germans, have so far talked about going. That’s not to say that the Germans or other country leaders are completely ignorant of the problem - Chancellor Merkel recently called the current situation Europe’s biggest challenge since the second world war. As well, various German officials have eagerly seized upon proposals of late that involve disciplining countries for violating agreed-upon financial norms. No doubt some of that reflects the culture’s Calvinist heritage, but it also indicates a certain recognition of the inevitability of German financial support.
Complicating the situation is the mistaken notion that wrenching austerity for all parties but Germany can work, either economically or politically. We can understand why the Germans are comfortable with it, but it isn’t going to work, and the longer the EU pursues it, the deeper their impending recession is going to bite.
Two maelstroms lie ahead (more than two, really, but we’re focusing on the West and the near term). The first is the notion that the transformation of the European Central Bank (ECB) into a lender of last resort, similar to our own Federal Reserve, is the key to European salvation. It isn’t, because it won’t make the bad debt go away anymore than the Federal Reserve did. It isn’t at all clear either that the inflation-paranoid Germans would agree to it. But one thing that is clear is that the markets are pinning their hopes on it. Yet it would help matters, that much we agree.
We feel safe in predicting that even a hint that the EU or ECB was willing to move in that direction would cause asset prices to rally strongly into year-end. The real thing might get stock prices to rally 20% or so before traders stopped to reflect - everybody would be too busy trying to make sure they didn’t get left behind in the performance tables. It would be a sucker rally in the end. But try telling us the last time the equity markets have taken the long view. For that matter, more than a few traders would fully believe it to be a sucker rally every step of the way, but would go all-in on the ride nonetheless. One of the quickest ways to lose money in the markets is to trade on the presumption of rational behavior.
The other maelstrom: we are dealing with a political process. No outcome is certain. We’re not going to take the vulgar route of sneering at leaders that ultimately the people have chosen. The reality is that these are controversial issues, dogged by honest divisions and partisan ideologies. The U.S. experience in 2008 shows the difficulty of making unpopular decisions - while Fed chairman Ben Bernanke and former Treasury Secretary Hank Paulson would instantly seize the chance to have a do-over on Lehman Brothers, there remains a hardy core on Wall Street and beyond (prominently represented on CNBC, for example) that rail against any and all attempts to stabilize the system. It won’t be any easier to sell the German public on ponying up for their neighbors than it would be to get Texas to bail out Massachusetts.
Our long-standing view has been that it will take the threat of imminent disaster for Germany’s own financial system to force the next big step toward supporting the system, much like the reality of market collapse forced our own Congress to reverse field on the TARP program. Given that the EU involves the approval of 17 governments rather than one, it may take more than a day or two for them to retrace their steps. Deciding who gets what is going to be contentious, to say the least.
That’s another reason why many expect the first relief to come from the ECB, despite new chief Mario Draghi’s apparent reluctance to take that direction. It will be a trying time for investors, and many will end up selling out at the bottom and not coming back. Not great for the long-term health of the system.
So far as the super-committee failure, anxiety has surged but we don’t think that the result will be the same as it was in July. For one thing, markets rarely sell off for long on the same fear the second time around. Until there is a more concrete event, such as a ratings downgrade (which doesn't appear to be on this quarter's calendar), we’re willing to bet that the markets will soon try to find a way to move past it and on to a December rally.
Here then are a couple of predictions: Europe’s much talked-about “Lehman moment” won’t come from Greece, which we have already compared to Bear Stearns, the over-leveraged Lehman cousin is Spain. And we will discover that the Western banking system, in its latest lemming-like rush for profits, is horribly in over its head again, this time with sovereign credit default swaps. The entanglement is much like AIG (AIG), Lehman, Goldman Sachs (GS) et al. Many banking CEOs will be gone by the end of next year.
But all that won’t come until 2012. And we don’t know if the EU will get it right or not. Happy Thanksgiving, and it wouldn't hurt to cross your fingers under the table.