Market At Risk Again As Finland, Netherlands Undermine EU Progress

Includes: DIA, EFNL, EWN, QQQ, SPY
by: Colin Lokey

On June 29, I published an article explaining the two key agreements reached at last week's EU Summit (the decision to renounce the European Stability Mechanism's 'preferred creditor' status on its bailout for Spanish banks, and the decision to allow rescue funds to be directly injected into struggling financial institutions) and why those agreements were so important. In that article I argued that the most important thing about the agreement was European policymakers' apparent recognition that the real problem in the EU is the toxic link between sovereigns and banks. This sentiment was echoed in a note to clients from Goldman Sachs:

"...the political commitment to break the link between sovereign and bank balance sheets has been established and to our eyes this is very important"

As important as this is, the sentiment must of course be translated to action for a commitment alone cannot extricate the eurozone from the debt crisis. Over the course of the last year or so, Germany has proved an impediment to progress by way of its staunch opposition to anything that even sounds like 'burden-sharing' (this of course assumes that the collectivization of debt is the proper course of action, but that is another argument). In recognition of this, I noted in the above-mentioned article that

If these policies are implemented, things could turn around rather quickly in Europe. It may be worth playing this for more than the requisite kneejerk 'EU'phoria rally. Watch the news this weekend to see if Germany recants. If there is no sign of backpeddling by Monday, long S&P 500 (NYSEARCA:SPY) and long (NASDAQ:QQQ).

As it turns out, it wasn't Germany that did the backpeddling, it was Finland and the Netherlands (two of the EU's remaining four AAA rated nations). On Monday, the two countries announced that they would block the purchase of distressed sovereign debt in the secondary market by EU rescue funds. Complicating matters further, Finland also said it would demand collateral for any loans extended to Spain that don't confer seniority on taxpayers. In other words: Finland doesn't want to renounce its seniority on the Spanish bank bailout.

On top of these rather disconcerting events, there is still of course the issue that the ESM treaty needs to be amended to allow for direct injections. This idea has been challenged of late and it now appears that the ESM council of governors can approve the change without the ratification of member countries' parliaments. However, the Netherlands now says

" was uncertain if a direct recapitalization of banks by the euro zone's permanent rescue fund would require a treaty change."

It appears then, whatever ground was given up by Germany is set to be taken back by Finland and the Netherlands. As such, it now makes little sense to assume that any of the proposals advanced at the EU Summit will take effect in time to avert a reescalation of the crisis in Spain and Italy. This seems especially true given that

"At least 40 billion euros is needed in the next few weeks to stop nationalized lenders Bankia, CatalunyaCaixa, NovaGalicia and Banco de Valencia collapsing, Spanish government sources say and it is not clear where that money will come from."

In light of these concerns, it appears any predictions of a sustained EU Summit-fueled rally were premature at best. Short S&P 500 , Nasdaq , long volatility.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in SPY, QQQ over the next 72 hours.