The European 'Solution'?

Includes: ERO, EU, EZU, FXE, IEV, VGK
by: Investment Pancake

You’ve probably read and heard now that the greatest threat to the financial system today is “too much debt”. If you believe that to be the case, then the European bailout appears to be no solution at all to the sovereign debt crisis because all the bailout does is to ladle even more debt onto the system. Far from a solution, the Greece bailout actually exacerbates the problem.

There’s another view, though, which is that there is nothing inherently wrong with “too much” debt. The problem, if anything, is that as with any bubble in any asset category, debt is not appropriately priced the inherent risks associated with owning it. For instance, it is not irrational to lend money to someone who is unlikely to repay the loan, provided you charge a high enough risk premium and hold enough other performing loans to offset the loss you expect to take on your risky loan. The crucial thing is that the lender must accurately price the risk, and prudently hedge it.

So let’s get back to European bailout package. The package is designed to do one thing only: buy time. The thought is that because capital markets move faster than political reform, if Greece, and other troubled nations, have time to get their affairs in order, then perhaps they can get into a better position to repay their loans. That, in turn, will lower their borrowing costs. And the lower those borrowing costs, the better these nations will be positioned to repay their loans. Which, in turn, lowers borrowing costs yet again. And so on.

Buy offering guarantees on the debt of less-credit-worthy nations, European governments hope to kick start this “virtuous cycle” today, and to stave off a next wave of the financial crisis. The real question investors should be asking is not whether these guarantees add more debt to the system. The question is whether these guarantees “artificially” reduce the price of debt issued by risky nations, so that investors in debt (banks in this case, mainly) cannot appropriately price the stuff and hedge their risks of owning it.

Is the price of risky sovereign debt mispriced currently, as a consequence of this past weekend’s actions? I propose that the situation is akin to a hopeless spendthrift (Greece) marrying a wealthy miser (Germany and other strong European nations). The notes issued by this spendthrift are now certainly worth more as a result of the marriage, as long as the wealthy miser has a sufficient net worth to cover the spouse’s reckless borrowing and spending.

The question you’d ask, in deciding whether to purchase the spendthrift’s notes, is this: just how rich is that wealthy miser? In the case of Germany, and the balance of prosperous European nations, the answer is “plenty”. You might also ask “will the wealthy miser be able to reign in the spendthrift spouse’s borrowing and spending habits sufficiently, to ensure that the wealthy miser doesn’t end up broke?” On that score, only time will tell.

But let’s get back to that notion about sovereign debt being inappropriately priced. This seems like an easy argument. The yield on a ten year US Treasury, for instance, stands below 4%, which after taxes, leaves an investor with a guaranteed loss once you take real inflation into account.

Put differently, investors in US Treasuries are actually PAYING to take risk. Granted, these investors consider themselves to be paying for the relative safety of lending to the US Government, but remember, lending is still a risky business regardless of who the borrower is. After all, the borrower has your money, and you don’t.

The rates the market charges on all debt – including that of sovereign nations like Greece - are keyed off these “risk free” rates which are, manifestly, in a bubble, since investors in risk-free assets are guaranteed only losses for their trouble. So is there a bubble in high-risk sovereign debt? It only follows of necessity, yes. But only because there is a bubble in the price of all safe debt.

What’s the end game, then? Ironically, the solution will come once investors role out of risk-free assets and start gaining more of an appetite for the risky stuff – equities, and similar assets. As we see that, the yield on US Treasuries will rise, lifting yields on all debt, only the increased risk appetite on the part of investors will lower the spreads.

Sounds like a rising tide will lift all ships, but as with everything in life, you give something up for everything you gain. I’d go with the theory that we’ll all pay for this with higher rates of inflation, and lower real value for most forms of currencies, to boot. Higher inflation, or crash the entire financial system? It's like asking whether you'd rather get slowly nibbled to death by ducks or get run over by a charging elephant.

Disclosure: Author has no positions in stocks mentioned in this story