Is Europe's Debt Crisis About To Reignite?

Includes: FEU, FEZ
by: Costas Bocelli

When the wind suddenly stops and the lake turns to a sheet of glass, even tossing the smallest pebble into the water can seemingly have a profound effect.

And that’s what apparently happened last week when troubles in Portugal’s banking system rocked the boat sending harrowing ripples across both sides of the pond.

European bourses sold off sharply. The EURO STOXX 50, Europe’s leading Blue-chip index for the eurozone, dropped four percent on the week.

And the spillover was felt in U.S. markets which saw the S&P 500 post its worst weekly decline since early April. But even though the index suffered its worst drop in over three months, the decline of just 0.9 percent was rather placid.

Complacent Springtime Markets

That’s how complacent markets have become since the springtime. It’s a soothing market landscape with very low volatility.

So when the parent company of a Portuguese bank that has a market capitalization of less than $3 billion dollars missed a bond payment, the fears of the sovereign debt crisis reigniting sent investors on a mad dash for the nearest exit.

The parent company in question is Espirito Santo International which has actually been under financial scrutiny and distress for several months.

The privately held company has a 49 percent stake in a listed holding company, Espirito Santo Financial Group, which in turn owns a 25 percent stake in Banco Espirito Santo.

Adding further layers of complexity is that Banco Espirito Santo has significant liability exposure in the parent company and the holding company because it holds hundreds of millions of Euros in commercial paper in the two entities, so the fears of the banks’ insolvency is the heart of the issue.

I know it’s confusing. The situation sounds like some sort of incestuous relationship playing out on a daytime soap opera television show.

But it’s not TV… rather it’s the perverse reality of many facets of modern day finance.

And the complexity or rather the lack of transparency is the primary reason for the strong breeze that blew through the markets last week and disturbed the calm glassy lake.

Risk Of Contagion

You see the issue in Portugal may in fact be an isolated incident, but the real threat lies in the risk of contagion spreading across the region.

That one little missed bond payment caused a Spanish bank to abort a bond sale. Greece failed to sell the entire allotment of a scheduled debt offer. Trading was halted in several Italian banks.

And most notably was the recent divergence of sovereign interest rate spreads in the eurozone. The most challenging issue for the ECB has been trying to manage the monetary transmission mechanism in a more cohesive manner among the 18 members of the common currency.

You see, during the various flare-ups in the sovereign debt crisis, yields in the stronger members like Germany, Netherlands and even France saw their interest rates decline while the weaker members (Portugal, Italy, Greece and Spain) otherwise saw them rise which places great strain on the entire bloc.

And while interest rates are near all-time historic lows, the recent divergence had contributed to last week’s sell-off.

The reality is that the European debt crisis hasn’t really gone away – it’s just been in a period of slumber, thanks in large part to many of the back stops the ECB has put in place over the past couple of years.

It’s bought some time… but markets eventually have a way of carving out the true path, even in the face of central bank manipulation, and perhaps the day of reckoning will someday come. But for now, I think the debt crisis will continue to hit the snooze button… at the very least until the end of the summer.

What That Means For Investors...

And that means that last week’s sell off was likely an overreaction to the situation surrounding the Portuguese bank.

In fact, last Thursday seemed to mark the low in the week after Banco Espirito Santo provided some transparency on the health of its balance sheet.

Even though the bank may have significant liability exposure in the commercial paper it holds in the parent and holding companies, the bank also disclosed a capital buffer of 2.1 billion Euros above the minimum regulatory requirement and any subsequent losses wouldn’t compromise its liquidity compliance.

Disclosure: None