"The only thing that ever consoles man for the stupid things he does is the praise he always gives himself for doing them."
-- Oscar Wilde
The euro's rapid breakdown from 145 to a low of 134.97 in just a matter of days reveals how precarious the current situation is. Unless the pattern changes significantly the euro is destined to experience a severe downward move over the next 6-12 months. In contrast, the dollar is projecting a rather strong rally, and possibly the Index could surge well past the 90 mark. While everyone is focusing on the PIIGS especially Greece, some attention needs to be directed at France. Many of its banks are facing potentially trying times. The problems facing the euro appear to be endemic; the only member who seems to be in a solid position is Germany.
French banks are to be loaded with Italian and Greek debt, and up until recently tried to make light o the situation. The cost to insure French sovereign debt against default surged to a new record in August. This problem is not limited to France only; financial institutions all over Europe are holding large amounts of Italian and Spanish debt. French banks such as Société Générale (OTCPK:SCGLF), have taken a beating as of late and the situation has taken a turn for the worse after Moody’s downgraded two of the largest banks in France.
Moody's Investors Service downgraded two of France's top banks, Societe Generale and Credit Agricole (OTCPK:CRARF), saying its concerns about their funding and liquidity profiles had increased in the light of worsening refinancing conditions. The ratings agency left France's largest bank, BNP Paribas (OTC:BNOBF), on review, saying its profitability and capital base gave it an adequate cushion to support its Greek, Portuguese and Irish exposure.
European finance ministers have been warned confidentially of the danger of a renewed credit crunch as a "systemic" crisis in eurozone sovereign debt spills over to banks, according to documents obtained by Reuters on Wednesday. "While tensions in sovereign debt markets have intensified and bank funding risks have increased over the summer, contagion has spread across markets and countries and the crisis has become systemic," the influential Economic and Financial Committee said.
There are several choices for dealing with debt laden members such as Greece; we discussed some of them in our last article on this subject. The most talked about ones are to allow Greece to default; this is unlikely at least, for the time being even though this is being discussed more and more behind the scenes. The other option is to come up with some sort of euro bond that guarantees the debt of all member nations. The Germans have adamantly stated that they are not interested in a euro bond and so have members of France’s National Front and Finland's True Finns party. The ECB and the eurozone governments have both been reluctant to come up with a long-term solution that the market finds pleasing. The main players want their cake and their pie, but this is simply not possible. One cannot keep coming up with patches to fix a ship that has sprung leaks all over the place; at some point, one will be unable to keep up with the new leaks and the ship will sink.
European banks are holding sovereign debt that is definitely not worth 100 cents on the euro; in some cases, the debt is worth even less than 50 cents on the euro. Recently, a lot of hoopla was made about the so called “stress tests” but none of these tests forced the banks to admit that their sovereign debt was no longer worth 100 cents on the euro; in essence, those tests were nothing but B.S and this was clearly demonstrated by the euro's inability to rally past 145 when the dollar was testing its six month lows.
In terms of strengthening their balance sheets, most banks in the EU have made very little progress when compared to American banks. The Global Financial Stability report issued by the IMF shows that banks in the U.S. increased their equity from 5.5% to 7.5%, and in the process have reduced their dependence on wholesale funding to 25% from 30%. British banks reduced their dependence on wholesale funding from 45% to roughly 34%. Banks in the eurozone have done almost nothing to improve their equity or their dependence on wholesale funding. Roughly 46% of their needs are met through wholesale funding. This is what is causing all this turmoil, for at some point they might not be able to roll over all their debt. Greece, Portugal and Ireland have already been shut out of the wholesale markets and are dependent on the ECB for all their funding. Potentially banks in other EU countries such as France (with large exposure to Sovereign debt from weak member nations) could face the same situation. Then things could turn really ugly.
Philip Finch, a global bank strategist at YBS states that the Sovereign crisis is escalating; “We haven’t seen policy makers come out with a plan that is viewed as comprehensive, coordinated and credible,” said Philip Finch, a global bank strategist for UBS. “We need confidence restored and there’s a lot of infighting.”
In a replay of what took place during the financial crisis of 2008, European banks have started to hoard cash effectively crimping the inter bank loan systems that keep the global financial system from running smoothly. This is an alarming development to say the least. Borrowing costs for banks in the U.S. have hardly budged, but the same cannot be said for most European banks where costs have doubled to almost 60 basis points; the highest level seen since early 2009.
The huge debt loads of Italy and Spain are now equal to Lehman and A.I.G - their downfall endangered the stability of the entire financial system. The IMF states that France’s deficit is projected to hit 5.7%, which is several points above the EU directive and 3.8% above the 1.9% estimate for Germany.
The head of the International Monetary Fund (IMF), Christine Lagarde on Sunday (28 August) called into question the health of European banks amid a stark warning about a global economic slowdown. Without "urgent" recapitalisation, "we could easily see the further spread of economic weakness to core countries, or even a debilitating liquidity crisis," she said, according to Bloomberg.
As everyone at the wheel appears to be asleep, nothing will be done until the situation is out of control. A repeat of 2008 is thus a possibility unless the top members of the eurozone come up with a workable plan that will eliminate any lingering doubts about the health of the weaker members in the zone. In the near future, we think that the chances of such a plan being implemented are virtually zero; hence expect vicious downward moves in the euro.
Despite a worsening of the situation, the top members of the EU and the ECB have not come up with a solid plan to address the crisis. They continue to waffle and pretend that all is going to end well, but it will not unless solid and concrete measures are taken to address all the problems the eurozone now faces. Political leaders are divided on what course of action they should take and are having a hard time reconciling their differences; they need to stop bickering and come to terms with the problem. This sadly will not occur soon.
On a final note, the world is not going to end. It will be made to look like it is, but in the end after a lot of pain, a solution will be hammered out. This provides the investor who can position himself properly with an opportunity to profit from the mess. Traders willing to take on some risk should use strong rallies in the euro as the basis for opening up short positions. One way to achieve this without getting into the futures arena is by purchasing EUO. As the dollar is projected to rally significantly higher, traders could play both sides of the game by also opening up positions in UUP.
The euro has taken out key support levels and is virtually assured of testing the opening ranges of 2011.
Disclosure: I am long EUO.