Much to the chagrin of the bears and the shorts, European policymakers have reportedly agreed to a set of proposals that, if implemented, could turn the tide in the battle to arrest the spread of the region's debt contagion. The developments come as a surprise to a market that has lost all faith in European leaders' ability (indeed their conviction) to put an end to the protracted crisis that has claimed Greece, Ireland, and Portugal and now threatens to cripple Spain and Italy. It is important for investors to understand why the measures announced by EU leaders Friday morning are so critical and indeed offer (for the first time) some real hope that the crisis may soon abate.
First, European leaders have reportedly agreed to renounce seniority on loans extended to Spain to bailout its ailing banks. Previously, bondholders sold Spanish debt en masse as the market feared the European Stability Mechanism's (ESM) 'preferred creditor' status would subordinate other claims should a credit event occur. As a result, the announcement that Spain would receive up to 100 billion euros to stabilize its financial sector had the opposite of the desired effect: far from sparking a relief rally, the news sent yields on Spanish debt soaring and anxiety reached a fevered pitch. Now that the preferred creditor status has been dropped, the fear of subordination should disappear and buyers for Spanish debt should slowly materialize.
Second, policymakers in Europe agreed to allow ESM funds to be directly injected into struggling banks, bypassing the sovereign middleman. This is absolutely critical, for it signals that European policymakers finally understand that in order to stem the crisis, the link between the sovereigns and the banks must be broken. Previously, bank bailout funds had to be channeled from the rescue vehicles through government balance sheets before they could be dispersed to the banks that needed them. The problem with this practice was that because the funds were effectively a loan to the sovereign, the receiving nation's debt-to-GDP ratio suffered from accepting the bailout money. This in turn triggered sovereign debt downgrades which caused the government bonds held by the bailed-out banks to deteriorate. Add to this the fact that a portion of the money that started the whole vicious cycle either was or was set to be contributed to the rescue vehicle by the country receiving it--a truly absurd predicament. Direct injections from the ESM to banks break this link by removing the condition that the funds must first be channeled through the receiving government.
These two policy decisions demonstrate that European leaders may finally understand what needs to be done to avoid the dreaded 'Lehman Redux'. Investors should understand that this could indeed be a game-changer. 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).