Europe’s banking crisis is somewhat different than the 2008 U.S. bank crisis. At the height of the bank panic, a run on the banks occurred where banks could no longer tap the U.S. bond market for capital. Banks couldn’t roll over debt. The resulting lack of “liquidity” threatened to spawn a full-fledged bank run. The government stepped in with bank-backed funding (TARP funds) to reassure bank customers and creditors. Ultimately, TARP halted the panic and eventually the vast majority of the banks were able to pay the government back, with the government making a profit.
Unfortunately, many believe that the problem in Europe stems from those institutions being insolvent, meaning that shareholders could be wiped out and borrowers won’t be fully repaid. In general, we don’t know if this is true. In the case of Greece, at least, it is definitely true. Greece can’t afford its current debt burden, so the owners of Greece bonds will definitely lose principal unless they are bailed out by someone willing to come to the table with a checkbook.
The Germans are one of the few entities with a big enough bank account to fund the bailout, but oddly enough the Germans aren’t anxious to subsidize the losses of its Eurocurrency partners.
Germany isn’t the only country working to resolve the problem. France, and others, are also working overtime to save the euro. Although neither camp wants to trash the euro, the two alternatives being considered are polar opposite prescriptions for how to resolve the crisis.
Our view is that the German plan – whatever it is – will prevail.
Germans (legalistic believers in the rule of conviction) advocate that the rule of law should determine what happens next. France and others in the creditor class (expedient believers in the rule of responsibility) believe that the end justifies the means. Aware of the suffering that would occur if the crisis isn’t resolved soon, France feels a responsibility to prevent economic catastrophe by whatever means are available. Germans want to use the current treaty to force the spendthrift nations to live within their means in order to protect lenders. Troubled free-spending nations in Southern Europe want to print money a la the U.S. “quantitative easing” policies in order to inflate their way out of debt.
It’s not a matter of right and wrong. People have values. Money doesn’t. Money, in and of itself, is value-less. Nor is it merely a matter of expediency. In the short-run, the best solution is to hit the printing presses. However, as the Germans remember, bad short-term fixes can have dire long-term consequences. While the socialists in Southern Europe push for a quick fix, the Bundesbank fears the hyperinflation which might result from a continuation of spendthrift policies.
As several experienced analysts have observed, it rarely makes sense to bet against the Bundesbank.
My best guess is that Germany won’t cut a check to Greece, per se, but eventually Germany will give the OK for a Quantitative Easing program in Europe. Europe can follow the Federal Reserve’s lead and simply buy up the outstanding debt of the troubled countries, assuring borrowers a market for Italian and Spanish debt.
Germany will not agree to this plan until it has extracted a price from the spendthrift countries that led them into the crisis. At summit after summit, Germany is enforcing the adoption of new austerity measures and tighter banking controls on other EU members. All but the United Kingdom have agreed in principle, although getting country-by-country approvals will take months.
These are not easy measures for Greece, Italy, France and the other EU member countries to adopt. They must be doing it for a reason, however. I believe that they are adopting these new policies with the understanding that once these policies are in place, Germany will step up to the table with much needed help. I believe that Germany is holding approval of a quantitative easing program hostage to these austerity and responsibility measures.
In the end, however, Germany must be holding out a carrot. Otherwise, why would the other countries agree to such politically costly treaties?
Until the final solution is in place, the risk is that a large bank could fail. It could happen any day, and one large failure could trigger others. Time is not the friend of a crisis.
Some have estimated that Europe needs to roll over or borrow nearly $250 billion in 2012. In the past 12 months, estimates are that the region has only succeeded in borrowing $17 billion. Somehow, despite markets that are effectively closed, Europe needs to find investors willing to risk nearly 15 times more money in 2012 than was wagered, unsuccessfully, in 2011. All the while, austerity programs and the near certainty of a new recession in Europe from sovereign spending cutbacks and bank credit-tightening make these investments much more risky next year than was the case in 2011.
Do you see anyone out there with a checkbook looking to make an investment in Europe? China took a pass. Republicans in the Senate have given a thumbs down to the idea that IMF funds (from the U.S.) be used. The Central Banks are on board, but the traditional political institutions outside of Europe won’t stand for it. Traditional fixed income investors aren’t going to fund the Old World until the entire region steps up to back the bonds of individual countries. Buyers of Spanish debt are on strike until they know that someone, other than Spain, is willing to back those bonds.
Until agreement is reached on a solution, yields are likely to ratchet higher until they are high enough to attract equity money into the arena. However, once the sovereign risk is taken out of the equation, Spain, Italy, Greece and others will once again be able to access the market.
Germany can say, all day long, that the current treaty won't allow the region to backstop individual countries. In reality, either an ECB-backed bond or some form of quantitative easing IS the end game for Europe, but Germany won't approve the plan until it has won concessions from its more profligate partners. It is blatent brinksmanship, but in a distressed situation the lender gets to write the rules.
The euro has been an interesting indicator. While the U.S. market goes up with each meeting in Europe (and there have been a lot of them), the euro itself is getting ready to re-test lows and is likely a better indicator of eurosummit achievement (or lack thereof).
However, once the solution is unveiled, the market could easily “melt up.” But will it melt up FROM current levels? Or back TO current levels?
In any event, we remain in a high risk market. We have reduced (but not eliminated) risk in equity oriented accounts. While the chances of a melt down and a melt up are roughly equal, the PAIN involved in a meltdown would drastically outweigh the happiness felt if we were to melt-up. Furthermore, judging by the price action of the Eurocurrency itself, the trend remains down, at this moment, so we remain on high alert.
The good news is that this is occurring in the background at a time when the U.S. economic turnaround is marching forward. In the long run, the good news surrounding the potential for a full U.S. economic recovery outweighs the headlines overseas. In the short run, all asset classes seem to be correlated, so it’s hard to imagine a crisis in Europe not coming back to haunt U.S. equity investors.
Arguably, it’s a great time to be investing in stocks, for many reasons. Unfortunately, an even better opportunity might be just around the corner. Having reduced our exposure to equities during the third quarter, we are busy kicking the tires on opportunities as the crisis unfolds. We intend to take advantage of the opportunity to buy solid assets selling at very attractive prices if events unfold as we anticipate.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .
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