George Soros recently made an excellent point in an interview with Spiegel that the origin of the euro crisis was when Angela Merkel stated bailout support would be granted from each EU member state individually, and not by the European Union. He goes on to highlight that this approach shattered a vision of an EU that could jointly protect the euro. That interview was one month ago, and now the situation has gotten worse. What should be apparent to politicians and central bankers in Europe is that the European financial crisis should not be handled piecemeal. Since the flawed European Banking Association stress tests in July there has been a hesitance to address the problem from a structural standpoint.
On July 15th, the EBA announced that 8 out of 90 European banks failed the stress tests. For the record, one bank in Germany (Heleba) decided to simply drop out and not be tested. An additional 16 out of 90 passed, but did so narrowly. All the very large European banks soundly passed the test. The flaw in the test was the manner in which the EBA segmented exposures into the “trading book” and “banking book” for each bank. The banking book, which is where 83% of the sovereign debt exposures reside, was not shocked, and sovereign debt was allowed to “run-off” and not be marked-to-market while doing so. It is no wonder that the market yawned after the results of these tests. The positive outcome was that transparency about what the European financials hold in terms of assets was greatly increased. The details of this test are contained in a working paper by the OECD.
The actual holdings of PIGS sovereign debt relative to tier one capital is not all that high for the European financial system as a whole. This issue is manageable and there is also increased transparency around the matter. The problem for European banks actually lies in the exposures to non-sovereign debt in problem counties is 9x greater than the exposure to sovereign debt itself. These include all types of lending to multinationals, small businesses and households. The issue here is indirect and much more opaque.
When Greece defaults (I see a restructuring as inevitable) the key will be the manner in which Europe’s SPV (ESFS) provides liquidity support to banks which can’t fund. This is absolutely essential in order to avoid a “run on the banks”. If depositors flee then prospects of a systemic Eurozone meltdown would greatly increase. The US saved the banking system with TARP which prevented a mass run on all US financials. Europe needs a TARP-like structure which takes the daily funding crisis off the table. This is a necessary condition for any sort of stability. If Europe can quickly support a TARP-EU, they would effectively buy time for certain European financials to run-off assets and recapitalize. The euro and the markets could stabilize. There are legal questions regarding the EFSF and the ECB debt purchases but time is not on the side of European governments and these type issues will need to be sorted out after the fact. While the issues I mention above are manageable the market is very fearful of European inertia. One possible resolution (which is consistently brought up) are Euro-bonds which would amount to debt that is backed by Europe as a monetary union. In short, the solution to this crisis is for a coordinated policy response that provides liquidity to the system, eases sovereign refinancing through bond purchases, and provides liquidity in unlimited size to banks that are deemed solvent. European government ownership of financials is likely to increase. There is potential for a sharp snap-back rally because priced into European shares are concerns that the crisis can’t be contained.
Today, European financials are under heavy pressure, particularly the French banks. Soc Gen, BNP, and Credit Agricole are all down 9-12%. The next round of fears relates to a potential downgrade of the French financials form Moody’s. I see this as very likely because these banks were placed on negative credit watch on July 15th and there is typically a 3-month review process. Since the funding environment is so much worse than 3-months ago it seems unlikely that any of these banks can skirt downgrade. We are in the midst of a crisis – this no longer about fears of a crisis – it is happening. When the leading financial institutions of Europe can’t fund themselves you are experiencing a crisis. Every day becomes important because time works against you as problems mount and confidence is dashed. Investors must simply await for the European solution. That is the risk on the table. This week I will be focusing on how to invest in the case that Europe lets things spiral out of control and a global recession takes hold. I still don’t think this is a likely outcome, but in order to invest prudently the downside must be incorporated into the process. I continue to believe that markets are attractive after factoring in a substantial but low probability downside stemming from Europe unraveling.