Diary of a Financier

Nothing to See Here: Eurocrisis Is about the Aggregate Debt, Not Just the Sovereigns

In Economics on Wed 5 Oct 2011 at 07:13

I think the ZeroHedge comments section best describes today’s 3:20pm rally into the close; hilarious:

‘Looks like someone put a mentos into a coke-bottle into the S&P.’

A telling sign of investors’ extreme bearishness (“smart money”), the rally was largely a product of short covering. Yet another stable of investors (“dumb money”) awaits with an itchy trigger-finger, waiting to pick up these value names at today’s deep discounts. This latter group’s presence was manifest in some of the Oil Service stocks like Haliburton (HAL) & Oyo Geospace (OYOG), which clocked double-digit percent gains into the close. Mad world.

The Financial Times served the intraday catalyst in a story that arrived just under the wire:

European Union finance ministers are examining ways of co-ordinating recapitalisations of financial institutions after they agreed that additional measures were urgently needed to shore up the region’s banks

“There is an increasingly shared view that we need a concerted, co-ordinated approach in Europe while many of the elements are done in the member states,” Olli Rehn, European commissioner for economic affairs, told the Financial Times. “There is a sense of urgency among ministers and we need to move on.”

In a sign that European governments were preparing to act, Wolfgang Schäuble, the German finance minister, said Berlin could, if necessary, reactivate support mechanisms it put in place in 2008 to recapitalise the banks. The mechanisms had expired and the German government had until now insisted they were not needed.

So, here’s the thing… Belgium & France already announced a coordinated effort to bailout Dexia (DEXB-BT) this morning. Let’s use Dexia as a microcosm of broader Europe:

  • Dexia Total Assets (2q2011)= €517.75B
  • Belgium GDP (2010)= €355.88B
  • France GDP (2010)= €1,932.80B

Dexia assets (%GDP)- 145% of Belgian GDP, 27% of French GDP.

With its assets totaling 145% of Belgian GDP or 27% of French GDP, “little” Dexia has warranted the combine powers of a couple EMU “core” constituents for a bailout. In contrast, “big” Societe Generale (GLE-FR) holds €1.16T in assets or 60% of French GDP. Mindful of the fact that governments will not have to shell-out for the entire balance of bank assets (merely the haircut), from where will come the capital to cover losses in a pan-European financial backstop? Dexia was certainly a liquidity problem a la Bear Sterns, but the solvency issues are the real concern in the Eurozone (a la Lehman). The solvency dominoes begin to fall when Greece inevitably trips.

Per the ERM I/Black Wednesday analogue, I’ve been so wedded to the thesis of a EMU collapse for so long now, that I must level with myself constantly. Today’s developments spur me to return to the fundamentals and acknowledge a few truths…

First, the fundamentals are not static. The premium/discounted market values floating around the fundamentals are all the more dynamic. This door swings both ways, for better or worse, for bear and for bull. While a sovereign default would force mark-to-market realizations & overnight/repo seizures, an engineered asset rally (“EuroTreasury” & liquidity A-bomb rumors) could allow PIIGS to conduct debt maturities/rolls without immediate reckoning. I think I’ve made it clear that I do not foresee such a rosy outcome (not even temporarily), but I acknowledge this as my [bearish] portfolio’s antagonist. As evidenced in today’s moonshot rally, this optimistic scenario–albeit remote–would leave the Street awash in Bears’ blood.

Recall the recent American experience, wherein small asset rallies completely changed ratios, valuations, confidence and ultimately expectations. US policymakers gushed liquidity in a shock-and-awe assault on deflation. Almost reflexively, a 2-1/2 year, 90% rally ensued. The rally has since withered toward a Great Regression, and it makes me wonder what kind of “shock-and-awe” Europe requires to reverse their crisis, compounded by sovereign debt woes. In fact, via the miracle of globalization, Europe traded alongside US markets throughout this global crisis. I have to wonder whether Europe is now a leading indicator for America or just altogether decoupling? My hunch suggests the answer is not so binary: with the spotlight on Europe, America has been lucky to merely regress into a “shakeout,” which I foretold this past spring. I’m saying that Europe has decoupled, dragged down by a half-baked currency union. I’m also saying that America can (and likely will) remedy her misfortune with carefully combine monetary & fiscal intervention on the other side of Europe’s reckoning. Therefore, a prolonged process in Europe would be the worst outcome for all parties.

Finally, at the end of the day, I’m reminded how overwhelming the Eurocrisis truly is, because it’s not simply an issue of governments rescuing sovereign debts–substantial in their own right. Eurocrisis incorporates the assets/liabilities of banks as well. Backstopping bank assets–even modest haircuts–requires a multiple of the capital I can aggregate from the line items on every EU sovereign’s balance sheet.

The funds will not come from the EU member states, because they don’t have access to the necessary firepower within reasonable means. Nor can I identify another private or sovereign entity–standalone or combine–with such capability… particularly given the backdrop of [German] inflation and global recession.

Good luck Messrs.

–Romeo

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