Oxstones Food for Thought – November 2011 – EU Slow Motion Train Wreck – Brakes Are Coming Off!
By Liu-Yue (Louie) Lam, Co-Founder, Chief Investment Strategist, Oxstone Capital Management, 11/11/11
Global Financial Crisis Part II – EU Sovereign Debt Crisis
In 2007-2009 you had U.S. subprime debt crisis. Now in 2010-2011 you have the EU sovereign debt crisis. This is the global financial crisis Part II. The next black swan is already here and the EU banking system is at serious risk of imploding. EU banks are required to hold risk-rated assets. What happens when those risk-rated sovereign assets are not really good quality? The problem becomes compounded when S&P, Fitch, and Moody’s begin a vicious cycle of downgrading these risk-rated assets. The rating agencies are just now getting started in terms of reviewing and downgrading all the countries in the EU. Therefore the pain is just starting.
European Financial Stability Facility (EFSF) is really Germany as Atlas
I am very doubtful EFSF can really stem the crisis. It’s not big enough at $500MM. Market rumors are EU will likely need much more – between $2 Trillion to $6 trillion to recapitalize the EU banking system. Current discussions mentioned EU can leverage up ESFS. But can you really leverage up debt on debt? Aren’t you supposed to have some equity to be able to leverage up? I don’t expect any country to put in the equity or any real collateral like their gold holdings. Another issue is – EFSF will need to borrow from capital markets based on the credit ratings of the individual EU countries. What happens when the remaining countries in the EFSF lose their own Triple AAA rating? It looks like France will most likely lose its Triple AAA rating in the near future. If the U.S.A. is not Triple AAA, can France really be considered Triple AAA? That leaves Germany shouldering the bulk of the EFSF to support the entire EU.
Who’s Next?
The extreme volatility over the past 4 months was directly connected to the EU debt crisis. The market has already predicted that Greece will default. The question now is who is next and when? Early next year? Maybe even late this year? Greece will default once Germany decides that it is prepared and ready to allow the default. Now with Italian bond yields above 7%, it looks like Italy may the next domino to fall. No one knows what will happen next. Would a controlled default still lead to a contagion effect among the remaining G.I.I.P.S.? I don’t think I want to find out and have been dialing back risks during the recent melt-up. The key issues is even if Greece and Italy can avoid default in the short run, you still have Ireland, Portugal, Belgium, and Spain as the next potential sovereign debt flare-ups. There is simply not enough capital to save all of them, so one of them is bound to eventual fall through the cracks and default. There is also a huge moral hazard dilemma at stake. Since the EU gave Greece a 50% haircut, does this mean the EU will now also have to give Italy, Ireland, Portugal, and Spain the same deal? Any of the remaining G.I.I.P.S. can play hard ball and hold the rest of the EU hostage until they get their own sweet heart deal as well.
What should we do?
The bottom line is the current issues the EU faces are systematic and structural and will not be going away anytime soon. It is very difficult to get all 17 nations to agree on anything, therefore finding a real solution might take too long and be too late. Although, I believe there is no possible way EU will allow anyone to default in the short run because the consequences are just too severe not only for the EU, but for the rest of the world. I believe we’re in the 7th inning of a 9 inning game so there’s still time in the game to be a hero. In the mean time, I will continue to divest of any short term holdings and just keep my long term strategic holdings. I will wait for the home run hitters to come out swinging for the fences before I go all-in. Meaning I will wait for the buy signal from the Fed to exercise Q3 and the ECB to join the money printing party with a massive sovereign debt buying program. This would be a great opportunity to ride up a final mother of all melt up in 2012 or 2013 and just before the next grand market crash.
Categories: Food for Thought, Oxstone Investment Commentary, The Big Picture, Western Europe