Last year the Europe Union (and the euro) teetered on the verge of collapse when the Greek financial crisis strained the viability of the EU construct. This year, as other EU countries domino in similar fashion, no one seems to care – certainly not the markets. Portugal’s government collapsed last Friday, and Standard and Poor has downgraded Portugal twice in the last week from A- to BBB-. S&P then proceeded to cut Greece’s rating further from BB+ to BB-. Yet, defying all reason, the markets have gone up.
So, why is the market reacting positively to this news?
Well, in the perverse logic of a shortsighted market, debt spending is good. Going into the European crises last year, there was no backstop for a European country in trouble. The provisions for sovereign collapse were unclear and hotly debated. Would Greece be kicked out of the Eurozone? What would happen to the Euro? Would bondholders suffer losses? How would this impact banks?
The solution? Europe quickly embraced the troubled American model, socializing risk, instituting multiple backstops, and implementing enough cross guarantees to ensure that sorting through them would be more difficult than, say, trying to figure out how may countries the US is at war with.
The primary organism responsible for this socialist backstopping is the European Financial Stability Fund, or EFSF. The EFSF has the authority to issue $440 billion in additional bonds backed by European Area Member States, or EAMS, which means that Greece is lending to Portugal through the EFSF, and Portugal is lending to Greece. The credit rating agencies have (naturally) given this bailout vehicle their highest rating, AAA. Go figure. The system represents nothing more than a European version of a collateralized debt obligation (CDO) or collateralized loan obligation (CLO). You may remember, CDOs and CLOs helped ruin the financial system in 2008. To certain market participants, garbage intermingling with trash with a spice of waste produces a sweet European fragrance.
Seduced by this “sweet” aroma, when a government like Portugal fails and a bailout is imminent, the market perceives it as a non-event at worst and as a positive at best, because CDOs and CLOs allow leverage to be piled upon leverage. When the economy is doing well, the prospect of leverage actually enhances returns. The EFSF offers a Euro version of quantitative easing, providing a tailwind for the market when the market is going up.
The European effort does not actually fix the system, and in true Americano style, it is a form of kicking the can down the road (Americans may not be great at soccer, but we are elite can-kickers). For this reason, the European debt crisis continues unabated, passing from one country to the next. There will be a day of reckoning; the question is the catalyst, of which there are many possibilities. Spain, by itself, could crash the entire fiesta, straining the best laid bailout plans based on pure size. The country I am particularly watching is Ireland. There has been chatter in Ireland about default on some of its bonds, which has the potential to start a chain reaction across Europe. It changes the game theory scenario. Default seems inevitable for many of the EU countries, but it can be pushed off at the expense of citizens for years. If Ireland defaults, Greece and Portugal should very quickly come to the conclusion that they can default also, bringing down the pyramid of leverage and instigating the European version of America circa 2008. Because the euro structure is much worse than the dollar, such a crisis also likely would create a currency panic.
The day is coming, but until it does, overweight market participants plump with profits will enjoy skinny-dipping with the false protection of a full tide. Someday the tide will go out, and it will be a very ugly sight indeed.
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