No changes see in financial crisis
Country Financial's Bruce Finks takes a look at how the Euro crisis is impacting our economy.
Published: Jul 9, 2012
The debt crisis in Europe seems to defy resolution. Each new stumble down the economic path is met with new resolutions by the heavily indebted to stop spending more than they have, followed shortly thereafter by an emergency weekend summit, followed by an announcement that briefly makes the financial markets feel better.
However, upon further examination of the actual terms of the announcement, the financial markets come to realize that nothing has really changed. All that has happened is that a new bandage has been placed over the gaping wound in the hope that the bleeding will stop and the patient will get better without having to actually go through the pain of a permanent solution that will last past the next weekend.
The latest case-in-point is the bailout of the banks in Spain announced on June 10. Spain claims it doesn’t have a sovereign debt problem like the rest of the PIIGS (Portugal, Italy, Ireland, Greece, and Spain). Its problem is one of highly leveraged banks that financed a housing boom based on the cheap credit that was thrown their way with the introduction of the euro.
Spain got so caught up in the housing boom that construction spending was more than 16 percent of gross domestic product (GDP) in 2007. For comparison, residential construction spending in the U.S. was about 5 percent of GDP in 2007.
As seems to be the case with central bankers these days, Spain’s central bank saw the housing bubble as no cause for alarm and continued with loose monetary policies to encourage the continuation of the housing boom.
However, prices of residences began to decline and soon many homeowners owed more on their houses than they were worth. Banks began to get houses back and the inventory of unsold homes began to climb, very similar to the situation in the U.S., except prices rose faster and fell harder in Spain.
As the housing decline continued, banks began to realize that the mortgages they held as assets on their balance sheets were not worth anywhere close to what value the banks were placing on them. If the banks reduced the value of the loans, it would wipe out their capital.
From a sovereign debt perspective, Spain is not quite as indebted as other Eurozone countries. But once you count the bank debt and personal debt, Spain is very heavily indebted.
The program announced recently is not a loan to the Spanish government, but a direct loan to the Spanish banks. As such, it does not appear to have all the strings attached that the loans to Ireland, Portugal, and Greece have had.
Shortly after the announcement, no one was sure whether the European Union (EU) will use the European Financial Stability Fund (EFSF) or European Stability Mechanism (ESM) to finance the bailout. It does make a difference which fund is used because ESM funds will get a preference over the sovereign debt of that country in the event of a default.
In other words, these new borrowings will be in line ahead of Spanish government debt in the event of default, which will make Spanish debt less attractive to potential buyers.
When the news was first announced, European financial markets gained and Spanish bond yields declined from 6.4 to about 6 percent. However, as market participants began to really look at the proposal, they began to see the flaws. Spanish yields on June 12 had climbed back to about 6.71 percent.
Just to add more fuel to the fire, Cyprus also has asked the European Central Bank for a bailout of around $125 billion, making it the fifth country out of the 17-member EU to ask for one.
Since the bailout for Spain appears more lenient than those given to Ireland, Portugal, and Greece, one has to think those other countries will be calling the European Central Bank to renegotiate their loan terms.
Meanwhile, U.S. banks are bracing for a new round of ratings downgrades from Moody’s, S&P, and Fitch.
Moody’s was threatening to reduce ratings for 17 large banks by the end of June and it is estimated that the downgrades could cost these banks billons of dollars in extra interest expense.
The downgrades also will make it more difficult for the money market industry to find investments to put in their money market funds. Most funds are required to own investments that are rated A-1/P-1. After downgrades, some of the banks’ paper will be rated A-2/P-2, which will disqualify it for inclusion in money market funds.
I know it seems impossible, but with fewer investments to choose from, money market funds will be vying for a shrinking universe of investments from which to choose and yields may fall from current levels.
The really sad news in all of this is that we believe interest rates can stay low for at least a year, possibly longer. Economies all over the world are so weak that there will be little in the way of inflationary pressures.
We also expect continued monetary stimulus from the Federal Reserve and most other central banks around the world in an effort to stimulate economies and ward off deflation. I’m afraid this means that we’re going to get more of what we’ve already seen for the past several years.
Bruce Finks is vice president for investments with Country Financial.
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