Europe Looks Better Up Close

12/06/2010 12:56 pm EST


Tom Slee

Retired- Financial Advisor, Money Manager, Gordon Pape Enterprises LTD

For all the dire trans-Atlantic headlines, the risks appear contained as the European Central Bank and China buy European bonds, writes Tom Slee in The Income Investor.

There seems to be no end to the European debt problems. Every few weeks we have another crisis. The moment Iceland is bailed out, Portugal runs into trouble. Then Italy becomes a serious concern. Now it is Ireland, and so it goes. No wonder a lot of forecasters have little faith in our recent market rally. Many of them are convinced that we are going to have another major international banking disaster, that there is a second shoe waiting to drop.
For example, noted Elliot Wave analyst Robert Prechter believes Greece will eventually default and send serious shock waves through the system. He is in good company. Moody's has downgraded Greek sovereign debt to Ba1; in other words, junk status.

This problem won't go away. It certainly worries the Bank of Canada, which specifically mentioned European sovereign debt concerns while shaving its 2010 gross domestic product growth forecast to 3% in August. So a few weeks ago I took advantage of a trip to Europe and had a closer look at the seemingly on-going crisis. As you would expect, there is good news and bad news.

Ireland’s Bad Hand
First of all, I found that by the time I arrived Greece had faded from the financial headlines, at least for the moment. Ireland was front and center as the European Central Bank stepped up purchases of Irish bonds in order to dampen interest rates and keep the Irish economy afloat. The media was full of horror stories about an Irish property bubble that had burst, bringing down banks and leaving vast stretches of half-finished housing developments.

Moreover, because the Irish government had only partially bailed out its banks, the sovereign debt was impaired while $10 billion of bad loans remained on the balance sheets of the weakest banks.

The important thing, however, is that the on-going Irish financial crisis is really a domestic problem. The country's property bubble was self-inflicted. There is no question of widespread toxic derivatives infecting the international system and posing a direct threat to other European countries, which was the sort of problem that caused the collapse in 2008. Sure, the Irish banks are in serious difficulties but there is little risk of contagion. There is no suggestion that North American banks are heavily exposed. 

The Pain in Spain
Similarly, the new Spanish bank crisis, which also erupted while I was traveling, appeared to be more of a domestic than an international problem. As usual, the media went overboard and there was a stream of alarming news about Spanish banks being forced to tap the government for rescue funds. In fact, the players in trouble were mainly Cajas, regional non-profit banks that had originally funded the Spanish building boom. Here again, there are serious losses but the Cajas are not going to contaminate major European banks.

It was also encouraging to see that analysts on the scene were relatively calm and pragmatic. Here in Canada, thousands of miles away, there is a tendency to dramatize European banking problems: everything is a "crisis". No wonder investors are worried. My feeling now, though, is that we are overreacting. Keep in mind that all of the countries with difficulties have recourse to a $1 trillion Stability Facility. Germany wants restrictions on this backstop but not before 2013.

Greece, the Sequel?
Having said that, Greece is a particular concern for several reasons. For a start, the country's national debt is front-end loaded, in other words funded with relatively short-term financing. The mean term is four years, compared to, for instance, Britain's 17-year average. As a result, Greece is constantly tapping the market and rolling over its issues. That keeps the debt high profile and tends to magnify the economic weakness.

Second, 99% of its sovereign debt is foreign owned and therefore on a string. To put that into perspective, only 47% of Ireland's sovereign debt is foreign owned and Spain, the other weak sister, has 27% of its debt in foreign hands. Obviously, a Greek failure would reverberate.

On other fronts, it was apparent that the Chinese are increasingly bullish on Europe. They are diverting more of their $2.45 trillion foreign exchange reserves away from US Treasury bills to euro bonds and deposits. That could force North American interest rates higher and burst our dangerous bond market bubble. So keep your fixed-income holdings as short as possible and stay overweight in government issues.

Let the Buyout Loans Roll
I was also concerned during my stay in London to see that European commercial banks seem to be dropping back into their old habits. They are supposed to be hunkered down, reducing risk, and rebuilding capital. Not a bit of it! Because business is slow, a lot of them are scrambling to participate in the few highly leveraged buyouts being negotiated. In October alone, five banks went on the hook for 500 million Swiss francs each as part of the Sunrise Communications takeover, the largest leveraged buyout since 2008. Local analysts are alarmed that, because lending opportunities are sparse, banks have relaxed their discipline. They are taking more risk in order to gain new clients. It all sounds very familiar.

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