Europe Is Skating on Thin Ice

12/08/2010 10:52 am EST

Focus: MARKETS

Michael Shulman

Editor, Short-Side Trader

Michael Shulman, editor of Short-Side Trader, points out who’s really getting bailed out and who deserves to be shorted.

Even if you haven't yet made money from the European financial problems, it's not too late. Europe failing means a falling euro, and a falling euro means a rising dollar—and that spells trouble for the overall markets.

We're at the very beginning of a major leg up for the dollar, and the dollar's rise will have a negative impact on commodity prices, stocks, and the market in general. If the rise is vigorous, it may even counterbalance the bullish trading winds created by Federal Reserve Chairman Ben Bernanke and the bond purchases known as QE II. The dollar's rise will also hit exporters who must generate their profits from overseas sales.

So here's the story: European profligacy is about to generate profits for our existing and new positions.

The endgame in the European debt crisis is taking shape, and bond traders don't like what they are seeing. As a consequence they are hitting sovereign debt, the euro, and European equities.

The Irish debt problem was supposedly resolved. Don't tell anyone that the government is wobbly and more than half the Irish people polled believe the country should back away from its 100%-government guarantee of bank debt and let the banks default.

Haircuts All Around 
The terms of the Irish agreement led to the announcement of a "permanent" bailout fund with "permanent" terms. The fund would replace the temporary fund in place, would be firmly in place by 2013, and after that date bondholders would take a haircut during future bailouts. The Germans got what they wanted, the haircut provision, and everyone else got what they wanted, something they could show the bond market.

So far, the bailout has not worked, as yields on Irish, Greek, Spanish, Portuguese, and now Italian debt are rising rapidly. The reason is simple—bond holders typically buy a mix of bonds based on their maturity, and bonds from 2013 on will become riskier.

The bear run has boosted the interest costs of short-term Spanish debt in the past two months by 40% and Italian debt by 30%. If this trend continues, interest costs will make debt service untenable and lead to more bailouts, or outright defaults.

The run on the sovereign debt of Spain raises a question of whether the current bailout fund is big enough. The answer is ambiguous: maybe, maybe not. Why?

The problem in Spain is not the total public debt—it's 58% of GDP, better than in many European nations and the United States. The real Spanish problem is busted property loans held by regional banks called cajas. No one knows how much debt is on their books or how much of the debt is bad. One such bank provided an estimate in June, but a formal audit recently showed its actual bad debt to be four times greater. Many caja bonds are owned by big Spanish and other European banks, so there could be a domino effect if things get out of hand.

Enter the Buyer of Last Resort
The European Central Bank (ECB) is now the primary buyer of many categories of debt and it will have to do its own version of quantitative easing to buy ever more bonds. If this is to happen it will occur before next summer, when a hard-line German is tipped to take over the bank. If the ECB does its own version of QE, the euro will get whacked big time.

What the politicians are not saying—and everyone involved in the process privately understands—is that the bailout is essentially a bailout of all European banks, especially German banks. The German and other banks hold enormous amounts of sovereign debt and have been allowed to use much of it as core capital. They also hold the bonds of banks in troubled countries, and any problem with this debt that requires a haircut to bondholders will severely hit the capital of many banks.

The bailout is also seen as rescuing the euro, and this too is a German priority. Why? If Germany leaves the euro its currency will appreciate sharply, making its export-driven economy very vulnerable. Germany's banks will be exposed to euro-based debt of other nations that these nations will be unable to pay off.

The two banks we have shorted, Banco Santander (NYSE: STD) and Deutsche Bank (NYSE: DB), are working for us. They will continue to do so.

[Tom Slee is more optimistic about Europe’s ability to cope. John Bollinger thinks the euro can’t survive in its current form. Igor Greenwald roots for Ireland to default and leave the German banks’ losses to the Germans.]

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