It Isn’t Safe in the Water Yet
08/18/2011 2:22 pm EST
Just in case you thought it might be safe to jump back in.
The Dow Jones Industrial Average is down 3.8% and the Standard & Poor’s 500 is down 4.3% as of 1:30 p.m. New York time.
The carnage is even greater in Europe, where the German DAX Index closed down 6%, the French CAC 40 down 5.5%, and the Euro Stoxx 50 down 5.3%.
The greater damage in Europe is only appropriate, since today’s fears focus on Europe’s banks.
First, a forecast from Morgan Stanley cut the Wall Street house’s projection for global growth to 3.9% in 2011, from a previous forecast of 4.2%. The forecast cited “recent policy errors, especially Europe’s slow and insufficient response to the sovereign debt crisis.”
Second, Sweden’s bank regulator warned that the country’s banks must do more to prepare for deterioration in Europe’s financial market.
“It won’t take much,” said Lars Frisell, chief economist at the country’s financial regulator, to cause a collapse in the short-term interbank lending market. “It’s not that serious at the moment, but it feels like it could easily become that way and that everything will freeze.”
He urged Sweden’s banks to do more to secure sources of funding that don’t rely on short-term debt markets.
Third, The Wall Street Journal reported that the Federal Reserve Bank of New York is holding talks with European banks about their ability to access the short-term money they need to fund their US operations.
Together, the three “data points” are enough to remind the financial markets of the dark days when the collapse of Lehman Brothers and the near demise of American International Group, Citigroup, and banks in the United Kingdom, the Netherlands, Belgium, and Ireland led to a freeze in the commercial paper market.
Banks that relied on that short-term debt market for funds found themselves cut off from that source, until the Federal Reserve and other central banks stepped in.
I’m sure that the thought today is “Could this be about to happen again?”
On the plus side, this time the crisis—if we are headed toward a crisis—is much more local and much less global. US banks are much less involved and much further removed from the locus of the crisis than in the post-Lehman days, when the US was the source of the financial disaster that threatened to take down the global financial market.
The worry now is of a kind of reverse contagion, where problems at European banks result in a freeze in the US short-term debt markets.
That seems a relatively remote possibility (yes, relatively remote does mean it isn’t impossible), since the exposure of US financial institutions to European sovereign and bank debt is relatively low, and the institutions that run the money-market mutual funds that once had the biggest exposure have been actively reducing their European holdings as the euro debt crisis has continued.
I can’t say there is no danger of contagion, but I think it is relatively small.
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On the negative side, the European debt crisis shows no signs of ending very soon. And the worries about the health of European banks, especially big French banks with very large exposure to Greece, Portugal, Spain, and Italy, are well founded.
National regulators in Europe have been all too willing to give their banks a pass on raising more capital and reducing their reliance on short-term funding. And so now the financial markets are left to fret that an important bank, in what had seemed a safe country until recently, will require a rescue.
As soon as your thoughts head in that direction, however, you run straight into the failure of the July 23 Greek II rescue package or the recent Merkel/Sarkozy talks to put any kind of credible rescue mechanism in place to handle an expanded crisis.
The new powers to intervene granted to the European Financial Stability Facility in the July 23 package can’t go into action until Eurocrats finish writing the rules and the 17 national governments that use the euro approve them.
Even then, the failure to expand the size of the facility—a failure underscored when the German chancellor and the French president said they didn’t see a need to expand the size of the facility—means there are significant doubts that the facility has the money to deal with an expanded crisis.
European leaders have shown no willingness to the take the bold steps required to reassure European and global financial markets. Merkel and Sarkozy again ruled out a European bond offering, for example. And with every turn in the crisis, the boldness of a bold step bold enough to stem the crisis increases.
Meanwhile, global financial markets are left twisting in the wind. I expect the pain to continue until either:
- global equities get overwhelmingly cheap—whatever that means now
- or the Europeans get their Financial Stability Facility in action (September or October)
- or a deeply divided European Central Bank decides that it has to behave like a central bank that is indeed the lender of last resort.
Oh sure, we’ll get another bounce when this market too gets oversold, but I don’t think that will mark the end of this rout.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of June. For a full list of the stocks in the fund as of the end of June, see the fund’s portfolio here.