Many investors have forgotten by now, but the current Euro-crisis first stirred during the summer of 2010, when the newly elected Greek government announced that its deficit would be substantially worse than anticipated and the total amount of Greek debt outstanding was much larger than previously disclosed. These announcements caused a stock market sell-off before a palliative was applied and fears receded. Investor fears have resurfaced with a vengeance in 2011, as it has become apparent that the so-called PIIGS economies of Portugal, Ireland, Italy, Greece, and Spain face serious difficulties due to their high debt levels and anemic economic growth. These problems have created market volatility, and with that, opportunities to own high quality bonds at attractive yields have arisen.
It is now clear that market participants with direct exposure to PIIGS debt, as well as counterparties to those market participants, face serious risks to their capital. Under the resolution plan currently on the table, banks holding Greek sovereign debt, including well-known institutions in France and Germany, face losses of 50% on those holdings. The situation is exacerbated by the fact that many French and German banks are significantly over-leveraged. The rub is that money-center financial institutions in the United States have substantial counterparty exposure to those same French and German banks with Greek and other PIIGS sovereign debt exposure. If you think all this is beginning to sound like 2008, you’re right. In the case of 2008, it was American homeowners that were over leveraged, and the many banks and pension funds that held sub-prime mortgage debt were negatively impacted. In the case of Europe, it’s the PIIGS that are over-levered and European banks that are exposed to this debt. Already we have seen Dexia, a French-Belgian bank, receive capital from the French and Belgian governments due to its exposure to Greek debt.
If you stand back and take a broader look, the Euro looks more and more like a political construct than an economic one. The predominant economies in the Euro-zone are efficient, technologically proficient, and export-driven; those of Greece and the other PIIGS are not. Even under the best possible near-term outcome, with Greece agreeing to impose austerity measures and substantially restructure its economy, is it reasonable to think it can successfully do so? Ditto for Portugal, Spain, and Italy? If, as is likely, reconfiguring the PIIGS economies takes longer and is more expensive than presently anticipated, will taxpayers in France and Germany tolerate yet another round of recapitalizing (with public funds) both their underperforming neighbors and their accident-prone banks? If not, will investors in the United States resist the temptation to pull funds from institutions here that have counterparty exposure in Europe?
If the near-term outcome of the Euro-crisis is less benign, perhaps involving a near-term papering over of the crisis followed by Greek backsliding and, ultimately, a messy default, will bank exposures to Greek and other PIIGS sovereign debt trigger a financial meltdown? Already, there are hints in the marketplace that “voluntary” debt write-downs would not qualify as default events protected by credit default swaps. If this is the case, the message for investors would be that there is no way to insure a portfolio against a potential cascade of defaults from the remaining PIIGS governments, the debts of which, in the aggregate, are many times the size of Greece’s.
Bottom line: unless everything goes absolutely, perfectly right, the Euro-crisis is going to be ugly and protracted as investors lose their nerve and rumblings of defaults reverberate around the PIIGS countries for many months to come.
At SNW Asset Management, we do not like what we see, as no current proposal actually moves toward resolving the underlying problems and tensions affecting the PIIGS and the European banks that own their debt. Even if one did, we feel that resolution of the underlying problems is a multi-year process, likely to be interrupted by periodic hiccups and market panics. To protect our clients from these effects, we have been reducing exposure to bonds whose issuers are exposed to the European crisis through counterparty risk. This has led to the sale of securities from money-center financial institutions such as Goldman Sachs and Credit Suisse. We will continue to evaluate our clients holdings and move accounts out of securities whose issuers have high Euro-counterparty exposure, even if underlying fundamentals and capital positions appear strong.
It has been said that within any crisis there is an opportunity, and we would say the current debt crisis in Europe is no different. The recent market volatility has caused yields on many high quality corporate bonds to rise relative to other securities, giving us an opportunity to buy securities with minimal exposure to the crisis at attractive yields. We continue to see opportunities in high quality taxable municipal bonds, bonds issued by domestic industrial companies with low debt burdens, and bonds issued by finance companies with low funding needs, strong balance sheets, and minimal European counterparty exposure. We believe that our focus on owning securities with strong credit fundamentals will, as it has since our firm’s founding, continue to help our clients achieve their financial objectives.