Last Friday I was given the opportunity to do the “vocational moment” at my Rotary Club. The purpose of the vocational moment is to briefly inform or educate the rest of the club about an issue related to your employment. I decided to fully explain the European sovereign debt crisis in under three minutes. I stood up and said, “They spent too much,” and sat back down to much laughter and applause.
When that died down, I returned to my feet and offered a more detailed explanation:
“You can think of the crisis in Europe in much the same terms that we think of the financial crisis in the U.S. over the past several years. In this context, instead of sub-prime debt being owned by banks, think of sovereign debt of the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) being owned by banks. Instead of Lehman Brothers going bankrupt, think Greece. Instead of the TARP, think the European Financial Stability Facility. The EFSF is funded to the tune of 440 billion euros by various countries in the European Union and it can issue loans to “bail out” sovereign countries, which in turn bail out banks around the world that own European sovereign debt.
“The EFSF has 440 billion euros and the European Financial Security Mechanism (EFSM) has 60 billion euros, for a total of 500 billion euros. The International Monetary Fund has agreed to kick in ½ of the EFSF/EFSM total, to the tune of 250 billion euros. So the total bailout package is 750 billion euros, or roughly $1 trillion dollars. Sound familiar? The ESFS has already lent money to Portugal (twice) and Ireland (once) where the loans were ranked AAA by all of the rating agencies. Would it surprise you to know that all of the member EFSF countries guarantee this debt, yet few of them actually have a AAA rating as individual countries? In addition, Portugal helped to guarantee the debt that was issued to bail out Portugal, and Ireland helped to guarantee the debt that was issued to bail out Ireland. Does that sound familiar? (In this context think of rating agencies as… uh… rating agencies.) Finally, consider that all of this sovereign debt is insured by banks in Europe and the U.S. who also own the sovereign debt. To be clear, U.S. banks own little of the sovereign debt itself, but do own their fair share of the insurance (called credit default swaps, or CDS). So here think AIG.
“The good news is that 750 billion euros is getting approved to backstop the debt of European countries that spent too much. The vote you may have read about last week (my talk was last Friday) involved Germany agreeing to expand the EFSF to 440 billion. The bad news is that the market never expected to have problems with the liquidity of Italy and Spain. Even though the EFSF is big enough to deal with the smaller PIIGS countries, it’s not nearly big enough if Italy is in danger of default. They are short to the tune of about $2 trillion. Even if Italy makes it through, European banks have stopped trusting each other enough to lend to each other, so they’re relying on the European Central Bank for overnight lending.
“Oh… the further bad news is that the last number I saw showed a 70% correlation between the performance of European stocks and U.S. stocks. Therefore, I recommend bottled water, canned goods, and a shotgun as a preferred asset allocation. Thank you.”