I wish I had better news.  The issues with the European sovereign debt crisis are very complex and key facts keep changing.  The EU and central banks are trying all sorts of “policy surprises” to try to regain market confidence to “kick the can down the road” further.

Readers Digest Version:  We may see a year end rally, but risk is high that some large banks could fail unless the policy changes announced last week solve the “collateral crunch” or we get “new policy surprises” such as the Fed announcing QE3 early.

Executive Summary:

Collateral Crunch:

• Despite the European Central Bank’s (ECB) commitment to provide “unlimited” funding for up to three years to banks, many weak PIIGS banks lack enough acceptable collateral and are finding it difficult to borrow enough to fund their short-term liquidity needs.The liquidity needs of weaker PIIGS banks are increasing because a growing number of corporate and individual depositors are transferring their money out of these banks to stronger banks in countries like Germany.

 

• Severe financial stress with European banks appears to remain despite the ECB policy changes last week to reduce the quality of the collateral they are required to post in order to borrow money from the ECB.  Banks and shadow banking institutions have been borrowing higher quality collateral from each other in order to meet ECB requirements for loans.

 

• The problem is that banks are afraid to lend to each other.  Risk is increasing that one or more of the major PIIGS banks could fail and trigger a financial crisis due to how large and interconnected all these banks are.

 

• The Telegraph late Friday said that the Eurozone banking system is on the verge of collapse.  A number of others are also raising the alarm as to the risk of banks failing as a result of this “collateral crunch”.  For a more detailed and in depth discussion, see the article that Cam Hui, portfolio manager at Qwest Investment Fund Manager, posted on Seeking Alpha below.  See also an earlier article written by James A. Kostohryz on December 8^th on www.seekingalpha.com.  He believes that unless we see a discernible improvement in the indicators of bank funding stress in the next few days that a “Lehman event” could happen by year end.

 

• Cliff Wachtel, the Chief Market Analyst for anyoption.com, believes that one possible explanation for Friday’s rally is the elimination of EU imposed bondholder losses on sovereign debt.  In other words, will not be exposed to 50% or greater losses on these bonds if the country defaults.  This allows PIIGS banks to continue buying PIIGS sovereign debt to fund their countries.  The EU is implying that public sector bailouts will continue because these banks can borrow an unlimited amount of money for 3 years from the ECB (who will print the money) and use it to buy sovereign debt without worrying they will have to share in the losses if the country does default. In other words, they did agree to a bazooka, but they can’t be open about it because it will infuriate German and other voters.  This is a quiet form of major quantitative easing.  It truly is a bazooka.

 

• The IMF is supposed to get $200 billion Euros to lend to these troubled banks, which also could help.

 

• The key question is, will the flight of capital out of these countries combined with the “collateral crunch” discussed above, prevent these banks from borrowing enough from the ECB to meet their own liquidity needs and to buy enough Italian and Spanish sovereign debt (combined with ECB purchases) to keep interest rates at sustainable levels? Will any major PIIGS banks fail sooner rather than later and trigger a financial crisis?  If so, can the ECB and Fed move fast enough to stop the resulting contagion in time?

 

Santa Claus Rally:

 

• Despite the huge risks we face, we can’t rule out a year end rally with the S&P 500 running back up to 1320 or 1340.  A combination of quarter end window dressing and Fed money printing (it has quietly continued to print money and grow its balance sheet) could push stocks higher in a low volume market – if these banks hang in there.  There is no way to really know how investors will react to all this news.

 

• However, unless the recent ECB changes quickly solve the “collateral crunch” we may see some hedge funds and other managers use this rally to exit their positions early in order to avoid the “rush for the exits” that is likely to happen after year end.

 

• The bottom line is that we may see a year end rally, but risk is very high until we see whether these most recent solutions will provide the liquidity needed or we get “new policy surprises” such as the Fed announcing QE3 early.

 

Thanks,

Lisa

 

http://seekingalpha.com/article/313085-is-the-eurozone-banking-system-about-to-collapse?ifp=0&source=email_authors_alerts

 

http://seekingalpha.com/article/312718-a-lehman-event-may-be-near

 

http://seekingalpha.com/article/313050-prior-week-eu-summit-fails-yet-markets-rally-here-s-why

 

Lisa Woodside, CPA, CFP(R), MST

Focused Wealth Strategies, PC

9375 E Shea Blvd, Ste 100

Scottsdale, AZ 85260

480-214-9719