Wednesday, April 28, 2010

European Debt Crisis right around the Corner?

I must admit folks that I am in awe of what I see each day in the financial markets. It's also very hard to make any sense of any it when it comes to investing.

Things that would have been considered tinfoil 4 years ago now have become reality. I mean heck: If anyone would have told me three months ago that Goldman Sachs would be accused of fraud I would have laughed in their face.

Yet(minus yesterday's hiccup), the market continues to march higher despite being surrounded by seemingly endless economic landmines that threaten to destroy our financial system.

I mean take your pick: Greece? The consequences of the Goldman Sachs trial on the TBTF banks? Portugal? Spain? Massive unemployment? Housing Collapse? Financial Reform? US National Debt? Derivatives? Inflation(I know they keep telling us there isn't any but just take a look at oil)?

All of these problems have fuses that could potentially take us all down if they get lit. The reason this is the case is because the world is all now interconnected financially. It doesn't matter whether or not the crisis is here or in Europe: If the European banks go down as a result of soveirgn defaults, the USA's banks will be right behind them.

That's why we must focus on the European debt crisis. The ramifications of a Greek debt default would be devastating despite it's small size.

Greece and Portugal alone are a half a trillion dollar problem:

2y Greek bonds hit 20% today which is unbelievably bad. Greece is rapidly becoming an Argentina 2001 on steroids. Spain was also downgraded today and their economy is over $1 trillion. Our banks basically avoided the two bullets above but the big bankers in Europe. This puts us at risk as a result.

For awhile it appeared that Greece would get bailed out and I still lean towards this theory, but I am starting to hedge as I watch the credit spreads blow out on the rest of the PIIGS. Making matters worse if the fact that it is beginning to put pressure on the debt of the other Euro countries.

This is rapidly becoming a situation where if you bail out one PIIG you need to bailout them all. The problem is the money simply isn't there to do it.

What's happened to Euro bond market this week is flat out stunning. The bond vigilantes in the USA must have hopped on a plane and flew over to Europe this week in order to have a little fun.

I don't see how this ends well. The only answer to this crisis IMO is to have the PIIGS leave the Euro and go back to their old currencies where they can then devalue them and inflate out of their fiscal disasters. The results of this would be catastrophic from a social chaos standpoint but I see no other way out.

Housing Collapse Part 2?

I may be early but I think it's unavoidable as we watch the homebuyer tax credit end this Friday.

The only part of the housing market that was really recovering since the bubble burst was the lower end of the market where buyers were taking advantage of the government's gift.

Making matters worse is the fact that these new loans were also done using more horrible lending standards via FHA. I spoke to one of my Wall St friends this week who had an interesting take on this: "FHA will go down just like Fannie/Freddie did because the lending standards haven't really changed".

I totally agree with him. Allowing a buyer with a 620 credit score to buy a house with only 3% down is a recipe for disaster! Why do we continue to make the same mistakes over and over again?????? 20% down with a DTI of 36% is the only way any financial institution should be lending. If housing prices have to collapse as a result so be it. It's the ONLY answer.

Making matters even worse for the housing market is the fact that the TBTF banks are preparing to dump massive amounts of foreclosures into the market. I have read one report where Bank of America is preparing to dump 600,000 foreclosures just by themselves!

I guess they must be getting tired of the millions of squatters who stopped paying their mortgages 2 years ago. The reality here is the banks can't afford to play this game anymore.

They also probably recognize that the economy is getting worse(despite what CNBC tells you), and they may be better off trying to dump them now versus dumping them later as unemployment continues to rise.

The Bottom Line

Hold onto your hats. Stocks and bonds in the USA may do well in the short term as a result of the chaos in Europe. There is a massive "flight to safety" going on over there and we will be the beneficiaries of it. This is also why you saw such a spike in gold this week.

Over the long term I expect the debt crisis to eventually end up over here as well. We are in no better shape than anyone else. However: Risk is relative and the perception by the markets for now is the USA is safer than Europe.

For now I agree. Europe is heading rapidly into a serious debt crisis. It will be interesting to see how it plays out. Be careful if you are short treasuries. Bonds over here should do OK for awhile.

I shifted some more of my portfolio out of treasuries and into cash this week despite my belief that bonds may do well over the next few weeks. I did this because I am afraid that the Euro debt crisis could potentially come over here in a heartbeat if things really start to unravel in Europe.

Be very very careful and keep a close eye on Europe. As for the Goldman debacle, I will get to that another day.

Disclosure: Sold US treasuries and government bonds.