"It's always darkest before it turns absolutely pitch black." - Paul Newman
I am loathe to write about Europe again, but since it is the topic du jour (and du mois and de l'année) I feel like a bit of history is in order. The sovereign debt crisis in Europe appears to be eerily reminiscent of what happened in the U.S. during the recent (circa 2007-2009) financial crisis. The U.S. followed a similar "it's all ok" pattern of government responses to a series of problems. While the headlines focused on issues in a large, liquid market that was theoretically immune from principal risk and therefore could be highly-leveraged in short-term or overnight markets (U.S. mortgage-backed securities then, European sovereign debt now) and the failure of a large investment bank with too much exposure to that market (Bear Stearns then, Dexia now), the real troubles were brewing in the so-called "shadow banking" markets of commercial paper and short-term interbank lending. What caused the ultimate demise of Lehman was that the markets ceased to trust its viability from a short-term liquidity standpoint – which caused the short-term liquidity event. Perception in banking becomes reality. This same fear quickly spread to Goldman Sachs, Merrill Lynch, Morgan Stanley, AIG and other companies without access to bank deposits or the Fed borrowing facilities. (For a great recap of this contagion, watch or read Too Big to Fail by Andrew Ross Sorkin – I thought the HBO movie version was excellent).
But wait, this time it's different, right? Europe's central bank, the ECB, is on top of this situation. It recently agreed to lend to banks for 3 years, trying to alleviate the short-term funding pressures that are building. But in a sign that European banks don't trust each other, overnight deposits at the ECB are at an all-time high, reaching $590 billion overnight on December 27th, 2011. For an interesting historical parallel, we can read Tim Geithner's speech titled Reducing Systemic Risk in a Dynamic Financial System on June 9, 2008 (after Bear Stearns' forced sale and other mortgage-market problems surfaced) while President of the Federal Reserve Bank of New York.
The combined effect of these factors was a financial system vulnerable to self-reinforcing asset price and credit cycles. The system appeared to be more stable across a broader range of circumstances and better able to withstand the effects of moderate stress, but it had become more vulnerable to more extreme events. And the change in the structure of the system made the crisis more difficult to manage with the traditional mix of instruments available to central banks and governments.
First Repair, Then Reform
What should be done to reduce these vulnerabilities?
Our first and most immediate priority remains to help the economy and the financial system get through this crisis.
A range of different measures of liquidity premia and credit risk premia have eased somewhat relative to the adverse peaks of mid-March.
Part of this improvement—this modest and tentative improvement—is the result of the range of policy actions by the Federal Reserve System, the U.S. Treasury and other central banks. Part is the consequence of the substantial adjustments already undertaken by financial institutions to reduce risk, raise capital and build liquidity.
These actions by institutions and by the official sector have helped to reduce the risk of a deeper downturn in economic activity and of a systemic financial crisis.
But the U.S. economy and economies worldwide are still in the process of adjusting to the aftermath of rapid asset price growth and unsustainably low risk premiums. This process will take time.
The full speech can be found here.
Four months later, Lehman Brothers, Merrill Lynch, Fannie Mae (FNM), Freddie Mac (FRE), Washington Mutual, Wachovia, and American International Group (AIG) all failed, were sold or effectively nationalized. Since the start of 2009, 384 banks have failed – that is, more than 6 months after the above speech. Only 25 failed in 2008 during the "height" of the banking crisis. 157 failed in 2010. Banking crises are rarely "solved" quickly.
So where are we today? Art Cashin of UBS as always summarizes it better than anyone. In his December 28th, 2011 note to investors he said:
Europe Rumbles Continue Beneath More Upbeat Headlines - Ever since last week's liquidity operation, most headlines out of Europe have leaned toward the reassuring side. Beneath those headlines, however, there are signs the strains remain and may, in fact, be growing.
European banks are making great use of the ECB's overnight deposit facility. Last night they parked $590 billion at the ECB breaking the record they had set the night before. They are clearly unwilling to lend to other European banks, highlighting the distrust and fear in the interbank marketplace. While the ECB's lending initiative calmed the markets somewhat, it apparently has done nothing to free up the logjam blocking interbank lending.
The distrust on the streets is said to be growing also. Barroom gossip says that safe-deposit boxes are in a demand that borders on frenzy. They allow you to take your Euros and convert them into something of value (gold, Swiss Francs, etc.) and sock it away in a safe place.
Others are said to be buying property in London and elsewhere lest you awake one day and discover that your Euros have reverted to drachmas or lira.
Savvy bankers are said to be setting up personal and communal trusts domiciled in places like the Bahamas, the Caymans or the Isle of Jersey. Some banks are offering depository accounts denominated (and repayable) in alternate currencies like the dollar or the yen.
We think a Lehman-like event would most likely be triggered by a run on a bank or a series of banks. The scramble for currency (value) protection among the public could turn into that bank run in the same way that a crowd can instantly turn into a mob. Watch the money flows out of Greece and Italy very carefully. The pot continues to bubble.
The run on the shadow banking system in 2008 is what precipitated the worst of the crisis. When money-market funds stopped lending to even General Electric in the fall of 2008, the gig was nearly up. If the Fed hadn't used its emergency powers to lend to non-bank companies, it is extremely likely we would be reliving the Great Depression right now. (As a side note, Dodd-Frank "reforms" now bar the Fed from doing in the future precisely what saved our economy from collapse in 2008-2009. Next time, and there always is a next time, the Fed will be nearly powerless to prevent a collapse.) Europe doesn't "get it" – the Germans are fighting their hyperinflation from the 1920s (see "This isn't My Problem", or "Why the German's Won't Bail out Europe.") instead of their imminent banking system collapse. It may well be darkest before it turns absolutely pitch black.
Despite the above retelling of "Fear Factor", there are opportunities to trade in this market – but if you are a "buy and hold" type, I still think you are better off playing defense and waiting for the possible events described above to transpire before going buying for the long-term. I recently bought a small basket of Goldman Sachs (GS), Citigroup (C), Morgan Stanley (MS), Bank of New York (BK), JP Morgan (JPM) and Metlife (MET) for a trade, although as always, those positions may change at any moment.
S&P 500 (SPX) Support and Resistance Levels:
Support: 1242/1244, then 1228/1230 and 1222/1225. Below that is 1210.
Resistance: 1265/1268, then a little at 1275, followed by 1285/1287.
Positions: Goldman Sachs (GS), Citigroup (C), Morgan Stanley (MS), Bank of New York (BK), JP Morgan (JPM) and Metlife (MET)