J.P. Morgan Weighs In On Europe

Some interesting comments from J.P. Morgan's Michael Cembalest (Eye on the Market):

1. Bailouts don’t change the level of debt that countries owe, it just shifts the creditors around. The latest steps remind me of the desperate attempts by US banks to lend more money on top of prior money during the late 1980s to Latin America, when Citibank chairman Walter Wriston’s “countries cannot default” thesis was left in ruins. For everyone that said last spring that “Greece 2009 is not Argentina 2001”, they’re right; Greece’s budget/trade deficits and debt/GDP were much worse.

2. GDP figures can be misleading indicators of risk. Greece, Ireland, Spain and Portugal (GISP) are small in GDP terms relative to Germany and France. But their banking systems grew to be very large (e.g., a 20% haircut on French bank exposure to GISP countries would wipe out French bank equity). Irish Finance Minister Lehinan intimated that Ireland asked to be able to apply haircuts to senior bank debt, and was told by the EU that it would make no money available if there were any haircuts, due to fears of contagion. What does that tell you about the risk of small countries, or the European banking system?

3. This crisis is not just about sovereign debt/deficits. Ireland and Spain were model EMU citizens, with deficits inside of the 3% Maastricht level for years. The problem: total sovereign, corporate, financial and household debt, and each country’s ability to service it. Despite reductions in its budget deficit and reduced reliance on ECB funding, we’re still very nervous about Spain. Why? Its economy is still on the brink of recession. Were it not for the ongoing collapse in imports, Spain’s GDP would have declined in Q3. BBVA and Santander should be able to ride out a recession due to international diversification, but the other half of the banking system (Caja banks) is another story entirely. Risks in Spain are not just about the banks; nonfinancial private sector debt is 220% of GDP, the highest in the world.

4. The politics may get more divisive. The EU imposed a deal on Ireland’s lame duck government that consigns the country to a very painful future1. The continued gutting of the Irish national pension fund is, to put it mildly, a controversial decision2. Meanwhile, Eurogroup president Jean Claude Juncker said this over the weekend: “I am concerned that in Germany, the federal and local authorities are slowly losing sight of the European common good”.

What would change our views? A full-scale German underwriting of the EMU problem. How likely is that? Wenn Schweine fliegen können (when pigs fly)…..

A full-scale German underwriting of the EMU problem. I'd say for a considerable time it's still safe to go outside without a hat.