Will Europe order a code red?

MarketWatch, May 5, 2010

Will Europe order a code red?

Commentary: The world attempts to handle the truth

By Todd Harrison

NEW YORK (MarketWatch) -- European Central Bank Council member Axel Weber said Greece's fiscal crisis is threatening "grave contagion effects," according to published reports.

Grave danger; is there any other kind?

Readers of Minyanville should be well versed in overseas risk. Professor Peter Atwater pointed to Eastern Europe as a sub-prime borrower over a year ago. Read Minyanville's "Eastern Europe, Subprime Borrower."

In January, we noted the risk of European Disunion in our Ten Themes for 2010 when we offered,

"The European Union is committed to the regional and economic integration of 27 member states, with sixteen countries sharing a common currency. That was a fine idea when it was first founded but the economic fallout of the financial crisis will put loyalties to the test.

Look for the Union to adopt more stringent guidelines in the coming year, including but not limited to distancing itself from the weaker links such as Greece and Ireland. Sovereign defaults, as a whole, should jockey for mind-share. This could conceivably spark a rally in the US Dollar, which could have ominous implications for the crowded carry trade." Read Minyanville's Ten Themes for 2010.

On Feb. 10, we shared a salient script for what is now unfolding. Given the parallels to the first phase of the financial crisis, we now have a proper context for the sovereign sequel. While many points were made, the takeaway was two-fold. Read Minyanville's "A Five-Step Guide to Contagion."

First, we noted the implications of a higher greenback for the crowded carry trade; hedge funds were long "risk assets" in size entering this year, funded by "cheap" dollars (the DXY (DXY 85.07, +0.99, +1.18%) has rallied 13% since the beginning of December). You haven't heard much about this in the mainstream press and perhaps it won't come to pass (given the staunch state of credit) but it most certainly should be on our collective radars.

AM Report: Strike Tests Greece, Europe

Greece was gripped by a nationwide general strike, in what is seen as a key test of the government's ability to shepherd through tough austerity measures in exchange for a multibillion-euro bailout. Charles Forelle, Evan Newmark and Mike Reid discuss.

Second, the simple yet scary analogy that was first shared by the sage Atwater: If sovereign lifeguards saved corporations when the financial crisis first hit, who will be left to save the lifeguards?

You, Lieutenant Weinberg?

The IMF, which presumably contained the contagion? That doesn't seem likely; we've seen that script before. Look at it this way; the FDIC was hemorrhaging capital on the way to insolvency until the Treasury issued TARP and recapitalized the banking system. J.P. Morgan Chase & Co. (JPM 40.50, -2.13, -5.00%) , Citigroup (C 4.01, -0.17, -4.14%) , Wells Fargo & Co. (WFC 31.07, -1.59, -4.87%) , Goldman Sachs Group Inc. (GS 141.80, -6.39, -4.31%) and Morgan Stanley (MS 27.29, -2.00, -6.83%) all lined up and lined their pockets.

We, the people, paid the tab and we're now chewing through the "other side" of that trade.

Overseas, there are two lifeguards; the IMF, which is funded by governments from around the world, and the European Central Bank. The chief difference between the stateside solution and the sovereign sequel is the motivation of the lifeguards and the magnitude of the waves. The ECB could conceivably print euros but it's an entirely different animal; the European Union is a monetary alliance with no unifying political federation.

Sovereign spreads continued to widen overnight, with Portugal (+13%), Italy (+11%) and Greece (+10%) leading the charge. That dynamic structural shift, coupled with percolating social unrest and political maneuvering -- German Chancellor Angela Merkel told parliament the Europe's fate is at stake -- will make for an interesting European Central Bank meeting on Thursday.

Kevin Depew noted yesterday on Minyanville's Buzz & Banter that speculation was circulating about possible aggressive ECB action. A few different banks sent notes to clients suggesting ECB may cut rates. The views from euro watchers ran the gamut from cutting refi-rates to zero, announcing a quantitative easing operation similar to the Federal Reserve to, you name it -- everything goes to zero. This would be needed, it was argued, to fully head off the euro zone crisis.

While there's a world of difference between the U.S. and Europe, we share commonalities with regard to the state of our respective unions. There are drugs that mask the symptoms, pushing risk further out on the time continuum, and there is medicine that cures the disease, in the form of debt destruction. As any drug addict will tell you, the "high" creates a synthetic sense of euphoria before causing a crash back to reality; in severe cases, after an overdose, that crash is unrecoverable.

While the path we take is more important than the destination we arrive at, and we must allow for game-changing regulation, all the fancy words, political posturing and engineered acronyms don't change one, simply, scary fact. The world is entirely too indebted and those cumulative obligations must eventually be paid. We can only hope a fight doesn't break out when governments around the globe reach into their empty pockets and attempt to save face.