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The Greek Oil Slick

(May 7, 2010)

(Guest Commentary by Rick Konrad – May 7, 2010)

Dear Subscribers and Readers,

For those who want to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in our regular guest commentator, Mr. Rick Konrad for a guest commentary.  Rick has been a regular guest commentator for several years and offers his unique insights to us in his twice-a-month mid-week commentaries.  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick will offer his views on the Greek fiscal crisis, the political structure within the Euro Zone, and the risk of contagion in our globalized world.  Rick continues to espouse cautiousness – and reminds us their careful stock selection remains imperative in today's treacherous market.  Without further ado, following is Rick's biography:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on (please see "Healthcare Reform – Is the Infection Spreading?” for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog.  You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been involved with grading CFA examinations.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.

“Now, as through history, financial capacity and political perspicacity are inversely correlated….So inaction will be advocated in the present even though it means deep trouble in the future. Here, at least equally with communism, lies the threat to capitalism. It is what causes men who know that things are going quite wrong to say that things are fundamentally sound.”

-J.K Galbraith, from The Great Crash 1929, written in 1954.

Needless to say, today's stock market action deserves some commentary from this battle scarred but disciplined observer of markets. The Greek “issue” has festered in European politics for some weeks.  Though this lovely Mediterranean pearl has been much criticized for its fiscal profligacy and politicians may have fought the reality of rehabilitation, nothing happened until the situation came to a head when interest rates on Greek debt hit 38 percent- entirely due to a buyers' strike by bond vigilantes who froze on the credit. Putting it even more succinctly, last week Greece for all intents and purposes went bankrupt.

Though some European leaders seem to view this as a bailout for a problem country at the periphery of Europe, the bailout really has nothing to do with Greece itself, though Greece will have to slash its deficit by cranking up VATs and cutting spending. The reality is that this is a bailout of European banks.

Not unlike our American mortgage crisis, Greece's problems stem from easy credit that's been flooding the place for years. Greek politicians, no doubt humbled by the riots in Athens approved the austerity package that represented the “pound of flesh” that the IMF and other European leaders demanded. Not exactly whole-heartedly…Greek lawmakers voted 172-121 to approve the austerity measures - worth about euro30 billion (US$38.18 billion) through 2012 - that will slash pensions and civil servants' pay and further hike consumer taxes.

It is very reminiscent of the scene just two years ago on the NYSE on September 29th, 2008 when Congress was debating Henry Paulson's TARP program…the House vote that initially failed to approve the TARP bill's bailout of banks (and its stupefying collection of ancillary pork.)  Bringing the issue to its negative result and demonstrating the inability for Congressional compromise resulted in a market down 777 points that day, the worst in history. We sure came close to eclipsing that record today. What killed the market that September day was the fact that the politicians really did not have their act together…their ineptitude resulted in toxicity and a murder of any confidence that investors had.

I think what has made the Greek situation so difficult stems from similar distrust. A group of different countries, speaking different languages, and in some cases still harboring deep historical grudges is difficult to operate in concert and synchronously. The Greek debt predicament once again rams home the fantasy of European Union- when swift decisions are needed, big and cumbersome governments and institutions do not allow for a coherent and unified response.

It is all somewhat reminiscent of  “A Nightmare on Elm Street” and Freddy Krueger's  continuous return appearances.  The  boogeyman just keeps coming back.

A coherent political system is something that we take for granted. Markets both here and in Europe are looking not only for a functioning banking system, but a fully coherent political system.  Stay tuned…more politics waits. Germany's parliament is expected to vote Friday on its 20% share of the euro emergency loan aid package. Despite heavy public opposition, and facing an upcoming election, lawmakers are expected to pass the measure. Keep your fingers crossed.

Let's examine some of the fragility that we see in the system. The European chains of contagion can be traced through banking data obtained from the Bank of International Settlements and Danske Bank. The BIS data is the sum of all exposures, both public and private debt.

Consolidated foreign claims of reporting banks, end of Q4 09 (% of GDP)

The total exposure of foreign Euro banks to the PIIGS countries is almost $3 trillion or about 21% of GDP with French and German banks accounting for 53% of the absolute exposure. According to Barclays Capital, French and German financial companies alone hold more than $100 billion in Greek government bonds. But as you can see from the table, the most serious relative exposure to PIIGS is through Ireland at 43%, France at 37%, and the Netherlands at 33% of GDP.

 As the saying goes in banking, a rolling loan gathers no loss. If banks that have bought sovereign bonds have them classified as “held to maturity,” despite the current crisis in confidence, the  P&L will not be too adversely hit.

Again, focusing on the macro scene which I believe will be a necessary prerequisite to understanding capital markets for the next few weeks, the relative size of the various EU member countries is important to keep in perspective. These figures are based on 2009 GDP:

Country GDP $, trillions Percent of Total EU S&P Credit Rating
Germany 3.35 20.38% AAA
France 2.68 16.27 AAA
UK 2.18 13.28 AAA
Netherlands 0.79 4.83 AAA
Sweden 0.41 2.47 AAA
Austria 0.38 2.32 AAA
Denmark 0.31 1.88 AAA
Finland 0.24 1.45 AAA
Luxemburg 0.05 0.31 AAA
Belgium 0.47 2.86 AA+
Spain 1.46 8.90 AA
Ireland 0.23 1.38 AA
Slovenia 0.05 0.30 AA
Italy 2.12 12.88 A+
Czech Rep 0.19 1.18 A+
Slovakia 0.09 0.54 A+
Cyprus 0.02 0.14 A+
Poland 0.43 2.62 A
Malta 0.01 0.05 A
Portugal 0.23 1.39 A-
Estonia 0.02 0.12 A-
Bulgaria 0.05 0.29 BBB
Lithuania 0.04 0.23 BBB
Romania 0.16 0.98 BBB-
Hungary 0.13 0.79 BBB-
Greece 0.33 2.01 BB+
Latvia 0.03 0.16 BB

Thinking rationally about European credit, it is important to remember than only 2.2% of European GDP comes from countries with below investment grade ratings and less than 5% from countries with non- “A” rated debt. Of course, this statement presumes that sovereign debt credit ratings have some meaning. Perhaps at this stage, they carry the same credibility as the politicians I spoke of earlier.

Globalization which provides so many economic benefits unfortunately carries one harmful element, which is contagion. Much like the attempted containment of the oil-slick in the Gulf of Mexico, the contagion of sovereign debt concerns, perhaps because of the strained and haphazard attempts at containment, will come ashore.

Strangely, Greece might not have been allowed into the EU except through cheating aided and abetted by none other than Goldman Sachs. Had Greece been outside the Euro, the ensuing default and collapse of the drachma might have been a fairly localized event and relatively easy to fix by the Central Bank of Greece. However, in a globalized world, things become much more complicated.

Bankers don't know the extent of each other's exposure to dicey credits primarily in Europe, and fear the worsening debt problems will erode the value of government bonds held as collateral. There is added pressure because the credit ratings of the banks themselves tend to be linked to those of their governments. Banks may become wary of lending to each other again, raising the specter of another global credit freeze. A return to frozen credit markets would threaten the global recovery and put added strains on already weakened bank balance sheets.

And, just as in the subprime debacle, regulators seem to have been asleep at the switch: even through the recent crisis, Europe's banking regulators re- classified Greek bonds as “risk-free,” allowing banks to hold them as collateral without holding onto extra capital to cover potential losses.

There had been a Black Friday about 150 years ago in May of 1866 when the London based banking firm of Overend, Gurney went insolvent. Walter Bagehot, a British businessman who became the editor-in-chief of the Economist wrote: “These losses were made in a manner so reckless and so foolish that one would think a child who had lent money in the City of London would have lent it better.”

Professor Alfred Marshall, one of the fathers of economic studies described:”The failure of one caused distrust to rage around others and to bring down banks that were really solid; as a fire spreads from one wooden house to another until even fireproof buildings succumb to the blaze of a great conflagration.”

The recovery of equity and credit markets since March 2009 has rested on recovery by the banks which were resuscitated by unprecedented government attempts to bolster confidence. Governments were playing for time…accommodating continued access to historically cheap credit provided an opportunity for banks to build profitability again, to restore capital and to bolster equity.

We have commented previously on the relatively low quality of the rally of the first quarter. The market had been charmed by “beat and raise” earnings reports regardless of valuation, business quality or long term prospects. The herding mentality that brought stocks up in the last few months remains embedded in the global markets' DNA and some severe volatility should be expected as news and rumors surface.

A year where risk-taking was re-ignited and encouraged by government policy has come to a fairly abrupt end. Careful selection of stocks where valuations, business quality and long term prospects matter will pay off in time. But in the interim, take it easy and be careful. Like the wave of the oil slick, it won't be pretty as this stuff hits the shore.

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