Tuesday, November 30, 2010

The European Situation and the Financial Markets

Are the financial markets the WikiLeaks of economics?

Politicians and economists and business people ignore what financial markets are saying at their peril.

The financial markets have not responded well to the “rescue” package for Ireland put together by the European Union. The news out of London: “The euro continued to slide Tuesday, falling to a 10-week low under $1.30 as Italian, Spanish, Portuguese and Irish bond-yield spreads all continued to widen relative to Germany.” (http://professional.wsj.com/article/SB10001424052748704679204575646211228101600.html?mod=WSJ_Currencies_LEFTTopNews&mg=reno-wsj)

“The euro had started the European day with a rally, helped by regular month-end flows in its favor. However, things turned sour again as it became apparent that the risks of contagion remained as strong as ever and that Italy is now being affected by the lack of investor confidence in the euro zone.

Like the debtor countries on the periphery, Italy watched the yield on its bonds rise relative to those of Germany as investors demanded greater returns for holding Italian debt.”

The Financial Times writes: “it is still hard to see how Ireland can repay all the debt it has now taken on. So it is unsurprising that the market sensed a fatal combination: governments lacked the means either to nix moral hazard or end the crisis by writing an enormous check.” (http://www.ft.com/cms/s/3/8540ea0a-fb9f-11df-b79a-00144feab49a.html#axzz16locxnQW)

The European banks still remain a problem. Not only do the banks have serious solvency issues facing them, the eurozone’s banking system is a much bigger proportion of the economy than the proportion found in other countries, especially the United States.
The financial markets are flashing a warning signal that the cost of insuring a bank default has risen severely in Europe and in Spain. Plus, given how large the banks are relative to the size of the economy, questions have arisen about the ability of these countries to continue to provide bailouts. The situation in the banking sector of Greece looks positively “great” relative to Ireland, France, Spain, and Portugal.

Yet people continue to ignore what the financial markets seem to be telling them. It is very easy to claim that the markets don’t really understand a situation or that the blame for a situation rests elsewhere. See, for example, the op-ed piece in the Financial Times, “Spain is threatened by a crisis made in Germany”: (http://www.ft.com/cms/s/0/bb515190-fbf2-11df-b7e9-00144feab49a.html#axzz16lsMDit2). Every time the author makes an argument that Spain stood up for Germany in earlier times, he only talks about individuals, not what was happening in the market place. He now makes the argument that Germany, out of short sightedness, is hurting Spain. There is nothing about markets or what markets are doing. It’s all personal, not business!

Spain has problems and the problems are of their own doing. Now they need to get their books in order. (See my post “Is the Euro Bad News for Spain,” http://seekingalpha.com/article/239065-is-the-euro-bad-news-for-spain.)

In the vast majority of cases I am familiar with, the people who ignore the information being generated by the financial markets end up losing. One needs to have an overwhelmingly strong case that the market is wrong before one places a bet. In fact, betting against the market is like setting up one-way bets for traders. (See my post “Interventionists are setting up one-way bets for traders”: http://seekingalpha.com/article/237076-interventionists-are-setting-up-one-way-bets-for-traders.)

Furthermore, when talking about the banks, we still find a lot of people not really understanding the difference between a liquidity problem and a solvency problem. A liquidity problem is a short-run problem pertaining to “asymmetric information.” Something happens, a bankruptcy in the case of the Penn Central situation, and the “buy-side” of the market begins to question the situation of other high-grade customers that have issued commercial paper. In cases like this a central bank provides liquidity to the market so that the buyers will return as prices begin to stabilize. But, this is a short-run event.

A solvency problem is much longer-term and the state of the organizations, banks in this case, is known in the marketplace. And, that is a problem as far as raising funds is concerned. Firms in this situation cannot raise funds because no one wants to lend to them due to their extremely weak financial condition. But, this is not a liquidity crisis, it is a solvency crisis. People would lend to the organization if they were not financially challenged.

Yet, this is what we read in the New York Times with respect to the European financial crisis: “Ireland’s banking problems are only the latest example of how seemingly solvent institutions can be brought to the brink because they cannot in the short term raise the cash needed to finance themselves. Only four months ago, Allied Irish Banks and Bank of Ireland were given a clean bill of health in the European Union’s official stress tests. One weakness of these tests was that they stressed solvency, not liquidity, although that may be remedied next year.

The two biggest Irish banks did not have a large enough base of stable retail deposits. The loan-to-deposit ratios at Allied Irish and Bank of Ireland stand at just above 160 percent, which made them excessively dependent on wholesale money from other banks and big investors. When that dried up, they had to turn to the European Central Bank. When deposits from corporate customers also started to flee, emergency action was required.” (http://www.nytimes.com/2010/11/30/business/global/30views.html?ref=todayspaper&pagewanted=print)

Maybe, just maybe, the stress tests were not strong enough, as many have claimed. Certainly “the markets” did not think that the banks were healthy. This is even admitted in the article: the banks were “excessively dependent on wholesale money” and “when that dried up” real problems ensued.

Come on…wholesale money is very sensitive to the financial condition of the banks. The banks may have passed the stress tests but they failed the market test. Who is kidding who? You believe the stress tests? I’ve got a bridge to sell you!

This is why many politicians and certain economists don’t like the market system. Market performance often contradicts the world views held by these politicians and economists. And, that makes them angry!

No comments: