Despite all of its best hopes, Wall Street will never escape what’s happening in the Eurozone.
The 1 trillion euro ($1.3 trillion) slush fund created to keep the chaos at bay is not big enough. And it never was.
Spanish banks are now up to their proverbial eyeballs in debt and the austerity everybody thinks is working so great in Greece will eventually push the Spanish economy over the edge.
Spanish unemployment is already at 23% and climbing while the official Spanish government projections call for an economic contraction of 1.7% this year. Spain’s economy appears to be falling into its second recession in three years.
I’m not trying to ruin your day with this. But ignore what is going on in the Spanish economy at your own risk.
Or else you could go buy a bridge from the parade of Spanish officials being trotted out to assure the world that the markets somehow have it all wrong.
But the truth is they don’t.
EU banks are more vulnerable now than they were at the beginning of this crisis and risks are tremendously concentrated rather than diffused.
You will hear more about this in the weeks to come as the mainstream media begins to focus on what I am sharing with you today.
The Tyranny of Numbers in the Eurozone
Here is the cold hard truth about the Eurozone.
European banks reportedly will have more than 600 billion euros ($787 billion) in redemptions by the end of the year. They come at a time when the banks have sustained billions in capital losses they can’t make up.
Worse, they’ve borrowed a staggering 316.3 billion euros ($414.9 billion) from the ECB through March, which is 86% more than the 169.8 billion euros ($222.7 billion) they borrowed in February. This accounts for 28% of total EU-area borrowings from the EU, according to the ECB.
There will undoubtedly be more borrowing and more losses ahead as interest rates rise further.
The process will not be pleasant:
- Credit default swap costs will rise, pushing debt yields to new highs while at the same time making fresh Spanish debt cost-prohibitive;
- The Spanish government will force national banks to buy debt at higher rates, triggering capital losses on their bonds;
- Those same losses will trigger margin calls, forcing banks to unload segments of their debt and equity portfolios;
- Rinse and repeat steps 1-3 until there is no more money, the public revolts, the EU splinters, or all three.
Unfortunately, this vicious cycle is already under way.
The Big Boys Go on the Offensive
Spanish 10-year bond yields pushed up to 6.07%. (Yields and prices go in opposite directions. If one is rising, the other is falling.) They relaxed slightly but…
At the same time, Spanish credit default swaps touched record levels, reaching 502.46 basis points according to Bloomberg News. That process actually began in February when traders starting upping the ante on Spanish debt.
Credit default swaps pay the buyer face value if the borrower – in this instance Spain – fails to meet its obligations, less the value of the defaulted debt. They’re priced in basis points. A basis point equals $1,000 on each $10 million in debt.
Wall Street sells them as insurance against default.
In reality though, they are like buying fire insurance on your neighbor’s house in that you now have an incentive to burn it down.
Let me briefly explain how the playbook works.
The big boys are going on the offensive and pushing the cost of insuring Spanish debt to new highs because they know that the Spanish government prefers more bailouts to pain. It’s the same thing they did with Greece, Ireland and Italy.
At the same time, they’re shorting Spanish debt knowing full well that there will be massive capital losses as Spanish bonds deteriorate.
What these fiscal pirates are counting on is the ECB and Spanish government riding to the rescue.
At that point, they will sell their swaps and go long Spanish bonds, thus netting themselves a two-fer.
This could be a good thing for savvy individual investors– at least temporarily.
The markets have become addicted to bad news. We cheer when central bankers step in with quantitative easing, conveniently forgetting things are so terrible we “need” it in the first place.
We’d rather take one more “hit” than step away from the narcotics of cheap money.
That’s why I expect a rally when the ECB is forced to step in no later than Q3 2012.
Keith Fitz-Gerald
Chief Investment Strategist, Money Morning (USA)
Publisher’s Note: This is an edited version of an article that originally appeared in Money Morning (USA)
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Why Wall Street Can’t Escape the Perils of the Spanish Economy
