8 days ago on a calm Friday evening S&P decided to downgrade the debt of the United States. This past week the markets were rocked in one of the wildest weeks in trading history.
While most felt that the market turmoil was due to fears about United States debt, the market responded by flooding into US treasuries bringing rates down to all time record lows.
The real reason for the turmoil was due to the contagion that took place over in Europe. The markets understand that a US downgrade now puts tremendous pressure on S&P to downgrade the debt of France. (currently AAA)
A downgrade of French government debt would then put pressure on French banks which saw their stock prices destroyed this week.
There is a bigger concern now in place as well. The European bail out fund called the EFSF (their TARP) is now almost exclusively backed by the credit ratings of Germany and France. (both AAA) If France were to be downgraded, that would leave Germany standing alone to backstop almost all the the toxic debt throughout Europe. (Greece, Portugal, Ireland, Spain, Italy, Belgium) If at some point, and we have not hit that point yet, Germany's politicians (or the people that vote them in) decide it is too much too take on, things will get very nasty.
The European Central Bank (their version of the Federal Reserve) has, up until now, played their hand very conservatively. They have only monetized (printed money to purchase) about $80 billion in Greek, Irish, and Portuguese debt. In comparison, just the most recent version of quantitative easing (QE2) from our Federal Reserve was $600 billion in size.
The ECB has pledged that they will begin to purchase the debt of both Spain and Italy. This was the most important news event of the year, which I discussed in The ECB Announces The Final QE.
Where do we go from here?
Spanish cities have begun to approach bankruptcy. Italian banks are loaded with toxic debt and bail outs appear to be nearing. France's GDP disappointed heavily this week raising concern over their ability to finance deficits. California's budget deficit continues to surge as their incoming taxes continue to shrink in size. Municipal bonds all across our country were downgraded this week after the US S&P downgrade. Japan and the UK have massive looming government debt issues they are beginning to face.
The entire world is awash with toxic subprime debt that is all interlinked throughout the global financial system like a mine field covered in nitroglycerin. The stage is set for the next Lehman to be triggered, but no one knows where the first explosion will come from.
A defensive portfolio built for a worldwide financial war is what will be needed to survive, and those that come out the other side will have the opportunity of a lifetime to purchase assets on sale.