The European Bailout Part One

The first of the coming European bailouts was announced today.  While it will be described as the end all solution to Europe's debt problems, for now it will only magnify the problem and set the stage for additional bailouts to come.

First the quick details of the program:

Part 1: The EFSF (Europe's version of America's TARP program) has been turned into a giant subprime fund that will be leveraged up to 1.4 trillion euros.  Who will be providing the funds for the debt that will be leveraged up?  The same countries that will use the fund to be bailed out.

Please re-read the last two sentences again.  Then again.  Okay, moving on.

Part 2: Greek debt owned by the private sector will be "voluntarily" marked down by 50%, reducing the debt burden on Greece.  Remember that word voluntarily because we will come back to it in a moment.  But first, let's look at how this will impact Greece's debt burden.

First of all, before getting negative, the fact that Greece will have a write down of any kind is a positive step.  Unfortunately in the very big picture you will see that this debt write down will end up hurting the European Union vs. helping.

Greece has a total government debt burden of 350 billion euros.  Private sector debt that is available to be written down 50% under this current bail out arrangement is 200 billion euros.

That means a write down of 100 billion off the backs of Greece that need to be paid.  Looks good so far, but let's discuss the first of many problems.

35 billion of this 200 billion is owned by Greek pension funds.  This money will have to be repaid by the Greek government with.......more Greek government debt.

This write down still leaves the country insolvent (130% debt to GDP) and only buys it time for the next round of bail outs. 

Now we have the use of the word "voluntary."  I discussed the importance of Credit Default Swaps on the European bond market in great detail in the following series, which is extremely important to review to understand the magnitude of today's bail out:

The Real European Debt Crisis
Enter Greek CDS: The Fork In The Road
Naked Credit Default Swaps Banned In Europe

By making the bank write downs voluntary they have not triggered a "credit event," which means that no CDS insurance payments will be triggered.  This completely changes the global investment landscape moving forward.  Investors who once used this insurance to hedge their portfolio's will now have to sell bonds in Europe to protect themselves.

This will speed up the decline in bonds for Portugal, Ireland, Belgium, Spain, and Italy moving forward. 

The second major impact of today's bailout will be how these countries, the next in line to receive bailout money, will behave moving forward.  They now know that not cutting spending is the best option, as you will be rewarded with a "sweet heart Greece deal" where the interest payments on your debt will be lowered and the amount of time you have to pay the debt will be extended.  Plus, you get to "write off" a large portion of what you currently owe. 

There is no need to cut spending now.  Keep the party going full speed.

Next let's look at the impact on the European banks.  As part of this "voluntary" write down, banks have been asked to raise 100 billion euros to strengthen their balance sheets over the next 8 months.  This number is laughable at best.  Banks in Europe are currently leverage at 26 to 1 with toxic debt. (Lehman was leveraged 30 to 1)

26 to 1 means that they have $1 in capital for every $26 in debt.  Or another way to think of it, if they have $100 in debt, they have less than $4 in capital as reserves against losses.  If the value of that $100 falls by over 4%, they are bankrupt. (Lehman)

The Greek write downs were 50% and this was only the first round for Greece.  Then they have write downs coming for Portugal, Ireland, Belgium, Spain, and Italy.  What happens when they do not have enough capital to stay solvent?  The governments will be forced to nationalize the banks.  Doing so will mean every country including France and Germany will need a bailout.

Can you see how it all comes full circle?  By bailing each other out with more debt, it only creates a larger problem.

At the end, the only solution, other than a complete financial meltdown (similar to what we almost saw in 2008) will be for the European Central Bank to begin to print money and purchase European debt on a large scale. 

Also remember that the European Union as a whole is only the opening act.  The crisis will soon move to Japan, the UK, and then the United States.  The exact date when each bond market will crack is unknown, just as the exact date Greek debt finally began to fall was unknown.

What we know is that all countries face the same exact issue and they will be dealt with by the financial markets in the same manner. 

Things are going to get extremely turbulent moving forward.  I expect massive swings up and down in all investment classes.  It is very important to step back and understand the complete picture so you do not get shaken out of the investments in the short term that will perform the best during the global sovereign debt crisis over the long term.