Wednesday, January 25, 2012

Three Reasons Why Europe Will Detonate

I'll give you three reasons why going long European equities (especially banks) is extremely risky right now.

First, the IMF is issuing yet another global recession warning driven by a persistent European insolvency threat.  These reports are almost getting old hat by now because investors have blown off previous warnings with no adverse effects.  Mme. Lagarde and crew project very few safe havens from a European recession.

Second, Greece and its creditors are unable to agree on principal writedowns that will enable further bailouts.  Those creditor banks and funds know all too well how their capital ratios will be damaged by any writedowns. European ministers are unwilling to agree to creditors' requested higher coupons to compensate them for the additional risk they would have to assume by purchasing new Greek debt.  

Third, the uncertainty over the Greek negotiations and the ability of the IMF and EU to fund more bailouts makes European banks reluctant to buy sovereign debt.  It will be fun to read future histories of this crisis to see just how many financial institutions are currently violating their internal risk profiles by owning too much questionable sovereign debt.  Lawmakers are late to the party by arguing that sovereign debt shouldn't carry a zero-risk weighting.

Sufficient evidence is out in the open for investors to use common sense.  Many hedge fund managers lack this common sense and will continue to buy European debt.  MF Global went long European sovereign debt and self-destructed.  They will not be the last institution to fail with that strategy.

Run for cover, investors.  Europe is going to implode on some unknowable date.  The contagion will cross the Atlantic.

Full disclosure:  No long positions in European equities or U.S. financial institutions at this time.