What Is The End Game For The European Debt Crisis?

Can Europe get out of its sovereign debt crisis by adding more debt? No. Can Europe grow its way out of its current debt problem? No. It will have a difficult time growing its economy at all next year.

To make matters worse, they have a banking system that is leveraged three times higher than the U. S. banking system. But, we’re not sure because of the lack of transparency in the banking system. For example, they do not have to mark their “toxic” bonds to actual, current market prices. They can price them just about where they want. The rules were changed to keep the banks from becoming insolvent. Just like the U.S.

But unlike the U.S., they cannot do what we did to keep the banks solvent. Their government structure and the limited power of their central banking system prohibit it. This could change with new legislation but it would take time and they would have to overcome the opposition from Germany. Germany has already experienced hyperinflation caused by runaway money printing (i.e., in 1923, Germany’s inflation rate was running at 10,000% per year.)

We all know what happened to Greece recently and the moral hazard of that “agreement.” If Greece could get a 50% reduction on $200 billion of debt and additional money to spend, why wouldn’t every other country be entitled to the same?

The result of that agreement has institutional investors selling European debt as fast as they can and are now coming after Italy; next will be Spain, then France.

Italy has $2.7 trillion dollars of debt and they and must rollover $300 billion of it within the next year. They do not have the money to finance this, if they could find buyers, at an interest rate over 5.5%. Last week they sold $3 billion with an interest rate of 6.1%.

As this unfolds, major banks will have to take enormous losses. Estimates are that U.S. banks have a $600 to $750 billion dollar exposure to European banks. This could cause serious problems for American banks.

I do not know exactly how this “debt crisis scenario” will unfold over the next two weeks, two months or two years. Will the ECB get the authority to print money so they can kick the can down the road a bit longer? There is, also, severe pressure on Germany to go along and let the ECB print. Germany will have to foot much of the bill.

Therefore, the end game it seems is either default or inflate their way out of this debt crisis.

Regardless of exactly how it unfolds, I think the banks are due for a serious correction. What is in question is the timing. We may be unable to prevent this European debt crisis from happening, but there are ways to preserve your capital or profit if you know what’s likely to happen ahead of time and can position investments appropriately.

The Zero Interest Program Is Doing Great Damage To Our Economy

Today, The Federal Reserve Indicated they would extend Zero Interest Rates beyond Mid-2013. This Zero Interest Rate Policy (ZIRP) is doing great damage to our economy. Here are a few reasons why:

1. ZIRP punishes savers and forces people to take on additional risk in order to earn needed income. Also, we need savings in order to get investment capital
2. ZRP hurts pension funds and insurance companies who depend on interest income to pay pensioners and cover insurance losses
3. ZIRP distorts prices and encourages malinvestments and new bubbles
4. ZIRP allows banks to make money from the carry-trade (by borrowing from the Federal Reserve at zero and then buying long-term Treasury bonds and capturing the difference in interest) basically risk free. We know the banks need the money.
5. ZIRP is not the way to get consumer spending back to bubble levels because the consumer credit cards are maxed out.

Also, the Federal Reserve is making things even worse with their latest “Twist” program.

This program has the Fed selling its short-term bonds (because demand is high due to world turmoil) and buying long-term bonds (10-30 years in maturity.) This is their attempt to drive down long-term interest rates to “help” the housing industry through lower mortgage rates. Someone should tell them that mortgage rates have been low for several years.

An even bigger problem is inflation. America’s $15 trillion in debt is currently financed at very low rates with an average maturity of less than five years. What happens when inflation hits and drives interest rates to the point where we cannot afford to refinance the debt we currently have? Look at the interest rates Europe is paying to get an idea (Greece two year bonds at 200% and Italy’s 10 year bonds at 8%.) Multiply that by $15 on our way to $20 trillion dollars.

What do you think is going to happen when the Federal Reserve stops buying Treasuries (the way they keep the rates down) and lets the market set interest rates based on time preference (how much interest one is willing to pay to buy the product now versus sometime in the future) and risk.

Be aware of what you can do in the current environment and prepare for higher interest rates in the future.