Several times over recent months, I have commented on how I felt the market was in for rough times in the months ahead. Months ago, I cited slowing industrial activity around the world as one of my concerns, and during the past couple of weeks economic news was dominated by reports of slowing economies in China and Europe as well as the U.S.
Having my observations proven accurate like this is sort of like being at the car races, knowing which corner of the track to watch for the next wreck and then getting to see it unfold in slow motion. So, let me tell you about another wreck about to happen right in front of us. Hopefully parts won't come flying our way.
A European banking crisis triggered by sagging values of sovereign bonds (those issued by nations, not companies) in Europe is coming to a head. Economic problems in Portugal, Italy, Ireland, Greece and Spain (the PIIGS) are nothing new, but clearly seeing the trigger for the crisis was new to me, so I thought I would report it to you so you can watch with me as it unfolds.
European banks are already staggering under the weight of many loan defaults as their real estate issues create a domino effect of problems there like ours do here. Reuters reported on August 31st that the International Monetary Fund (IMF) estimates that European Banks already face a shortfall of 200 billion Euros. They have problems, to say the least.
Recent IMF "stress tests" of European banks conveniently overlook losses on sovereign debt held on bank balance sheets because banks report sovereign bonds they own at their original purchase prices rather than current market values.
This phony accounting by European banks is like you and I saying our house is still worth what it was 5 years ago. Talk about burying one's head in the sand!
One report mentioned that PIIGGS countries have issued 970 billion Euros in debt. Another report in ZeeNews.India.com mentions that write downs of the value of PIIGS bonds that have occurred have been in the 21-50% range.
Without boring you with the math, if European banks faced reality and wrote down the value of the PIIGS bonds they hold by 21%-50% a lot of those already shaky banks would be insolvent. It is only a matter of time before this reality rocks European markets big-time.
For sure, there will be a bailout attempt of some sort by the more solvent European countries, but this issue also has the potential to destroy the European Union if more fiscally conservative countries (Germany, in particular) decide to walk rather than keep bailing out spendthrift states. Another alternative is that Germany will recast the EU in its own image with more German-like controls.
As Sergeant Schultz from Hogan's Heroes would say "You Vill Pay Your Bills!!"
One bit of wreckage that could come flying our way is markdowns in the value or even complete defaults of sovereign debt held by US money market funds. Many of the highest yielding money market funds get those yields by investing in junk bonds, and PIIGS bonds are currently among the junkiest of the junk.< /p>
If you shop for money market funds mostly by looking for the highest rates, that means your funds are taking high risk and this is the kind of market that high risk comes back to bite investors. There is an old saying in the investment world that is taking on new meaning these days, "Bulls can make money, and bears can make money, but pigs (now including PIIGS owners) usually get slaughtered."
This is not a time to be taking a lot of risk.
About the Author: Will Hepburn is President and Chief Investment Officer of Hepburn Capital Management LLC , in Prescott, Arizona. Will specializes in implementing and teaching innovative investment strategies that “Adapt to Changing Markets.” Will is a past President and current board member of the National Association of Active Investment Managers.
For more information on Mr. Hepburn, visit HepburnCapital.com
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