The Next Market Bubble

Bulls and bears alike wonder when the next market bubble will emerge and pop.  In recent years, major stock market downturns have come from bursting bubbles.  Recessions, threats of war, terrorist attacks and other disturbances have caused market ripples.  But the big gut wrenchers--the nosedives that wrecked your retirement--have come from the popping of asset bubbles.  The gross over-valuation of tech stocks in 2000, the ridiculous real estate lending of 2005-07, those are the events that clobbered equities.  What does the future portend?

Today, the mess in the Middle East grips our attention.  Medieval atrocities by the Islamic State, a mosh pit with weapons in Gaza, mind-numbing slaughter in Syria and sectarian strife in Iraq appall and fascinate.  But none of them will significantly drive down stock valuations.  They just don't have the economic impact.  The Ebola epidemic is now raging out of control in West Africa.  But America's economic exposure to West Africa is miniscule.  And the disease isn't likely to present a major threat to the industrialized world.

Is there an impending market bubble that could burst and dynamite the world's financial system?  The answer is maybe, in Europe.   The European economy is slowing.  Growth is seen only on alternating Sundays.  The EU stays afloat on a cushion of sovereign and bank debt--a lot of it.  With Europe's slowing economy, it will be tough to pay down this debt and expedient to refinance by issuing even greater amounts of debt.  Risks to larger members like Italy and France are rising.  The EU is a financial and currency union without a unitary government.  Thus, it is tailor made to borrow in bulk without governmental controls to interfere.  We in America know from the 2007-08 mortgage crisis what happens when you bulk up on debt that can't be easily repaid.  The vast amount of European debt presents potential systemic risk, just like the vast amount of American mortgage debt outstanding in 2007.

Exacerbating Europe's problems is the war between Ukraine and Russia.  As Russia's direct involvement in combat is becoming increasingly clear, the war is likely to have ever greater impact on Europe.  Sanctions by the West will probably be heightened, and Russia's retaliation will likely hit Europe harder than America.  Europe's financial system could begin to totter as the EU is pushed into recession and capital flees the Old World.  (Indeed, part of the buoyancy of U.S. stocks can be attributed to the arrival of capital now fleeing Europe.)  A run on the Euro could be the straw that breaks the bubble's back.

The European Central Bank, as always, does a fan dance about how accommodative it will be.  While it's become much more interventionist in the past couple of years, it remains constrained by its anti-inflation charter and the stolid, ever-frowning Germans. Maybe the ECB will save the day.  Or maybe not.

Europe's economy, as a whole, is larger than America's.  A tummy ache there could affect the rest of the world.  if you're worried about where the next bursting asset bubble could come from, keep your eye on Europe.

The EU Bubble

Today's kerfluffle in the stock markets over the debt default of an entity affiliated with Portugal's largest bank reminds us that if there is a financial bubble anywhere, it's in EU sovereign and bank debt.  EU sovereign debt and the debt of EU banks have become almost synonymous.  That's because they are linked by a problematic circularity.  EU banks have invested heavily in EU sovereign debt.  EU nations, in turn, have pretty much become the guarantors of the debts of their banks.  Thus, the banks borrow to invest in sovereign debt, and the sovereigns in turn guarantee the banks' debt that funds the sovereigns.  It's rather clever, as long as nothing goes wrong.

However, one could note that EU banks and sovereign nations appear to be burdened with each others' liabilities, and that the guarantees of EU nations accordingly have limited efficacy.  Given that the EU and its banks, in toto, can be reasonably described as overleveraged, this circularity can become a circular firing squad if there is a run on a major EU bank or an EU sovereign member nation.  This is particularly so since no EU nation can issue its own currency and pay its or its banks' debts with printed money.

Of course, the European Central Bank has in recent years made a show of pointing to shining armor it could don and white horses it could mount to ride to the rescue if there is another European financial crisis.  And it has adopted accommodative, money printing-like maneuvers when the going got tough (like letting EU banks use sovereign debt as collateral for borrowings at the ECB without any discounting of their face value).  If the dustup across the pond is limited to Portugal, the ECB should be able to find one way or another to keep the cookie from crumbling.  But if other EU nations, particularly larger ones like France, begin to waver, the EU financial bubble could burst in a nasty way.  The economic consequences could be bad.  Given the growing extremism in Europe, the political consequences could be worse.

There are some asset classes in the U.S. that may be getting bubbly.  Many Internet stocks are suspect. Housing except for the $1 million and up price range seems to be struggling.  In addition, small cap stocks haven't been doing well recently and may turn out to be a bubble bursting.  But it's unlikely that the frothiness of these asset classes could re-trigger the Great Recession.   On the other hand, if the EU sovereign nations can't keep their banking systems on an even keel, then all bets are off. 

The Central Banks' Failure to Eliminate Risk

Now, it's Cyprus--tiny Cyprus, with 0.2% of the EU's GDP--that's shaking up the financial world.  The Asian stock markets are falling on Monday, March 18, 2013, and stock futures indicate that the European and U.S. stock markets are also headed downward.  Runs have already started at Cyprus' banks, and a bank holiday was declared for Monday, in order to stop the outflow of rats from the ship. 

The proximate cause of the panic is a proposed EU bailout for Cyprus that includes taking from depositors at its banks 6.7% of deposits under 100,000 Euros, and 9.9% of deposits exceeding 100,000 Euros.  Surprisingly, this tax (which is to help pay for the bailout) would hit small depositors that were supposed to be fully insured up to 100,000 Euros.  The bailout violates a sacrosanct principle of bank regulation--that deposit insurance cannot be impaired.  Deposit insurance is the key to depositor confidence, and the foundation of commercial banking.  America's banking system recovered from the Great Depression (which saw thousands--yes, thousands--of bank failures) only when deposit insurance was instituted.  If you scare depositors, an entire banking system can go belly up in less time than it takes to scramble a couple of eggs.

The powers that be which fashioned the Cyprus bailout--the EU, the European Central Bank and the IMF--imposed the depositor tax because of the somewhat shady doings of Cypriot banks.  They extended the scope of their businesses way beyond their home island, accumulating assets amounting to twice the size of Cyprus' GDP.  Reportedly, around half of their deposits are from Russians, and suspicions of money laundering, tax evasion, and other alleged shenanigans lurk.  The stolid burghers of northern Europe have been wrinkling their noses over the unsavory aromas rising from Cyprus' banks, and they evidently view a tax on depositors as fair compensation for the trouble the EU is now being put to.

Whether or not the deposit tax is fair is, from a commercial standpoint, pretty much irrelevant.  The financial markets thrive on confidence.  The EU's financial crisis eased last summer when the head of the European Central Bank said, in substance if not words, that he would authorize the printing of money to prop up failing EU member nations.  The bond vigilantes backed down.  But the Cyprus bailout's tax on deposits is the opposite of money printing, and implies that losses are possible for holders of deposits in banks at other weak EU nations.  There's nothing that shakes confidence like the prospect of losses, especially if one was supposed to be insured against them. 

The financial markets have been coasting on a mellow buzz from toking up on central bank monetary accommodation.  Ultra low interest rates and quantitative easing have taken the edge off volatility, and the markets seem to know no fear.  But there is no way to eliminate financial risk.  You can only transfer it somewhere.  The Cypriots apparently wanted to transfer the risks and costs of their bankruptcy as far north as they could.  But the folks up north didn't seem to cotton to that notion.  So the risks and costs blew back, and as we now see, blowback can be nasty. 

Who knows how this will all end.  No doubt high ranking officials on both sides of the Atlantic are engaged, even as we write, in frantic discussions to figure out how to prevent the spread of financial contagion.  The baseline problem is that the EU as a whole hasn't decided how to allocate the costs of resolving its financial crisis.  This is probably a harder problem than the resolution of the U.S. government's current dysfunction, since, in Europe, people from disparate countries and cultures must somehow find common ground.  Since these are the same people who fought two horrendous World Wars against each other in the 20th Century, it remains unclear if they will succeed.

In the meantime, remember that central bank monetary policy can provide a methadone high, at best.  It won't last forever, and the aftermath may be a real downer.  It's fine to feel good about the financial markets right now.  But keep in mind that the central banks cannot eliminate financial risk, and if you relax your vigilance, risk could bite your left ankle in a flash.

Politics Keep the Economic Crises Going

We are vividly reminded today that the economic crises bedeviling the world are political in nature.  The election deadlock in Italy, with leftists likely to control one house of the Italian Parliament, and rightists and leftists apparently in  a draw in the other house, is a vote against austerity and centralization of the EU's governance. Although the political nuances differ from Greece's initial anti-austerity vote last year, the Italian election, like Greece's, signals that numerous voters have yet to learn the words of the pan-European version Kumbaya.  Another election in Italy may well be needed, or the country will be unable to stay on track to meet the EU's expectations.

In America, sequestration now seems almost a certainty.  The arbitrary cuts imposed by sequestration were supposed to be unpalatable to either party, and would therefore incentivize both parties to cut a real deal.  Fat chance of that in these days of political dysfunction.  Truth is there won't be a real deal.  That's why the Dems and Republicans kicked the can down the road when the fiscal cliff loomed and the debt ceiling threatened to descend like the Sword of Damocles.  The government right now can do little more than bring its foot back for another kick.  The one silver lining in the clouds is that the economy seems to be recovering to some degree.  The better the economy does, the lower the deficit will be.  We should hope and work for economic growth, because that is the only politically feasible solution to the budget deficit.  The federal government needs to repair and upgrade infrastructure, adopt a pro-growth immigration policy, work hard to cut the growth of health care costs (perhaps the biggest expense in future federal budgets), and work toward supporting and expanding educational opportunities while reducing the cost of education.  (Internet-based instruction may be a great way to educate at much lower expense, and should be encouraged and supported.)  The current squabbling in Washington over budget cuts and tax increases is a game of musical chairs that no one can win.  We have to take a different approach.

The Great Anxiety

The Great Recession has morphed into the Great Anxiety.  Economic growth is tepid, enough so that it inspires little confidence.  Unemployment, still high, is falling, but so slowly that consumers' animal spirits remain tame.  Individual investors, confronted by three year highs in the stock market, celebrate by fleeing.  The members of Congress devote their energies to calling each other finks, rat finks, double rat finks, and triple rat finks, while the nation veers toward a fiscal vortex.  Both candidates for the Presidency, although individually quite intelligent and accomplished, swap lies about how the other is lying and inspire little more than resigned sighs from their supporters.  The Federal Reserve is operating the only show in town, and its program consists of printing money, printing money while riding a bicycle sitting backwards, printing money while juggling eight balls and printing money while doing double somersaults on a trapeze.  But the Fed can't do much to resolve the problems in Europe, which is now sliding into recession even as the sovereign debt crisis gets kicked farther down the road.

If the Federal Reserve Board is correct in believing that public confidence is crucial to economic growth, then we are a long way from healthy, sustainable growth.  By all current indications, whichever candidate for President wins won't inspire much confidence.  Congress appears likely to remain divided between a Republican House and a Democratic Senate.  Gridlock isn't that big a problem when the economy is strong.  But it is deadly when the economy is moribund.  For better or for worse, a somnolent economy needs a decisive government, and we probably won't have one. Can kicking isn't a sound federal economic policy.  Both Japan, and more recently, the European Union, have vigorously kicked the can numerous times.  The problem, though, is that business people and consumers all know that the can is still there, and can bite them in the butt big time.  So they don't make big commitments; they don't go exuberant.  Can kicking virtually guarantees stagnation.  Yet can kicking has been the order of the day in Washington.

In a time when lukewarm coffee is all that you can hope for, invest cautiously.  It's not a bad idea to hold some risk assets.  But limit your exposure, and avoid the riskiest.  Hold a good dollop of stable assets, and don't stretch for yield.  One important way to give your net worth a boost is to save more.  Remember that the thriftiest squirrels have the best chance of surviving winter--and the coming winter could be cold indeed.

Pan Europeanism's Gambit

It would appear that a group of key European leaders combating the EU financial crisis have coalesced around the banner of Pan Europeanism.  Mario Draghi, head of the European Central Bank, has positioned the ECB to start financing struggling EU governments.  This is a paradigm shift from past ECB policies, and moves the ECB toward the money printing mode of the Federal Reserve and the Bank of England.  Recently, Angela Merkel, Germany's Chancellor, has spoken of cutting Greece a break on its austerity obligations under the terms of the EU's bailout for that nation. Such magnanimity is at rather sharp odds with her tough stated positions not many months ago.  The recent election in France of Socialist Francois Hollande shifted the EU's political center of gravity toward more accommodative measures--Hollande's notion of austerity is to raise taxes on the wealthy and give them a taste of austerity. 

The award of the Nobel Peace Prize to the European Union may be the latest move in the gambit to persuade skeptical northern European taxpayers of the need to keep the EU together.  The point is that failure to stay together will raise the specter of another continental war.  Although actual war seems highly unlikely in today's non- and often anti-militaristic Europe, the subliminal message is clear. 

The Nobel award is like a mutual admiration society of Pan Europeanists high fiving each other. The political in-crowd on the continent has to be very pleased with itself at the moment.  But the baseline problem for saving the EU remains whether or not northern European taxpayers are prepared to foot the bill for keeping the whole shebang together.  If not, the $1.5 million or so that comes with a Nobel Prize won't matter.  An interesting question is who will the EU select as its representative to receive the award.  Here's betting it's Angela Merkel, who needs political cover.

The Bank Run Deposit Insurance Doesn't Protect Against

A slow motion run on banks in Greece, Spain and other distressed Euro bloc nations has been taking place ever since the sovereign debt crisis blew up two years ago. Recent news reports indicate it has accelerated, particularly in Greece. The top 1% and others in distressed nations have been moving money to banking havens such as Switzerland and Luxembourg, and stable nations like Germany and the UK.

Depositors have two reasons to flee banks in troubled countries. One, those holding deposits exceeding the 100,000 Euro limit on deposit insurance in the Euro bloc have much to lose if their local bank collapses. Two, depositors in any nation that potentially may depart the Euro bloc confront the risk of compelled conversion of their deposits into a new, depreciated currency. Greece presents a vivid example of the latter problem. Conversion back to the drachma could sharply reduce the value of Greek bank deposits. There is no deposit insurance that protects against losses sustained when one's home nation drops out of the Euro zone and adopts a depreciated national currency. Some Greeks have been withdrawing Euros from ATMs (presumably to pad their mattresses). Others have been moving Euros electronically to safe haven nations.

The capital mobility created by the adoption of the Euro facilitates such bank runs. Since the Euro bloc, by definition, eliminates the problems of currency conversion, moving funds from one Euro bloc nation to another is easier than in the bad old days of national currencies. The upside of increased capital mobility is that money was supposed to go where it could earn the highest return, which was thought to promote economic efficiency and greater overall prosperity. The downside is that capital can more readily flee ugly situations, even if it's needed to help finance a nation's way out of ugliness.

The European Central Bank might be able to stop the burgeoning bank runs. The core mission of central banks is to promote depositor confidence. The ECB seems to have been lending many billions of Euros to Greek and Spanish banks. But it won't print money, and that limits its options if the run quickens. The Euro bloc, a 21st Century financial innovation, may have laid the foundation for an old-fashioned 19th Century financial panic. Time will tell.

Fools Among the Holders of Greek Debt

A couple of months ago, most holders of Greek government debt reluctantly agreed to a deal to take a loss (called a "haircut" by the financial cognoscenti) of about 75% of the nominal (i.e., face) value of the debt as part of the second bailout package offered to Greece by the EU. Another aspect of that deal was the Greek government would institute austerity measures in order to reduce its future need for debt. The coalition government then governing Greece, a pushmi-pullyu shotgun marriage of two opposing parties, solemnly agreed to the austerity measures.

Just a couple of days ago, Greek voters gave the coalition government something like a machine gun divorce, placing bootprints on the behinds of the coalition parties and effectively putting a Communist politician in the position of calling the shots. It's been decades since Communists in any democratic nation have had a scintilla of political power. But there's never a dull moment with the ongoing economic and financial crisis.

Needless to say, the Communist leader, Alexi Tsipras, isn't of a mind to embrace austerity. He does say he wants Greece to remain in the Euro zone. And why not? Since the beginning of the EU sovereign debt crisis, Greek governments have made promises about fiscal probity and austerity, gotten promises of bailouts, not quite fully lived up to their promises to throttle back spending, and gotten bailed out anyway because the wealthy EU nations always blinked first. The Greek Communists might as well play the same game, and take credit for any blinks they can induce.

Meanwhile, back at the ranch, those holders of Greek debt who agreed to the 75% haircut must be wondering how foolish they now look to the people on whose behalf they manage money. It's well understood that there is political risk associated with speculating in sovereign debt. Politicians will, when push comes to shove, favor their constituents over money managers in the top 1%. Nevertheless, professional financiers dabbling in sovereign debt are supposed to be able to assess political risk astutely. Just two months after the second bailout deal, they've lost the benefit of their bargain because of a political risk that was staring them in the face when they agreed to the haircut.

Private investors will be reluctant to play in the EU sovereign debt sandbox in the future. It's not a winning strategy to take a big haircut and then find out two months later that you have to deal with a newly risen Communist politician.

With the evaporation of private investment interest in the sovereign debt of weaker EU nations, the European Union will have a problem. A fairly large one, in fact. Its member nations can't function without debt. But, with natural investors unwilling to lend their savings, EU sovereign debt (at least for the weaker member nations) would have to be financed by the European Central Bank. The ECB would protest that this violates the letter and spirit of its charter. But what choice will it have? The EU doesn't have a mechanism for defenestrating a member nation, however badly it behaves. And its undercapitalized banking system is up to its ears in the sovereign debt of weak EU nations and can't afford to keep booking losses.

But if the ECB starts to monetize the debt of weaker EU nations (which it already is doing in shadow form with its three-year loans to large member banks), the debt of the wealthier EU nations will become less attractive to private investors. A big money print by the ECB will inflate the Euro in Germany just as it inflates it in Greece, and no creditor wants to hold debt denominated in a potentially inflationary currency. If private investors step back from German sovereign debt, the EU game will be up.

In the end, the wealthier nations will probably leave the EU, and possibly create a smaller currency union with each other. Or they may just go it alone. Either path will garner the interest of private holders of capital. And that would be the way to restore true financial stability.

Distribution of Income and Wealth is the Issue

As much as many politicians--mostly on the right--try to deny it, today's politics are all about the distribution of wealth and income. Democrats, with President Obama at the forefront, have made financial inequality a crucial element of their 2012 platform. Republicans argue against new taxes, and for the long term reduction of taxes and the shrinkage of the federal deficit. That, too, affects the distribution of financial resources, mostly in directions unfavorable to middle class and modest income households. Long term cuts, to be effective, would have to come to a large degree from Medicare and Medicaid, which verge on insolvency in the relatively near future. Social Security benefits may well shrink over time, although the cuts aren't likely to be apocalyptic. The 1% won't have to trim their sails much if the Republicans have their way. Most of the rest of us will notice the increased costs we would bear.

The Euro crisis is all about the distribution of economic resources. As a whole, Europe has more than enough money to resolve the sovereign debt crisis. But a lot of the money that would have to be paid out to bond vigilantes would come from the good burghers of northern Europe, and they have no appetite to cover chits signed by spendthrift members of the EU. Reality is the Europe isn't a whole, and its continental wealth isn't available to cover the debts of profligate nations. The thrifty don't want to distribute their wealth to the prodigal.

In China and India, even as substantial middle classes emerge with the turn toward capitalism, hundreds of millions remain mired in poverty. The governments of both nations, in different ways, grapple with difficult problems of distributing the fruits of growth. China also confronts a demographic problem far worse than America's; its principal solution to date has been to slash the safety net once provided by the iron rice bowl. Both nations equivocate when asked to commit large sums to bailing out Europe. How can they explain to their citizens why they should save much wealthier Europeans from themselves?

In times of brisk economic growth, the expanding size of the pie makes sharing easier. Stagnation, however, brings out harpies. Increasing growth is the obvious solution. But that, for sure, falls into the category of more easily said than done (for elaboration on this point, call Ben Bernanke, Fed Chairman and Tim Geithner, Treasury Secretary).

Since the times when humans clung together in small groups of hunter-gatherers, distributional questions have existed. Hunting is a hit or miss process (pun intended), and the lucky hunter bringing down a deer would expect to share it with the entire group, just as the next day, another lucky hunter would share.

In a modern free enterprise system, protection of private property rights is important to provide incentives to work, save and invest. But market forces, alone, do not always produce distributions of financial rewards that comport with societal needs and norms. The demands of market-based economies altered social structures. Extended families disappeared as children reaching adulthood move hundreds and even thousands of miles away to find suitable jobs. Family-based safety nets evaporated as families splintered. But market forces make no provision for those injured on the job, the sick, the disabled, the laid-off or other unfortunates; and most certainly not for the elderly who no longer wish to or can work. Government programs were necessary to fill the gap.

There are no easy answers to distributional questions. But it's important to debate and decide them, because they are among the most crucial issues of the day. Trying to silence President Obama by accusing him of class warfare is tantamount to avoiding the central point in today's political dialogue. Whichever side you take on the question of the size of federal deficits, or the allocation of tax burdens, you're talking about the distribution of financial resources. A nation that faces up to the responsibility of dealing with this problem has a chance to reach the accommodations that lead to social harmony. A nation that ducks the issue and indulges in political mudslinging will face a grim future.

The Greek Debt Crisis and the Failure of Credit Default Swaps

The Greek debt crisis, from which the entire European sovereign debt morass arises, comes down to a dispute between the Greek government and a group of private investors who hold large amounts of Greek bonds. These investors, many of whom appear to be hedge funds, are refusing to swallow as much loss as the Greek government demands. The Greek government is threatening default. The investors respond by, in essence, saying, "Go ahead. Make my day."

If the Greek government defaults, the investors will turn to credit default swaps they bought to protect against losses on Greek bonds. These CDS's are like insurance coverage against a Greek default. The government wants the investors to "voluntarily" agree to concessions, which wouldn't trigger CDS payouts. The investors have bargained hard, apparently emboldened by the knowledge that they can turn to their insurers if negotiations fail and Greece defaults.

Although usually described as insurance, the CDS's in this instance are being used for speculative purposes. The hedge funds may actually profit more by forcing the Greek government to default, than by working toward a consensual resolution. A default could have severe consequences, triggering a credit crisis in Europe that could circumnavigate the global financial system at the speed of a broadband Internet connection and plaster the world economy with a major credit crunch. Economic dislocation and recession would surely ensue.

When an "insurance" contract turns out to encourage recklessness, it has failed. Insurance is meant to protect against outsized loss, not to encourage insureds to foster or instigate losses. CDS's appear to be motivating speculators to disrupt a nation's finances. That's undesirable, no matter how you look at it.

Regulators and the financial services industry have done little to prevent derivatives, and credit default swaps in particular, from wrecking the financial system, as happened in 2008. Now, derivatives again pose a similar danger. People who don't learn from their mistakes are doomed to make them again. A sense of impending doom is growing.

The EU Sovereign Debt Crisis: A Farewell to Globalization?

Today, the Federal Reserve announced a new round of stress tests for the six largest American banks to find out how well they would withstand a market discombobulation emanating from the EU sovereign debt crisis. Translated from regulatory speak to plain English, this is a strong hint to the big banks that they straightaway ditch as much of their EU exposure as they possibly can, devil take the hindmost. Those banks that don't move with alacrity will be required to boost capital levels, an exercise detested by bonus loving bank executives (which would be about all of them).

It is ironic that the Fed would try to quietly build a firewall around the U.S. banking system. It has preached internationalism throughout the past four years as the financial markets belly flopped, and maintains generous dollar-denominated lines of credit to foreign central banks. The latter measure helps the dollar fulfill its role as the world's reserve currency, ensuring that there are enough dollars for the wheels of commerce. But encouraging major U.S. banks to offload Euro-denominated obligations de-globalizes. In effect, the Fed is saying, "Lafayette, nous allons partir."

Euro-denominated investments will face downward price pressure if U.S. banks begin casting them away. The Fed surely knows this would be bad for the EU's banking system, which is desperately reaching for any lifeline in turbulent seas. One can't help but wonder whether the Fed has concluded that the EU may not be able to pull itself out of its nosedive.

Italy: A Financial Run in the Making

If you ever wanted to see what a bank run looks like, you can watch the 1946 film, It's a Wonderful Life, starring Jimmy Stewart, or you can watch Italy. Greece's deterioration in the past few weeks laid the foundation for Italy's distress. As Greece was sucked down the drain, Italy began wavering, and then wobbling. Now, yields on Italy's bonds are skyrocketing, exceeding 7%. That's the range bond yields for Greece, Ireland and Portugal reached before those nations went down the tubes. Italy isn't literally a bank, and holders of Italian bonds can't go to the counter and make a withdrawal. All they can do is sell in the secondary market for whatever price is available, and lots of them are.

Rumor has it that the ECB is buying Italian bonds in an effort to stabilize the situation. But that would be a temporary measure. The ECB by itself is a wee bazooka, unless it starts printing money and that's not allowed by its charter. The EU has already announced that it has no plans to bail out Italy. Indeed, its bailout fund, the EFSF, doesn't have enough money to bail out Italy. Nor does the IMF. Nor do the Chinese or the Brazilians. Eyes will inevitably turn toward America. But the political situation here precludes a fiscally funded bailout for Italy. And the Fed, which has no compunctions about printing money, can't print Euros. Its bazooka uses different ammo.

Italy is on its own, and Jimmy Stewart is no longer around to step in and calm things down. It's up to Italy to persuade the fixed income vigilantes that it can pay its debts as they fall due. That's a tall order in this time of Euro-skepticism.

Compared to Italy, Greece has a small amount of sovereign debt outstanding. Yet Greece's problems were enough to knock down a major European bank, Dexia, and a significant American brokerage firm, MF Global. If Italy's bonds maintain their downward trajectory, it's entirely possible that more financial firms will fail. Sadly, we don't have enough readily available information about the bond holdings, derivatives exposures and counterparty risks of financial institutions to easily predict which ones might be in trouble. That lack of information exacerbates the potential for systemic risk. Volatility reigns supreme in the financial markets.

The Greek Referendum: What European Union?

Is there even such a thing as the European Union? The Greek prime minister, George Papandreou, has just announced an impromptu referendum to be held toward the end of this year, in which the Greek people will decide if they will accept the austerity and other measures required by the EU's bailout of Greece. The referendum was not previously mentioned by Greek leaders to the EU, and the EU is displeased, to put it mildly. It's holding back a bailout payment of 8 billion Euros that was to have been given to Greece in mid-November. Greece hasn't back down, and EU leaders are suggesting that Greek voters be asked to decide whether or not Greece should remain in the EU. Who knows? The Greek electorate may respond with a digital salute.

The Greek prime minister also faces a no confidence vote this Friday, Nov. 4, 2011. His legislative majority has been shrinking, and he officially has just barely enough votes to survive. If the no confidence vote fails, Greece will hold early elections. Those could further delay implementation of the EU's bailout plan.

The referendum and no confidence vote throw a massive wrench into the EU's governance "process." As it is, the EU has no established way to deal with a problem like the ongoing sovereign debt crisis, in which its very existence could be threatened. Europe's leaders have been winging it, meeting every week, and issuing innumerable upbeat press releases to manipulate the financial markets upward. Somehow, this ad hoc process produced a back of the envelope bailout that might at least delay the day of reckoning. But all the EU's efforts have now been suspended by the unexpected announcement of the Greek referendum and no confidence vote.

The referendum and no confidence vote demonstrate that there simply is no European Union. At its moment of greatest crisis, the fate of the EU rests on a snap decision by a Greek politician to hold a plebiscite and a no confidence vote. No one else in the EU signed off on this sui generis procedure. Yet, the EU, its currency, its financial system and its economic fortunes rest on the political vagaries of a country whose GDP is maybe 2% of the EU's GDP. There isn't a European Union. The EU has no rules, no governance process, no decision makers and no efficacy. It's like a group of people who have jammed themselves onto a very small life raft and are working against each others' efforts to keep the thing from tipping over.

If the EU blows up, the rest of the world will be dragged down as well. All this because of the political dysfunction of a nation with 0.5% of the world's GDP. That the fate of the European Union, and the world's financial system and economy, should rest on the electoral process of a small nation like Greece suggests that the interconnectedness of the world's financial system and economy has gone too far. Technology, derivatives and other linkages allow capital--and more importantly, financial risk--to flash around the globe almost instantaneously. While that's good when life is copacetic, reality is that some days are rainy. Today's hyperquick, hyperactive, and opaque financial system guarantees not only that capital flows immediately to the most attractive profit opportunity, but also that risk and financial contagion move equally fast in unpredictable, and therefore unhedged, ways. It may be time to establish significant limits on the extent to which financial risk can be palmed off. When faced with risk, people have a tendency to become responsible. But when you can pass the hot tamale to someone else, expediency trumps maturity. What we desperately need today is responsible behavior.

The only firewall left for the financial system is the taxpayer. Because taxpayers are becoming increasingly stressed, central banks have printed or will resort to printing money. This isn't a solution, just a kick of the can down the road. The Greek prime minister's decision to hold a referendum and no confidence vote serves as a reminder of a truth that is rarely acknowledged: there is no way of the current financial crisis without serious pain for everyone. The Greek prime minister is asking Greeks to grow up, face the fact that they will have to endure tough times, and agree to take their castor oil. Sooner or later, the rest of the world will have to do the same. But their politicians and other leaders continue to spin tales of Lake Wobegon, where everyone is in the top 1% and occupies only executive suites.

The Really Bad Thing MF Global Did

Perhaps the worst thing MF Global did wasn't lose a pile of money speculating in hinky European sovereign debt, although that was a pretty astounding belly flop for a firm run by a former Chairman of Goldman Sachs. It was that the firm evidently tapped hundreds of millions of dollars of client funds for its own use as its fortunes tumbled. See http://www.marketwatch.com/story/mf-global-tells-officials-clients-money-used-ap-2011-11-01 and http://www.cnbc.com/id/45122955.

The financial markets have, since the Middle Ages, been built on trust. Without trust--especially by customers of financial institutions--the financial system couldn't exist. Brokerage firms such as MF Global are required by law to segregate customer assets and keep detailed records of customer accounts, so that the other people's money with which the firm is entrusted remains intact. When a firm uses customer funds for its own purposes, it violates the most fundamental principle of the customer-broker relationship: that the firm will be a faithful custodian of the customer's assets.

MF Global's customers appear to have primarily been big, fast money players, hedge funds and the like that can move their accounts at a moment's notice. MF Global also appears to have financed its activities with short term credit--financing that can evaporate faster than frontrunner status among GOP contenders for the Presidency. Running a firm with short term financing and professional money managers for customers is like drinking with a bunch of Good Time Charlies. If the bar stops running a tab for you, your drinking buddies will duck out the door muy pronto.

With the news about MF Global indulging in some helpings of customer money, a lot of hedge funds and other customers will be giving their brokers sidelong glances, looking for any flinching, eye shifting, throat clearing, hand rubbing, feet shuffling, or other signs of uncertainty. Lawyers up and down the length and breadth of Wall Street are preparing customer requests for withdrawal of accounts in draft form, ready to be delivered by e-mail, courier, snail mail, Pony Express, and even carrier pigeon at the first hint that a broker is in even a scintilla of trouble.

By casting a dark shadow over the trust between customer and broker, MF Global may have done far more damage to the financial system than its proprietary trading losses and whatever ripple effect that may have with the firm's counterparties. Now, every broker on the Street is suspect. Prudent money managers may presume that their brokers are guilty until proven innocent. The chances of further instability in the financial system has increased. Tighten your seat belt, because the ride could get rockier.

Dexia and MF Global Holdings: Canaries in the Financial Markets?

Financial market volatility as we've had in recent months inevitably takes a toll if it continues long enough. A few weeks ago, a large Belgian-French bank, Dexia, was bailed out and partially nationalized after sustaining heavy losses from the European sovereign debt crisis. This weekend, news services report that MF Global Holdings, a financial services firm, is on the ropes because of sizeable losses in proprietary holdings of European sovereign debt. MF Global and its advisers have reportedly been seeking to sell part or all of the firm, but no transaction appears imminent. This evening (Sunday, Oct. 30, 2011), we now learn that the firm has hired bankruptcy lawyers. http://www.marketwatch.com/story/mf-global-hires-bankruptcy-lawyers-wsj-2011-10-30?link=MW_home_latest_news, and http://www.reuters.com/article/2011/10/30/us-mfglobal-idUSTRE79R4YY20111030?feedType=RSS&feedName=topNews&rpc=71.

Because Dexia is a bank, its bailout was not a particular surprise. The EU could hardly allow a major bank to collapse at this moment of crisis, lest its entire financial system nosedive.

MF Global, however, isn't a bank and doesn't have a hovering government Sugar Daddy waiting to hand over a blank check. It brokers derivatives transactions, and its operations include the clearance and settlement of derivatives trades. It also trades for its own account. The firm reportedly held about $6.3 billion in hinky European sovereign debt, and disclosed a quarterly loss of $191.6 million on Oct. 25, 2011. Moody's and Fitch have lowered MF Global's credit rating to junk, which could disrupt its normal access to credit. Some brokerage customers have apparently been exiting, stage right. Press reports indicate that, to maintain liquidity, MF Global has drawn down two bank lines of credit. Its banks include Citigroup, Bank of America and J.P. Morgan Chase. That these big boys would allow MF Global to tap out its lines of credit indicates a difficult situation. One surmises that MF Global may be facing a potentially major run by customers and, with its banks' assistance, is doing whatever it can to buy time to find an acquirer.

MF Global hired three of the largest law firms in New York to assist in a possible bankruptcy: Skadden Arps Slate Meagher & Flom, Weil Gotshal & Manges, and Sullivan & Cromwell. Chances are it wouldn't hire firms of this size and stature unless something very big might happen very soon. These firms can, on a moment's notice, throw legions of lawyers onto a matter such as a bankruptcy of MF Global. The retention of such massive potential legal resources doesn't signal a bright near term future for MF Global.

What's unclear from news stories is the condition of MF Global's derivatives clearance and settlement operation. Such operations typically are protected by the capital of the settlement and clearance firm, which may also hold collateral from counterparties. A crucial question is whether losses from the proprietary trading could spill over into the brokerage operation and impair its ability to honor its brokerage and clearance and settlement obligations. If so, the value of an unknown quantity of derivatives transactions could be thrown into doubt. Were that to happen, a pathway for financial contagion could open up and spread outward into the larger financial system. If there is a potential for financial contagion to spread, expect the Federal Reserve to open the monetary floodgates.

The MF Global situation provides yet even one more reminder that we really need to implement a new regulatory regime for derivatives. The possibility that a derivatives broker, that provides clearance and settlement services, might put customers at risk from its proprietary transactions is simply unacceptable today. For many decades now, clearance and settlement in the stock markets have been legally insulated from proprietary trading, and separately capitalized. Mistakes and misjudgments at proprietary trading desks shouldn't be able to blindside clearance and settlement customers. The Dodd-Frank legislation provides a framework for making clearance and settlement in the derivatives market much more rigorous and secure. With all the volatility we've had, it's entirely possible that more financial firms beyond Dexia and MF Global are headed for the shoals. How many more canaries in the financial markets need to stop tweeting and fall over before we have reform?

The EU's New Bailout: Who's the Sugar Daddy?

The EU's new bailout plan may be a somewhat clever bit of financial engineering. But one wonders if it isn't too clever by half.

For political purposes, holders of Greek debt "voluntarily" agreed to 50% haircuts, giving Greece about 100 billion Euros (or $140 billion) of debt relief. It's important that the haircut be deemed voluntary, or credit default swap counterparties (i.e., insurers against a Greek default) would have to make payments to holders of Greek debt. Such payments could make the contagion spread farther out into the financial system and financing costs for other weak EU member nations could rise. Plagues are harder to contain the wider they extend, so preventing this deal from triggering a requirement for CDS payments was deemed essential.

How voluntary the haircut is depends on how much you avert your eyes. With the heads of the German and French governments directly "discussing" the issue with them, Greek debt holders may have received considerable official guidance as to where their hearts and minds lay. Since most Greek bonds are held by banks that are "volunteering," those banks won't seek payment under their CDS contracts. The nonbank holders of Greek debt could do so, but they don't hold so much that they couldn't be paid off in full if necessary without disturbing the waters tumultuously.

Of course, CDS dealers may be alarmed tonight. If CDS holders can't recover in a scenario such as today's, there would be little incentive for them to continue buying CDS's, and the CDS market could collapse. Some might think that would be a good thing. While most financial industry bigwigs, economists and politicians would say that the connectedness of the world's economy and financial system is good, there can be too much of a good thing. With so much of the international financial services industry devoted to shifting risk around, instead of helping real businesses raise capital, it's reasonable to ask whether financial interconnection has been taken too far.

But we digress. The haircut banks will take on Greek debt will be softened. Greece will issue 100 billion Euros of new debt for the remaining 50% of the old debt that isn't being written off. This new debt will be supported by 30 billion Euros (or some $42 billion) provided by the EU as collateral. In other words, the EU is absorbing 30% of any losses on the new debt. But where will the EU get this 30 billion Euros? The EU's rules preclude central bank printing of money.

That leaves you-know-who to foot the bill.

The big banks in the EU will be required to boost their capital by a combined 100 billion Euros (or $140 billion) over the next eight months. This should help create a firewall around the EU sovereign debt crisis, and hopefully prevent it from spreading beyond the weak nations that are already on the ropes. One minor detail, though: where will the 100 billion Euros come from? Although EU banks might be required to refrain from paying dividends, and try to issue new stock to raise capital, it's doubtful they can put together 100 billion Euros in the next eight months. With the tens of billions of losses these banks are facing from Greek and other debt, they may not have that much in the way of profits to add to capital. And what legion of private investors would want stock of the pigs in a poke that the EU's banks have become?

That leaves you-know-who to recapitalize the EU's sick banks.

The third component of the new EU bailout is the leveraging of the remaining uncommitted 250 billion Euros in the EU's bailout facility created last year, the EFSF. Apparently, this money will be used to guarantee 20% to 25% of the value of new bonds to be issued to replace dodgy debt of shaky EU members. Because of the guarantee, it is hoped that bond vigilantes will accept lower interest rates on the new debt that will alleviate the financing costs of the spendthrift nations that are dragging down the EU. In theory, this isn't a bad idea. All we need now is a trillion or so Euros (or about $1.4 trillion) to invest in the new leveraged bonds.

Rumor has it that China and Brazil might help to bail out the EU. China has a $6 trillion GDP and Brazil's is $2 trillion. It's hard to envision these two developing nations trying to explain to their own less well-off citizens why anything approaching $1.4 trillion of their wealth should go to bail out the much wealthier citizens of the EU. China may kick in a few tens of billions, Brazil somewhat less. But that would leave well over a $1 trillion to go.

Politics prevent the U.S. from directly providing any assistance. The IMF, with a balance sheet in the range of $400 billion, couldn't bite off a real big chaw of the needed $1 trillion plus. And with the effectiveness of CDS's to offset default risk now in question, what army of private investors would touch these puppies with a ten-foot pole? Perhaps the EU's banks could be persuaded to "voluntarily" buy some of this sh . . . stuff. But at this point, the EU's banks aren't much more than conduits for losses to fall on you-know-who.

That leaves you-know-who to pick up the tab.

Taxpayers of the wealthy EU nations may be approaching a state of bailout fatigue. Add up the $42 billion in collateral for new Greek bonds, $140 billion for bank recapitalization, and $1 trillion or more for leveraged bonds, and you get $1.2 trillion plus. The good burghers of Germany, the Netherlands, Austria and the other wealthy EU nations will, at a minimum, scowl deeply when they realize what the new EU's new bailout means. Perhaps they'll cough up the money. Then again, when this much is involved, they may balk.

Without solid sources of funding, the EU's new bailout is the same as the emperor's new clothes. Clever financial engineering doesn't amount to jack if there isn't enough funding to make it work. And even if you look high and low, it's hard to find the EU's sugar daddy.

Credit Rating Agencies: the EU Targets the Messengers

The Wall Street Journal reported on P. A11 of its October 21, 2011 edition that the European Commission, the executive and administrative arm of the European Union, may ban credit ratings for the sovereign debt of EU member nations that are in bailout negotiations or receiving bailouts. In other words, the credit reporting agencies would not be allowed to issue ratings for EU sovereign debt that investors would really want to have rated.

Information is the lifeblood of the financial markets. Without adequate information, there is no rational way to price a financial instrument. The value of information is well-evidenced by the flurry of recent insider trading cases brought by the SEC and the U.S. Department of Justice. Information can be so valuable that some people will break the law to get it.

Now, the EU proposes to have investors plunk their money down for the debt of dodgy nations without knowing a crucially important piece of information--the credit rating. The credit rating agencies attained their prominent role because the financial markets are too complex, arcane and obscure for even many intelligent and diligent investors to comprehend. While these agencies have hardly covered themselves with glory in recent years, their assessments are held by many to be important (as well as being pertinent to those institutional investors that by law can hold only investments with certain ratings).

Shushing up the credit reporting agencies will have precisely the opposite effect intended by the EC. If deprived of important information, investors will become less confident, and their interest in buying or holding non-rated debt will diminish. The price of non-rated debt will likely plummet, and only vulture funds will profit. Other institutional investors and banks will take more losses than they've already sustained. The ability of the weak members of the EU to access private capital markets will evaporate, and Europe's taxpayers will be presented with more chits to pay.

That the EU wants to muzzle the messengers confirms the profound difficulties of its situation and the diminishing chances of successful resolution. Such blatant acknowledgement when the EU's leadership still claims it can wrassle this debt gator tells you that panic has set in among EU insiders. And where there's panic, bad things are likely to follow.

The Failure of Bank Stress Testing

The EU sovereign debt crisis has put the lie to bank stress testing. Stress tests--analyses that supposedly test a bank's ability to survive one or more hypothetical financial crises--have been used by American and European regulators in an effort to evaluate the strength of banks. The American tests weren't followed by the immediate bailout of tested banks (although TARP, bounteous Federal Reserve subsidies and credit lines, and politically driven changes in accounting rules were much more important to their survival than stress testing).

Europe's tests were embarrassingly less accurate. Weeks after passing the first round of stress tests last year, major Irish banks needed government bailouts. Dexia, a Belgian-French bank that just got a bailout, passed the stress tests twice. This summer, stress test results announced in July indicated that only eight European banks failed, having a combined capital shortfall of 2.5 billion Euros ($3.5 billion). Now, as EU leaders squabble over the terms of the next humungous bailout, current estimates of the capital shortfalls of EU banks range as high as 80 billion Euros. To go from needing 2.5 billion Euros this past July to perhaps 80 billion a period of three months is suggestive (to say the least) of flaws in the testing process.

Comically, Europe's banking regulators are about to conduct a third round of stress tests. Major European banks are reportedly trying to shrink their balance sheets and beef up their capital in anticipation. But what's the worry? Based on our experience with the past two rounds of stress tests, we already know what results will be announced. All that's need is for the EU's regulators to figure out what assumptions are necessary for them to sound Panglossian.

You can make stress tests come out any way you want, by using the right assumptions about how bad the financial markets will get and how to value assets. Europe's stress tests might provide good fodder for the opening monologue on the Tonight Show. But don't bet your badly battered retirement savings on them.

Barack Obama's Lucky Breaks

Barack Obama is a lucky man. Even as the economy idles in neutral and his ratings sink, good things keep happening to him.

Lucky Dollar. Europe's debt crisis is getting worse--a Belgian bank was just nationalized, which means more liabilities for Belgian taxpayers. The dollar remains attractive and capital is flowing into high quality dollar denominated assets. Interest rates remain low but the strengthened dollar prevents a flood of capital out of the U.S.

Bad Guys Can't Hide. U.S. counterinsurgency forces have successfully dealt with bin Laden and Awlaki. Although this is mostly the result of patient, painstaking intelligence work, there's an element of luck in these successes and Obama has been very lucky in the war against terrorism.

Occupy Wall Street. This largely spontaneous protest movement provides the Democrats with an opportunity to organize a counterweight to the Tea Party. In his typically cautious style, Obama waited three weeks before speaking favorably of the Occupiers. The protests give him an opportunity. He's lost most of the popular groundswell that got him elected in 2008, and Occupy Wall Street let's him recover some of his losses. Not all Occupiers like Obama. But not all Tea Partiers like the Republicans and that didn't prevent the Republicans from co-opting the Tea Party movement.

Stock Market Loves Big Government. Ignore what Wall Street says and watch what it does. Today, the Dow Jones Industrial Average rallied some 330 points on vague promises by France and Germany to do something or other to support their banks. Also heartening for stocks was Belgium's nationalization of a sovereign debt-laden bank, Dexia and, Belgium's, France's and Luxembourg's guarantees of some 90 billion Euros of Dexia's future borrowings (which presumably would be used to pay existing creditors off). In other words, losses that would have fallen on financial market participants will now fall on European taxpayers. If you're a banker, you gotta love that. Since Obama's principal policy options at this point are one variant of big government or another, he's lucky to have a stock market that will cheer his every policy success.

The European Union: All For . . . Well, Let's Think About This

Like the middle of a horror movie, this weekend's inconclusive meeting in Poland of Europe's finance ministers revealed growing realization of how scary the EU's sovereign debt problems have become. The ministers couldn't agree on how to stop Greece's plunge toward white water. But did they did acknowledge the need to strengthen the capital positions of their banks. In plain English, this means they haven't figured out how to put out the forest fire. But they are leaning toward building firewalls around their own borders.

This subtle shift toward self-preservation is a small step back from Greece's outstretched hand. Just a few months ago, European leaders loudly, if not entirely convincingly, proclaimed all for one, one for all. Now, their eyes flick nervously from side to side as they maneuver to see who gets the hot tamale (read, the cost of yet again bailing out the Greeks). Private capital is vamoosing from the markets for the sovereign debt of weak EU member nations. The ECB has stepped in by buying, or lending against, the dodgy debt. But that can't continue indefinitely, as the ECB isn't supposed to be a bailout fund. Greece has repetitive failure syndrome when it comes to meeting the conditions for bailout monies from the EU. While Germany and France have thus far dispensed enough bailout funds to prevent Greece from technically defaulting, they can't continue writing blank checks forever.

Some of the finance ministers testily rejected suggestions by U.S. Secretary of the Treasury Timothy Geithner to increase leverage for pan-European bailout funding, and to apply greater fiscal stimulus. Of course, it's their money he wants them to spend, and their national wealth he'd put at risk. So he's not quite the hit as was, say, George Marshall.

What the EU would be willing to do--the $64,000 question--remains a mystery. Perhaps the ministers like it that way. Last week, the stock market rallied almost 5% on nothing more than gossip, whisper and innuendo about European intentions to do the right thing, or something like that. If a few leaks and whispers to journalists can turn the markets around like this, why spend any money on bailouts? Just keep gabbing to the financial press, prop up the markets, and wink at your constituents while gullible stock investors make you look good.

Europeans are very good at inaction. As long as the stock market responds so deliriously to talk therapy, expect the EU to yak ad nauseum. There's nothing like a free ride, and last week's stock rally cost the EU nothing. One might harbor suspicions about stock valuations based on politicians babbling. But, then again, as we know from the tech bubble and the real estate/mortgage bubble, markets love bubbles. The European sovereign debt crisis will bubble along until some unexpected singularity pops up and the bubble painfully bursts. Then, investors will once again learn that irrational hope doesn't translate into financial gain.

But, in the short run, the EU and other government officials, ever Pavlovian, will dangle faint glimmers of hope. Today's market is all government, all the time. Take government out of the picture, and the market tanks. Knowing that, the Fed will reincarnate the "Twist" at its meeting this coming week--not the dance (perish the thought of Fed Governors dancing), but a lengthening of maturities in the pool of Treasury securities held by the Fed. This maneuver is meant to make the yield curve undulate, with shorter term rates rising a bit while mid-length maturities drop. Whether it will actually stimulate the economy is open to question, but one suspects that the Fed's main goal is to keep stock investors giddy by at least creating the appearance of not sitting on its hands. (Parenthetically, the Fed's Twist will flatten the yield curve, and a flat or inverted yield curve is often taken by market prognosticators as a sign of an impending recession; but interest rates are now completely controlled by government fiat, and entrails aren't likely to mean what they used to mean.)

The G-20 is meeting toward the end of the week. This consortium of large economies provides the EU and the U.S. with another public relations opportunity to hint at succor for distressed EU member nations. While it's doubtful that the G-20 will offer more than vague expressions of concern, you can bet that it will do a little fan dance for the stock market to lure in those investors desperately seeking any straw to grasp. One could fairly observe that this silliness can't continue forever. But market bubbles last longer and rise higher than anyone might reasonably expect. And this is a government bubble. Politicians, being quintessential windbags, will bloviate as long as anyone is around to listen. So this bubble might last for a while. But when the government bursts--and all bubbles eventually burst--who will provide the bailout?