Eerie Similarities Surround European, U.S. Crises
Dec 3, 2010 Comments Off Pat Dollard
You’ll have to excuse many in the markets if it feels like that old Bill Murray movie “Groundhog Day.”
The panic gripping European bond markets in recent weeks is scarily similar to the fears that brought Wall Street to its knees two years ago.
In each case, asset bubbles imploded, financial markets seized up, leaders denied the extent of the problem, markets targeted the weakest link and taxpayers stepped in to save the day with bailouts that failed to address moral hazard.
“It’s eerie how similar that process has been. It just does not instill confidence,” said Peter Kenny, managing director at Knight Capital Group.
Both crises, of course, also share a parallel root cause: too much debt.
The U.S. was blindsided by a housing slump that left highly-leveraged Wall Street banks on the hook with toxic mortgages. Likewise, many European countries like Greece and Italy have racked up large amounts of debt, while Ireland experienced a housing bust that led to a bailout of its banks it could hardly afford.
Panics Spread, Denials Ensue
It’s also striking how each financial crisis preyed on its victims, going from one weakest link to the next.
In 2008, Bear Stearns, Wall Street’s smallest investment bank, became the first to experience a crisis of confidence, resulting in a fire sale to JPMorgan Chase (JPM: 39.63 ,+0.32 ,+0.81%). Six months later, the crisis claimed its next victim: Lehman Brothers, which became the largest bankruptcy in American history.
Similarly, last April Greece was the first European nation to see its bonds tumble and credit default swaps spike to such a level that it was forced into a bailout. It took seven months for the next weakest link — Ireland — to agree to its own rescue.
In each case, the bond markets didn’t stop there. On Wall Street two years ago, the markets targeted Merrill Lynch, Morgan Stanley (MS: 25.63 ,+0.04 ,+0.16%) and even Goldman Sachs (GS: 162.19 ,-0.12 ,-0.07%) next. Seeing the writing on the wall, Merrill quickly agreed to be swallowed up by Bank of America (BAC: 11.84 ,+0.17 ,+1.46%) and Goldman and Morgan converted to bank-holding companies.
This week Portugal and Spain sought to prevent the crisis from spreading to their nations, with Spain enacting a new package of reforms on Friday aimed at raising revenues to pay off its steep debts.
“While it may be panic, I think it may be well placed in some cases,” said Charlie Geisst, a finance professor at Manhattan College.
Denials fell on deaf ears in both Europe and Wall Street. In the U.S., big banks like Lehman swore they were healthy and regulators promised the subprime problem that sparked the financial crisis was contained.
In Europe, Greece and Ireland insisted they didn’t need help for weeks and months before finally accepting help.
“The history of central banks and governments drawing a line in the sand and then having the market walk all over them is a long and colorful one,” said Jim Rickards, a market intelligence consultant at Omnis. “The more these governments say they are not in trouble, the more they tell me they are in trouble.”
Moral Hazard Ignored
In each crisis, regulators have chosen not to address moral hazard, meaning investors, banks and nations have little incentive to avoid the same risky decisions in the future.
The U.S.’s TARP rescue may have helped stop the bleeding, but it did not make banks reform their shoddy risk management practices or force bondholders to take a haircut on their investments. In fact, aside from Lehman, most bondholders avoided punishment for their risky bets.
“These bondholders know they are buying a risky asset. Why should they be guaranteed a return?” said Cam Harvey, a finance professor at Duke. “Sometimes you win, sometimes you lose. They should be in the losing situation.”
Fearing a backlash that could make it hard to borrow from the bond markets, Europe hasn’t made bondholders take haircuts during the continent’s rescues of Greece and Ireland. While those concerns are probably merited, the approach also does little to change the risky behavior by both investors and policymakers.
“The longer you put that off, the bigger the rattle is going to be,” said Kenny. “The whole issue of moral hazard has been completely absent from the conversation. That’s why this all seems so surreal.”
Key Disparities
Of course, these crises are hardly identical and the differences could be crucial in determining whether Europe escapes its immediate crisis as the U.S. has.
The most important difference between the two incidents may be their size.
The Wall Street meltdown was actually quite “manageable,” Harvey said, pointing to the fact the U.S. banking sector’s liabilities accounted for just 15% of gross domestic product in 2008.
On the other hand, Europe’s banking liabilities as a percentage of GDP are much more daunting: 35% in Greece, 36% in Spain, 60% in Germany and France, 86% in Italy, 156% in the U.K. and a whopping 285% in Belgium, according to The New York Times.
European leaders also have more political headaches and fewer tools at their disposal than American officials had in 2008.
For starters, U.S. regulators had the advantage of managing the affairs of just one country. Europe is struggling to deal with a crisis that spans 16 separate nations with 16 separate needs, ideologies and problems.
Because the euro zone nations share a common currency, individual countries aren’t able to devalue their currencies as the U.S. has done by flooding the markets with more dollars. By printing more dollars, the Federal Reserve has been able to keep the dollar’s value low, thereby boosting exports.
“That’s a huge constraint on what [Europe] can do,” said Harvey.
Given those challenges, Harvey believes Europe’s crisis “is not manageable” and will likely lead to an unwanted outcome, such as debt restructuring, some kind of default or even the collapse of the euro.
