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Clarity on the Europe Crisis

Pat Dorsey, CFA

Pat Dorsey: Hi, I'm Pat Dorsey, director of equity research at Morningstar.

With the credit crisis in Europe surrounding Greek's potential inability to pay its debts roiling U.S. and global markets, I thought it would be worthwhile getting some intelligent voices in on the discussion. I'm happy to have with me today the associate director for our banking team, Matt Warren, and securities analyst David Sekera, who has a lot of experience on the fixed-income side of things, to maybe help us put some context into what's been going on in Europe and how it might affect things here in the U.S. and globally.

Thanks for joining me, guys.

Matt Warren: Good to be here.

Dorsey: So big picture, a couple of weeks ago the European authorities announced a trillion-dollar shock-and-awe rescue package that had pretty much every securities market jumping up three, 3%-4% on Monday morning. A trillion bucks is a lot of money but doesn't seem to have been enough. Why is that?

David Sekera: As we've seen at the end of 2008 and beginning of 2009, the fixed-income markets seem to try and test the policymakers' resolve. And they want to make sure that it's really going to be there at the end of the day. Still needs to get passed through the different parliaments over in Europe. And we want to to see exactly how this mechanism is going to work at the end of the day.

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Dorsey: Because it was pretty thin on details when it was announced, right?

Sekera: Right.

Dorsey: Matt, anything you want to add to that?

Warren: In my mind it was a step in the right direction because what you had was the spreads on sovereign debt and your European bank debt was widening out. It wasn't trading very well. And that could lead to essentially a liquidity crisis if that continued down that road. So by putting a backstop in place to make sure that sovereign countries and the largest banks can roll their debt is a critical element of trying to arrest what's been going on in the markets and kind of turn it in a better direction.

Dorsey: Speaking of spreads, the spreads have really not improved that much though have they since that package was announced?

Sekera: Like the equity markets, spreads did tighten in quite a bit once that was announced, although we have seen spreads begin to widen out again, and we're starting to get to the same kind of wide levels that we saw before that announcement.

So now, interestingly enough, what we've also seen is increasing widening in especially the European financial spreads as opposed to the U.S. domestic spreads. We've gotten to those wides this morning, we seem to be holding there and, in fact, it looks like maybe we're kind of bouncing off of those wides. And it looks like maybe the market is getting a little bit more comfortable with the package.

Dorsey: And so do you think what the fixed-income markets are hoping for are just more details surrounding this package or perhaps some more concrete commitments by various European authorities?

Sekera: I think additional headlines will definitely help. Having some more concrete commitments will definitely help. And we also need to see the details of the package. When are ... the different countries going to be able to draw on this line? What are the terms of the line? What do they have to agree to? What kind of austerity measures are they going to have to agree to before they're able to access that line?

Dorsey: So let's turn the topic a little bit, Matt, maybe to this issue of contagion that people talk about. And just to put it bluntly, what does the ability of Greece to pay back its debts have to do with say Caterpillar's ability to sell big yellow machines that move dirt around?

Warren: There's a long chain between those two, but nonetheless they are connected. It's a question of if you're going to have sovereign failure in the EU, that's a big deal, because we're not talking about a small, immaterial region of the world financially. And so Greece itself might not be the most material link in that chain.

But if it becomes a situation of dominoes, so if Greece defaults and has a low payback on their debt, the folks that hold Portuguese debt, Spanish debt, are going to get awfully nervous that the EU is not there to back up the situation. So that debt is going to start trading much wider. And then you'll have problems with rolling debt. It could basically create problems with rolling debt in those countries as well.

And at some point you really need the European Union as a whole to really put in a firewall. You can question whether it should be at Greece, or at Portugal, or maybe you wait until the big country of Spain--which would be, in my opinion, kind of the linchpin in terms of the dominoes.

But you have a problem with sovereign debt. Banks own this sovereign debt so if you have large countries default, there's a lot of debt out there at European banks and insurance companies and everything else. So then you could have large financial institutions fail. If that happens, they're counterparties to all the large global banks, including ours, so then you'd have a problem with banking globally, you'd have a problem with the capital markets globally, then you'd have a problem with GDP globally.

And so there's a lot of links in that chain but if it does continue to escalate, that's where it could go ultimately.

Dorsey: Now with the names changed, it sounds like what you just described was the fall of 2008 and the subprime crisis in the U.S. What similarities and differences are there? Or are they pretty much exactly the same? Between what happened to cause the credit markets to lock up in late 2008, and what seems to be evolving in Europe right now?

Sekera: On the credit side, we are seeing very, very early indicators of some of the same kind of liquidity issues that we saw here in the United States. For example, what we call the TED spread, which is an indication of credit counterparty risk among the financials. It's starting...

Dorsey: It's basically how nervous banks about each other's ability to lend to each other.

Sekera: Exactly. And we are starting to see some widening in that over the past week. It's not to levels that I'm concerned about yet, but we've gone maybe from the mid-teens up to the low 30s, on basis point spread right now. It's still within pre-financial-crisis historical norms, but that trend is a little bit concerning. If it got up to 50, that would be the point where I would start to get increasingly more concerned that the banks really are very concerned about lending to one another.

Dorsey: And there's political risk here, right? Because you think about what happened in late '08, with the initial failure to pass the TARP package here in the U.S. And that kind of caused the markets to become a little unhappy for a while. But here you're dealing with not just one governmental entity, i.e. the U.S. Congress, you're dealing with several of them, who all have pretty much different interests, right?

Warren: Yeah, I view the politics as extremely difficult. We had enough problems politically to orchestrate the bailout of our financial institutions. And that's actually, banks earn money, so if you bail out the large banks, they can earn that money back, and pay you back, in most cases.

Here we're talking about they're trying to orchestrate a bailout of Greece, who might, ultimately, not be able to pay back all that money. I think that's a fair question on whether they can.

And then you have different interests, different sovereign, fiscal, authorities. You have very complicated politics of the ECB. I think that definitely adds a layer of complexity, and I think the markets are reacting to different politicians in different places, speaking out of one side of their mouth, and then the other, and really complicating the issue beyond what it already is.

Dorsey: And just to pick on something you mentioned, about Greece perhaps not being able to pay back its debts. Right now, the policy of the EU seems to be to kick the can down the road, sort of put a band aid over the wound. Why is that the better solution, than simply allowing Greece to default, bondholders take a hit, and you just kind of hopefully stop things right there?

Warren: I guess, in my opinion, it's Greece isn't the most material of the situations. And you could probably say the same about Portugal. But, really, when you get to Spain and Italy, these are large countries with a lot of debt, that a lot of financial institutions own. So if Spain and Italy were to ultimately come into trouble, as the dominoes continued to fall, that's where you have a real problem.

So the question is, just tactically, do you want to stop it dead in its tracks with Greece, which is where they seem to be going? Or are you willing to let a couple of countries potentially fail? And then draw the firewall on the more important, larger, countries. I think that's a debate they've probably been having in Germany and several other countries.

Dorsey: The odds of that are pretty good.

Warren: But it's an important question. You could argue one way or the other, but it's harder to stop the dominoes. I think we already saw that, in the last go-around here, in the last financial crisis.

Dorsey: It's a good point to wrap up on, which is that so much of this ties into basically political risk, and trying to handicap what different political parties in different countries in Europe, want to do. And experienced folks in this industry--I think you made the same point to me, David--say that political risk is the hardest thing to handicap. And, at the end of the day, that's kind of what we're waiting to see what happens, right?

Sekera: Yeah. As we talked about in our Credit Weekly last week, just the transparency difference from analyzing credit, fixed-income credit, from a sovereign perspective, versus a corporate perspective, is just a completely different animal. For us, we're much more comfortable being able to analyze a corporate issuer, really get our arms wrapped around it. Understand the inherent risks, understand the cash flows, understand the business, and be able to look at our risk-rewards, and figure out the upside and the downside.

Whereas, looking at sovereign issuers, as you mentioned, there's political risk. There's foreign exchange dynamics. By the time you get information out of a lot of sovereign countries, it's often outdated, and it's stale. Corporate issuers, you have a nice conference call every quarter. You get additional clarity. You can pick up the phone. You can call management, ask them questions.

Dorsey: You mean you can't pick up the phone, and call the Greek prime minister, and kind of get straight answers, David?

Sekera: I would love to. That would be a very interesting conversation.

Dorsey: No, those were great points to make. And I think, at the end of the day, we just kind of have to wait and see what plays out in the EU. Because, as Warren Buffett mentioned in the annual meeting a couple of weeks ago, we haven't seen this movie before.

...Where you have different entities with control over their budgets, but without control over their monetary policy. The euro is an experiment, and, at the end of the day, the experiment's going through some tough times right now. And we'll have to see if it ultimately succeeds.

I'm Pat Dorsey, and thanks for watching.