A Crisis Comparison

Pat Dorsey: Hi, I'm Pat Dorsey, director of equity research at Morningstar. It's another day in the life of "As the Euro Turns." First we had worries that Greece would default, then we had the massive shock and awe $1 trillion euro rescue package. And now we have the markets worried that perhaps the Europeans and the ECB may not back up that package as much with actions as they did with words.

A lot of folks are talking about, "Well, this just feels like 2007, 2008 all over again. We're just waiting for the sovereign version of Lehman. We're just waiting for that to happen, and then contagion will spread, and we'll be back to the very tight credit and financial lockup we had a couple of years ago across the world, but especially the U.S."

I think there are, though, two important differences between what happened in the U.S. housing market, which of course then affected the rest of the world in terms of the credit system, and what's happening right now in Europe. There are two big differences, as I see them, one good and one, frankly, not so good.

The difference that is actually I think positive in the sense of the current crisis going on in Europe is that the liabilities are much more transparent. If you think about what was happening in the U.S. housing market, especially with the subprime market in 2007, 2008, first of all, it was very difficult to know just what the scale of the problem was, because all of these mortgages had been made and sliced up and resold and securitized in lots of different ways. It was very difficult to get a feel for the scope of the problem. And, of course, the ultimate borrowers, all of these subprime borrowers, these people with poor credit, or who had been flipping houses and chasing a little bit much, there were literally millions of disaggregated agents. And so the ability to repay depended on all of their different individual financial conditions, and, of course, the prudence, or lack thereof, of the lending officer that made the loans.

Further complicating the situation, you had lots of lots of funky new products: collateralized loan obligations, CDOs, CDOs-squared, all kinds of things that really made the scope of the problem pretty tough to figure out.

I would argue that the current situation in Europe is much more transparent. We know were Greece is; I can find it on the map. I know where Portugal is; I can find that on the map, too. And I can get a pretty good feel of just how much debt is outstanding from either country, and just how much in taxes each country is bringing in in order to pay off that debt; just how much revenue they have to pay off that debt.

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So that means that although we may not know exactly who holds all the Greek debt or all the Portuguese debt, or Irish debt, or whatever, we have a pretty good feel of who the ultimate borrowers are--Greece, Portugal, etc.--and their ability to repay, or again, lack thereof.

So in that sense, I think this situation may not be as bad as ours was in 2007, 2008 because, frankly, the liabilities that are in question are much more transparent.

Now, for the bad news, which is that, at least in the U.S., you had some initial confusion and conflicts over how to solve the problem.

We all remember that when the first TARP package was not passed, the U.S. stock market did not take this too kindly and promptly smacked Congress in the face and said, "You should pass this now or the credit market is going to lock up pretty badly." And, of course, the U.S. Congress was all in the same boat. If the U.S. financial system locked up, they were all pretty much in deep trouble.

Now, unfortunately, not the same case in Europe. The Germans, and the French, and the Italians are in very different boats, in fact. Some are fiscally much more responsible than others. And so their interests are not aligned. And in fact, the ultimate incentives of all the politicians in the U.S. in late 2008, eventually they figured out were aligned, and that if the U.S. went down, they were all going down with it.

Now, Europe is a little bit of a different story. The incentives are not as aligned. Germany has very different incentives than, say, Italy does because their sovereign balance sheets are in very different shape. And because of that, the likelihood of dithering, the likelihood of actions not backing up bold words, such as the case in the trillion dollar package that was announced a week, 10 days ago, well, the odds of that are much higher. The odds that these bold words don't actually translate into actions, they are much higher.

And that is political risk at the end of the day, and political risk is about the hardest thing for financial markets to price. It raises the price of uncertainty quite a bit, because you just don't know which way politicians are going to go. There are a lot of different elements in there.

So I think that's probably the biggest negative with regard to the current crisis, relative to what happened in the U.S. in 2007, 2008, is that the actors, the different heads of European countries and the folks at the ECB, they, frankly, have different incentives. So they may not all be willing to take the same pain that the U.S. Congress was in, say, pushing all the liquidity out and passing TARP and giving the Fed the authority to do what it did.

So two big differences I see when you try to make an analogy between the current crisis in Europe and the U.S. subprime crisis; one positive in that the liabilities are much more transparent than the liabilities that caused all the trouble in the U.S. housing market. But, of course, on the flipside, there's always a dark cloud to every silver lining, the fact that the incentives are very, very different for the main actors in Europe, whereas the incentives in the U.S. were, at the end of the day, much more aligned because we were, frankly, all in the same boat.

I'm Pat Dorsey and thanks for watching.