Todd Harrison: Here Comes the Contagion

Times are tough and those struggling to make ends meet have focused their efforts close to home.

That’s a natural instinct but it doesn’t change the fact that problems on the other side of the world affect us all. To fully understand the depth and complexity of our current conundrum, we must appreciate how we got here.

It is widely accepted that grieving arrives in five stages: denial, anger, bargaining, sadness, and acceptance. If we apply that psychological continuum to the financial market construct, it offers a valuable lens with which to view this evolving crisis.

Denial

In April 2007, policymakers assured an unsuspecting public that housing and sub-prime mortgage concerns were “well contained.” Minyanville took the other side of that trade and argued that the nascent contagion extended all the way around the world. (Read more in Well Contained?)
In August 2007, as the Dow Jones Industrial Average traded near an all-time high, Canadian officials told investors it would “provide liquidity to support the stability of the Canadian financial system and the continued functioning of the financial markets” before systemic contagion ensued. (See also The Credit Card)

In March 2008, Alan Schwartz, CEO of Bear Stearns appeared on CNBC to assuage concerns that his firm was facing a liquidity crisis. “Some people could speculate that Bear Stearns might have some problems since we’re a significant player in the mortgage business,” he said, “None of those speculations are true.”

On January 28 of this year, Greek Prime Minister George Papandreou offered that Greece was being victimized by rumors in the financial markets and denied seeking aid from European partners to finance the country’s budget deficit, according to Bloomberg. As we know, European issues are now staking claim as the next phase of the financial crisis.

Anger

Two of my Ten Themes for 2010 are relevant to this discussion. The first is the “tricky trifecta,” or the migration from societal acrimony to social unrest to geopolitical conflict. Populist uprising, the rejection of wealth, and an emerging class war are symptomatic of this dynamic, as is the unfortunate fact economic hardship traditionally serves as a precursor to war.

The other theme is the notion of “European Disunion,” as I wrote in early January:
 

The European Union is committed to the regional and economic integration of 27 member states, with sixteen countries sharing a common currency. That was a fine idea when it was first founded but the economic fallout of the financial crisis will put loyalties to the test.

Look for the Union to adopt more stringent guidelines in the coming year, including but not limited to distancing itself from the weaker links such as Greece and Ireland. Sovereign defaults, as a whole, should jockey for mind-share. This could conceivably spark a rally in the US Dollar, which could have ominous implications for the crowded carry trade.

European discontent continues to simmer with labor strikes and social strife as efforts are made to map an amenable plan before €20 billion ($28 billion) in Greek debt comes due in April and May. While that amount is far smaller than what financial firms faced in September 2008, the dynamic is earily reminiscent. (Read also Pirate’s Booty)

Bargaining

By the time it was evident sub-prime mortgage woes weren’t contained, the damage already occurred. Our government reactively responded to the crisis by consuming the cancer in an attempt to stave off a car crash. (See also Shock & Awe)

As the European Union and International Monetary Fund wrestle with how to address the sovereign mess, our financial fate can be drilled down to one very simple question: Will we see contagion, as we did with Fannie Mae (FNM), Freddie Mac (FRE), AIG (AIG), Bear Stearns and Lehman Brothers, or will the current congestion be contained in the context of an evolving globalization?

The bulls will offer that corrections must feel sinister if they're to be truly effective. They’re right, of course, but I will remind you of a salient point made by Professor Peter Atwater on Minyanville. If sovereign lifeguards saved corporations when the financial crisis first hit, who is left to save the lifeguards?

Over the last few weeks, we’ve seen significant widening in overseas credit spreads, including Hong Kong, Switzerland, Indonesia, Malaysia, Portugal, and New Zealand. As markets are fluid and policy takes time, the lag must be factored into the fragile equation, particularly as the European Union is structurally interlinked.
Sadness 
We can talk about how the capital market construct forever changed, how our constitutional rights have been challenged or how the lifestyles of the rich conflict with the struggle to exist. While those dynamics remain in play, they miss an entirely more relevant point for purposes of this discussion. (See The Declaration of Interdependence)

Social mood and risk appetites shape financial markets. One of the greatest misperceptions of all time was that The Crash caused The Great Depression when The Great Depression actually caused The Crash.

It’s been a full year since Minyanville fingered Eastern Europe as a modern day incarnation of a sub-prime borrower. The question is therefore begged, what if Greece is Fannie Mae, Portugal is Freddie Mac, Spain is AIG, Argentina is Wachovia Bank, and Ireland is Lehman Brothers? (Also read Eastern Europe, Subprime Borrower)

Contagion, by definition, arrives in phases and we must remember that Greece is a symptom of the problem, not the problem itself. Regardless of what IMF or Euro Zone "cross border solution" we see, it'll simply buy time, much like the bearded nationalization of Fannie and Freddie pushed risk out on the time continuum.

Given the trending direction of social mood and the discounting mechanism that is the market, the perception that defines our financial reality must remain front and center in the mainstream mindset.

Acceptance

In September 2008, we offered that the government invented fingers to plug the multitude of holes that sprang open in the financial dike. That imagery would again apply if there were viable fingers attached to a healthy and able arm.

While many dismiss the notion that Greece or Portugal “matter” in the global financial construct, I’ll explain why they might. Concerns in the Euro Zone could manifest through a “flight to quality” in the US Dollar, as it has to the tune of 8% in the dollar index (DXY) since the December low.

Those hoping for a stronger greenback should be careful for what they wish, much like the "lower crude will be equity positive" crowd learned in 2008. In an “asset class deflation vs. dollar devaluation” environment, a weak currency is a necessary precursor to -- but no guarantor of -- higher asset class prices. (Se Hyperinflation vs. Deflation)

The hedge fund community currently has the carry trade on in size. If the greenback continues to strengthen, the specter of an unwind increases in kind. Should that occur, asset class positions financed with borrowed dollars would come for sale across the board.

The point of recognition will eventually arrive that our debt issues are cumulative; when that happens, the contagion will no longer be contained. In the meantime, as we edge from here to there, be on the lookout for the unintended consequences of European austerity initiatives, including but not limited to social unrest and the abatement of risk appetites.
Risk management over reward chasing as we together find our way.

Contagion Is a Myth; Only Weak Countries Catch It

May 10 (Bloomberg) -- Greece sneezes and Portugal catches a cold. Portugal coughs and Spain falls ill. Spain runs a fever and Italy comes down with the flu.
Contagion, or contagion theory, is sweeping the euro zone, where Greece’s debt crisis is infecting neighboring countries and threatening to make its way across the Atlantic to U.S. shores.
At least that’s what we’re told on a daily basis. European Central Bank council member Axel Weber warned last week of “grave contagion effects” for countries that have adopted the euro. “Greece Fuels Fears of Contagion in the U.S.,” trumpeted a May 6 Wall Street Journal headline.
I hate to pour cold water on that theory, but healthy countries aren’t susceptible to Greece’s disease. The sick ones, already plagued with high debt levels and bloated state budgets, don’t need a carrier. Capital flight from these countries “is not evidence of contagion,” said economist and author Anna Schwartz.
Of course, Schwartz said that in 1998 following the Asian financial crisis. In “International Financial Crises: Myths and Realities” (the Cato Journal, Vol. 17 No. 3), Schwartz punctured the notion that financial crises spread from the initial source to innocent victims. Nations are vulnerable because of their “home grown economic problems,” she said.
Schwartz’s insights are equally valid today. Capital isn’t fleeing sovereign debt markets in Spain and Portugal because Greece can’t pay its bills. Bond yields are rising because of an increased risk those countries may find themselves in the same boat as Greece: unable to meet their debt obligations.
Chronic Defaulter
OK, maybe not quite as leaky a boat. It would be hard to match Greece’s record of spending half the years since its independence in 1829 in default or rescheduling its debt, according to economists Carmen Reinhart and Ken Rogoff, authors of “This Time is Different.”
A single currency, it turns out, isn’t a panacea for everything that ails Europe. The 11 nations that scrapped their sovereign currencies and adopted the euro in 1999 never constituted an optimum currency area as envisioned by economist and Nobel Laureate Robert Mundell, the father of the euro.
“They don’t have a mechanism to deal with crises when they come up,” says Michael Bordo, professor of economics at Rutgers University and author of a book on the history of monetary unions. Europeans knew if they ceded domestic monetary policy to a centralized European Central Bank they would need “labor mobility and/or transfers from healthy states to weaker ones to deal with asymmetric shocks,” he says.
Fiscal Transfers
Europe has neither. Political union is still a dream. Germans are still Germans, and Greeks are still Greeks. The man on the street in Dusseldorf probably doesn’t understand why the German government has to fork over what could be his pension to a country for whom default is a way of life.
Political union isn’t a prerequisite for dealing with a sovereign debt crisis. What’s needed is some kind of a priori agreement on how fiscal transfers are to be carried out, says William White, chairman of the Economic Development and Review Committee at the Organization for Economic Cooperation and Development. In the case of the euro zone, “they were short of a few fiscal elements,” he says.
It’s far from clear the German public would have supported such transfers from strong to weak countries, White says. Especially if it’s the same profligate nations, such as Greece, that keep feeding at the trough.
Wake-Up Call
That said, European leaders have invested too much political capital in a united Europe to turn back now. Germany’s Parliament approved a package of loans to Greece on Friday, part of a 110 billion euro ($142 billion) package from the International Monetary Fund and European Union. Greece approved an austerity plan in exchange for the bailout.
“This should be a wake-up call to design mechanisms to deal with crises and enforce the rules” on debt and deficits, Bordo says.
The 1992 Maastricht Treaty outlined four convergence criteria for joining the European Monetary Union, including a maximum deficit-to-GDP ratio of 3 percent and debt-to-GDP of 60 percent. Last year Greece’s deficit and debt were 13.6 percent and 115 percent, respectively, as a share of the economy. All of the infected countries, and a few that haven’t caught the disease yet, are well in excess of those limits. The U.K., for instance, which is benefiting from capital flight out of Europe’s Club Med countries, ran a deficit last year that was 11.5 percent of GDP.
Investors may flee the U.K. at some point, but it won’t be because it caught anything from Greece.
Incubation Period
There is no question we live in an interconnected world. Subprime mortgage defaults by homeowners in Irvine, California, infected banks in Europe and Asia, thanks to the miracle of securitization.
So yes, European banks that hold Greek debt are vulnerable to losses. The interbank lending market is showing signs of stress. And the austerity measures required in Europe’s peripheral countries may spill over into reduced U.S. exports. That’s not the kind of contagion we keep hearing about.
On the other hand, it would be a mistake to interpret the flight-to-quality into U.S. Treasuries last week as a sign of immunity. The U.S. is already infected with the debt virus. It’s still in its incubation period.
(Caroline Baum, author of “Just What I Said,” is a Bloomberg News columnist. The opinions expressed are her own.)