Europe’s Flight to Quality

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Play me another hand,

Lose everything I am,

Until we meet again.

ELO, Electric Light Orchestra, Poker

Europe has up to now pointed the finger at the US, with disdain and possibly even a bit of brotherly annoyance at the mishaps of its adventurous, risk loving offspring. Europe has traditionally been more conservative, less leveraged – European stock markets had only gotten sort of a glimpse (albeit a dizzying one!) of the so-called “irrational exuberance”; economic growth had neither skyrocketed nor plunged and helping out with the Iraq problem while lending a bit of a sympathetic ear to the “humanitarian” side of the equation meant that it had also played its geopolitical cards somewhat more prudently – or so it would seem.

But during the second half of 2008, the picture started to change dramatically. In the stock markets, banks became the weak link, without warning. Europe’s champion of economic growth (the “European tiger”), Ireland, suddenly showed its first tangible, worrisome signs of fiscal problems. UK banks were quite uncharacteristically the first casualties and then focus turned on the usual suspects, peripheral debt laden economies such as Portugal and Greece, (along with Italy and Spain) that would (presumably) have trouble financing their debt. But the downhill was so steep, that even if this played out in the most catastrophic way imaginable – and so far it has not – it would actually probably be among the lesser of Europe’s worries.

Austria’s banking sector has bet 65-70% of the country’s GDP on Eastern Europe. The total debt of Eastern Europe seems to be in the ballpark of a staggering 1.7 trillion [ The Telegraph ]; under a worst case scenario, a very significant part of that could end up in default.

Essentially, all Eastern European economies are in danger of default, with Poland being in an admittedly better position but still in trouble. Back to the West, Greek banks – especially the National Bank of Greece (NYSE: NBG) – show fundamentally healthy balance sheets, but there is a substantial exposure to eastern economies (and therefore the risk of future write-downs and write-offs). NBG is further overexposed to the problematic Turkish economy, through its fairly recent acquisition of Turkish Finansbank. Austrian, Greek, Swedish, Belgian and Italian banks hold essentially the bulk of eastern debt. The banking sector of all these countries would be hard pressed to bail out the failing economies of the region while maintaining liquidity for their own markets as well. And re-routing funds received under bail-out schemes could very well prove destabilizing politically in the short term.

If US subprime loans had a “toxic” effect on markets, this could prove to be the coup de grace. Western Europe’s banking sector seems to be overextended and overleveraged in its futile attempt to gain market share and reap the benefits of financing the spectacular Eastern bloc economic growth. The only economy in relatively good shape is Germany, which, however, is now contracting at an unprecedented rate. In fact, despite its adherence to essentially healthier fiscal practices, Germany will be hit a lot harder in the coming months should the rest of Europe actually fall in depression, as its economy depends heavily on exports to these economies.

The real trouble for global economy, however, lies in the transcontinental interrelations and the intermarket implications of these facts. Investors have traditionally tried to diversify by dividing their investments geographically or by industry sector and via risk categorization; but apparently, in a global economy this simply is not possible anymore. The collapse of one market spells doom for another, pretty much like the (now happily forgotten) “communism expansion domino effect” the West has successfully thwarted in the last decades of the previous century.

Simply put, the investor in a Portuguese or Swedish bank is buying quite a lot more than that; some banks are so overextended that one is actually buying an option on Eastern Europe’s economic growth. Going further down the chain of interrelations, US banks and mutual funds are very likely to be exposed to European banks either as stock or bond holders – or even just as contracting parties in swaps, forex or project financing deals: the pit is practically bottomless.

The real issue is not the full or partial nationalization of banks and other problematic entities; it’s not about whether we deal with the current crisis as a liquidity or solvency situation and it’s not about quantitative easing. These are real, tangible and valid issues, truth to be told; but the real problem is our perception of finance and more broadly, economics: if all players act following game theory, then it follows that everyone is or eventually becomes a gambler. Gamblers can afford to get wiped out, because there is always the next (on- or offline) casino where they can try their hand and because they gamble their own money and future. But states and financial institutions seem to freely gamble away with everyone’s money and meddle with everybody’s future – not to mention that last time I checked, an average pocket pair usually is not reason enough to go all-in before the turn.