Italian Contagion

Just a couple of weeks ago, with the supposed “solution” to the Greek crisis, many market participants thought that the politicians had bought at least several months of relief from the European debt crisis.  But, just as the markets attacked the stocks of both Morgan Stanley and Goldman Sachs after the failure of Lehman, it should have been expected that the markets would go for the European Monetary Union’s (EMU) jugular, Italy.  And, it didn’t take long.

Too Big To Bail

Logically, Italy’s debt was always going to be the issue that determined the EMU’s fate.  That is because Italy’s sovereign debt outstanding is over €1.6 trillion (compared to €345 billion for Greece, and €150 billion for both Portugal and Ireland), its debt/GDP ratio is a punishing 120%, and its estimated annual funding needs will run at roughly €250 billion.  That annual funding need is larger than the other European PIGS (Portugal, Ireland, Greece and Spain) combined.  Because the remaining capacity of the ESFS (European Financial Stability Facility) is just €320 billion, it is not big enough to finance Italy’s borrowing needs for more than a year, much less deal with Ireland, Portugal and Spain.  Thus, Noruma Securities had dubbed Italy as “Too Big to Bail” (TBTB).  In the end, it would be up to Germany and France, the two biggest economic powers in the EMU, to save Italy, the third biggest economy.  That would require a commitment of more than €500 billion, or about 10% of their combined economies, a figure that is probably not politically doable.

Nonchalance

While there appears to be some concern in the financial markets about the European debt issues, the markets appear nonchalant about it.  The “contagion” so far appears to be limited to some of Europe’s banks and to the markets for PIIGS debt (Portugal, Ireland, Italy, Greece and Spain).   For example, the VIX for U.S. equities is barely off its lows.  Our belief is that this situation is much more serious than embodied in the current market reaction, and the “contagion” could easily spread worldwide:

• A selloff in Italian bonds could put pressure on the Italian banking system (which holds 6.33% of Italy’s sovereign debt according to JPMorganChase), which could lead to fears of insolvency.  This, in turn could lead to bank runs and perhaps some failures.  But it surely would require government intervention (perhaps nationalization) and capital raises (if possible);
• Any resulting bank bailouts would add more debt to an overburdened Europe, thus exacerbating an already critical debt situation;
• But, the most dangerous “contagion” is most likely in the Credit Default Swap (CDS) arena which is extremely difficult to quantify because it remains unregulated.  As with Greece, any default runs the risk of triggering CDS payments.  And, it is not known if the CDS counterparties have sufficient capital to pay in the event of a default by Greece, much less Italy.  For all we know, there may be another AIG out there, or perhaps a CDS event may fatally wound a large systemic worldwide financial institution.

Our view is that this situation is much more dangerous than the markets have priced in.

Robert Barone, Ph.D.

Matt Marcewicz

July 12, 2011