Tuesday, November 30, 2010

If You Kick a Can Down the Road Long Enough...

If you kick a can down the road long enough you will eventually reach an intersection or a dead end. We can't help but picture a child kicking a can down a quaint dirt road. Its a peaceful and bucolic. Now, that same kid but caught in an intersection, and not just any intersection, but of two 4-lane roads during rush hour with no traffic lights! Melodramatic imagery aside, the attempt to bailout Ireland has thrown these two concepts into the spotlight.

First and foremost is the contagion risk. This is not new. We saw it with U.S. banks and have been fighting it on the sovereign side for the past 9 months. PIIGS is at risk of becoming BIG PIGS.  Not only have the spotlights refocused on Spain and Portugal, but Italy and even Belgium are gaining some notoriety. "G" is in twice since Greece is already back renegotiating their prior bailout. But at this rate, the "G" could eventually become Germany as it continues to take on the obligations of other countries.

Second is that for the first time we have a recipient that does not seem to want the bailout. Ireland seems extremely reluctant to take the money. There is a real movement growing to just take the pain. Perhaps their anger at bankers may be clouding their judgement and making this option appear better than it is, but it is the right option. The austerity plan is more of a fiction than our New Year's resolutions.  Sure, they sound great, but what is the realistic chance of any of this occurring?  ZERO!  So the recipients are becoming more reluctant to live with the consequences of bailouts and are starting to seriously contemplate just dealing with it now.  Since politicians have finite terms in office maybe some of them are more willing to deal with it than corporate CEOs who have huge upside from kicking the can down the road.

This is an interesting development to watch.  We would imagine that at least some politicians in Greece are contemplating ditching the whole plan and scoring major populist points. And the countries providing the bailouts are also getting tired, and possibly scared. Germany, in particular, seems to be realizing that one possible end game is that all the bailouts will eventually drag them down. They are caught in a dangerous situation. They have played the "loaded bazooka" game to make the capital markets blink and lend to the weaker countries. Well, the capital markets have done their work and realized it is not safe to lend to some of these countries. Now Germany is trying to figure out how to make people lend money without having to take risk themselves. Very tricky and unlikely to work out.

As the street realizes that the big countries do not really want to bailout the little ones, we will see continued pressure on sovereign debt. We are still amazed that the U.S. contribution to the bailout has not hit the mainstream news.  The media has dubbed this a European Debt Crisis. Really, this is just the continuation of the debt crisis that started in the U.S. Too many people borrowed too much money. Everyone relied on either income or assets appreciating to repay the debt, or at worst that someone would just roll the debt over at maturity. It started with U.S. subprime borrowers. It has worked its way up to prime borrowers, smaller banks (the number of FDIC takeovers continues to grow) and weaker countries. It had hit big banks but that seemed to have been resolved. Its starting to hit bigger countries - Spain and Ireland. There is some concern it is starting to hit municipalities.

What scares us more than anything, is that the problem of borrowing too much spreads beyond those currently mentioned. Can France, or Germany, or even the U.S., run into trouble? Not likely right now, but it would be foolish and arrogant for those countries to proceed as though they are immune from the consequences of too much debt and not enough income. The mantra of decoupling is coming through loud and clear. Every stock bull is mentioning the good economic data. This week has a lot of economic releases. IF the economic data does not come in strong, the market seems very susceptible to a sell-off. It seems to me that most people are back to being long, have bought the recent dip, and are buying into the argument that European debt issues will be contained. We think its unlikely that they remain contained and that if we are right and the market is long, we are due for a continued pull back. GM stock continues to hold the issue price. It has come close to breaking it a few times, and that would probably put some additional pressure on the market. MUB was weak again. LQD was okay, but not strong and shares outstanding continue to trend lower. Recent new issues are well offered. Always a telling sign is when it gets hard to move recent new issues. Too many flippers and not enough real long term holders. Whenever it gets difficult to trade recent new issues, the market has sold off as people eventually start the cycle of buying CDS, buying index, and hitting "throwaway" bids on bonds. There is enough data out there that we could rally, but away from that, its getting hard to see what takes the market higher/better in the near term as the government bailout game seems almost over.

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