Why the Fed is Better Than the ECB

If there is any doubt that buyers are out there, last week’s 5-day rally should provide plenty of proof. Assuming that we are not poised for another of recession, stock valuations are attractive.

On the other hand, if there was any doubt that Europe’s debt problems are a millstone around the stock market’s neck, today’s action should clear that up.

I’ve discussed the chain of events of Greek default that leads to contagion. European banks own $123 billion or so in Greek debt. U.S. Money Market funds own European bank debt. If (when) Greece defaults on its debt, European banks take a hit to their capital base and the stocks fall. That in turn, will make the cost of insuring that debt rise.

So, U.S. Money Market funds aren’t buying as much Euro-bank debt anymore. They’ve cut lending. And that will mean that Euro-bank bond yields will rise, prices will fall and the insurance (credit default swaps) will rise.

Banks need a steady flow of capital to do business. The cost of capital has a major influence on profitability. Costs for Euro-banks are rising, which means profits are falling.

Combine falling profits with the potential for a smaller capital base and you start to have problems.

At the end of the day, this is a confidence issue. Though on a smaller scale, it’s still similar to what occurred during the financial crisis. Banks and other financial institutions didn’t know what was on other banks’ balance sheets.

Rather than lend to a company that had Lehman Bros.-like exposure to bad mortgage debt – the kind that could sink a company in a matter of days – banks just stopped lending to each other.

This is starting to happen in Europe. And to make it worse, the European Central Bank is reducing the amount of sovereign debt it purchases.

At this point it’s worth pointing out how the Fed’s promise to guarantee all loans and averted a much more serious outcome from the financial crisis. Banks could lend with some confidence that they wouldn’t lose their money.

So far, the ECB has been unable to make a similar type of guarantee, bailout funds are capped, and so there is little confidence that a potential debt crisis in Europe is being managed.

Where does it all end? I still think Greece will default, banks will take the haircut, and then we’ll see where things stand. As far as U.S. stocks, the fallout from a Greek default should yield a nice buying opportunity.

What it means for Europe is less certain. Actual default from Greece will impact its ability to raise cash in the bond market. But at the same time, its balance sheet will look a lot better.

The fear is that the problems will spread to Spain and Italy. While this may not be likely, it’s with the realm of possibility, and so, has a real impact.

I think we may have seen an important catalyst for Bank of America (NYSE:BAC). I’ve been calling the stock broken and unfit for investment since it broke below $9 a share on August 4.

But Friday , CEO Moynihan said that putting Countrywide into bankruptcy is an option. Hallalujah. Countrywide has cost BofA $33 billion so far. And that doesn’t include lost market capitalization. It’s probably the worst acquisition in stock market history.

I have to give BofA credit for attempting to honor all of Countrywide’s liabilities. But at some point, BofA is risking its own survival. So the option of putting Countrywide in bankruptcy could save BofA billions in future costs.

Right now, this announcement is a threat to the various entities that are suing BofA and don’t want to take a settlement. Moynihan is telling them to take the settlements that are in the table, or they may get nothing.

Anything that clarifies BofA’s mortgage liability is a bullish catalyst. And we my be seeing it with this Countrywide announcement.

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