The Guest Blog

Farr: European Contagion Spreads

Conditions in Europe took a turn for the worse yesterday as S&P downgraded not only Greek bonds, but also Portuguese bonds. And as I write, S&P just cut Spain's rating from AA+ to AA. Greek debt is now trading at "junk" status (BB+) with 2-year notes commanding yields in the high teens.

While the Portuguese and Spanish governments are in better shape (now rated A- and AA, respectively), investors are worried because the Greek problems started the same way. Ratings agency downgrades led to higher borrowing costs, which led to higher budget deficits, which led to even higher borrowing costs and additional pressures on ratings.

As we have mentioned in previous market commentaries, there is a long list of European countries with high debt and deficits relatively to their respective GDP's.

While Portugal and Spain are the most recent targets of S&P downgrades, Italy or even Ireland could be next.

For its part, the European Union has been slow to respond to what appears to be a growing risk of contagion.

As the Wall Street Journal points out this morning, the stakes have been relatively small so far as Greece and Portugal represent only small fractions of the EU economy. However, Spain is the eurozone's fourth largest economy and is running a deficit of 11.2% of GDP (compared to 9.4% in Portugal and 13.6% in Greece).

The ramifications of the sovereign debt crisis in Europe are far-reaching and potentially severe.

Despite a commitment of 45 billion Euro to Greece by the IMF and EU, the Euro fell to its weakest in a year against the dollar. Investors on Monday shed risky assets of all flavors for the safety of German and US government bonds. Bank stocks across Europe are trading lower as investors assess their exposure to higher-risk sovereign debt. And while banks in the US have very little direct exposure to Greece, many analysts are comparing the European problems with the beginning of the sub-prime mortgage crisis in 2007. We all know how that turned out.

In a vacuum, roughly $400 billion in Grecian debt is not a problem.

The problem is that the banks and other governments that own Greek debt remain in a very precarious state due to losses sustained as a result of the financial crisis and global economic downturn. These entities cannot afford further losses or they themselves could become vulnerable. In the US, banks are still not lending because: 1) they are worried about further loan and securities losses (if unemployment and/or housing prices get worse); 2) they are unclear as to the future regulatory landscape (ie, how much capital they will be required to hold); and 3) the securitization market remains a shell of its former self. So even though US banks hold very little Greek debt directly, it is easy to see how an escalating European crisis can affect lending and therefore economic growth in the US.

This is especially true as the sub-prime contagion remains fresh in everyone's minds.

Debtor Nations

We remain cautious on the banks.

Sovereign debt risk is just one in a list of risks that we believe the market is under appreciating as bank stocks soar to 52-week highs.

Among the other risks are soaring home foreclosures, the potential for further housing price declines, potentially onerous new financial regulations, shrinking balance sheets, and liberal accounting rules.

Moreover, given the complexity of current global financial conditions and the nearly 80% increase from the March lows, we remain defensively positioned in our client portfolios.

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Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C.  Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.