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New York: July 04, 2011
By John Stephenson

The tattering of Europe's periphery has touched off strains throughout Europe as politicians and traders contemplate a potential disorderly default in Greece or Ireland . The nightmare scenario that the market is contemplating is that a default of Greek debt causes a crisis of confidence in government debt throughout Europe, which, in turn, triggers a banking crisis in Europe that quickly spreads to international banks and rapidly envelopes the world in its second global financial crisis.

Adding to the pressure cooker effect in Europe is a culture of entitlement which has made it next to impossible to implement the draconian austerity measures needed to get the European periphery back on to a firmer fiscal footing. The spending cuts and tax increases needed to bring peripheral Europe 's finances back under control only serve to drive a greater percentage of the local economy underground, causing government revenues to plummet while debts and deficits soar.

This would exacerbate the European debt crisis, as sovereign debt default could quickly spread to other systemically important institutions. The most likely method of transmission is through the global banking system. French banks are Greece 's biggest creditors, with direct exposure estimated at $57 billion to both private and public debt. German banks are the second largest creditors to Greece with exposures totalling more than $34 billion, while Spanish banks have significant exposures as well. Greek banks hold around 17 percent of their country's national debt, while the European Central Bank (ECB) is on the hook for some 18 percent of the more than €330 billion of outstanding Greek debt. In total, the ECB has taken on some €100 billion of Irish, Portuguese and Greek debts against a capital base of about €10 billion.

The ECB began buying up government debt earlier this year in an effort to provide liquidity and to try and prevent yields from soaring out of control, which they ended up doing in spite of these efforts. Other banks, seduced by the juicy yields on Irish, Portuguese and Greek sovereign credits, began loading up as well. Further exacerbating the problems for banks was a Paul Volcker-inspired set of international banking regulations known as the Basel accords.

The Basel accords are a series of international banking laws and regulations issued by the Basel Committee on Banking Supervision. Under the current set of regulations, known as Basel II, banks were required to hold more capital in reserve for riskier assets than for less risky assets. Under Basel II, government debt is considered to be risk free and therefore banks acquiring government debt don't need to set aside regulatory capital to comply with the Basel accords. For European banks, this was manna from heaven.

Under Basel II, European banks could reap juicy yields by speculating in the credits of deeply indebted nations, such as Greece and Ireland , while receiving preferential regulatory treatment of their balance sheets since these credits were deemed to be risk free. This allowed the European banks to further leverage their balance sheets, boosting short-term profitability but dramatically increasing their risk profiles.

It's ironic that a set of bank regulations designed to reduce risk, may in fact be responsible for concentrating risk and, in the process, transmitting problems in small national economies throughout the globe. Also under the microscope as a result of the sovereign debt crisis in Europe is the capital asset pricing model (CAPM) which is the academic underpinning of modern finance. If governments are so indebted that their bonds cannot be considered risk free, then what is the yardstick with which financial professionals can begin to measure and value corporate debt, stocks and other more risky assets? Unfortunately, there are no easy answers. And in this uncertainty has only served to increase risk and volatility in the global capital markets.

Further complicating matters is a $600 trillion notional global derivatives market. The insolvency of a major European bank could have profound implications for the global financial system as the collapse could set off a ripple effect which would sweep through the derivatives market. U.S. banks have sold some $90 billion in credit default swaps on Portuguese, Greek and Irish debt to European banks and those transactions may come unstuck if the daisy chain of disasters spiralling out of the European periphery slices through the middle of the global derivatives market causing that market to come unglued.

Bank stocks have responded to the various doomsday scenarios by selling off rather dramatically. This has helped drag most of the major indices into negative territory over the last several weeks.

And while the possibility of a Greek contagion still looms over the market, the recent sell off in stocks has set the stage for a powerful recovery later in the year. The slowing global economic outlook is already yielding some modest benefits such as lower gasoline prices at the pump, as the Arab Spring premium that has been building in the crude oil markets, has all but disappeared. A bounce-back in Japan 's economy could do wonders to rebalance the global manufacturing supply chain and boost the fortunes of automakers and steel companies. Capital investment usually rises during the initial stages of an economic expansion phase, suggesting that many early cyclical stocks could be poised to outperform the market in the months to come.

But in spite of the current doom and gloom, agriculture and gold sector securities remain surprisingly resilient, suggesting that these sectors may offer shelter from the storm. And while it's always hard to predict when the market will bottom, the future winning bets will be in the sectors with rock-solid fundamentals. Steel, commodity producers and autos may be your best bets as late 2011 and early 2012 unfold.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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