The Eurozone: Disaster or Just a Drag?

Published Tue, Jun 5th, 2012   Matthew Weinschenk, Senior Analyst

The eurozone’s not looking good…

And with all the institutions involved, the possible bailout scenarios and the potential new currencies, it’s so complex that it’s barely worth your time to try to unravel.

Still, the outcome will make a very real difference in your life.

Will the European debt crisis be a major event, shattering the global economy as with the U.S. financial crisis of 2008. Or will it be something more manageable, less game-changing?

Yesterday, my colleague, Karim Rahemtulla, suggested that based on his reading of the VIX (or Volatility Index), the eurozone crisis isn’t as bad as many think.

I wholeheartedly agree, but my own findings are based on a different indicator, one that doesn’t just measure volatility, but the underlying health of financial markets, specifically in Europe.

And what it suggests is that the eurozone crisis won’t end as badly as the U.S. financial crisis of 2008.

But before looking at the indicator itself, here’s a quick review of what exactly made the financial crisis in the United States so severe.

Simply put, the banking crisis was a breakdown of trust between the banks themselves.

You see, to operate, banks borrow very short-term loans from each other and from central banks. So when mortgage-backed securities collapsed, banks couldn’t trust each other. In turn, this short-term funding dried up and banks couldn’t meet their daily obligations.

It was this crisis of short-term funding that brought down Lehman Brothers and Bear Stearns, and it would’ve destroyed others had it not been for bailouts.

Fortunately, there’s a very clear way to measure the trust between banks and the fears of another meltdown, known as the Libor-OIS spread.

There’s two moving parts to this measurement: Libor (or the London interbank offer rate) – the interest rate at which banks are willing to lend to each other. And OIS (or overnight indexed swap) – a derivative contract that’s tied to the overnight rate of lending.

Using an OIS swap, a bank can guarantee that its short-term funding is supplied over a longer period, while still paying interest rates close to the overnight rate.

The spread between Libor and the OIS is a measure of how scared banks are of continuing funding to flow from other banks.

Essentially, it’s a barometer of the fear of bank insolvency.

Let’s look at the Libor-OIS spread for the United States through the 2008 crisis. The chart goes back to 2005, so you can see what rates were like in a time of non-crisis.

Looking at the current Libor-OIS spread for Europe, you see a similar pattern. Fears of eurozone trouble certainly raised rates in early 2012, but lately they’ve declined. It’s currently at 39 basis points, barely higher than 30 basis points for the United States.

This means that while there are indeed fears in the eurozone, the banks largely trust one another to avoid collapse in the coming months.

There are two reasons for this.

First, the European crisis has unfolded at a slow burn. Accordingly, banks have arranged their balance sheets to prepare for a variety of scenarios.

So whatever happens with Greek, Italian and Spanish bonds, the banks know who holds what and what those bonds are potentially worth.

Even more important, the European Central Bank (ECB) has signaled that it‘s prepared to pump billions into the system to keep the financial machine working smoothly.

Where does this leave us?

I’m not suggesting that running the printing press at full blast is best for the world economy over the long term.

I’m also not suggesting that select parts of Europe will avoid a nasty recession.

But I do think you can rest easy knowing that a major collapse and crisis doesn’t appear to be imminent.

Of course, we’ll be monitoring the Libor-OIS spread to keep abreast of sentiment in Europe (and we currently have a European turnaround investment picked out for WSD Insider readers).

Until then, if the bankers lending and borrowing billions each night can sleep easy, I think you can, too.

Ahead of the tape,

Matthew Weinschenk