The Macro Strategist

David P. Goldman

+1 917 915 2985
dgoldman@macrostrategy.com

Who Cares About Europe?
Friday, November 18, 2011
SUMMARY
 Neither the financial nor the real economic impact of the European crisis will derail
growth in the rest of the world.
 US banks have low net exposure to European debt; the "contain" argument focuses
on gross exposure and counterparty risk. But counterparty risk on plain-vanilla CDS
contracts is easily managed by the central banks. The risks to US banks in the
present dust-up bear little resemblance to 2008.
 We continue to avoid European exposure of any kind.

Exhibit 1: US Exports to Asia vs. Europe

Europe has been a
drag on the world
economy all
along. The world
is used to it.

Source: US International Trade Commission

in Spain. The number of Western Europeans aged 15-49 will fall from 113 million today to just 92. that the continent is undergoing a demographic implosion. the decline will be 26%. The demographic decline of the Club Med countries is irreversible. except.5 million in 2050.The Macro Strategist Why Europe Doesn't Matter Exhibit 2: US Exports by Country Europe matters less and less… Source: FRED And there's a reason for Europe to matter even less in the future. literate and culturally related immigrants from Latin America. perhaps. a 20% decline. which has access to young. In Southern Europe. namely. 2 Who Cares About Europe? .

namely that US banks could be "greatly affected if contagion continues to spread beyond the stressed European markets (Greece. and French and German banks— even presuming default in Southern Europe and the destruction of their entire enterprise value—will continue to meet current obligations. but it is unlikely that anyone actually read the report before hitting the direct line button and screaming "Sell. American banks' direct exposure to the PIIGS is "manageable" at about $50 billion for the six largest banks—a figure long circulated in the market—or less than 9% of Tier I capital.9% of US exports. calculation. then "the outlook for US banks will darken. France and the UK go bankrupt along with Italy and Spain. and Southern Europe's share will effectively vanish. including the indirect impact on German and French output. Even a collapse of the Italian economy would have a minor impact on US output." That is.The Macro Strategist Exhibit 3: Population Aged 15-49 in Western and Southern Europe …and will matter even less Source: UN World Population Prospects (Constant Fertility Scenario) No matter what Europe does." But France and Germany are not going bankrupt. It simply states the obvious. Portugal and Spain). Italy. The Contagion Non-Story Payback is a Fitch Yesterday's last-hour drop in US stock indices followed the release of a Fitch Ratings report on the European exposure of US banks. At present Italy absorbs less than 0. or insight into the crisis." Why Fitch pays people to publish such things is its own business. Fitch is saying that if Germany. The so-called "gross exposure" of US banks (including their counterparty risk to European banks) is "ultimately manageable. The report itself contains not an iota of new information. Ireland. its relative share of world economic activity will shrink rapidly." Fitch wrote. 3 Who Cares About Europe? .

along with AIG and other insurers. counterparty exposure (the gross volume of all derivatives contracts outstanding) has fallen by half since 2007. They had written insurance contracts on the insurance contracts. Exhibit 4: Total Derivatives Contracts Outstanding Total derivative contracts outstanding are down by half Source: BIS In fact. 4 Who Cares About Europe? . The contingent claims on top of the leverage left the banking system entirely insolvent.The Macro Strategist Once burned. more than a year of lies and prevarication lulled the market. the US banking sector has been shedding risk since late 2008 and continues to do so. As we argued November 1 ("Where's the Risk in American Banks?"). But things really were different then: banks held phony AAA's backed by evaporating subprime assets in Structured Investment Vehicles with 70:1 leverage. twice shy: market participants remember a year's worth of assurances from American banks that all was under control during 2007 and 2008. Between the failure of the Bear. Stearns levered AAA mortgage hedge fund in June 2007 and the collapse of Lehman Brothers in September 2008.

and by 2012 most of the outstanding balances will have disappeared... A significant proportion of credit derivative contracts were written for synthetic collateralized debt obligations (the issuer would write protection against a basket of names in the CDS market. On balance. US financials (e.The Macro Strategist Exhibit 5: Non-Treasury Securities as a % of US Banks' Total Holdings Risk continues to vanish from American bank books Source: FRED In 2008 almost the whole of the securities portfolio of American banks was in risk assets. and parcel out this income to different classes of bond holders). and more than half their securities portfolio is now in Treasuries. collect income in return for doing so.g. That business collapsed in 2008. US banks have shed about 80% of those holdings. XLF) remains our favorite trade. overwhelmingly in AAA-rated subprime. shorting European financials (e.g. 5 Who Cares About Europe? . EUFN) vs. The contracts outstanding continue to run off.

US Financials (XLF) 6 Who Cares About Europe? .The Macro Strategist Exhibit 6: European Financials (EUFN) vs.

The Macro Strategist Exhibit 5: CDO Issuance Toxic waste is amortizing away into a vanishing pool of legacy assets Source: SIFMA 7 Who Cares About Europe? .