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

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, namely, that the
continent is undergoing a demographic implosion. The number of Western Europeans
aged 15-49 will fall from 113 million today to just 92.5 million in 2050, a 20% decline.
In Southern Europe, the decline will be 26%. The demographic decline of the Club Med
countries is irreversible, except, perhaps, in Spain, which has access to young, literate
and culturally related immigrants from Latin America.

2 Who Cares About Europe?

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, its relative share of world economic activity will shrink
rapidly, and Southern Europe's share will effectively vanish. At present Italy absorbs
less than 0.9% of US exports. Even a collapse of the Italian economy would have a
minor impact on US output, including the indirect impact on German and French
output.

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. The report itself contains not an iota of
new information, calculation, or insight into the crisis. It simply states the obvious,
namely that US banks could be "greatly affected if contagion continues to spread
beyond the stressed European markets (Greece, Ireland, Italy, Portugal and Spain)."
That is, American banks' direct exposure to the PIIGS is "manageable" at about $50
billion for the six largest banksa figure long circulated in the marketor less than
9% of Tier I capital. Fitch is saying that if Germany, France and the UK go bankrupt
along with Italy and Spain, then "the outlook for US banks will darken." Why Fitch
pays people to publish such things is its own business, but it is unlikely that anyone
actually read the report before hitting the direct line button and screaming "Sell."
But France and Germany are not going bankrupt, and French and German banks
even presuming default in Southern Europe and the destruction of their entire
enterprise valuewill continue to meet current obligations. The so-called "gross
exposure" of US banks (including their counterparty risk to European banks) is
"ultimately manageable," Fitch wrote.

3 Who Cares About Europe?

The Macro Strategist

Once burned, 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, more than a year of lies and
prevarication lulled the market. But things really were different then: banks held
phony AAA's backed by evaporating subprime assets in Structured Investment
Vehicles with 70:1 leverage. They had written insurance contracts on the insurance
contracts, along with AIG and other insurers. The contingent claims on top of the
leverage left the banking system entirely insolvent.

Exhibit 4: Total Derivatives Contracts Outstanding

Total derivative
contracts
outstanding are
down by half

Source: BIS

In fact, counterparty exposure (the gross volume of all derivatives contracts

outstanding) has fallen by half since 2007.
As we argued November 1 ("Where's the Risk in American Banks?"), the US banking
sector has been shedding risk since late 2008 and continues to do so.

4 Who Cares About Europe?

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, overwhelmingly in AAA-rated subprime. US banks have shed about 80% of
those holdings, and more than half their securities portfolio is now in Treasuries.
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, collect income in return for doing so, and parcel out this
income to different classes of bond holders). That business collapsed in 2008. The
contracts outstanding continue to run off, and by 2012 most of the outstanding
balances will have disappeared.
On balance, shorting European financials (e.g., EUFN) vs. US financials (e.g., XLF)
remains our favorite trade.

5 Who Cares About Europe?

The Macro Strategist

Exhibit 6: European Financials (EUFN) vs. US Financials (XLF)

6 Who Cares About Europe?

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?