Morningstar Advisor - February/March 2012 - (Page 40)

Spotlight Exhibit 4 Euro Bonds Were Risk-Free, Until They Weren’t: Once trouble hit, the bond yields of individual countries’ sovereign debt diverged sharply. Yield to Maturity of Benchmark 10-Year Bonds % Greece Italy Portugal Ireland Spain Germany fixed exchange rates. If the ECB does not cave in, it may become a central bank without a currency to manage. Likely Scenarios 35 30 25 20 15 10 5 01/92 Source: FactSet. Several disastrous scenarios are possible. Depositors may lose their confidence in banks. Greece (or Portugal or Ireland) might decide to quit the euro—also leading to bank runs. Or austerity might lift a populist, anti-Europe government to power, setting off a cascade of defections from the currency area. The cost of returning to national currencies seems high. From a legal standpoint, it would be a colossal mess to figure out how to honor euro-denominated contractual obligations. A Frenchman told me: “Once the omelet is made, you can’t put the egg yolks back into the shells.” The euro project was flawed from the outset, but mending it should bring more benefits, at least in the long run, than quitting it. Common sense suggests that leaders will avoid a blowup. The most likely outcome, I still believe, is that Europe does just enough, just in time. In the next few months—or is it weeks?— I envision both banks and sovereigns coming perilously close to defaulting. The ECB would finally be forced to keep everybody on life support, with the stated goal of preserving financial stability. The EU would then cobble together enough reforms to please the central bank, although not enough to ensure the long-term economic success of the currency. The euro would be saved, but for how long? Eurozone countries got themselves in a monetary straitjacket, then failed to develop fiscal institutions that would strengthen the whole and lived the illusion that sharing a currency was the same as sharing a Treasury. There is no time for the eurozone to ease its way into a more integrated pact. The only options are radical monetary intervention, default, or a split-up. K Francisco Torralba, Ph.D., is an economist with Morningstar Investment Management. 01/94 01/96 01/98 01/00 01/02 01/04 01/06 01/08 01/10 patient needs a defibrillator. The eurozone must immediately stem the loss of confidence in sovereigns and banks alike. The ECB is the only institution that can do that. Should the central bank declare that it commits unlimited funds to supporting sovereign debt, the bond vigilantes would retreat. They cannot fight a bond buyer with an infinite balance sheet. So far, however, the ECB has doggedly refused to make large purchases of national debt. For one thing, Article 123 of the EU Treaty prohibits the central bank from financing the public sector’s obligations. By buying bonds, the hawks in Frankfurt argue, the ECB would risk fueling inflation and losing credibility. By not buying them, I would say, the central bank risks depression and deflation, neither of which fits the bank’s mandate. Alternatively, the ECB may fund sovereigns indirectly, via the banking system. The central bank would lend to banks at cheap interest rates and insist on receiving sovereign debt as collateral, thus supporting demand for such debt and keeping yields low. This way the central bank would not be violating the letter of the law. Banks would remain liquid and would earn the handsome spread between the sovereign yields and the ECB rates to boot. Unfortunately for banks, this scheme is unlikely. Encouraging banks to turn ECB loans into more purchases of sovereign debt would imply an increase in borrowing beyond their already-high leverage levels. Also, ECB dislikes bond purchases because the central bank would gain de facto control of both the banking system and sovereign finances. Because the wholesale credit market is dry, banks are at the mercy of the ECB. If the central bank asked them to provide, say, Spanish debt as collateral, banks would buy Spanish bonds. If the Spanish government did not address its fiscal issues to the ECB’s liking, the central bank would drop Spanish bonds out of its list of preferred debt—by applying a steeper discount on Spanish collateral. Banks would then sell Spanish bonds and invest in whatever the ECB suggested them to buy. Spain would be forced to follow the bank’s dictum, or default. Large-scale purchases of debt do entail risks. Still, in the short term, there is probably no other way to avoid defaults in a context of fiscal austerity, economic recession, and 40 Morningstar Advisor February/March 2012

Table of Contents for the Digital Edition of Morningstar Advisor - February/March 2012

Morningstar Advisor - February/March 2012
Contents
Contributors
Letter From the Editor
Make a Difference Stories, Not Debates
How Concerned Are You About Europe?
Analytical and Independent
What to Ask When a Fund Manager Leaves
Past, Present, Future
Have Financials Gotten Cheap Enough?
Four Picks for the Present
Investment Briefs
Tactical Funds Miss Their Chance
Specialty Retail: Ad Hoc Opportunity
How Europe Is Making Its Crisis Worse
Impact on U.S. Economy Will Be Minimal
European Banks: Bargains or Value Traps?
Don’t Count the Euro Out Yet
Europe on the Brink
GoodHaven Realizes Its Vision
How Index Trading Increases Market Vulnerability
Nonlisted REITS: Handle With Care
Safety Picks for the Many Moods of Mr. Market
On the Prowl for Large- Blend Index-Beaters
Our Favorite Mutual Funds
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
The Math That Matters

Morningstar Advisor - February/March 2012