It all started with a relatively small problem: Greece, a country with a high level of indebtedness relative to its GDP, got downgraded. “Green shoots” were perking up everywhere here in the US and Europe as people were optimistic that the recovery we were hoping to get from the fall of ’08 was taking shape and gaining traction.

“A downgrade won’t be so bad if this recovery takes hold and Greece will be able to grow its way out of its problems. Plus, it’s just Greece. It’s not like we’re talking about Germany or anything.” That was the conventional wisdom two years ago. Whether it was an overdose of Hopium or just the typical whistling by the graveyard, who knows? At any rate, it doesn’t matter now. This situation has moved beyond Greece. It has moved beyond Portugal and beyond Ireland. Spain, Italy, and France are now at the center of a crisis that started with that Greek debt downgrade.

Two AAA-rated countries shouldn’t be trading this differently. And yet, they are. Perhaps this is another situation where a AAA rating isn’t worth much. Consider these two tables from the International Monetary Fund’s Fiscal Monitor, which it published in September:
 

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General government debt-to-GDP ratios between France and Germany are relatively similar, yet when you look at the percentage of nonresident debt holders each country has, there’s a distinct difference: More French debt is held by non-nationals than German debt. Seventy percent of US general government debt (that’s federal debt plus state and local government debt) and 95 percent of Japanese general government debt are held domestically. This next chart compares the government debt holders of the US, the UK, and Japan with Greece, Ireland, and Portugal:
 

 
A stark contrast, this. But it also shows why one country (Japan) can seemingly borrow ad infinitum with no increased borrowing costs, while some of the countries in question have to be much more cautious. Borrowing bases (i.e., who your creditors are) do matter. Indeed, if a tree fell in a Japanese forest, I’m not sure anyone would see it or hear it if the forest was half as insular as Japan’s debt market is.
 
That’s an important distinction to make because tensions between debtors and creditors have been on the rise for the past few years, and what is being played out in the sovereign debt markets is the ultimate expression of that tension. Like a tragic symphony movement that builds to a crescendo, the action in debt markets has become volatile, loud, and frenetic. You know it’s all building to something somewhere in the future, it’s just questions of what, when, and how.
 
Because of where the banks sit in the modern economy, they’re a transmission mechanism for greed when they’re lending and fear when they’re not. And judging by overnight swap rates, they’re not lending much:
 

 

 

 

Don’t feel like home… he’s a little out…
And all these words elope… it’s nothing like your poem…
Putting in… inputting in… don’t feel like methadone…
– Pearl Jam, “Nothing As It Seems”
 
You’ll notice I circled the rates in the upper left hand of each chart. I did that because I wanted to try to build a swap curve in my mind’s eye and get a sense of its shape. Here’s a hint: It’s inverted. Swap rates on overnight money are higher than they are for 1-month, 3-month, and 1-year. A sign of stress, for sure.
 
You’ll also notice that I put in a blue vertical line right around July 2010 and a horizontal one that extends from July 2010 to the present. I did that because I wanted to answer a question: What has happened with swap rates since the European Central Bank called in €442 billion of emergency loans to banks on June 30, 2010? Well, the proof is in the charts. Rates have only moved higher and funding has gotten more erratic. Kind of like a junkie going through withdrawal, the banks seem to be having a hard time coping with less cheap liquidity laying around.
 
If only liquidity were the only thing that needed to be addressed. There’s also the delicate but not so subtle issue of capital adequacy, especially since European banks need to have core capital ratios of 9% by June 2012. But who is going to invest in European banks nowadays?
 

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So if you’re not feeling particularly bullish about your prospects to raise capital, you only have one other choice: Reduce the size of your balance sheet. That means selling assets and write-downs. But what do you sell? You sell the stuff that has a bid, not the stuff that’s dragging your balance sheet down.
 
Which probably means the companies that were what we thought they were (see Too Big to Fail System: On Its Way Out?) are having to do some massive selling to raise capital. Which probably explains why French, Austrian, Dutch, and other sovereign debt will be sold instead of the Greek, Portuguese, Irish, Italian, or Spanish debt that is still being held on to. Because if you try to sell that stuff now, you’re not just taking a hickey on that loss; you’re taking something else that you won’t be able to lie about by saying you had an entanglement with a vacuum cleaner.
 
So what are the solutions? Everyone says they don’t want defaults (for now) and this situation has become too difficult to handicap, so defaulting on the debt is out. That really leaves us two scenarios: ECB purchases of sovereign debt as a lender of last resort or some sort of fiscal consolidation.
 
Let’s take the ECB purchasing sovereign debt first. The first issue is that the ECB can’t do this without making it look like a bailout, which they are prohibited from doing. Bank of England Governor Mervyn King recently said this on the subject (emphasis, mine):
 

This phrase “lender of last resort” has been bandied around by people who, it seems to me, have no idea what lender of last resort actually means, to be perfectly honest. It is very clear from its origin that lender of last resort by a central bank is intended to be lending to individual banking institutions and to institutions that are clearly regarded as solvent. And it is done against good collateral, and at a penalty rate. That’s what lender of last resort means.
 
That is a million miles away from the ECB buying sovereign debt of national countries, which is used and seen as a mechanism for financing the current-account deficit of those countries, which inevitably, if things go wrong, will create liabilities for the surplus countries. In other words, it would be a mechanism of transfers from the surplus to the deficit countries. That’s why the European Central Bank feels, and with total justification, that it is not the job of a central bank to do something which a government could perfectly well do itself but doesn’t particularly want to admit to doing.

 
So there you go: Good collateral at a penalty rate. But with the current state of play in Europe, I’m not sure anyone can tell what is “good collateral” anymore. Plus, a lender of last resort only applies to banks. So the banks would have to queue at the ECB’s refinancing operations with their sovereign debt, accept whatever haircut the ECB put on it (it probably wouldn’t be that harsh) and agree to the penalty rate that the ECB charges for the privilege of pledging that sovereign debt to them.
 
And so the banks will have to find someone/something to lend to so they can pay the ECB back. They will have to chase risk somewhere. Chasing risk? In this environment? To get the ECB their money back? Good luck with that. And you can probably assume that whatever time is bought from such a deal won’t be enough for a good number of banks. Because you can only use liquidity to mask a solvency issue for so long. Plus, what’s to say the ECB wouldn’t be asked to do the same for French, Dutch, Austrian debt? What if buying Italian and Spanish debt to cap their borrowing costs isn’t enough?
 
The other option folks are talking about is some sort of fiscal union, or perhaps some sort of cooperative arrangement could be developed. Fiscal union implies common governance, common safety net arrangements, and common wage and cost structures. That is not something you agree on quickly, and it’s not something you can do with sovereign debt holders breathing down your neck, either.
 
But you can negotiate some sort of cooperative debt agreement where nations could agree to treat each other’s sovereign debt as their own and do what King pointed out — provides the means for the development of a mechanism for transfers between surplus and debtor countries. Once you come to a sort of cooperative/burden-sharing agreement, then you can work out the governance and cost structure issues that come with fiscal union. This would probably also give the ECB cover to loosen interest rates and give sufficient cover to devalue the euro.
 
Because ultimately we’re talking about trying to make an entire continent competitive, not just a few countries. But it will take a lot more time to achieve than the markets want to give policymakers at the moment. The peripheral European countries’ risk profiles would improve, while the core/surplus countries would decline. But an equilibrium would be found in debt ratings across Europe.
 
So where do we go from here? I don’t know for sure, but it seems clear that we have not seen the last of this situation. And regardless of what path gets taken, darkening social mood will hang over Europe. Because while some of these ideas to improve Europe will take years and decades to implement and see the results, the markets and the people are demanding action and results now. There’s a genuine disconnect here, and it’s not a question of money.
 
It’s a question of time.

No positions in stocks mentioned.