Half of the Eurozone Downgraded:
Time to Start Worrying

After 36 years, France has lost its coveted AAA credit rating.

S&P downgraded France’s AAA credit rating one notch to AA+ late Friday, and the bad news didn’t stop in France.

S&P maintained its outlook as negative for the country, which means that there is a one in three chance of a further credit rating downgrade in 2012 or 2013, should France’s situation continue to deteriorate.

Considering the continued economic weakness in the eurozone, as I’ve been detailing, the challenges facing France are daunting. The country’s response to the credit rating downgrade is to announce reforms (austerity measures) by the end of the month.

The problem is that—as with any reform—there is short-term economic pain as the measures are implemented. Considering the economy is probably already in a recession, any reform threatens to exacerbate economic weakness.

S&P didn’t stop there. The rating agency downgraded Italy’s credit rating two notches to BBB+ and kept its outlook negative for the already struggling country. S&P cut the credit ratings of Portugal and Spain, and stripped Austria of its AAA credit rating as well.Germany kept its AAA credit rating, with its outlook as stable.

In total, of the 17 member eurozone countries, more than half—nine—were downgraded. Only four countries survived the carnage to retain their AAA credit rating:Germany, the Netherlands; Finland; and Luxembourg. Sounds like a great place to invest, doesn’t it?

The immediate problem is that these countries will have to pay more interest on their debt. Like a household, when it is time to renew your mortgage, if interest rates are now seven percent when you were paying three percent previously, then you need to cut spending somewhere else in order to make up the difference.

Considering how weak economic growth is (most likely a recession) and considering how the austerity measures are hurting the average person, this extra interest cost is the last thing these countries need as they desperately try to rein in their debt.

To add more fuel to the raging crisis, many countries need to “renew their mortgages” or roll over a significant amount of debt in 2012. For the entire eurozone, roughly €700 billion needs to be rolled over in 2012, with roughly €200 billion alone in the first quarter (source: Bloomberg). This will be a task that’s easier said than done.

Since these higher interest rates intensify an already difficult situation, many countries are going to look to roll over their debt with the European Central Bank (ECB), so they can pay lower rates than what the market would force them to pay (e.g. in keeping with the example, paying three percent instead of the market rate of seven percent).

Luckily, the ECB has created the €440-billion European Financial Stability Facility (EFSF) where countries can go directly to roll over their debt at lower rates. The ECB was hoping to use their combined clout to create an AAA EFSF that would help countries pay lower rates.

However, of the 17 nations of the eurozone that contributed to EFSF, France was the second largest contributor, which naturally resulted in S&P downgrading the credit rating of the EFSF to AA+ from AAA.

The takeaway from these latest developments is that, try as they might, the troubled countries in the eurozone are looking at paying higher interest rates in 2012, which will only weaken their economies further. This will translate into a drag on growth in both China and the U.S, not to mention Germany, which exports to these countries.

This exacerbates the issue in another way, dear reader. Please follow me here.

European banks and governments own European debt (so do U.S. banks). This latest downgrade of European credit ratings means that the European debt that the banks and governments are currently holding is now worth less in the market’s eye: you own an asset that has now depreciated in value (like a car after a few years of use). This is another consequence of the credit rating downgrade that will continue to depress the economic growth of eurozone nations, because, today, they are worth less than they were yesterday.

Michael’s Personal Notes:

As if the big U.S. banks didn’t have enough trouble.

Besides the large U.S. banks’ exposure to Europe and to the derivatives on their balance sheet (off-balance sheet items, which is why no one can evaluate what they’re really worth), there is another issue—a lawsuit—that could cost the big banks billions of dollars and negatively impact their corporate earnings in a significant way.

There is a private antitrust lawsuit that has a staggering five million retailers against Visa Inc. (NYSE/V), MasterCard Incorporated (NYSE/MA), and 13 of the big banks, including Citigroup, Inc. (NYSE/C) and JPMorgan Chase & Co. (NYSE/JPM)—15 major financial institutions in total that could see corporate earnings plummet if this antitrust suit gains traction.

The plaintiffs—the retailers—are accusing the 13 big banks and the credit card companies of colluding to charge fees for credit card transactions that are much higher than a competitive market would command.

Not only are the retailers demanding compensation for overpaying for these fees—dating back to 2004—but they are also probably seeking a permanent fee reduction going forward. The defendants argue that MasterCard and Visa are public firms, which immediately implies they compete with each other for business, outside of the oversight of the big banks. There go the corporate earnings of MasterCard and Visa (if this suit progresses).

The plaintiffs believe they have a very strong case to show that this is one club—the credit card companies and the big banks are intertwined into one. As such, there really is no competition, forcing retailers to pay whatever the fees demanded are.

It is estimated that, in 2009, industry-wide, the fees amounted to some $40.0 billion (source: JPMorgan). Taken over a period of eight years, one can immediately see that the fees amounted to a few hundred billion, which means that even a small settlement with this lawsuit can potentially translate into billions of dollars of losses for each of the big banks’ corporate earnings.

Some banks, in their regulatory filings, have acknowledged the lawsuit and cited some possible implications for their corporate earnings, with Citigroup having gone a step further, detailing its portion of the possible costs of the lawsuit to its corporate earnings at $254 million.

A ruling, expected very early in 2012, will determine if the case can move forward as a class-action lawsuit. Although it is impossible to determine how this case will turn out, it presents yet another risk to owning big banks—impacting their corporate earnings in a major way. Despite the fact that many of the big banks are already down in price, this lawsuit provides yet another reason why the big banks should be avoided in 2012.

Those big bank stocks…no matter how cheap they’ve become…I’m still negative on them.

Where the Market Stands; Where it’s Headed:

It’s actually amazing. Yesterday, the Dow Jones Industrial Average sneaked in another small gain. All these small, ride “the wall of worry” gains have put the market up two percent for the year.

As I have been saying for months, we are in a bear market rally in stocks that started in March of 2009. I’m waiting for the final blow-off on the upside before this bear market rally throws in the towel.

What He Said:

“When I look around today, I see falling stock prices…I see falling house prices…and prices for retail goods stores declining. The media has it all wrong blaming (worrying about) inflation. In my opinion, the single biggest threat to the U.S. economy and to the Fed in 2008 is deflation. You can bet the Fed will expand the money supply and drop interest rates aggressively as deflation starts to rear its ugly head.” Michael Lombardi in PROFIT CONFIDENTIAL, December 17, 2007. Michael was one of the first to warn of deflation. By late 2008, world economies were embedded in their worst state of deflation since the Great Depression.