What does the debt market have to say about all this? Unsurprisingly, the cost of so-called credit-default swaps is spiking. Remember credit-default swaps? They played a big role in the 2008 financial meltdown, helping to bring the United States' biggest insurance company, American International Group, to the brink of financial ruin until the U.S. government bailed AIG out. Investors—and speculators—use credit-default swaps as either a hedge against possible default or an affirmative bet that default will occur. When the cost of credit-default swaps is rising, that means investors and speculators think default is becoming more likely. These days an index that measures the cost of insuring against the default of senior bonds issued by 25 European banks is soaring, according to Paul Amery, editor of IndexUniverse.eu. Indeed, according to this index, Europe's banks are more likely to default on their debt than at any time in recent memory (excepting the peak of the financial crisis in March 2009 and the panic when news about Greece's problems first hit the headlines last spring). Another index, which measures the cost of insuring against the default of subordinated bonds, is trading at levels akin to those at the height of the crisis. The debt market is the grimacing theatrical mask of tragedy.
The stock market, meanwhile, is the smiling theatrical mask of comedy. Amery points out that the Stoxx Europe 600 banks index, which tracks the stocks of banks, has gained a stunning 120 percent from its March 2009 low. Granted, last year European bank stocks fell about 8 percent, making them the second-worst-performing of 19 industry groups, according to Bloomberg. But if equity investors were as worried as debt investors are about the prospect of defaults, then the stocks should have continued to fall. A basic rule of finance is that debt is senior to equity. That means investors in a company's debt suffer losses only after that company's equity has been wiped out. But in this instance equity is acting as though it were senior to debt; the stock market seems to think the banks are sitting pretty while the debt market seems to think the banks are heading off a cliff.
What's making equity investors bullish? Well, there are a few isolated reasons to be optimistic. Last week the sale of debt by both Spain and Portugal went better than expected. Both China and Japan have announced that they plan to help the European Union support its debt. There are rumors that the European Financial Stability Facility might even buy government bonds itself, thereby helping to prop up bond prices while removing them from bank ledgers. Overall, banks' exposure to the troubled debt of other countries is falling, suggesting that someone, maybe the European Central Bank, may be helping out the banks by buying the dodgy debt. Maybe Europe is going to act like one big country after all.
The credit-default-swap market, meanwhile, may be overreacting. Because credit-default swaps are used by hedge funds and other traders, the prices can reflect a piling-on effect, as traders see a trend and jump on it not because they know anything, but because others are doing it.
But if previous experience is any guide, it's the debt markets that will likely prove right. Time after time in the financial world, it's been the debt markets, not the equity markets, that have offered the first glimpse of panic to come. Back in the days of Enron, the cost of insuring against default began to soar long before the company's stock began to plummet. More recently, Amery points out that before the subprime crisis, collateralized debt obligations were divvied into "tranches" of equity and debt, and the equity slices continued to signal that there would be no losses even after the prices of the debt slices had begun to plummet. It may be that there are technical explanations for this phenomenon in collateralized debt obligations, but take a look at the performance of well-known stocks in the early innings of the credit crisis. By early 2007, even as the prices of mortgage-backed securities were falling off a cliff, stocks like Bear Stearns and Countrywide were hitting all-time highs. The Dow itself hit an all-time high in the fall of 2007!
If Europe is headed for a fall, that isn't just a concern for Europe. According to that Bank for International Settlements report, U.S. banks have $353 billion of exposure to Europe's PIGS, meaning that defaults would hit our banks, too. And a good chunk of the earnings of companies in the S&P 500 comes from Europe. In that sense, maybe the project of turning the sovereign nations of Europe into a unified European Union was more successful than we know. Maybe, while we weren't looking, it annexed us.