(From MIR of February 18,2009)

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Eastern Europe and Its Potential Effects on Other Markets––Over the past month or so, I have alluded to the problems which several countries in Eastern Europe were facing. Those problems are rapidly coming to a head. Like the U.S., Eastern Europe has a debt problem, but this one is rooted in foreign currency mortgages, which are coming unwound.  Along with what appears to be a banking meltdown in Ireland, the amount of capital which the core European countries may need to stump up in order to bailout not only their own banks, but entire countries from Ireland to Eastern Europe is beginning to be priced in.

Across Eastern Europe, a significant number of mortgages have been written in Swiss Francs.  In Poland, the number of Swiss Franc mortgages may be as high as 60%.  From Hungary to the Baltics, problems of debt which cannot be repaid, funding in the wholesale markets, which is no longer available, to options exotica and mortgage funding in foreign currencies (see chart of SF/Hungarian Forint), are accelerating.  Bank systems in Eastern and Western Europe are at risk.  But this is not just a European banking problem.  My hunch is a meaningful amount of CDS were written on European banks by U.S. banks.  So if Eastern Europe ok, the effects may well be felt around the world, but particularly so in the West.

Some European authorities are trying to move quickly to stop the bleeding.  Austria's finance minister Josef Proll attempted to put together a 150 billion Euro rescue package last week, to which the Germans replied it was not their problem.  It will be.  I also note that Peer Steinbruck, Germany's finance minister, in yet another example of what goes around, comes around, after lambasting the U.S. and it's banking system just months ago, is now saying Euro- region countries may be forced to bailout other EU members which face problems refinancing their debt.  He named Ireland as being in a very difficult situation.  Unless I am geographically challenged Ireland is not in the East, but like Spain and Portugal, which are also having financial issues, they are in the EU.

On Monday, while America's markets slept, the Polish Central bank made the following comment.  "The decision to enter ERM2 is based on both political and economic grounds.  The research carried out shows that it's hard to find economic arguments supporting entering this mechanism in the current situation.  (1) This is potentially big.  If Poland chooses to de-link itself from the Euro, this will have political repercussions, but the economic/market will also be huge.  If Poland weakens the zloty, a run on the currencies of Eastern Europe is likely to ensue and that will spell real trouble for Western European banks.  I have seen one estimate that 74% of the $4.9 trillion in loans to emerging markets come from Europe.  The BIS data indicates Western European banks have more than $200 billion in exposure just to Poland.

I believe the EU's financial system is in real trouble and there is no version of the Federal Reserve in place to salvage the big Western European banks.  The ECB is charged with fighting inflation, not turning on the printing press.  There is no policy framework in Europe for dealing with failing countries/banks.  This suggests there will be far greater stress which hits the prices of the European financial stocks and that at some point the Euro is going to turn up against the Dollar.  This is when I think an every man for himself mentality may take over.  Should we believe that the Germans will bailout Spain?  Or Portugal?  Or even Poland?

Sources: Bloomberg Data, Bloomberg News

BIS data

“Banks face Eastern Europe Downgrades, Moody's Says” By Zoe Schneeweiss and Niklas Magnusson.  Bloomberg News.  February 17, 2009.

“Steinbrueck Says Euro States May Bail Out Members” By Rainer Buergin and Holger Elfes.  Bloomberg News.  February 17, 2009.

“Failure to save East Europe will lead to worldwide meltdown” By Ambrose Evans-Pritchard. Telegraph.co.uk. February 15, 2009.

(1) “Poland’s National Bank: Too early for first stage of Euro, Warsaw, (dpa)”.  Bloomberg News.  February 16, 2009.