European Contagion Turns Positive, Will It Last? (TZA, FAZ, FAS, TBT, TLT)

Shah Gilani: After European leaders announced a plan to stem Eurozone and global panic over Greece’s potential default and shore up capital at beleaguered banks, positive contagion is lifting stock markets from one end of the planet to the other.

What’s not to love?

Well, the plan itself, for one thing. It’s so full of holes that unless it’s tightened-up, detailed, actually agreed to, financed and executed, it’s nothing but an outline in the sand.

Don’t get me wrong, it’s a start. But, the question investors have to ask themselves is, if the plan isn’t written in stone and if they’ve missed this rally, is now the time to jump back into equities?

The answer is yes and no.

Understanding where the risks are and how to position yourself to profit on the heels of this new global positivity requires looking at the European bailout plan as proposed, and measuring it against the realities constantly unfolding in the future.

Let’s start with the plan and measure it against what you should be watching in the days, weeks, and months ahead.

The Devil’s In the Details – Especially When There Are None

What has been proposed is a plan to ask private banks to “voluntarily” exchange some $300 billion (210 billion euros) of current Greek debt for new debt to be issued by Greece. The banks are being asked to take a 50% haircut. That means the debts they were owed will be cut in half. Instead of Greece owing $300 billion, the country will owe its creditors $150 billion (105 billion euros).

The two immediate issues here are:

  1. How many banks will voluntarily execute an exchange of Greece’s obligations?
  2. How are they going to plug holes in their Tier 1 capital when they write down $150 billion of losses?

As of now, there is no answer to the first question. It remains to be seen how many banks will willingly eat Greece’s bad cooking. Back in July, banks were asked to voluntarily take a 21% haircut on their Greek holdings. Practically none of them did.

The only thing that’s different this time around is that if the banks exchange old bonds for new bonds, the new bonds “may” have some first-loss provisions that would offer some protection if Greece defaults.

Yet, even that is a dicey proposition, since there currently is no number in place for first-loss provision. In fact, there isn’t even an explanation of how the first-loss provisions would be backstopped or who would pay up on the losses.

Also, first-loss provisions relate solely to who gets paid when in the case of a default. They have nothing to do with banks taking losses if the market price of newly issued bonds tumbles. That’s especially troubling now, since accounting rules require banks to not only show unrealized losses, but to add capital to offset those losses, as well.

And that’s just the first problem.

The second is that in order for Greece to potentially guarantee some portion of its new bonds, it’s going to need at least $43 billion (30 billion euros).

So where will it get that money? Well, the plan implies the International Monetary Fund (IMF).

At this point it’s important to understand that of Greece’s $500 billion (350 billion euros) of outstanding debt, $300 billion is held by private banks and the remaining $200 billion (140 billion euros) is held by institutions. These institutions, which include the IMF, are NOT volunteering to take any losses on their holdings. They want to get back 100% of what they’re owed. So, they are willing to pony up more backstop money against the losses banks could see, as long as in the final rinse they get back everything they’ve lent.

So where’s the $150 billion in capital that’s needed to shore up the banks that are supposedly going to take 50% haircuts going to come from? Probably the IMF, with new money added to its coffers by the Chinese. And that’s the only way the Chinese are likely to participate in this high-stakes game of blind man’s bluff.

Now the question of how much you should invest in this rally.

Pick Your Poison

As I said, the plan at this juncture is nothing more than a line in the sand. And the sand is shifting.

The markets have rallied hugely. If you’ve missed this major push north and want to get in, do it very gingerly. We could see markets rally through year-end based on the positive contagion from the perception that this plan is going to be detailed, financed and executed.

Buy with caution and use very tight stops. I would suggest 10% to 15% stops.

On the other hand, I would be equally at ease shorting this rally, also with tight stops.

As a trader, that would be my choice. I believe we’ve come too far, too fast. We’ve been rocketing higher on short-covering and hopes that the threat of European contagion would be addressed and conquered.

Well, it’s been addressed, as in, “hello, my name is uncertainty.”

And as far as conquering the systemic problems in Europe, we’ve still got a long way to go. This plan is nothing more than a liquidity backstop to a solvency problem.

The only way this situation will be fixed for good is if Europe’s insolvent countries are afforded enough liquidity to grow their way out of their budget holes.

Good luck with that.

France, Europe’s second-largest economy, in September saw a wide measure of its unemployment tick up by some 4.175 million people. The government has reduced gross domestic product (GDP) forecasts to 1.75%, but private economists are putting that number closer to 1%.

Germany has been slowing down, as have almost all other European countries.

And so many questions still linger.

What will required austerity measures do to future growth prospects? What social and political implications will the continent have to deal with as it tries to extend and pretend that it’s not really one giant debtor-in possession? What will fuel growth if there’s no bank capital to finance it? What will happen if structural recession is the new normal? And what will happen if we get sequential crises via Portugal, Italy, or some other debt-laden country?

For investors wanting to jump onto rallying markets, I say be careful. We’re not out of the woods. And for investors thinking about fading this rally, I say give it a shot.

Just don’t forget the devil is in the details and sand is not concrete.

Related: Direxion Daily Financial Bull 3X Shares ETF (NYSE:FAS), Direxion Daily Financial Bear 3X Shares ETF (NYSE:FAZ), iShares Barclays 20+ Year Treasury ETF (NYSE:TLT), ProShares UltraShort 20+ Year Treasury ETF (NYSE:TBT), Direxion Daily Small Cap Bear 3X Shares ETF (NYSE:TZA).

Written By Shah Gilani From Money Morning

Shah Gilani is the editor of the highly successful trading research service, The Capital Wave Forecast, and a contributing editor to both Money Morning and The Money Map Report. He is considered one of the world’s foremost experts on the credit crisis. His published open letters to the White House, Congress and U.S. Treasury secretaries have outlined detailed alternative policy options that have been lauded by academics and legislators.

His experience and knowledge uniquely qualify him as an expert. Gilani ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When the OEX (options on the Standard & Poor’s 100) began trading on March 11, 1983, Gilani was working in the pit as a market maker, and along with other traders popularized what later became known as the VIX (volatility index). He left Chicago to run the futures and options division of the British banking giant Lloyds TSB. Gilani went on to originate and run a packaged fixed-income trading desk for Roosevelt & Cross Inc., an old line New York boutique bond firm, and established that company’s listed and OTC trading desks. Gilani started another hedge fund in 1999, which he ran until 2003, when he retired to develop land holdings with partners.

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