Vaccinate Against This Fiscal Contagion

Editor's Note: Special Contributor Michael Lewitt publishes the highly regarded The Credit Strategist, and was recognized by the Financial Times for forecasting both the financial crisis of 2008, and also the credit crisis of 2001-2002. His 2010 book, The Death of Capital: How Creative Policy Can Restore Stability (John Wiley & Sons) was included in the curriculum at the University of Michigan and Brandeis University.

The European financial crisis is often pushed out of the headlines by crises of a more incendiary variety. That might suggest the problem has diminished. It hasn't.

The saga of Portual's Banco Espirito Santo is a sure sign to investors that the European financial crisis is anything but over.

Mario Draghi and the European Central Bank (ECB) may keep its finger in the dike, but the dike is only going to spring more holes.

European banks are still highly leveraged. Their investors are likely to run for the hills at the first sign of trouble, and governments are going to be reluctant to bail them out unless they feel that their collapse poses a systemic risk.

Global investors are, for the most part, shrugging off the problems at Banco Espirito Santo, but European investors are not taking things so lightly. Here's why you shouldn't, either...

This Country's Woes Will Stress a Troubled System

On Monday, July 14, the parent company of Banco Espirito Santo announced the need for a debt restructuring. Then it was disclosed that Rioforte Investments SA, which controls Grupo Espirito Santo's non-financial arm, is likely to default on an 847 million euro loan and may have to file for bankruptcy. The bank's stock fell another 10% and is down 32% over the past four days. The stock traded as low as $0.355 cents mid-day yesterday, its lowest level in 21 years.

Banco Espirito Santo was the only one of Portugal's three largest banks not to seek a bailout during the financial crisis, but it has suffered since then. It hasn't paid a dividend in three years and posted a 417.6 million euro loss in 2013. It claims to have a sufficient capital cushion to absorb losses on the 1.18 billion euro of exposure it has to its parent company, but we all know that when investors lose confidence in a bank the issue no longer becomes one of dollars and cents.

Portugal's broader economy continues to struggle along with the rest of southern Europe. In May, business lending collapsed by 8.23%. While the economy is expected to grow this year (the European Commission forecasts 1.2% growth for 2014), unemployment is still 15.4% and is expected to remain high for years to come. Portugal's fiscal deficit is expected to be about 4% this year and 2.5% in 2015 according to the IMF and its debt is equivalent to 130% of GDP.

The last thing the country needs is to bailout its second-largest bank.

Portugal's 10-year prices fell and yield jumped by 24 basis points to 4% from Friday's close of 3.58%; Portugal's five-year credit default swaps (credit insurance that measures investors' view of the risk of Portuguese sovereign credit) rose by 19 basis points to 215 basis points to a four-month high.

On the larger stage, the European bank stock index dropped as well by 2.7% to the lowest level since December 2013. While the potential collapse of a bank in Portugal doesn't threaten the entire European banking system, the sell-off shows that it doesn't take much to shake the illusion of stability in Europe.

For the most part, however, the problems in Portugal are being ignored by global investors in another sign that the only thing that matters to them is what central banks are prepared to do.

Investors expect European banks to use as much as $1.36 trillion of cheap loans that will be made available by the ECB to buy sovereign debt from weaker sovereigns such as Portugal, Spain, and Italy. Even though these funds are intended to be used to finance household and business lending, it does not appear that the ECB is prepared to restrict the use of those funds to those purchases.

Accordingly, sovereign debt of weaker nations continues to rise despite signs of problems such as those in Portugal.

Don't Fall for This "Recipe for Disaster"

The wholesale dependence of investors on the generosity of central bankers is certain to end badly. As more money pours into mispriced sovereign debt, yields on that debt will remain far lower than justified by economic fundamentals.

Such distortions can only end one way - in a massive correction that burns investors and leaves them nursing huge losses. Memories are short, but it was errant central bank policies that contributed to the last financial crisis, which occurred a mere five years ago.

One would think that the problems in Portugal would remind investors that relying on these same central banks to bail them again is a recipe for disaster.

Investment value creation, such as real equity or commodity-driven wealth building, persists, ironically, despite central bank machinations, rather than because of them.