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The Greek Bailout, the CDS Market, and the End of the World

A not-so-funny thing happened on the way to the latest Greek bailout.

The terms and conditions of the bond swap Greece agreed to before getting another handout constitutes a theoretical default – but not a technical default.

That's not funny to CDS holders.

Greece hasn't defaulted (so far), but some of the buyers of credit default swaps, basically insurance policies that pay off if there is a default, claim the terms and conditions of the bond swap constitutes a "credit event" or default.

If it is, they want to get paid.

While on the surface this looks like a fight over the definition of a default, underneath the technicalities, the future of credit default swaps and credit markets is at stake.

In other words, the ongoing Greek tragedy is really becoming a global tragedy of epic proportions.

The Next Act in the Greek Bailout?

Here's the long and short of it.

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Crisis in the Eurozone: The Reality of the European Downgrades

It turned out to be a ruinous Friday the 13th for Europe last week.

After the close, Standard & Poor's downgraded nine of the sovereign states in the European Union (EU).

That included dropping Austria and France to AA+ status from their formerly lofty AAA rating.

While the decision was expected, and will most likely be followed by additional downgrades from the other rating agencies such as Moody's Corp. (NYSE: MCO) and Fitch Ratings Inc., it's the knock-on effects that will have larger implications for investors around the world.

In the Wake of the European Downgrades

The first and most obvious effect was the downgrade of the European Financial Stability Facility (EFSF) that followed on Monday. In the wake of Friday's bad news, the EFSF was also dropped to a AA+ rating.

According to the S&P:

"We consider that credit enhancements that would offset what we view as the now-reduced creditworthiness of the EFSF's guarantors and securities backing the EFSF's issues are currently not in place. We have therefore lowered to 'AA+' the issuer credit rating of the EFSF, as well as the issue ratings on its long-term debt securities."

The S&P also warned more EFSF downgrades would follow if the ratings of other individual states dropped in the future.

In a warning the EFSF could fall below AA+ the S&P said:

"Conversely, if we were to conclude that sufficient offsetting credit enhancements are, in our opinion, not likely to be forthcoming, we would likely change the outlook to negative to mirror the negative outlooks of France and Austria. Under those circumstances we would expect to lower the ratings on the EFSF if we lowered the long-term sovereign credit ratings on the EFSF's 'AAA' or 'AA+' rated members to below 'AA+'."

So where do we go from here?

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S&P to Eurozone: Fix It or Else…

By timing its downgrade threat to the same week as a key European Union (EU) summit on the debt crisis, Standard & Poor's is essentially telling Europe's leaders to "Fix it or else."

The ratings agency said late Monday that it had put the credit of 15 Eurozone countries, including AAA-rated Germany, on a 90-day watch. The move means each affected country has 50% chance of a downgrade.

European leaders are scheduled to meet in Brussels Dec. 8 and 9 to discuss EU treaty changes that would mitigate the debt crisis, such as restrictions on budget deficits. German Chancellor Angela Merkel and French President Nicolas Sarkozy unveiled an outline of the plan Monday.

The timing of the S&P warning "could hold leaders' feet to the fire and force them to go through with a comprehensive solution," Peter Jankovskis, co-chief investment officer at OakBrook Investments, told Reuters.

Reaction of the world's stock and bond markets was muted, with investors apparently looking ahead to the summit.

Money Morning Capital Waves Strategist Shah Gilani said it was "about time" the ratings agencies started to get serious about credit ratings in the Eurozone, saying they were behind the curve on such problems as mortgage-backed securities.

"Now they're pushing their new "ahead of the tsunami' PR campaign," he said. "Their PR agenda aside, they're right to be knocking these credits down to reality."

They Had it Coming

S&P listed several reasons for its warning.

"After a good two years of trying to manage the crisis, the political efforts have not been able to arrest matters," Moritz Kraemer, head of European sovereign ratings at S&P, told the Financial Times. "It is our view that this is a systemic stress, a confidence crisis that affects the Eurozone as a whole."

Those "stresses" include tightening credit, rising government bond yields, squabbling among Eurozone leaders about how to cope with the crisis and the rising risk of a Eurozone recession next year.

"We are approaching a very important moment where the crisis could take a very significant turning point for the worse and we want to warn investors," Kraemer told The FT. "Considering how the crisis has deepened and the challenges that they are facing, [the summit] is the last good opportunity that policymakers have."

Although the S&P said it would take the results of this week's summit into consideration, no one should doubt the agency's resolve. This past summer S&P followed through on a similar threat to cut the credit rating of the United States to AA+ from AAA following the debt ceiling crisis debacle.

"S&P's view is that the political outcome will also drive creditworthiness, and I don't think anyone in their right mind would dispute this point," Ashok Parameswaran, an emerging-markets analyst at Invesco Advisers Inc., told Bloomberg News.

More Turmoil Ahead

Should this week's Eurozone summit fail to go far enough to please the S&P, the real fireworks will begin.

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Rising Government Bond Rates Push Eurozone Debt Crisis to the Precipice of Collapse

Rising government bond rates are making it increasingly costly for several key Eurozone nations to borrow money, stoking fears that the sovereign debt crisis has reached a critical stage.

Yields on 10-year Spanish Treasury bonds rose to 6.8% during yesterday's (Thursday's) auction – uncomfortably close to the 7% level at which many experts feel is unsustainable. When the 10-year bond yields of Portugal, Ireland, and Greece passed 7%, each was forced to seek a bailout.

Just last week the 10-year bond yields of Italy crossed the 7% threshold. Though yields dropped back below 7% after Italian Prime Minister Silvio Berlusconi stepped down, the respite proved short-lived. The Italian 10-year bond yield fell back to 6.84% yesterday but is expected to stay in the danger zone for the foreseeable future.

Perhaps more worrisome is the rise in French bond yields. While France is not one of the troubled PIIGS (Portugal, Ireland, Italy Greece and Spain), it has deep financial ties to those nations. French 10-year bonds now yield 3.64%, twice that of equivalent German bunds despite both nations having a top-tier AAA credit rating.

The cost of borrowing is rising even for nations that until now had been outside of the fray, like the Netherlands, Finland, and Austria.

"Momentum is building," Louise Cooper, market strategist at BGC Partners, told MarketWatch. "Ten-year French borrowing costs are now around [two percentage points] greater than Germany, Spanish borrowing costs are rocketing and 10-year Italian debt is yielding over 7%. The hurricane is approaching. Time to batten down the hatches."

Economic Damage

As the Eurozone debt crisis deepens, many analysts worry that the rising government bond rates could put the brakes on lending and lead to a credit crunch such as the one experienced during the 2008 financial crisis.

In the short term, however, the steady stream of scary news is taking a toll on the stock markets. The British FTSE 100 was down 1.58% and the French CAC 40 was down 1.78% yesterday, while the Dow Jones Industrial Average fell 134.79 points, or 1.13%.

"Investors keep thinking that the powers that be in Europe are getting in front of this – only to be disappointed when additional bad news emerges," observed Money Morning Capital Waves Strategist Shah Gilani. "That's why we're seeing these whipsaw trading patterns that are so frustrating to retail investors who've been schooled to buy and hold. The reality is that this will get much worse before it gets better."

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Three Psychological Stumbling Blocks That Kill Profits

Face it, the past 12 years have been horrible for most investors.

This is not necessarily because the markets have been rocky, but rather because the vast majority of investors are hardwired to do three things that kill returns.

You can blame Washington, the European Union, debt, high unemployment, or half a dozen other factors if you want to, but ultimately, the person responsible is the same one staring back at you from your bathroom mirror in the morning.

That's why understanding the bad habits you didn't know you had can be one of the quickest ways to improve your financial wealth.

Here's what I mean.

Dalbar, a Boston-based market research firm, produces annual research that compares the returns of stock and bond markets with those of individual investors. The latest, covering the 20-year period ended last year, shows that the Standard & Poor's 500 Index returned an annualized gain of 9.1%. That stands in sharp contrast with the measly 3.8% gain individual investors averaged over the same timeframe.

Fixed income investors didn't do any better. According to the Dalbar data, t hey gained a mere 1% a year versus an annualized return of 6.9% for the Barclay's Aggregate Bond Index.

In other words, investors' self-defeating decisions contributed to an underperformance that was 58% below what it could have been for stocks and 85.5% below what it could have been for bonds.

Why?

Three reasons: recency bias, herd behavior, and fear.

It's All About Perspective

Recency bias is what happens when short-term focus trumps long-term planning and execution.
It's what happens when somebody yells "fire" and everybody runs for the same exit at once despite having entered through any of half a dozen doors in the auditorium. Simply put, recency is recent knowledge that overrides longer-term thinking and memory.

This is why momentum trading works, for example, or the news channels seem to cover the same stocks at nearly the same time – because a huge number of people are focused on exactly the same companies simultaneously. Logically, they then become the subject of increased attention and tend to move more strongly or consistently.

The question of why is the subject of much debate among human behaviorists, but I chalk it up to the fact that human memories tend to focus on recent events more emotionally than they do longer-term plans that are put together with almost clinical detachment.

And the more extreme the events or the news, the sharper our short-term focus becomes.

That's why, according to "Mood Matters," a book by Dr. John Casti, one of the world's leading thinkers on the science of complexity, "bombshell events are assimilated almost immediately into the prevailing [social] mood" where as longer-term cycles bear almost no witness to gradual change.

If that doesn't make sense, think about what happened on 9/11. Most of the world's major markets bottomed within minutes of each other on short-term panic and emotion. Then, when trading resumed days later, they began to climb almost in sync as highly localized events once again faded into the longer-term fabric of our world.

And that brings me to herding.

The Herd Mentality

We'd rather be wrong in a group than right individually so the vast majority of investors tend to make decisions, and mistakes, together en masse.

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Five Companies to Avoid Until the Eurozone Debt Crisis is Over

U.S. companies with significant exposure to Europe will take a profit hit regardless of how the Eurozone debt crisis shakes out.

The financial strain of Europe's efforts to avert default among its troubled members – Portugal, Italy, Ireland, Greece and Spain (PIIGS) – has set the Eurozone on course for a recession even if its efforts succeed.

Yesterday (Thursday) the European Commission dropped its forecast for growth in the Eurozone to just 0.5% from its previous estimate of 1.8% in May. The commission blamed austerity measures, which were aimed at lowering budget deficits, but ended up eroding investment and consumer confidence.

"The probability of a more protracted period of stagnation is high," said Marco Buti, head of the commission's economics division. "And, given the unusually high uncertainty around key policy decisions, a deep and prolonged recession complemented by continued market turmoil cannot be excluded."

Falling consumer demand has already begun to affect the bottom lines of many U.S. companies that derive large portions of their revenue from the Eurozone bloc.

"In light of cutbacks in government spending, tax increases and waning business confidence, there already has been some [company] commentary on slipping appliances, bearings and heavy-duty trucks demand," Citigroup equities analyst Tobias Levkovich told MarketWatch. "In many respects, these early remarks are a worrisome sign."

For example, General Motors Co. (NYSE: GM) on Wednesday said the debt crisis would prevent it from breaking even in Europe this year. And Rockwell Automation Inc. (NYSE: ROK) on Tuesday warned of declining capital spending in Europe next year.

Although sales to Europe account for only 10% of revenue for the Standard & Poor's 500 as a group, several sectors have far more exposure to the Eurozone.

The auto sector derives 27.6% of its sales from Europe, followed by the food, beverage and tobacco sector at 22%, the materials sector at 19.8%, the consumer durables and apparel sector at 16.2% and capital goods at 16.4%.

"Europe is a major component to the U.S. economic engine and it is a concern," Howard Silverblatt, an analyst with S&P Indices, told MarketWatch. Silverblatt noted that while a European recession may not necessarily take down the U.S. economy, "it has an impact that will move stocks."

Here are five U.S. stocks that have significant exposure to Europe and leveraged balance sheets high – making them risky investments until Europe gets back on its feet:

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MF Global Bankruptcy Exposes Vulnerability of U.S. Banks to Eurozone Debt Crisis

The bankruptcy of MF Global Holdings (NYSE: MF) was a distressing signal to investors that it is possible for U.S. financial institutions to fall victim to the Eurozone debt crisis.

MF Global filed for Chapter 11 bankruptcy Monday after credit downgrades led to margin calls on some of the $6.3 billion in Eurozone sovereign debt the bank held. The position was five-times MF Global's equity.

Although the major U.S. banks have less exposure relative to available capital, their many tendrils in Europe – particularly to European banks – will inevitably drag them into any financial meltdown in the Eurozone.

Even the U.S. banks' estimated direct exposure to the troubled European nations of Portugal, Ireland, Italy, Greece and Spain (PIIGS) is disturbingly high – equal to nearly 5% of total U.S. banking assets, according to the Congressional Research Service (CRS).

And according to the Bank for International Settlements (BIS), U.S. banks actually increased their exposure to PIIGS debt by 20% over the first six months of 2011.

But the greatest risk is the multiple links most large U.S. banks have to their European counterparts – many of which hold a great deal of PIIGS debt.

"Given that U.S. banks have an estimated loan exposure to German and Frenchbanks in excess of $1.2 trillion and direct exposure to the PIIGS valued at $641billion, a collapse of a major European bank could produce similar problems inU.S. institutions," a CRS research report said earlier this month.

Of course, the major banks say their exposure to the Eurozone debt crisis is much lower because they've bought credit-default swaps (CDS) to hedge their positions. Credit-default swaps are essentially insurance policies that pay off in the event of a default.

Unfortunately, this same strategy was one of the root causes of the 2008 financial crisis involving American International Group (NYSE: AIG) and Lehman Bros.

"Risk isn't going to evaporate through these trades," Frederick Cannon, director of research at investment bank Keefe, Bruyette & Woods Inc., told Bloomberg News. "The big problem with all these gross exposures is counterparty risk. When the CDS is triggered due to default, will those counterparties be standing? If everybody is buying from each other, who's ultimately going to pay for the losses?"

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Two Ways To Add Income to Your Portfolio as a Currency Investor

For the past 30 years, my grandfather has been living the retirement dream, thanks to a few strategic stock plays.

Here's the interesting part: My grandfather never knew a thing about stocks. He didn't know how to value them, or when to buy and sell.

But he did know the power of income.

You see, as a child of the Great Depression he saw stocks differently than we do today.
His generation didn't buy stocks for the possible capital appreciation.

Instead, they bought stocks based on the dividend yield – and the consistency of that dividend.

They had lived through uncertain times, so they only trusted investments that offered fairly certain income.

That's why now, as we find ourselves back in uncertain markets, you want to make sure your portfolio includes interest-bearing and dividend-yielding assets.

Passive dividend income arrives no matter what's happening in Greece, or how long U.S. Federal Reserve Chairman Ben Bernanke decides to hold rates at record lows. It comes as long as the company remains strong.

Which means my grandfather's strategy is worth copying.

How to Live Comfortably During Uncomfortable Times

My grandfather started with certificate of deposits (CDs) in the late 1970s and early 1980s. These were the high-interest days, so these CDs paid 16% to18% interest. He got that nice, passive "certain" income for as long as that party lasted.

Then once interest rates dropped and all his CDs matured, he looked for the next round of certain income. He had just retired from the telecom industry and believed AT&T Inc. (NYSE: T) was a good long-term play.

Best of all, AT&T paid a 6% dividend yield. So he wisely invested his CD income into AT&T stock and then sat back and waited.

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Southeast Asia: Strong Growth, Humming Factories, No Debt Crisis

Gloom has enveloped most of the investment landscape these days, but there is still one region that offers strong growth and serious returns.

I'm talking about Southeast Asia.

There was a time when investors scoffed at the likes of Singapore, Thailand, Malaysia and Indonesia. But no one's laughing now. The naysayers currently are all too busy pulling their money out of the regions they always assumed were safe – the United States, Europe, and even the trendy BRICs (Brazil, Russia, India, and China).

Indeed, there are precious few flourishing economies in the world today, and none look as promising as the ones you'll find in Southeast Asia. We're talking about countries that have pro-market governments, thriving manufacturing sectors, ample natural resources, and – with the exception of Singapore – wage levels that can still grow a great deal before pricing themselves beyond their Western competitors.

That's quite a lot by today's standards.

Just take a quick look around the rest of the world and you'll see what I mean.

Searching for a Savior

U.S. growth has fallen off a cliff and no amount of "stimulus" seems likely to get it back on track. Economic growth in Europe is stalled as well, and the continent is further jeopardized by the potential collapse of Greece and the European Union (EU). Even Australia and Canada, both with strong mineral and energy sectors, seem to be slowing as demand wanes in the wealthy West.

Emerging markets seem like a better bet for our money at first glance, but they, too, have problems when examined more closely.

Brazil and China are battling inflation. Brazil has a government that seems unable to stop spending, while China has a thoroughly corrupt government and a banking system with an enormous hidden bad debt problem. Russia is a snake pit, from which a foreign investor is unlikely to escape alive. And India, while growing rapidly, has a serious inflation problem and a government as corrupt as it is economically inept.

Fortunately, one incandescent bright spot shines through the darkness: Southeast Asia. So let's take a look at some of the investment opportunities being illuminated.

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In Today's Crazy Markets, Here's the One Global Region to Invest in Now

Money Morning global investing guru Martin Hutchinson has identified the one global region that he's focusing on as the world's next big profit play.

You'll be stunned to see what he's discovered.

But you'll also be wise to listen.

Read More…