Eye on the Market I October 24, 2011 J.P.Morgan Topic: A biological look at the latest attempt to resolve the European Monetary Union debt crisis; US Q3 earnings The EMU (technical name: Economic and Monetary Union, common name: European Monetary Union) is beginning to bear more and more resemblance to its aviary twin: the flightless, awkward, and bumbling' emu (drornaius novaehollandiae). Europe's long-awaited sovereign and bank bailout package will soon attempt liftoff; we will know more after yet another summit on Wednesday. There are flaws that may weigh this emu down, as annotated in the picture below. Why is this so important? Bank recaps in Sweden (`92), the US ('92, '08), Japan ('99) and Asia ('98) were close to marking the bottom of the equity market cycle....but were not designed using the equivalent of the "Goal Seek" function in Microsoft Excel. Will the EMU bailout fly? The annotated version For purposes of determining bank capital needs. the EU is NOT going to apply a stress test per se, but a simple mark-to-market exercise on sovereign bonds. That's why reported recap needs are only 75-100 bn Euros. Using mark- to-market levels is less conservative than prior EBA sovereign loss assumptions. and the planned exercise does not assign loss estimates to corporate. household and commercial property loans. The process appears Goal-Seeked to maximize EFSF proceeds available to backstop sovereign debt la.bl. Demand (depth. pricing) for Italian or Spanish bonds with a first- loss guarantee from the EFSF is unproven EFSF direct guarantees could be a possible violation of EMU bailout restrictions [c] ► Risks to France's AAA rating from the extension of too many guarantees to either the EFSF or its own banks idl No stress test this time. but we still have reservations about the prior one. as it only assumed 1.3% for household. corporate and commercial property loan losses over 2 years. This compares to the current market-implied loss r