Eye on the Market I October 5.2011 J.P.Morgan What may be coming in Europe: a multi-faceted muddle-through plan that could reduce systemic risk As shown below, the last couple of months have seen no fewer than 10 inflection points in global equities. The latest surveys show that Europe is heading for recession, but that has been known for some time. What most of these gyrations reflect is perception of systemic risk emanating from the European banks. Earlier this week, we wrote that there is downside risk ahead, since the resolution of the European problem is still too distant and unclear to make out. The Dexia announcement may have changed things by accelerating the end-game. Dexia's share price collapse reflects the pressure European banks are under. Dexia ($750 bn in assets), which passed the translucent EBA stress tests with flying colors (twice), saw its market capitalization fall below the face value of its exposure to Greece on Tuesday. Options for France and Belgium were running out; it is unclear how many assets Dexia had left that it could pledge with the ECB. A hurried announcement was made by the Belgian finance minster that Dexia's bad assets would be placed in a Bad Bank2, thereby protecting depositors and other senior creditors. World Equity Index: confused and sometimes misled Dexia's share price collapse Level Price per share, Euros 1350 €10 1300 1250 1200 1150 1100 1050 Sep-11 Oct-11 Sep-08 Mar-09 Source: Bloomberg. Sep-09 Mar-10 Sep•10 Mar-11 Jul-11 Aug-11 Source: MSCI, Bloomberg. Sep-11 So, let me offer the following possible events that Dexia might set in motion that could reduce systemic risk from Europe: • Before the EFSF is ratified, France and Germany independently guarantee/recapitalize their national champion banks; they presumably will not leave Dexia as the safest one. With the bad bank approach, losses would be worked off over time, as in prior iterations of this approach (e.g, China after 2000)