The Debt Dominoes Are Falling One By One

Back in July, I wrote about the

but no one was caring that much. The article related to the problems in the U.S., where we eventually saw S&P downgrade U.S. debt. Yet, the issue of a debt domino is easily just as applicable to Europe as well. Last week, when everyone thought

equity markets rallied. In the past two days, we have seen a sharp sell off in risk appetite, and equities have fallen sharply. Yields have blown out in Italy and Spain, and have fallen sharply in the U.S. and Germany, considered to be the two safest bonds in the world. Italian yields are now well over 6%, beyond a comfortable level for the government to operate. Yesterday with around two hours left to trading, Greece Prime Minister George Papandreou announced that he wanted to hold a referendum on the severe austerity measures it would have to take from the EU summit held last week. This spooked the markets, and sent stocks plunging towards the close. Today, we saw sharp downturns in Europe, and the U.S., as yields on Italian ten-year debt were at a spread of 450 basis points over German bonds. The 450 basis point spread is right at the level where margin calls might come in, and additional selling pressure in Italian debt might happen. As this is a very fluid situation, reports came out just a short while ago that a referendum is getting increasingly unlikely. That is because George Papandreou has almost no confidence from his government, and the Greek government might collapse as early as tonight. Papandreou only has 151 votes for the referendum, and needs more. The only way to really to fix Europe is to have a Eurobond, which German Chancellor Angela Merkel has long said she is

When Merkel and French President Nicolas Sarkozy held their disastrous

a few months ago, Sarkozy did leave open the possibility for a Eurobond, but further down the road. Mr. Sarkozy, we are further down the road now. The

in Europe who has talked about the potential for a Eurobond has been EU Economic and Monetary Affairs Commissioner Olli Rehn. In comments back in August, Rehn discussed the potential for Eurobonds. “The report will, if appropriate, be accompanied by legislative proposals. These euro securities would aim to strengthen fiscal discipline and increase stability in the euro area through markets,” wrote Rehn in a report obtained by Bloomberg. If a Eurobond was enacted, no doubt Germany would be the one bearing the brunt of the weight, with close to $70 billion in additional costs to help bail out its weaker Euro siblings. Although Merkel has objected to having a Eurobond, she has also said that she will do whatever is necessary to keep the Euro intact. Germany is not going back to the Deutschemark, despite what some conspiracy theorists on the web will have you believe. Last week, the EU summit said it would leverage up the European Financial Stability Facility four or five times to get it $1 trillion or more, depending on what the actual amount of money is in the fund. With banks needing to raise $178 billion in capital and Italian debt blowing out, the EFSF at $1 trillion is not sufficient. It would need to be levered to almost $3 trillion to really solve Europe's problems. Or, you can institute a Eurobond. Unless Europe can get its act together and fix its debt situation, the markets will force a resolution and it will not be pretty. One by one they will fall, just like in dominoes. Just like dominoes, they will keep falling until it all comes crumbling down.

Traders who believe that either the Eurobond comes to fruition or the EFSF gets expanded to $3 trillion might want to consider the following trades:

Traders who believe that neither of these options happen may consider alternate positions: