Saturday, October 29, 2011

Europe - Are We There Yet?

Said simply, the answer is no.

Here are some images taken from various blogposts today:

Protesters in the Puerta del Sol, Madrid
From an Athens article today
Notice the Nazi uniforms and helmets
So where are we? Most of what you will read in the MSM is reporting that Angela pulled it off, or that Merkel and Sarkozy pulled it off - a complex diplomatic dance that finally arrived at a Grand Bargain solution: a three part deal combining a plan to raise bank capital levels, a voluntary restructuring of Greek debt, and an increase in the EFSF "bailout fund" from $440 billion Euros up to as much as $1.3-$1.4 billion Euros. The markets took off on Thursday, after the deal was announced, then gave up a bit on Friday. The Italian bond auction Friday was a mixed bag at best: the 10 year bonds had to be priced to yield 6.06% to sell, above the 6% "affordable limit" and higher than pre-deal.

What gives? The long and the short of it: no new money came in, over what had been pledged in July in the 440 billion Euro deal. Banks have been told to raise Tier 1 capital to 9% by June: indications are most will get there by selling assets or not renewing existing commitments, as opposed to raising fresh money. Holders of Greek sovereign bonds have been heavily strong-armed to take a "voluntary" 50% haircut, bringing Greek debt/GDP ratio to 120% in 2020. The just-finally-approved $440 billion Euro European Financial Stability Facility (EFSF) will be levered up to as much as $1.4 trillion Euro by using part of the original commitments to provide first loss credit insurance on new Italian or Spanish sovereign bonds. Additionally new money may come in from China or Japan, or both, to combine with a portion of the EFSF funding in SPVs (Special Purpose Vehicles) to buy new Italian or Spanish bonds.

So with no new money (until/unless China and Japan come in), we are supposed to solve the Euro crisis essentially with mirrors. Color me skeptical. Or more precisely, incredulous.

There are some very specific flaws in the deal: the haircuts must be "voluntary" so we don't have to call it a default, which would trigger CDS insurance contracts (this is ridiculous on is face, and it may yet trigger an unexpected credit event blowup); neither the ECB nor the IMF are taking the 50% haircuts the banks are forced to take (so Greek debt does not come down by 50% overall); plans for levering up the 440 billion Euro EFSF fund call for 20% first loss insurance, which may be much too low (recovery rates on failed sovereign bonds are never as high as 80%; the first loss insurance may need to be 40-50%, instead of 20%, cutting the fund leverage at least in half - nowhere near enough).

But let's focus on the bigger picture: why hasn't the European Central Bank been backstopping European sovereign and bank credit; and what is all this austerity going to do to the social fabric in the Eurozone and the chance for Europe to grow its way back into economic health?

The answer to question one is simple: Germany is adamant that the ECB not be used to fund sovereign debt, at least not as the primary lender of last resort. Periodic secondary market purchases to keep Italian and Spanish yields below the dreaded 6% level are not welcomed by the Bundesbank or the German political class - but they are tolerated. But no primary backstop, or fiat money issuing/Euro printing - which is the role our Federal Reserve plays in the US. What would it take to change this perspective? A collapse of Euroland, most likely, and even then, a change of mind would not be a sure thing.

So without the ECB stepping up as lender of last resort, the Eurozone structure remains fragile. Everything may slog along, with mini, hence manageable crises; but the markets will remain on edge (take a look at the Italian bond auction Friday, with yields breaking above 6%). Is every one ready to walk on eggshells for the rest of their lives?

But what I think will blow this deal up, and lead us to the next phase of the Eurozone crisis, which could be a systemic event, is the fierce and unrelenting focus on austerity. Take a look at the images at the front of this post. This forced austerity is tearing at the social fabric, within countries and between them. The North of Europe is punishing the South. And the arrogance of Merkel and Sarkozy has not been concealed. The shared smirking and rolling of eyes at their joint press conference last week, when asked whether they were confident Berlusconi and the Italians could get their budget-cutting, deficit-reducing act together, was truly horrible to see. Italy was outraged. Greece has been pilloried, marginalized, condescended to and humiliated. Ireland, Portugal and Spain have fared a bit better, but not much. Unless you intend to go to war, this strategy, over time, will simply not work.

But the other thing that won't work will be the economy. Just watch. None of the countries will make their numbers. Portugal, Greece, Spain and Italy will all miss their targets. Ireland, which has had a bit of an uptick, may be an exception, but I'm not betting on it. France is slowing down. The signs are that Germany is as well. And in the middle of all this, the banks - every major bank in every European country - will be cutting back on lending aggressively in the next few months, to get their capital ratios in line with the 9% target, including offsets for what they must eat on their Greek debt. Slow already. Banks pulling back more. Result: more slowdown, more missed numbers.

At some point. as growth stalls, and there is no money for demand stimulation, and if the ECB remains on the sidelines, the market will conclude that the picture simply does not and will not and cannot make sense - at which time, things will unravel and fall apart.

I am still predicting a Lehman-like market rejection of the Eurozone, unless the ECB steps up and commits to backstop both banks and sovereigns. When? No idea, but probably within six months.

Hang onto your hat.

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