Eurozone Sovereign Debt Crisis

You have to hand it to Draghi & Co. Without so much as lifting a finger (or if you prefer “pressing the money print button”), they have managed to keep the Eurozone markets buoyant through the summer holidays. Politicians and Central bankers have kept the Algo machines purring, as they keep making the right noises. Comments such as, “don’t bet against the Euro”, “ECB to buy periphery bonds to maintain a cap on yield gap with German Bunds”, “Spain to seek fully fledged bailout” have all bruised the “shorts”. 

The Bernanke show also came and went with more words, no action. They remain prepared to start QE3 but not quite now. You may well ask, “if not now, then when”? With US elections round the corner, and the Republicans beating down on the Fed actions to date, it is now unlikely that there will be QE3 in 2012.  

The August ECB meeting shot “blanks” and the markets initially fell but then gave Draghi the benefit of doubt, and more time. The buoyancy in the markets has allowed Italy to successfully place €4bn of 10-year paper and European corporates to raise almost €7bn last week alone. However, in a worrying development, a €3bn 10-year offering by the EFSF ended up undersubscribed.

The next ECB meeting on September 6 could be a “tell”. If the ECB does not start buying Spanish bonds soon after (say, because Spain does not seek ESFS assistance, which is a precondition for ECB action), volatility is likely to return with a vengeance. Furthermore, if the German courts rule against (or strongly criticise) the ESM on 12 Sept (they are deciding whether the sovereign rights of the German people are being infringed by the changes suggested to the ESM), all hell will break lose. FYI, Morgan Stanley sees a 40 percent chance that the Court bans Germany from ratifying the ESM treaty.

Meanwhile, the fundamentals continue to deteriorate across Europe. Greece is broke (is, has been, and now likely will continue to be), unemployment, and consequently, social strife are increasing. Politicians and Central Bankers continue to play a dangerous game of feeding the debt problem instead of solving it.

If you thought 2012 has been volatile to date, hang on because “you ain't seen nuthin' yet”.

Many central bankers in the past have made solemn pledges stating “we will do what it takes to preserve the integrity of [name your currency]”. Such a statement usually sparks off a short covering rally amongst the “speculative” community, but inevitably ends up with lower prices. Recall the efforts made by the Bank of Japan to keep USD strong vs. JPY over the years. It currently fetches just JPY 79 to USD 1, a breath away from its all-time low.

In short, these pledges rarely work. Draghi also added the immortal words, “believe me, it will be enough”, words that may come to haunt him soon enough. However, as the statement was made, the equity markets shot up, sovereign bond yields for the peripheral countries fell and the Euro moved from 1.20 to 1.23 in a matter of minutes.

Now, there are only two plausible measures to slow down the Euro crisis – fiscal integration amongst the sovereign nations in the EU (i.e. all for one and one for all) or monetisation (i.e. print Euros to buy sovereign debt). Since the first is not in the ECB’s mandate, the Draghi statement was interpreted as suggesting the imminent commencement of a large scale bond purchase operation, backed by printing Euros, if necessary. The markets have also been goosed by apparently leaked statements by members of the Fed that this week’s meeting will see the re-commencement of QE in the US.

There are certain obstacles that the central banks will have to contend with. Although the politicians have supported Draghi, the German Bundesbank was quick to denounce the statement. After all, bond purchases will sit on the ECB balance sheet, most of which is owed to the Germans. In other words, Germany ends up with a greater burden of risk of Italian and Spanish defaults. Without German consent, it’s hard to see a large scale buying operation taking place. On a secondary point, the greater the volume of ECB purchases, the greater the risk of subordination for existing bondholders. This will creep in soon enough after such purchases commence.

In the US, the economic numbers have been dismal with unemployment persistently up. At the same time, sales, GDP, manufacturing and servicing indicators are all down. As the chart below shows, the earnings season in the US has also been a major disappointment. Many pundits have therefore suggested the Fed will start QE3 this week.

However, this is election season in the US and the Fed may not want to be seen as helping the incumbent party. Furthermore, there is growing evidence that inflation is ticking up. If an easing is perceived by the $16 trillion odd creditors of the US bonds as being “slack on inflation”, we could see long term rates spiking up in the US, which is not what the Fed wants. Finally, you have to ask yourself this question, “will the fed embark upon QE3 when the S&P equity index is close to 1400 or will they use that bullet when the markets are much lower”?

What has so far been an extremely technical game of chess between the markets and central banks has been transformed into a poker match. The market will now call “show” and it is up to the central banks to deliver. If their hand falls short “buy will become bye bye”.

The answers will be with us soon enough! 

Following the late night EU summit, London woke up to find the risk markets in a buoyant mood.  The “short term measures” announced at 4.30 am (GMT) this morning included the ability of  ESM and EFSF to directly fund European banks without the attached austerity programs.  Spain, Italy and Ireland have now joined the rock stars who Dire Straits once wrote a song about, complaining they get “money for nothing...”

The news was accompanied by a number of self congratulatory messages, high fives and a group hug amongst the EU leaders. Crudely put, they claim to have “nailed this sucker” (again).  In keeping with the spirit of the summit, Germany duly lost the Euro 2012 semi final to Italy.  This leaves us with Italy vs. Spain and going by bond yields, Italy should just about clinch the final 1-0.    

Since both facilities were designed to buy Sovereign debt and not bank debt, it would have to be ratified by all the 27 EU member states.  Meanwhile, the real solution – to get a credible German balance sheet behind this mess – is off the immediate agenda and EU leaders will wander off into their well deserved summer breaks having saved the Eurozone...for at least a few more weeks. 

ESM - European Stability Mechanism
EFSF - European Financial Stability Facility

The function of the Markets is to set prices efficiently. Any initiative that artificially influences the price setting mechanism introduces false incentives. Influenced markets distort the ability of willing buyers and sellers to set prices correctly. Once the effectiveness of the artificial influences wane, the market corrects violently. This partly explains the crash of 2008 and the ongoing crisis. Bailouts, QE’s, LTRO’s and various schemes to provide liquidity into the market may have staved off a sharp crash but cannot solve a solvency crisis - we simply owe more than we can afford to pay with the assets we hold. Either a credible balance sheet has to stand behind these debts or assets have to be disposed, losses have to be taken and many institutions have to be shut down. This is a difficult task given the inordinate significance of the finance sector on the economy as a whole. A dramatic shrinkage will not only cost bankers their jobs but many ancillary businesses that have grown up around them. It is very unlikely that politicians will take this choice. 

And so we continue with various games to improve liquidity in the system. The ECB announced last week that a wider range of securitized collateral would be allowed. Collateral will require lower haircuts and there is talk of dispensing with the requirements for the collateral to be rated. This presumably is a consequence of major countries like Spain and Italy headed to be rated as “junk” by all the rating agencies. The EU hope that by allowing ABS collateral, banks would bid up prices of real estate linked loans, transforming them into ABS and borrowing against the collateral from the ECB at much cheaper rates. 

Increasingly lower quality collateral weakens the ECB Balance Sheet, which has Germany as the biggest creditor. The Bundesbank is naturally unhappy with this ECB measure. Without Germany's full backing, it will be difficult to implement these collateral changes effectively. So, we have another measure that looks to be headed to the dustbin. 

Meanwhile, Greece wants more money and an easing of austerity measures. It is unlikely to ever keep up to its end of the bargain as its income projections are probably too high and the political cost of the internal devaluation too high. Germany is trying to understand which is cheaper, a Greek exit or continued funding. As it stands, Greece staying in is probably cheaper but if Spain and Italy also has to be bailed out, all bets are off.

Spain released consultants reports on likely capital shortfall at Spanish Banks. Magically, it came in at €60bn on their stressed model. But the market is not buying it. The €60bn capital gap assumes almost €65bn of profits within the banking sector which is optimistic. The asset values in LTV calculations are still considered to be too high. An auction of a selected assets would be better to establish values rather than paid consultants and auditors. The risk of course is that the funding gap is 2X or 3X larger than currently estimated. As we write, Spanish 10 Y Sovereign Bond Yields have crept up above 7%. This suggests that a full bailout of Spain still cannot be ruled out. "Hasta la vista, baby".

QE           Quantitative Easing
LTRO       Long Term refinancing Operations
ABS          Asset Backed Security
LTV          Loan to Value

With New Democracy (ND) scraping through in the Greek elections, Europe appears to have avoided another bullet in this ongoing game of Russian roulette. The Greeks are divided for sure, with Syriza polling almost 27% of the vote, compared with ND at 30%. Right on cue, EU leaders have started making statements that austerity conditions in the previous bailout package will be relaxed, presumably predicated on a new coalition government up and running promptly.

European stock markets and Euro rallied when the markets opened late Sunday night (London time) but have given most of it away during Monday trading hours. Spanish bond yields have crept up above 7% again and its stock market is down 5% from the highs this morning. Dealing room chatter is that with Syriza marginally losing, the EU & G20 standby liquidity injection is no longer needed and the market is disappointed. In other words, the addict craving for another dose of the liquidity drug is willing to push the Greeks over the cliff to get it. This indicates that its wrath will be directed toward Spain and Italy in the coming days and weeks.     

All hopes are now directed westwards and there is talk of additional QE being announced in the US this week. You have to ask yourself though, if the market eagerly anticipates QE3, will the actualisation of that event really make that much of a difference. We may be entering into a different phase of the crisis, where people start questioning the integrity, effectiveness of the doctor and the prescribed medicine, instead of the discipline of the patient.

Are we approaching yet another “cliff event” this weekend? If by some chance, Syriza wins the Greek election outright, it would be interpreted as a “no”  to staying within Europe. A Greek exit, while manageable in isolation, has become infinitely trickier with the opaqueness and size of the OTC derivative market that inextricably links financial institutions to each other and has the potential to cause contagion across the financial sector worldwide. Various sound bites coming out of rating agencies, heads of central banks and even CEO’s of major European banks on the Armageddon that will follow, does not help. EU officials publically discuss potential economic sanctions on Greece, and other EU nations, in the event of a withdrawal or EU breakup. These include capital controls, border controls, and limiting size of ATM withdrawals. None of this inspires confidence!

Greek depositors are already withdrawing close to €1bn a day and at least one UK broker has suspended € FX trading this Sunday (who trades FX on a Sunday??), advising clients to be net flat across € denominated assets this weekend or risk getting closed out on Monday in the ensuing volatility. 

The stakes are high and the rhetoric should give the Greek electorate pause for thought as they go to the polls on Sunday. However, this could all backfire if Syriza does win on Sunday, which could well be a game changer for Europe. The likely first reaction of investors will be to run and ask questions later. On the flipside, if one of the pro austerity parties emerges victorious, look for the “mother of all rallies” next week.   

This is all happening at a time when the crisis around Spain and Italy intensifies. Italian 10 year bonds now yield 6.25% whereas Spain is at 7% (almost 1% higher than last Friday before the announcement of the €100bn bailout). The headline in one of the Italian newspapers says it all! 

It might well take a cliff event for Europe to come together.

There has been a lot of chatter around the €100bn loan promised to Spain over the weekend. Clearly it does not solve the underlying Eurozone crisis and increases Spain’s Sovereign debt by the €100bn, or whatever amount is eventually disbursed. The lack of further austerity measures has also irked the Irish (who just voted to stay with the Euro) and the Greeks (who will vote next week) who face social upheaval as a result of the internal devaluation imposed on them, in return for their bailouts.

There is also a question mark on whether the funds will come from the EFSF¹ (whose credit standing is reliant on the EU members, of which Spain is a key member) or the soon to be established ESM² (which, as a preferred creditor, raises the specter of subordination of existing Spanish bond holders). ISDA³ have confirmed that the mere subordination of existing Spanish bonds will not trigger the approximately $14.3bn (net) of English law written CDS on Spain. This will be triggered only if or when Spain changes the terms of the existing sovereign debt. Besides, the EU leaders have worked out after the Greek fiasco, that it’s unwise to kowtow to the whims of the CDS market - even if a trigger is hit, there is no payment from CDS seller to buyer if Spain continues to pay its obligations on time.

All said and done, the weekend should be considered a positive one for the Eurozone crisis as a whole. There were no late night frantic meetings trying to arrive at a plan before the markets opened in Asia. All it took was a phone call between the EU and Spain on Saturday afternoon followed by an announcement in the evening. The money will allow FROB⁴, the Spanish bad bank equivalent, to buy assets from banks and sell into the market. Perhaps a TARP⁵ style program will allow FROB to sell assets to institutional buyers who will benefit from a 1^st loss guarantee from the Sovereign, along with some funding. The sweetened deal will likely drive prices of the assets up as buyers queue up for the deal.  A classic “win win”.

The markets opened higher on Sunday night and then gradually sold off through the day to end at their lows. If there is no continued selling this morning, this could indicate that after the “buying the rumour and fading the news”, we could be entering into the next “risk on” phase. If the market sells off hard from here, panic could ensue as investors will worry that a bailout has failed.

Either way, expect lots of volatility, which is what you get with a recovering patient on a high dosage of drugs. However, the next few days will be a “tell” on how the summer is likely to go.

1. EFSF is the European Financial Stability Facility
2. EMS is the European Stability Mechanism
3. ISDA is the International Swaps & Derivatives Association
4. FROB is the Fund for Orderly Bank Restructuring
5. TARP is the Troubled Asset Relief Program

Everything changes! Spain has decided that it does, after all, need a bailout, although a “limited” one. Just two weeks ago (28 May), the PM Rajoy stridently insisted that “Spain does not need a bailout”. 

It’s not quite clear what the quantum for “limited” is, but Fitch’s explanation of Spain’s downgrade yesterday may hold some clues ...  “the cost to the Spanish state of recapitalising banks stricken by the bursting of a real estate bubble, recession and mass unemployment could be between 60-100 billion Euros”. As a reminder, that is the hole that Spain needs to fill in addition to their ongoing funding needs. 

Who will fund this bailout? As the chart below shows, the EFSF/ESM mechanism is unlikely to have sufficient funds to meet the need of all the countries looking for help. The Spanish stock market has risen almost 10% off its lows last week whereas the German DAX has risen only 2.5%. This is the markets way of telling us that Germany is on the hook!      

Source: Zerohedge

Meanwhile, the politics continue. The EU have said they have not received any request from Spain. Spain says their consultants will tell them how much to ask. Their consultants presumably have several pre-prepared slides on “how well Spain is doing with its austerity measures etc”, with placeholders for the actual size of the bailout. That presumably will come from the Spanish government themselves. 

Nothing changes!