Satyajit Das: European Death Spiral – End Games Posted:  Jan 2011 By Satyajit Das, the author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives”   Politics now increasingly dominates the economics. Commenting about the EU bailout of Ireland, the Irish Times referred to the Easter Rising against British rule asking: “was what the men of 1916 died for a bailout from the German chancellor with a few shillings of sympathy from the British chancellor on the side”. An Irish radio show played the new Irish national anthem to the tune of the German anthem. In Greece, the severe cutbacks in government spending have resulted in strikes and violent protests on the streets of Athens. Faced with cutbacks in living standards, Europeans are fighting back. The Rolling Stones’ late sixties anthem has been resurrected in Europe: “Everywhere I hear the sound of marching, charging feet, boy/ Summer’s here and the time is right for fighting in the street, boy.” In many countries, governments, often unstable coalitions, are struggling to pass legislation, implementing necessary spending cuts or tax increases. In Ireland, the opposition parties have promised to re-negotiate the bailout package if elected at an election due early in 2011. In Germany, the paymaster and strength behind the EU, Europe’s biggest tabloid Bild asked “First the Greeks, then the Irish, then…will we end up having to pay for everyone in Europe?” In December 2010, a special EU meeting, convened to discuss the situation, provided a clear pointer to how events might evolve. At the meeting, the German view, set out by Chancellor Angela Merkel, prevailed. The meeting rejected any attempt to increase the scope and amount of the existing bailout facilities. The E-Bond proposal was quietly shelved. The EU agreed to formalise the ESM through a short amendment to the Lisbon Treaty. The new facility would be inter-governmental with any Euro Zone member having a national right of veto. The facility was highly conditional, capable of being triggered only as a last resort. A key element was the requirement for “collective action clauses”, effectively forcing lenders to bear losses. The provision, which must be included in all European government bonds after June 2013, would require the payment period to be extended in case of a crisis. If the solvency problems persisted, then further extension of maturity, reductions in interest rates and a write-off in the principal would occur. In addition, new bailout funds would automatically subordinate existing debt and have to be paid back first. Chancellor Merkel’s position reflects the views of the German constitutional court, which endorsed European economic and monetary union prescribed in the 1992 Maastricht treaty only on the basis of the treaty’s no-bail-out provisions. This influences the need to impose losses on investors. It is clear that the stronger members of the EU, led by Germany, have decided to limit future liability in bailouts. As membership of the Euro prevents large devaluation of the currency, economic adjustment will require reduction of the budget deficit and deflation. As Greece and Ireland demonstrate, more rigorous deficit cutting may not return the countries to solvency. The EU proposals implicitly recognise that over-indebted countries cannot sustain currency debt levels. The reduction of the debt burden will have to come through restructuring or default, with creditors taking losses. Unless confidence returns rapidly or the EU changes its position, it seems restructuring or defaults by several peripheral European sovereigns may be unavoidable. Investor concerns that the Greek and Irish did not solve the fundamental problems may be confirmed. The safety nets are now seen as unlikely to be large enough to rescue larger countries, like Spain and Italy, if they require support. Investors will need to take losses. Large volumes of maturing debt mean that the test is likely to come sooner than later. The heavily indebted European sovereign states face $2.85 trillion of maturing debt in the period to 2013. Portugal, Italy, Ireland, Greece and Spain have bond maturities of $502 billion in 2011. The financing needs of Greece, Ireland, Portugal and Spain over the last quarter of 2010 and 2011 are Euro 320 billion, rising to Euro 712 billion if Italy is included. In addition, private sector borrower in these countries face maturities of $988 billion of corporate bonds and $200 billion of syndicated bank loans over the same period. Likelihood of low economic growth, failure to meet IMF plan targets, further banking sector problems and credit downgrades exacerbate the risk. A Faraway Continent In the prelude to World War 2, British Prime Minister Neville Chamberlain dismissed the German occupation of Sudeten arguing that it was “a quarrel in a far away country between people of whom we know nothing.” North American and Asia have been bystanders as the European crisis developed. Increasing concerns are evident, as European problems now threaten global recovery. China, which contributed around 80% of total global growth in 2010, has expressed growing concern about the problems in Europe. Trade between China and the EU, its largest export market, totals around $470 billion annually, contributing a trade surplus of Euro 122 billion for China in the first nine months of 2010. Any slowdown in Europe would affect Chinese growth. China is also a major holder of Euro sovereign bonds, standing to lose significantly if problems continue. China has indicated preparedness to use some of its $2.7 trillion of foreign exchange reserves to buy bonds of countries such as Greece and Portugal. A slowdown in China would affect commodity markets, both volumes and prices, and commodity exporters such as Australia, China and South Africa. Minutes of a 7 December 2010 from the central bank of Australia, one of the world’s best performing economies, indicated increasing concerns about developments in Europe. A continuation of the European debt problems, especially restructuring or default of sovereign debt, would severely disrupt financial markets. Losses would create concerns about the solvency of banks, in particular European banks. In a repeat of the events of September 2008 (when Lehman Brothers filed for bankruptcy protection and AIG almost collapsed) and April/ May 2010 (prior to the bailout of Greece), money markets could seize up, as trust about the ability of parties to perform contracts evaporated. In turn, this volatility would feed through into the real economy, undermining the weak recovery. Unless resolved, the European debt problems will affect currency markets and through that channel the global economy. Any breakdown in the Euro, such as the withdrawal of defaulting countries or change in the mechanism, would result in a sharp fall in the new currencies. In turn, this would, in the first instance, result in large losses to holders of debt of those countries from the devaluation. Depending on the new arrangements, the US dollar would appreciate abbreviating the nascent American recovery. This may compound existing global imbalances and trigger further American action to weaken the dollar. Further rounds of quantitative easing are possible, setting off inflation and de-stabilising, large scale capital flows into emerging markets. In turn, the risk of protectionism, full-scale currency and trade wars would increase. A breakup of the Euro would adversely affect Germany, which has been growing strongly. A return to the Deutschemark or, more realistically, an Euro without the peripheral countries may result in a sharp appreciation of the currency, reducing German export competitiveness. As the Australian central bank noted in its December 2010 minutes: “… the deterioration in the situation in Europe over the past month had increased the downside risks to the global economy. How this would ultimately play out, and the implications … were difficult to predict. It was possible that conditions could settle down, as they had after the episode of financial instability in May. Alternatively, an escalation of the current problems was not out of the question. If this prompted a fresh retreat from risk-taking in global financial markets, it would probably have more impact … than any trade effect.” End Game Events since the announcement of the bailout package in early 2010 have been reminiscent of 2008. Then, the optimism following bailouts of Bear Stearns and other troubled American banks produced premature. The promise of China to purchase Portuguese bonds is similar to the ill-fated investments of Asian and Middle-Eastern sovereign wealth funds in US and European banks. Eventually with each successive rescue and the reemergence of problems, the capacity and will for further support diminished. The EU rescue of Greece and Ireland are also reminiscent of US attempts to rescue its banking system, with more and more money being thrown at the problem. The strategy was defective, preventing the creative destruction required to restore the system to health. The actions may have doomed the economy into a protracted period of low growth, laying the foundations for future problems. At the time of the Greek bailout, the real question was: “If Euro 750 billion isn’t enough, what is?” Increasingly, markets fear that there may not be enough money, to solve the problem painlessly. In 11 May 1931, the failure of a European bank – Austria’s Credit-Anstalt – was a pivotal event in the ensuing global financial crisis and the Great Depression. The failure set off a chain reaction and crisis in the European banking system. Some 80 years later, European sovereigns may be about to set off a similar sequence of events with unknown consequences. As Mark Twain observed history may not repeat, but it may rhyme.

Warning Sign or False Positive – Divergence Between Stock and Credit Markets on Eurobanks Posted: 12 Jan 2011 12:04 AM PST One of the noteworthy features of 2007 was a pronounced divergence in sentiment between the bond and stock markets, with the credit indices sending out warning signals while equities continued to soar higher. This is hardly surprising; an old joke is that the bond market predicted 9 of the last 4 recessions. We are seeing the same type of divergence again, this time in European bank stocks. And if the credit worry warts are correct, this could be a harbinger of bigger shocks. The Eurobanks are at the heart of the interlinked European sovereign/bank solvency crisis. The European market is also more connected to the US than most analysts chose to admit, with roughly 25% of S&P earnings coming from Europe. And with virtually all asset classes linked in the dynamic of “risk on-risk off” trades, an elevated risk reading in Europe would propagate to other markets. Paul Amery of IndexUniverse provides some details: According to one view of the world, reflecting credit market sentiment, European banks are more likely to default on their debt than at any time in the last few years, save for the peak of the financial panic in March 2009 and the worst moment of the Greek crisis in early summer last year. Another collective opinion, however, that of the equity markets, tells us that bank shares are relatively cheap… The Markit iTraxx Europe Senior Financials index, which measures the cost of insuring against the default of a basket of senior unsecured bonds issued by 25 European banks, traded above 200 basis points on Monday January 10 for the first time since June last year. June 2010 was a period of heavy speculation about possible default on Eurozone government debt. The 200 basis points index level had only been breached once before, in early March 2009, and that reflected widespread panic about the safety of leading bank names. The Markit iTraxx Europe Subordinated Financials index, meanwhile, hit 375 basis points in trading on January 10, well above any levels recorded in 2010 and only just shy of the record daily high of 405 basis points, hit on 9 March 2009, the day both credit and equity markets hit bottom. By contrast with the credit markets, however, indices of bank equity prices are still well above the lows recorded during the worst of the financial crisis. At Monday’s intraday (euro) price of 198.45, the Stoxx Europe 600 banks index, for example, an aggregate measure of European banks’ share prices, was 120% higher than on the March 9 2009 market bottom. The index is down by just over 15% from year-ago levels, and banks have been one of the poorer performing sectors in an equity market that’s been making positive ground. But we’re still nowhere near the crisis lows. Yves here. One cause for the difference in readings may be uncertainty about bank resolution regimes. Negotiations are under way now, and credit market investors are reacting to the notion that they will be expected to be a hit. Stock market investors, ironically, appear more sanguine, either postponing judgment until details are worked out, or perhaps believing that the measures will never be used, given the fact that major banks are international, and bankruptcy laws in various nations are not being changed to accommodate bank wind-downs. Back to Amery: Bank equity investors may simply not be paying that much attention to what’s going on in the credit markets, said Suki Mann, credit strategist at the London branch of Société Générale. Technical factors, such as the demand to hedge bank risk, may also be leading to the relative underperformance of credit indices, he explained. “The equity market doesn’t seem to be focussing on default risk, while credit markets are,” said Mann. “The resolution regime only matters if a bank is restructured, so you could argue that, absent a default, equity investors don’t have to worry too much. Look at what happened to BP last year, for example – its credit default swap reached 600 basis points at one point, then two weeks later was at 85. Are the credit indices a real measure of bank default risk? I’d argue no – they are reflecting market sentiment more than anything.” “There’s also demand by dealers to hedge the default risk of specific banks by using Markit’s broad credit indices for financials, since the market for credit default swaps in single bank names is thin,” explained Mann. “This is also contributing to the increase in credit index spreads.” Perhaps bond investors are losing patience with the Perils of Pauline quality of Euromarket rescues (today, it’s Japan that has ridden in from stage right to save the distressed damsel, since the Germans appear to be tiring of the role) and want it to be over and done with, while equity investors cheerily assume that an euro breakup or even defection is just too messy, hence the authorities will muddle through somehow, which means the banks will be OK too. But like it or not, this drama will reach a resolution, perhaps sooner rather than later. Seems to me the European Union  is in a tight rope walk itself not unlike the Fed and Politics via Corporations and Big Banks  in the U.S....