Tuesday, September 27, 2011

What Germany Wants From an EFSF ECB Deal

The markets are enjoying a relief rally at the moment in the expectation that the latest proposals to fix the Eurozone Sovereign Debt crisis by leveraging up the EFSF via the ECB. Besides all the legal difficulties in carrying out this plan, there are also significant political issues to overcome. Putting aside the issue of Slovakia for a moment-where according to most reports the July 21 EFSF expansion plans are not likely to be ratified- the key questions relate to the quid-pro-quo benefits to the Northern European nations. In other words, what is in it for the Germans?

Leveraging the EFSF, What's in it for Germany?

And it’s not just the Germans interest that needs to be satiated. Austria, Luxembourg, Netherlands and Finland are all believed to be closer to the German position at the ECB. Therefore, it is worth taking the time to try and see what the Germans want out of an EFSF ECB deal.

Frankly, the only way that this deal can be sold to the Germans, Dutch, Austrians and Finnish is if it comes attached with a significantly stronger legal framework that is commensurate with fiscal union. Herman Van Rompuy is due to put forward proposals on fiscal union at an EU summit on Oct 17-18 and this meeting will be crucial to the future of this kind of EFSF leverage deal.

If measures towards fiscal union are not approved and, this sort of deal is approved, than the potential for a long drawn out period of difficulties in Europe is assured. We will have low growth for many years to come and potentially tumultuous circumstances.

Moral Hazard and the Debt Crisis

The danger here is the same danger that caused the financial crisis. Moral Hazard. Unfortunately, we have not dealt with this in financial sector but that doesn't mean we have to encourage it in the Public Sector too. The Germans are right. The debt problems are structural and need to be dealt with in this way. If you keep bailing out Governments and institutions, then they will not change. It is a symbiotic process. If Governments don’t structurally reform, they will be punished by the bond markets and end up going towards unsustainable debt paths.

Jens Weidmann's Speeches

In fact, Bundesbank Chief Jens Weidmann articulated this point in a few speeches recently..

The European Council therefore agreed that financial assistance should be granted to countries with severe refinancing problems, a substantial part of which is provided by Germany. This financial support is intended to buy time for the affected countries to conduct necessary structural reforms and implement consolidation measures in order to regain market participants’ confidence in the soundness of their public finances and their competitiveness. The assistance is therefore bound to adjustment programs, which each recipient country has to fulfill.

However, the reduction of interest payments on the financial aid has weakened the incentives for countries in an adjustment programs to re-establish sound public finances via fiscal and economic reforms and return to the capital market. Furthermore, the conditionality of the support measures has been loosened by the recent decisions of July 21st. This weakens the underlying principle of European Monetary Union that each country has to bear the full consequences of its own fiscal policy.  Contrary to what is actually needed in order to overcome the sovereign debt crisis, we risk seeing the propensity for excessive deficits rise even further in the future

The last point is critical.

If this is how Governments are reacting to the limited bond buying program, than what will it be like when the EFSF is expanded to E2 trillion?? Will Berlusconi carry on making austerity measures or, will he figure that it’s all ok now because someone else is going to backstop Italy's debt?

Germany Rejects Eurobonds

As Weidmann puts it..

A communitisation of debt would be sure to result in a substantial redistribution from sound to unsound countries. In addition, Eurobonds, in and of themselves, would actually be rather counterproductive to solving the fundamental problem that led to the outbreak and spread of the sovereign debt crisis. In short, I believe that the risks associated with Eurobonds far outweigh their potential benefits.
...and in itself this is nothing more than a restatement of the principle of rejecting the notion of privatizing profits (Berlusconi et al and their political popularity) and collectivising risk (the rest of Europe pays Italy's bills) and, we know how that strategy ends up.

Hence the calls for fiscal union...

In my view, enshrining strict deficit and debt limits for national budgets in EU legislation is pivotal to achieving a stable fiscal union and reliably shielding the Euro system’s single monetary policy from unsound public finances. These limits would then apply to all levels of national government, including central, state and local government and the social security systems; the EU would need to be granted ultimate powers of intervention to ensure that the limits are effectively implemented in practice.

In a fiscal union, these powers of intervention would have to be extensive enough to ensure that national governments lose their sovereignty over fiscal policy when deficit and borrowing limits are breached, if not beforehand. Consequently, the national parliaments would no longer have ultimate decision-making authority over government budgets; their decisions would be subject to approval by a central body.

So, clearly, Germany wants moves towards fiscal union. Let's hope they are successful.

Weidmann, Jens Public Speeches

Monday, September 26, 2011

The Plan to Save the Eurozone

A multi-trillion plan to save the eurozone is being prepared according to an article in the Daily Telegraph. Such a development is long overdue, so I thought it would be interesting to analyse the key takeaways from this speculation. The article can be found linked here and I will look at it point-by-point

First, Europe’s banks would have to be recapitalised with many tens of billions of euros to reassure markets that a Greek or Portuguese default would not precipitate a systemic financial crisis. The recapitalisation plan would go much further than the €2.5bn (£2.2bn) required by regulators following the European bank stress tests in July and crucially would include the under-pressure French lenders.

This implies that the banks are indeed in need of recapitalisation, despite the protestations of many of their senior executives. Such a move will be dilutive for existing shareholders. However, before we conclude that this is a done deal, lets recall that the banks will do everything they can to avoid public money because they want to retain the independence to carry on awarding their staff with inordinate salary and bonuses.

The banks are set up in the interests of their staff not the shareholders. In fact, one of the biggest problems in 2008 was the reluctance of banks to mark to market their assets because they didn’t want public money. They exacerbated the crisis. Gordon Brown had to force RBS to take public money!

Officials are confident that some banks could raise the funds privately, but if they are unable they would either be recapitalised by the state or by the European Financial Stability Facility (EFSF) – the eurozone’s €440bn bail-out scheme.

In my humble opinion, institutions do not like making investments in assets that are about to be diluted. We can see this in the price action of stocks prior to rights issues. Whereby, the institutions that know-via inside information-that an issue is coming up, simply do not buy in. They wait until afterwards. I suspect the same thing will happen here. In addittion, many of the Sovereign Wealth Funds got burnt in 2008 with investing in the banks. They are unlikely to want to repeat the experience.

Officials are working on a way to leverage the EFSF through the European Central Bank to reach the target.
The complex deal would see the EFSF provide a loss-bearing “equity” tranche of any bail-out fund and the ECB the rest in protected “debt”. If the EFSF bore the first 20pc of any loss, the fund’s warchest would effectively be bolstered to Eu2 trillion. If the EFSF bore the first 40pc of any loss, the fund would be able to deploy Eu1 trillion.
Using leverage in this way would allow governments substantially to increase the resources available to the EFSF without having to go back to national parliaments for approval, which in a number of eurozone countries would prove highly problematic
So, let’s get this clear. On Sep 29 the Bundestag will vote on the EFSF expansion plans, which entail allowing the current E440bn EFSF to buy Government debt and to aid European banks. After which, on Nov 4, the new plan will be released which involves using the ECB to leverage up the EFSF in a way that obviates the necessity for getting national parliaments to approve.

 Whilst this Machiavellian piece of politicking is almost admirable in its sheer insidiousness, it is hardly a shining example of democracy at work. But there is a reason for this cunning plan


As quid pro quo for an enhanced bail-out, the Germans are understood to be demanding a managed default by Greece but for the country to remain within the eurozone. Under the plan, private sector creditors would bear a loss of as much as 50pc – more than double the 21pc proposal currently on the table. A new bail-out programme would then be devised for Greece

So Greece will default and remain in the Euro. Now, if you share my view that Ireland and Portugal are also insolvent than similar default programs will have to be extended to them in future. This is not such a problem as the EFSF would-under these plans-be expanded enough to deal with them. Moreover, the ECB can probably deal with losses on PIG. Italy and Spain are a different proposition, however, I am rather more positive in their debt positions, provided they continue their austerity programs.

Conclusions on the ECB and EFSF Plan

In conclusion, I would add a few more points here to these projected plans
  • The ECB’s capital (which is going to print money in order to buy debt and help banks recapitalise) is held by the Central Banks of its constituent countries. This means that the risk is simply being shuffled onto the Governments balance sheets and away from the institutions that bought Sovereign Debt in the first place. So, yet again, the principle that bond holders must-at the largesse of everyone else- never be allowed to lose money is still the guiding light of policy.

  • Moreover, the central banks are going to have to take on extra risk, which should mean that their credit ratings come under risk. Theoretically, sovereign bond yields should rise. In a sense, the Governments are now resorting to off-balance sheet leverage (via their capital in the ECB) and trying to convince investors to continue to buy their own debt. Now where have we heard this before?

  • As soon as you start guaranteeing Governments support, then moral hazard kicks in and I suspect the reforms will dry up. This is likely to create a situation with striking parallels to Japan. In other words, Governments not making reforms and, zombie banks supporting zombie industries in order to create the employment and social support in order to buy the political capital to keep the game going. This suggests continuing anaemic growth for Europe.

I suspect these plans would work to avert a crisis but they would also condemn Europe to years of low growth. Worse, the plan seems to be that European Governments should be morphing themselves towards the Southern European ‘model’ of throwing money and inflation at problems rather than the German model of fiscal discipline and inflation control.

 It should be the other way around!

Tuesday, September 20, 2011

Bank of China Halts Foreign Exchange Forwards and Swaps with French Banks

The Bank of China has stopped FX forwards and swaps trading with several large European banks, according to sources. This is a worrying development because US Money Market Funds have already helped to cause liquidity problems with European Banks by cutting European exposure to French Banks. These are all inevitable signs of negative sentiment which manifest themselves in this chart which is the extra cost of swapping euro interest payments for dollars. Essentially, it goes up as  the demand for dollar liquidity goes up...

Euro Swap Five Year Spread

One-Year Chart for EUR SWAP SPREAD     5 YR (EUSS5:IND)

'Bank of China, a big market-maker in China's onshore foreign exchange market, has stopped foreign exchange forwards and swaps trading with several European banks due to the unfolding debt crisis in Europe, three sources with direct knowledge of the matter told Reuters on Tuesday.
The European banks include French lenders Societe Generale Credit Agricole and BNP Paribas and Bank of China halted trading with them partly because of the downgrading from Moody's, the sources said'

…will only raise stress further.

It is worth pausing and reflecting that before the recent Italian Bond Auction, the Italians were keen to confirm that they had been talking to the Chinese over ‘selling debt’. This blog was vocal in being critical of this pseudo ramp in an article linked in here, and this sceptical approach has been confirmed by this latest news. China appears to be more of a danger than a solution here.

Too Big To Fail, Failed

Following the financial crash in 2008, many politicians garnered significant political goodwill by proclaiming the desire to end the moral hazard implicit in ‘Too Big To Fail’ financial institutions. For example, Obama and the UK Chancellor George Osborne both promised to end the possibility of this returning to haunt the global economy. Unfortunately, nothing has changed. The current Euro zone Sovereign Debt Crisis-with Portugal, Ireland and Greece surely headed for default- is actually a crisis for the banks that bought this debt. The necessity for them to be recapitalized and the concomitant knock-on effects to the global economy are the true worries here.

If they weren’t ‘Too Big To Fail’ then the concerns would be far less. These banks bought this rubbish debt. No one forced them too. Why not just let them face up to the consequences of their actions, in the same way that everyone else does?  However, in this ‘Scared New World’ the key principle seems to be that bond holders must never be punished and, banks must continue to be allowed to game the system whilst hiding behind the ‘greater good’ argument.

So, essentially, it’s the same issue as 2008. In other words, ‘Too Big To Fail’ is still guiding the global economy. Meanwhile, Banking pay and bonuses are going up. Go figure.

Wednesday, September 14, 2011

Italian Bond Auction

Italy has been busy with bond auctions this week and managed to get out E6.5bn in bond issuance yesterday. Equity markets rallied and many investors breathed a sigh of relief from the ongoing European Sovereign Debt Crisis.

However, lets puts this into context.

According to the FT, the ECB has bought over E143bn in bonds as part of their bond buying program. Half of this has happened in the last five weeks.  With a back-of-envelope calculation, it is not unreasonable to assume that the ECB has bought around E30bn of Italian bonds over the last month.

Therefore, the Italian auction is hardly a cause for celebration. In a previous post, the key banking stress indicators were outlined and, before being optimistic for equities these indicators must turn positive. Otherwise, there is no point in the ECB actions. Readers can find these banking stress indicators here

Furthermore, looking at how the bond markets reacted after the auction, it is clear that the bond markets were not impressed and are showing increasing signs of stress...

In fact, the bond auction saw Italy borrowing (despite ECB manipulation) at highs after the initial ECB intervention...

One-Year Chart for Italy Govt Bonds 10 Year Gross Yield (GBTPGR10:IND)

...Italian CDS are through the roof...

One-Year Chart for Republic of Italy (CITLY1U5:IND)

and the Italian-German yield spread is at an all time high...

One-Year Chart for ITALY 10 - GERMANY 10 SPREAD (.ITAGER10:IND)

It doesn't look good.

As for the speculation over China buying Italian bonds; the timing of the press speculation smacks of  a desperate attempt at 'supporting' the Italian auction. The subsequent confirmation by Italian officials on the day of the auction was wonderfully prescient. Has it really come to this? Italy now has to 'ramp' its bond auctions via the press?