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!

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