Europe approaches failure

It seems that yesterday was ‘peak optimism’ for Europe and now we are on the downward leg. It is becoming very clear that whatever the deal is now is all that it is going to be, and that is if it can even get off the ground. This was nicely summed up in a statement overnight by the Austrian finance minister:

Austria needs to ensure it retains its triple-A rating and needed to take into consideration what it could afford, she said, adding that there was no risk at the moment for Austria’s rating. However, triple-A countries such as Germany, the Netherlands, Austria and Finland have signaled that they can’t imagine paying out much more new money, Fekter said.

On top of that, we saw Merkel make statements that Germany was not in support of a draft summit document that suggested that EU Ministers would push for the ECB to continue purchasing sovereign debt. So once again Europe has hit the limits of its dual incompatibilities and now seems to be struggling to deliver on the 3 point plan. The meeting of the 27 nation finance ministers that was to take place before Wednesday’s EU summit has been cancelled. This actually isn’t that bad given that none of those minister’s were capable of actual enacting decisions without their leaders anyway, but it demonstrate yet again just how clumsily this process is being managed.

The 3 parts of the new plan (EFSF, private sector write-downs, bank re-capitalisations) are tightly coupled and the major piece that need to be decided first is how much of a “voluntary” write-down can be taken on Greek debt before it considered a credit event. 60% seems to be the number that the European leaders are aiming for, yet I note that ZeroHedge has post quoting Barclays that this number is not acceptable:

In our view, there is little doubt that a large notional haircut of c. 50-60% would be considered a credit event, consequently triggering CDS contracts

As far as I can tell the Germany has been pushing this number and seems to have little regard for the possible CDS fallout. France and the ECB on the other hand seem to be extremely concerned about it. Obviously these plans were always going to have to be weighed up against private creditors accepting a deal and the rating agencies accepting the flow-on effects without downgrading sovereign participants, but it now seems that the plan is unravelling slowly, or at least reaching a point where nothing more can be added.

We now have the added weight of a decision by the Bundestag and, as I have repeated a number of times, we are still to hear the opinions of a number of the more hard-line AAA countries such as Austria and The Netherlands. This being the case I fear the plan is inadequate to meet the expectations that it is a “comprehensive” enough to head off further European economic trouble, so unless we see some “surprises” from Wednesday’s summit I get the feeling that European leaders are approaching the point of failure to meet the task they set themselves.

As I mentioned yesterday I am watching Italy as it seems to be imploding under the pressure. That continued overnight as the Italian Prime Minister struggled to convince his coalition party leader to back his plans to raise retirement age to 67. According to the Wall street Journal a compromise of some sort has now been reached but it is yet to be seen whether a “compromise” is acceptable to the rest of Europe. Greece has been budgeting itself into financial oblivion, yet the Italians seem happy to play Europe against itself and continue to do so.

Given that Italy is the new centre of European distress it will be very interesting to see how the summit is going to handle Berlosconi who seems to have almost lost control of his country at a time when strong leadership is vital. Italy has 600 billion euros worth of bonds to issue over the next three years to refinance maturing debt, given the ECB is already stalling at additional purchases with the backing of the Germans, you have seriously got to question whether Europe has the ability to get make it through.

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  1. Looks like gold may have mistakenly priced in an agreement to more bailouts in last night’s trading. It seems BOJ is looking at easing its currency in case Europe does. If there is no agreement in Europe then all markets will take a hit.

  2. So uh… pardon my ignorance again, but isn’t that what the CDSes are designed to do? To provide insurance in the event of a “credit event”?

    Is the issue that no-one quite knows what will fall out of the CDS events if (when) they’re triggered? If so, I’m going on the view that the risk management at the firms issuing these CDSs is FUBAR as usual.

    • That’s a reasonable assumption, except as we can see with AIG in 2008, buying “insurance” is quite different from collecting insurance.

  3. I don’t understand the credit event issue. It is quite likely that no matter the haircut, be it 60%, the ISDA can simply decide that it doesn’t constitute a credit event and all will be well. What kind a financial instrument is this CDS that politics can create pressure to ignore a clear-as-day involuntary haircut/default? After all, how would a committee with a handful of people really decide to create a potential financial crisis when turning a blind eye will absolve them of any trouble?

    The very fact the banks are being threatened makes any haircut involuntary.

    • If I was sitting on a pile of CDS against a Greek default I’d be on the phone the minute there was a whiff of anything closely perceivable to a default, demanding the value of the bond be paid. Until that point I’d still have to pay the insurance premiums, so the sooner the default, the better.

    • It’s up to The International Swaps and Derivatives Association to decide if a haircut is voluntary or not. If it’s voluntary (as in 21%) there is no default, but once it gets to 50-60%, well very few investors are going to take that voluntarily.

      • Yes, that is what I wonder. How much influence does the EU and other leaders have on the ISDA. And how is it that the 40% being offered is still considered ok. If I was holding these CDSs, I would feel cheated and defrauded if I wasn’t paid out after a 40% haircut. But that’s exactly what will happen.

        • Well swaps were supposed to be a way of hedging yourself against losing your bonds, but unfortunately they have become a tool for ‘speculators’ to gamble with, which is why Governments want to ban them (you may need a subscription to view)

          So the holders of the CDS in this case are mostly not the bond holders, in which case the CDS holders will be clamouring for the ISDA to declare a default. How much the EU can influence that is anyones guess.

          • Thank you for replying to my posts Stan.

            I support a default being decided simply because it would speed up the journey to its inevitable end rather than kicking the can down the road some more.

            If it causes trouble it is the fault of regulators not speculators.

            We also need additional pain to have a chance of realizing that financial institutions need to be reined in. At the very least, separated from deposit taking banks.

            Thank again.

  4. rob barrattMEMBER

    Greeks are running to the banks to collect their money. Greeks are burning their tax returns.
    Soil is runing from the bottom of the CDS mountain. European banks are perched halfway up…..

  5. According to the summit has now been cancelled, probably due to Merkel and co finally coming clean on the fact that there IS NO WAY to resolve the Euro issue, which we all knew anyway.

    Although I did hear one good suggestion – Germany to sponsor a military coup in Greece. Dictatorships aren’t allowed in the EU, so that’s an instant problem solved. Of course as the pressure rachets up in Greece that may actually happen with or without Germanys help.

  6. To paraphrase PK, if it wasn’t so tragic, we would be laughing at this daily theatre of the absurd.

    Meanwhile, BoFA seems to be making some taxpayer funded funeral arrangements for itself – busy moving “assets” from its Merril Lynch unit to the FDIC insured retail banking unit.

  7. Markets seem to be quite relaxed about all of this. I think the understanding is that although the Europeans won’t “solve” anything by tomorrow, they nevertheless can kick the can down the road some more and that there will be more money printing by central banks worldwide, as is being hinted at by the US Fed.

      • I’m troubled but not surprised. I won’t even be surprised when they start firing up the printing presses to repay debts. Probably in Europe before the US but still. Flawed understanding of economics ad debt coupled with a 100% discount rate for the future ensures such outcomes.

      • It’s the “new normal”. Never fear, doom will come, maybe even by 2012, but first we need a stock market rally for XMAS!

        • Agreed, this feels like an endgame approaching. I’m in cash, gold & silver. Out of debt, out of real estate, and only govt insured amounts in various banks (<$250K).

          • Me too, out of RE and sitting mostly in cash. Some speculative positions (15% of total capital), that’s it. No PM’s.

    • The debt-deflation cycle really has its own momentum now. Portugal, Spain, Italy, France, Greece are all being irresistibly drawn into a whirlpool of debt, insolvency, fiscal crisis, market spasm, economic implosion and political crisis. These countries have effectively linked their economies to a synthetic-gold standard – the Euro – and the remedy for them has to be same as in the past. They have to de-link their economies from the Euro.

      There is no alternative exit. There will be costs arising from the dislocation this will cause, but they face the costs of total seizure if they do not exit the Euro zone.

      I have a tentative proposition to make, and would really appreciate comment from the MB brains-trust…as follows:

      Effectively, the Euro has become a D-Mark/H-Guilder/A-Schilling (call it the MGS) composite by another name and it has been used as a reserve currency by both MGS and non-MGS economies. However, the supply of Euro has been insufficient for the Euro to serve as a reserve currency. Increasing the supply of Euro over time would have required the MGS economies to operate in external deficit in the same way as the US economy has since the 1970’s.

      However, the main object of MGS economic policies have been to achieve external surplus, a significant part of which has been drawn from the debtor-economies.

      The pricing of Euro between Euro States has been detrimental to the competitiveness of the deficit economies; however, the value of the Euro – the synthetic MGS – in relation to global currencies has been artificially depressed. This has supported the German/Dutch/Austrian external balance in relation to both their European markets and their non-European markets.

      The results can be seen in the widely divergent paths in public finance, incomes, employment, investment and competitiveness between the European economies. Currency union has not brought about economic convergence and in fact never could. It has merely concealed divergent tendencies that now threaten to take the deficit economies into a deflationary spiral

      This is a structural flaw that cannot be resolved by anything other than the dissolution of the Euro.

      Am I right?

  8. Link from Rota Fortunae

    Its All Connected: A Spectator’s Guide to the Euro Crisis

    Looking at this picture, following all the arrows. Is Japan the only country in a position to complain about the Euro-crisis?

    I’ve even heard our highly esteemed Prime Minister J. Gillard, has some good advice for the Europeans. What about Japan? I think (personal humerous opinion), they should be the ones restructuring Europe.