The Never-Ending Eurofiasco
Imagine if the local fire chief, in the spirit of conservation, decided he’d use no more than 1,000 gallons of water to put out any given house fire. Do you think the citizens would support that policy if their town was burned to the ground? And, yet, this is the same approach that eurozone leaders are using to address the debt crisis. The central bank (ECB) has virtually limitless resources (Think: printing press) to defend the debt of the individual states and to act as lender of last resort, but the eurocrats won’t hear of it. They refuse to use the ECB as every other central bank in the world is used. They’d rather reinvent the wheel by creating a funky, improvised emergency fund (European Financial Stabilization Facility or EFSF) that’s massively leveraged and which only provides a 20 percent “first-loss” guarantee on sovereign bonds. So, for example, if Italy goes belly-up in the next year or so and can’t repay its debts, then Mr. bondholder gets a whopping 20 cents on the dollar. Such a deal!
Can you see how ridiculous this is?
Look; US Treasuries are backed by the “full faith and credit” of the United States of America. What are Italian bonds backed by? Or Portuguese bonds? Or Irish bonds?
Under this new regime, they’ll be “partially” backed by a dodgy, undercapitalized insurance fund. That ought to shore-up investor confidence.
Is this any way to run a multi-trillion confederation of states?
And the EFSF is only part of this latest Eurofiasco. There’s also a special purpose investment vehicle (SPIV) that will be used to attract foreign investment. (Re: China) EU leaders assume that the Chinese are so yield-crazy that they’ll scarf up hundreds of billions of these (toxic?) EU bonds to stack atop their cache of USTs. Dream on. Apparently, Nicholas Sarkozy has already been on the horn to leaders in China inquiring about future investments. But, so far, no takers. The truth is, investors are exiting Europe as fast as their two feet will carry them, not lining up to get back in.
The good ship Eurozone is taking on water from all sides, which is why yesterday’s stock market moonshot was such a surprise. As soon as Wall Street got a whiff of Europe’s “breakthrough agreement” on Thursday, the Dow went through the roof, over 300 points on the day. Less than 24 hours later, however, the mood is notably more somber. The details on all the critical points–(Haircuts on Greek debt, bank recapitalisation, EFSF etc)– remain sketchy, while skepticism abounds. Here’s a clip from Bloomberg on Friday:
“U.S. stocks fell, trimming the longest weekly rally since January in the Standard & Poor’s 500 Index, as scrutiny deepens on Europe’s latest measures to contain the region’s sovereign debt crisis….
“The devil is in the details,” Don Wordell, a fund manager for Atlanta-based RidgeWorth Capital Management, which oversees about $47 billion, said in a telephone interview. “Europe is trying to do anything to solve its problems. Still, there are lots of questions on how the plan is going to work and how they are going to fix their debt issues.” (Bloomberg)
Ah, yes, “the details”. One of the details that’s been clarified is the fact that the credit markets are not “on board”, in fact, credit spreads have shrugged off the happy talk and continue to widen. This is from Reuters:
“Italy’s borrowing costs jumped to record levels on Friday, underlining its vulnerability at the heart of the euro zone debt crisis and scepticism about whether the struggling government of Prime Minister Silvio Berlusconi can deliver vital reforms.
The 6.06 percent yield paid at an auction of 10-year bonds was the highest since the launch of the euro and not far from the level reached just before the European Central Bank intervened in August to cap Rome’s borrowing costs by buying Italian paper.
Italy, the euro zone’s third largest economy, is once more at the centre of the debt crisis, with fears growing that its borrowing costs could rise to levels that overwhelm the capacity of the bloc to provide support amid chronic political instability in Rome.” (Reuters)
So bondholders haven’t been duped by all the “breakthrough” hype. Yields are climbing higher which means it will be harder for Prime Minister Bunga-bunga to fund the Italian government. After all, what good is an insurance policy (EFSF) if you can’t get funding; that’s the question? Unfortunately, their are fewer buyers. Why? Because investors have lost faith in the Eurocrats ability to fix the situation. No one gives a hoot about the EZ’s big pile of money.(The EFSF will be $1.4 trillion) What they want is the “full faith and credit” of some institution that can underwrite the whole mess. Is that hard to understand? That’s what central banks do. This is from Bloomberg:
“The rate at which London-based banks say they can borrow for three months in dollars (Libor) rose for the 35th day, the longest run of increases since November 2005…
The dollar Libor-OIS spread, a gauge of banks’ reluctance to lend, widened to 34.66 basis points …the highest closing level since July 3, 2009.
The TED spread, or the difference between what lenders and the U.S. government pay to borrow for three months, widened to 41.79 basis points from 41.46 basis points yesterday, heading for the highest closing level since June 23, 2010.” (Bloomberg)
Okay. So the credit gauges are blinking again and yesterday’s announcement provided no relief at all. Banks are still reluctant to lend and credit conditions continue to tighten. And now that EU banks will be forced to increase their capital cushion, you can bet there will be another debilitating credit crunch. Take a look at this from Bloomberg:
“European banks say they have to cut assets to help satisfy a government push to boost capital faster than planned to insulate them against the sovereign debt crisis. That may trigger a credit crunch for companies and consumers throughout the 17-nation euro zone, helping to push its economy into recession, say Citigroup Inc. and Deutsche Bank AG analysts.
Leaders meet today in Brussels to approve a plan to increase lenders’ capital by about 100 billion euros ($139 billion). Banks say they will more likely achieve the new requirements by shrinking rather than raising cash from shareholders, a scenario they want to avoid partly because their share prices have fallen 30 percent this year….
“History shows that bank recapitalizations provide the catalyst for the credit crunch,” he said in an Oct. 20 note. “Japan learned this in 1998, and the U.S. and the U.K. in 2008. Continental Europe’s lesson starts now.”
Banks across Europe have announced they will trim more than 775 billion euros from their balance sheets in the next two years to reduce short-term funding needs and achieve the 9 percent in regulatory capital required by the Basel Committee on Banking Supervision ahead of schedule, according to data compiled by Bloomberg….
“The banks need to deleverage, but if they choose to deleverage by cutting assets not by raising equity then it will have negative consequences for the economy,” Simon Maughan, head of sales at MF Global Holdings Ltd. in London.” (“European Banks Warn of Credit Drought”, Bloomberg)
So, EZ leaders–after having already triggered a mini-Depression in the PIIGS with no end in sight–are on course to intensify the downturn by forcing the banks to dump hundreds of billions of dollars of assets onto the market thus pushing down prices and increasing financial market distress. Sounds like a plan. The alternative to this would be that the individual governments recapitalize the banks at their own expense which would mean higher taxes, diverting revenue from public services, and (here’s the corker) a steep downgrade by the ratings agencies. So, it’s a lose-lose-lose situation.
And what about those “overnight deposits” that banks have been squirreling away at the ECB because they’re afraid to leave their money in other banks? That must have improved now that a “comprehensive” deal has been worked out, right? This is from Bloomberg:
“The European Central Bank said banks increased overnight deposits to the most in more than two weeks.
Euro-area banks parked 218.1 billion euros ($308.8 billion) with the ECB overnight, up from 204.4 billion euros the previous day and the most since Oct. 10. They borrowed 2.7 billion euros in emergency overnight funds at the marginal rate of 2.25 percent, up from 1.8 billion euros a day earlier.” (Bloomberg)
Everything is worse. The Eurozone is imploding, and it’s imploding because the policies they’re implementing are, well, stupid, which is to say, they won’t work. And investors know they won’t work which is why they keep fleeing Europe en masse.
Can you blame them?
Mike Whitney lives in Washington state. He can be reached at email@example.com