Further Musings: European Summit Edition

As we have seen repeatedly since the beginning of 2010, when it comes to Europe stock markets are willing to accept at face value big numbers being tossed around as showing progress…for a while. John Hussman noted last Monday investors willingness to easily swallow previously unimaginable numbers with undue credulity:

The most depressing display of math-illiteracy by investors last week was the excitement over a report suggesting that France and Germany had agreed to a 2 trillion euro bailout package for Europe, which triggered a “risk-on” tone for the rest of the week, even after the report was retracted as inaccurate. It was almost beyond belief that investors took that report seriously, but people have become so tolerant of unbelievably large figures that virtually any bailout number can now be tossed out without triggering the least bit of scrutiny. Notably, 2 trillion euros is more than the GDP of France, and is half the GDP of Germany and France combined. Moreover, Europe has just gone through a tooth-pulling process just to approve 440 billion euros for the European Financial Stability Fund (EFSF) from all EU members combined.

So barring new dedicated funds from Germany and France, which had zero chance of being forthcoming, the only way you could morph 440 billion euros into 2 trillion euros was for each of those 2 trillion euros to really be only 22 euro cents of protection. In other words, you could only say that the EFSF would “protect” 2 trillion euros in European debt by limiting the protection to about 20% of face value, without using any of the funds to recapitalize banks or deal with much deeper probable losses on Greek debt (50-60%). Those losses alone will gulp down a large chunk of the EFSF (not to mention post-default needs to stabilize Greece over the longer-term, which the Troika estimates at another 450 billion euros).

So, what did he (and frankly myself) expect would happen? His thoughts and our comments in bold:

The bottom line is:

a) European leaders will likely initiate a forced bank recapitalization within days; (Check, though likely not large enough)

b) Greece will default, but the new hold-over funding may give the country a few more months; (Check, to the tune of 50% haircuts so far, though none for official holdings, just private owners.)

c) the EFSF will not be “leveraged” by the European Central Bank; (Check)

d) banks are likely to take haircuts of not 21%, but closer to 50% or more on Greek debt; (Check)

e) much of the EFSF will go toward covering post-default capital shortfalls in the European banking system following writedowns of Greek debt; (to an undetermined extent, though for now it is being claimed it will not be much)

f) the rest will most probably be used to provide “first loss” coverage of perhaps 10% on other European debt, which may be sufficient to limit contagion provided that implied default probabilities on Italian and Spanish debt don’t breach that level and the global economy stabilizes; (Something along those lines)

g) uncertainty following a Greek default is likely to create significant financial strains, even in the absence of a recession;(We will find out)

h) all bets for stability are off if the global economy deteriorates markedly from here, which is unfortunately what we continue to expect. (We will see)

We will point out that the major stock markets of the world have made little  progress since April of 2010 when the market first discovered that Greece mattered. I still remember when strategists were mocking the idea that a country as small as Greece could be a truly important issue. Add in a deteriorating situation in Portugal and Ireland to complement less likely, but far larger in consequence concerns in Italy and Spain and we get a metastasizing problem, not a solution. We expect that despite the recent rally lower prices are likely coming for European equities.

As I mentioned Thursday morning, I am extremely skeptical that emergency summit number 14 will work even as a can kicking exercise, but maybe I am missing something. I am sure it doesn’t solve anything. At best it buys time. I am unsure how much however.

Below we provide a roundup that covers a fair part of our recent reading on the crisis, though the reactions and analysis keep coming. Of course we have been discussing the potential for further crises in Europe since 2008, with particular concern over the incredible leverage in the European banking industry. Bizarrely, given the market response, the assessments are overwhelmingly negative. Our own assessment of how investors should view the situation will be fleshed out at the end.

Ed Harrison looks at the contradictions underlying the European plan. He is skeptical. In fact, he points out that if targets are missed in peripheral countries that the plan is to double down on enforcing austerity upon the countries struggling citizens.

The Economist sees it as a fig leaf that won’t keep the most important parts covered.

Sadly, this latest deal promises to be no more enduring. At best, it will buy time before the next round of panic. At worst, it may push the euro zone into catastrophe. “This is certainly no summit to end all summits,” said Sony Kapoor, managing director of Re-Define, an economic think-tank in Brussels. “Once again, good economics has fallen victim to bad politics.”

Ambrose Evans-Pritchard makes the obvious point that without the European Central Bank as a backstop that the plan is at extreme risk of failure.

For example, Gavyn Davies wonders who is going to supply the trillion Euros needed?

Roger Bootle is so negative he believes it will result in the breakup of the Euro.

Wolfgang Munchau is positively scathing and insists this will not work. Personally, I can’t see how he is wrong, but once again maybe I am missing something.

At first blush Cullen Roche is more enthused than I am, but he feels it does nothing to solve the structural problem:

This is a step in the right direction. By recapitalizing banks and enlarging the EFSF they have set a nice sized rifle on the table. Unfortunately, this is just more of the same in greater size. Ultimately, none of these measures will resolve the true cause of the crisis which is rooted in the currency and the incomplete currency union. Until Europe resolves the imbalance caused by the single currency there is no reason to believe this crisis has ended. I still believe the ultimate resolution here will involve fiscal transfers of some sort directly to the sovereigns that resolves the lack of sovereignty issue. That likely means e-bonds or a central Treasury at some point. We are clearly not there though this statement buys them time.

Later however Cullen noticed an ominous fact. While the equity market responds to political blathering like Pavlov’s most lemming like dog, the European bond markets are less than impressed. Unfortunately for European leaders, it is the green eye shades of the bond market they need to impress, not the manic depressive stock markets of the world.

As you can see in the chart below, yields on the 10 year Italian bond initially fell, but have since recovered all of their lost ground since the announcement last night.  What’s going on here?  Why are the equity markets responding so favorably while the bond market barely budges? I think the message from the Italian bond market is quite clear – this is not a real solution to the Euro crisis.  Equity markets are more hyperbolic and looking at the near-term.  One is saying, “the coast is clear for now” while the other market is saying “there is much work to be done here”.


The Italians have made bold targets for the coming months.  It’s eerily reminiscent of the targets the Greeks have been setting for years now.  Can they grow their economy during a balance sheet recession while the government sector contracts?  The math says no and talk is cheap.  The Greek experiment confirms this.  Italian bond markets are shrugging their shoulders at this plan.

This morning Portuguese and Italian bond yields have risen above where they were before the summit. In fact, Italian bond yields are at their highest levels since joining the Euro.

Daniel Gros isn’t surprised. He points out investors would probably not want to buy new bonds under the terms proposed, that it would undermine the value of existing bonds, it is illegal, and given how negotiations have proceeded why would an investor believe they would honor the payouts anyway?

Erik Swarts of Market Anthropology feels we are not only not past the crisis stage, he feels we are approaching a final market resolution:

  • The comparisons of Greece to the subprime crisis is still of value, when contrasted with how our own market expressed itself on the Continuum of D’s (yes it is my own) – Denial, Discovery, Discounting and finally – Despair. After this week’s historic rally, I believe it is safe to say Europe is now in the honeymoon period between the Discounting stage and where the rubber finally meets the road – the Despair stage. Where you can find a harmonic equivalent with our own crisis, is in the late 2007 tape where the Fed started to ease and where some major financial institutions, such as Countrywide, American Home Mortgage and Northern Rock started to fail. What interests me particularly in that period that I have mentioned in my previous notes (see, Here), and which rhymes technically with this market – is the extremely negative breadth artifact that accompanied the lows in August of 2007. In hindsight, the breadth readings make sense, because we now know the final lows were much further down the road in 2008 and 2009. In 2007, the market was between emotions and riding the false hope that the crisis was resolved rather tranquilly. As Yogi would say, “It’s deja vu all over again” these days.

Of interest to US equity investors is he is tracking the market impact within the movements of the S&P 500. So this is not just about Europe, but the US stock markets as well in his mind.

Felix Salmon points out that despite claims that US (and obviously non US) banks claims that they do not have much exposure to Europe, it is very likely untrue. MF Global’s troubles may be the tip of the iceberg.

If you take its numbers at face value — and Morgan Stanley does mention that they’re unaudited — then the bank has $287 million of exposure to Greece, $1.8 billion of exposure to Italy, and negative exposure to Portugal and France, thanks to all the hedges they’ve put on. They’re fine!

But of course, if Italy and/or France suffered a major financial crisis, there is no chance at all that US banks — including Morgan Stanley — could emerge unscathed. It’s very worrying to me that Morgan Stanley is putting out these kind of numbers — it implies that people at the bank actually believe that they have no exposure to France. While the real exposure is something that can’t be hedged away with a bit of counterparty-hedging and some judiciously-chosen credit default swaps.

He then goes on to show how such attempts to figure out exposure in the past turned out horribly wrong. In this particular case the last point is pretty obvious. If Europe’s leaders get their way Credit Default swaps will not even be triggered. They believe avoiding the payouts is a short term benefit, but that is hard to quantify. What we can be sure of is that a lot of people will lose money, including banks who thought they were covered due to their swaps. Scarier, is that banks use swaps to determine their capital adequacy.If swaps cannot be relied upon to pay off when debt is given a 50% haircut then they are essentially worthless. Will that not require banks raising more capital or reducing their balance sheets? I guess we will need to see.

Citi’s Willem Buiter thinks the failure of CDS to payout would be a tragedy and potentially disastrous .

So what happens to Credit Default swaps? The Macro Man thinks they are a Dead Parrot, at least sovereign default swaps. Janet Tavokoli agrees.

Matt Levine disagrees. Felix salmon says we should all calm down on this, the market for Greek CDS is working fine.

The irony? The proposed insurance that leverages the ESFS to be big enough to work, would likely use some form of CDS!

Ken Rogoff thinks the end is still some countries leaving the Euro, especially Greece.

Cardiff Garcia and the Alphaville team at the Financial Times point out that deleveraging is inevitable as European banks are required to rebuild their balance sheets. The question is how negative the outcome is in the short term, and how short the short term is (as past efforts to deleverage have been a drag on growth for many years.)

On that theme Richard Baldwin feels this buys a little time, but sows the seeds of its own destruction:

The EZ Summit is short-term good news – it defused the bomb that threatened Europe with a generation-defining economic catastrophe. That’s why markets liked it. But the solution relied on short termism. Two features of the rescue make a recession much more likely.

  • The voluntary, ad hoc nature of the bank recapitalisation will induce banks to engineer a massive credit crunch.
  • The renewed emphasis on national austerity will induce EZ members to engineer a massive fiscal contraction.

All of this is to happen over the next six to nine months regardless of deteriorating macro prospects. The EZ is headed for a recession.

This recession will undo all the October packages work – weakening banks, sovereigns and Greece.

Expect another EZ crisis Summit before Spring 2012

We  are of the opinion that the settlement opens the way for some quite reasonable requests from Portugal, Ireland and possibly other, larger states for similar treatment. Ireland being a special case. Their trouble is their banks went bust. Then, rather than let them go bust and cause all kinds of havoc for the banks bondholders in Germany and France, they decided to take over the bank debt. Instant economic collapse. Now that Greece has been given a 50% haircut on their debt, why not the Irish?

As John Mauldin pointed out in “An Irish Haircut” they may insist:

When you press politicians and establishment types (and I did) who are against unilaterally disavowing the debt, a strange thing happens. I kept asking, “But the voters seem to want to forego the debt. And the math suggests that Ireland can’t pay back these foreign bankers without great sacrifices.” At first, they would point out that Ireland is doing what needs to be done: cutting spending and payrolls. We are not Greece, they say; there is a need for “respectability.” But when pressed, they would come around to admitting that, “Yes, Ireland will get a haircut.” Everyone I met expected it to happen. The difference was the path to the haircut. But while the politics matter, the destination is the same.

Some favor doing it outright. Others truly believe they will be offered a haircut when Greece and Portugal get theirs. They fully expect it. In a meeting with an establishment-insider economist (off the record), who was at the table when the first deal was done, he said there was an implicit understanding with the IMF (and ECB) that whatever was offered to Greece, et al. would be available to Ireland. So Ireland went along with the bailout to keep from imploding the euro and averting a crisis that would have been biblical in proportions. The future of the euro is now not in their hands, because by taking on the debt they did not blow the euro up. Which could have happened, because European politicians were not ready for such a crisis.

David Williams certainly wants to insist:

The big fear in Europe is that we would ask for the same type of deal. And why wouldn’t we? After all, we are locked out of the market and we are encumbered with huge bank debts which will take years to pay off , all incurred in order prevent contagious bank defaults across Europe two years ago. In addition, every cent we pay for the likes of Anglo, AIB or Nationwide, the less we will have to spend on the Real Ireland economy and the longer the stagnation will be.

There is a direct connection between the debt deals in Europe today and Ireland’s empty shops and high unemployment. Imagine if we had a 60% write down on our debts like the Greeks. Our total national debt is €170 billion. So the figure would be €102 billion written off. So imagine a scenario where we decide to be good boys and suggest that although we are “entitled” to such a deal based on equal treatment for all the Eurozone’s members, we would only aim to have all the rogue banks’ debts cancelled. The figure on debt cancellation would be in the region €50 billion. This would be just over 32% of GDP. Imagine how much breathing space this would give us? And we wouldn’t even be asking for equal treatment with the Greeks.

But France and Germany are particularly keen to break this link and to ensure that Greece is a special case because French and German banks are on the hook here to Irish banks. This is why President Sarkozy has gone on a smarmy charm offensive.

Last Sunday, ahead of the Eurozone negotiations, Sarkozy a man who had tried to kick us when we were down a year or so ago, adopted the new approach of Gallic Flatterer, when he publically said Ireland was the model economy that all of Europe’s other weaker economies should follow. How pathetic. And do you know what? We lapped it up.

We are being killed by flattery and rather than taking this enormous opportunity to clean up our balance sheet, we are succumbing to cheap flattery because we are insecure.

Finally, we suggest Stratfor, John Mauldin and John Hussman’s latest thoughts on Europe to round out your reading.

Our Conclusions

So why are we so convinced we will have further turmoil?

Let us start with the positives. They agreed on something, not an insignificant accomplishment given the number of countries, institutions and egos involved. However, there is a lot that they didn’t agree on, though they hide that in vague language. Second, the 50% private haircut. While we are suspicious of it, it shows some realism about the need for large losses to be taken by someone. At least movement down the road to leaving fantasy land is a start. Unfortunately there is much further to go.

  1. The haircut is nowhere close to large enough to put Greece on a sustainable path. The cut in principle once official holdings of Greek debt are taken into account is around 30% if one assumes Greek pension funds will be required to take a hit. Around 16% if they are not. Either way Greece will still be in the midst of a full blown depression and need to borrow at least 109 billion from their creditors at rates that lead to a disorderly default. We suspect that eventually we will see writedowns of at least 80% to stabilize the situation.
  2. We believe Europe is in recession and it will worsen. This almost assures that austerity will not accomplish what is hoped for in Ireland or Portugal. Both countries will eventually demand haircuts on their debt as well. Look for Portugal to start appearing in the news more and more.
  3. Spain and Italy can through austerity make it, but on terms that their populations may not be willing to accept, especially as the economy worsens.
  4. We believe that the games being played in the CDS market inject an element of uncertainty that may cause yields in Europe rise further than they otherwise would.
  5. The amount of capital banks are being required to raise is not adequate to alleviate concerns.
  6. The guarantee plan is highly unlikely to work. In essence the EFSF will be selling us story bonds as Bruce Krasting discussed several weeks ago. How popular are story bonds? Not very. Protecting 20% of the principle does not mean much in the case of a sovereign default. No country trashes its credit rating to impose a 20% haircut. See Greece. Thus we doubt the bonds will be very popular or reduce interest rates greatly.

We have other concerns, but these are some of the major ones. So what is an investor to do? We suggest that better opportunities in Europe will show up down the road. Even if a solution, such as turning the ECB into a real central bank and fiscal integration of Europe, is arrived at the path to that point will be very rocky and take place during a recession. We are looking at the October lows as an entry point for a modest increase in exposure to Europe, with more on extended weakness. Our ideal would be for yields in the Eurozone to be in the 6% to 8% range as nice indicators of extreme undervaluation. If that happens it is time to start scaling in aggressively. That is obviously a long way from here, but it is what we saw in 2009. If we can get there again….No reason not to dream.