The reality of the worsening European situation came home to roost on Wall Street this week. Last week’s “summit to end all summits” offered up only broad brush strokes to begin with, and even those were rapidly erased by plans for a Greek referendum on the deal. A rumor circulated earlier today that the referendum was dead, but that has since been refuted by the Greek government. It appears that either the Greek government collapses or the referendum will occur – and neither outcome is good for market participants looking for certainty in these uncertain times.
Let me suggest this as well – that even if Greece comes back on board with the existing agreement, the damage is already done. Three thoughts today:
A deepening Eurozone recession is inevitable. Even if full-blown financial crisis is avoided, the cost will be continued austerity programs that will sink the Eurozone economy ever deeper into recession. This will only exacerbate the problems facing European banks as nonperforming loans rise, which will be on top of the credit contraction to follow plans to have banks recapitalizing themselves with private money by next summer.
The unintended consequences of the EFSF. The EFSF was already a farce to begin with, underfunded and relying on leverage to cover up a lack of money. The farce continued as European leaders sought handouts from China to fund a project they themselves were not committed to. Then the lack of details within the latest plan is hampering the ability of the EFSF to issue debt. From the FT (hat tip to Zero Hedge):
The bond from the European financial stability facility will seek to raise €3bn ($4bn) and will be in 10-year bonds rather than a 15-year maturity because of worries over demand, say bankers. A 10-year bond is more likely to attract interest from Asian central banks than a longer maturity.
Bankers familiar with the issue said the EFSF had been considering a €5bn issue. However, the EFSF has denied this, saying it had always sought a €3bn issue…
…EFSF officials decided to price this week because market conditions might deteriorate if they hold off any longer, according to bankers.
The bond is expected to price at yields of about 3.30 per cent, about 130 basis points over Germany, the European market benchmark. This represents a big mark-up since the middle of September, when existing 10-year EFSF bonds were trading at about 2.60 per cent, only 70bp over Germany.
Now the insurance component of the EFSF is blowing back in their faces. From the FT:
“It is kind of ironic: it is Draghi’s first day. His first decision is ‘yes, buy Italian bonds’,” said Gary Jenkins, head of fixed income at Evolution Securities. He added that the move to make Europe’s rescue fund, the European financial stability facility, issue insurance on new Italian and Spanish debt was deterring buyers: “They have created a situation where the only people buying Italian debt are themselves.”
A trader of Italian government bonds said: “It was meltdown at one point before the ECB came in. There were no prices in Italian government bonds. That is almost unheard of in a big market like Italy. There were just no buyers and therefore no prices.”
By not creating a backstop for previously issued bonds, the Europeans have clearly identified those bonds at risk of default. If the Europeans are not willing to buy or insure the bonds, why should investors? Answer: They shouldn’t. Consequently, the ECB was forced to do what it hates, buy Italian debt, and even then yields climbed above 6%, nearing levels that many believe is the point of no return for Italy.
Moreover, one should question the what is the meaning of “insurance” for Europe. I can’t imagine the ESFS actually making good on any promises to insure bondholders, as the Europeans appear adept at defining defaults as “voluntary” and therefore not credit events covered by insurance.
Will the ECB be Europe’s white knight? I think we all agree that lacking a lender of last resort, Europe has something of a credibility problem. As in, no credibility. And it has been pointed out repeatedly that the ECB could step into this role. After all, we are talking about the future of the Euro, which should be something of a concern for central bankers. And, as noted by Kash Mansori at The Street Light, by guaranteeing a price for Italian debt, the ECB would like have to buy far less than they think. But here is the problem – why should the Italians get an ECB backstop at 6%, while the Irish pay 8% and the Portuguese 12%? Politically, the ECB needs to backstop either everybody equally or nobody. Setting a ceiling on Italian debt alone risks setting off a firestorm of public anger within those nations already struggling under the weight of austerity programs. And note that even if the ECB does come into the fight, the will only do so in return for additional austerity. In other words, they might stave off financial collapse, but not recession.
Bottom Line: No matter how many summits they have, there is no easy out for the Europeans at this point.
This post originally appeared at Tim Duy’s Fed Watch and is reproduced with permission.
One Response to “Aftershocks”
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