By Jonathan Chen
It seemed as if all hope was lost in Europe, that the issues between the banks, Germany, France and the ECB were too many to get a deal done. Then around 10 p.m. Wednesday, the futures started to move higher, and we learned that Europe had reached an accord, at least for now.
"The eurozone has adopted a credible and ambitious response to the debt crisis," said French President Nicolas Sarkozy at a news conference. European Commission President Jose Manuel Barroso added that, "Europe is closer to resolving its financial and economic crisis."
Here are some of the details we know from the summit attended by German Chancellor Angela Merkel, French President Nicolas Sarkozy, and the other heads of the European Union countries:
- The European Financial Stability Facility, EFSF, is going to be leveraged four to five times. Currently the fund has $440 billion in it, but I have seen some reports that it has as little as $250 billion in it. In short, nobody really knows what it has in the fund. With the leverage, it would bring the EFSF to $1 trillion. That would suggest a current size of the EFSF of $250 billion.
- The European banks, such as Deutsche Bank (DB), BNP Paribas, Societe Generale, and others have to raise a cumulative $178 billion in capital.
- Greek debt is getting a 50% haircut, but not all Greek debt. Greek debt held by the ECB will remain at par, while debt held by the banks will get cut. Additionally, the hope is to get the debt to GDP ratio down to 120% in Greece by 2020. According to a report from Bloomberg, the bond holders were threatened with a full Greek default, so they took the 50% haircut. I suppose getting 50 cents back is better than nothing.
- The banks are going to have to raise additional Tier 1 capital, with the level raised to 9%, up from 5%. It can be raised privately, nationally, or from the EFSF.
- Lastly, the EFSF will actually be two different funds. The first one will guarantee the first loss position, and the second fund actually buys the bonds in the private markets.
Despite all the "details" from this week's summit (remember we had a summit on Monday too that did nothing), there are still a TON of questions.
Is $1 trillion enough, especially considering Italy's bond market is well over $2 trillion? The yield on Italian 10-year debt is under 6% now, but it is nowhere close to 5%. If the contagion spreads to Italy, the EFSF cannot handle Italy plus everyone else. The Italian bond market could see a huge drop, or perhaps crash and burn, if the country does not follow through on the reforms it promised. The EFSF became a "he said, she said" deal, and it still is, as no one knows how it will be leveraged.
Will the banks be able to raise the additional Tier 1 capital in the private markets?
If they cannot, that will constrain the EFSF. The banks need to raise $178 billion in capital. Since no one knows how they will leverage up the fund, how the fund gets to $1 trillion is anybody's guess. $250 billion is barely enough to cover the banks' additional capital needs, never mind buying bonds in the private markets.
Will China take part in the EFSF?
There have been rumors that China would take part in the EFSF, and European leaders are going over there this week to talk about it. It is in China's best interest to have a healthy Europe, but what happens if the credit markets freeze up again? Will the world's bankers (China) be happy? Probably not.
Sure the equity markets are rallying today, and credit spreads have eased up a little bit after the news came out last night, but that does not mean Europe was saved over night. Greece still has a massive debt-to-GDP ratio, and Greek pension funds are going to bear the brunt of the 50% loss. Greece is in a depression, and it does not seem like anything is getting better any time soon.
The euro is rallying on this news, but Citi put out a research report this morning, saying to short the euro all the way to $1.3150, and potentially all the way to $1.2860, which is the low of the year. This suggests that Citi does not believe that anything really was solved, that it was just smoke and mirrors. The stop loss on the trade is $1.4260.
Credit default swaps, especially eurozone ones, are essentially worthless now, as the ISDA did not declare this a credit event - despite Greece technically defaulting on its debt. The CDS market has been made a mockery, but there have been calls to regulate CDS a hundred times if once, and it never happened.
Still, we have no details on how the fund is going to get leveraged, and whether the banks will be able to raise the capital in the private markets. It sounds like we were left with more questions than answers. There were some concrete details, of which Merkel, Sarkozy, and others are to be commended. They got SOMETHING done, but not everything.
Enjoy the "hopium" while it lasts. It may not last much longer.
Traders who believe that Europe really did fix its problems might want to consider the following trades:
- Consider going long the CurrencyShares Euro Trust (FXE), as the euro could rally back to the $1.45 level.
- The European banks were soaring after the announcement and the short squeeze might continue if more details come out about the recapitalization.
- Higher beta names also performed well the day after. Consider tech names like ARM Holdings (ARMH) and Qualcomm (QCOM) for a trade.
Traders who believe that this was nothing but smoke and mirrors may consider alternate positions:
- Consider shorting the S&P 500 ETF (SPY), as we still do have a ton of questions. This fiasco will go on seemingly for a long time.
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