Eurosolution, A Quick Guide Through The Options

Includes: EU, FXE
by: Shareholders Unite

There are a few problems out there in the euro zone, like the dire state of Spain. It's banks are facing mounting losses from a housing crash, bust property developers, an economic slump and, as a result, capital flight:

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They need recapitalization to the tune of 80-100B euro:

UBS' analysts estimated the overall bank recapitalization needed to be near €100bn, deliberately above a consensus of €80bn or so. (Credit Suisse, for example, estimate additional provisioning needs of just over €150bn..) [FTAlphaville]

And this might not be all:

Barclays Capital says Spain's housing crash is only half way through. Home prices will have to fall another 20pc to clear an overhang of one million excess properties. That will bleed banks to death. The Centre for European Policy Studies puts likely write-offs at €270bn. [The Telegraph]

You might also want to keep in mind that according to Edward Hugh from Spain Economy Watch, Spanish banks have made €2 trillion of loans from a deposit base of €1.2 trillion. There are even worse estimates, here is Alberto Gallo from RBS:

Alberto Gallo from RBS says Spain will need an EU rescue package of €370bn to €450bn to bail out its crippled property lenders and limp through to 2014, pushing public debt to 110pc of GDP.

Then there is the Greek election with a possible Greek exit as a result, and a deepening economic slump in the euro zone, all on the backdrop of a slowing world economy. Dangerous times ahead. What can be done by the authorities? Here are a few of the strategies to put out the fire that is spreading in the euro zone. A useful place to start would be to recapitalize Spanish banks (or even to let one or two go bust), but who will pay for that, and at what price?

Euro-wide bank deposit insurance
Had such a scheme been in place, at least there would be much less reason for deposit flight from Greek and (to a lesser extent Spanish) banks. Usually, such schemes are paid by banks in advance as a percentage of deposits and the fund is build up in years. Even Mario Draghi, the ECB president, is in favor:

Draghi was pushing for dramatic action, where German taxpayers (and those of a few other countries) would be stuck with the bill. He called for the establishment of a Eurozone-wide centrally supervised (by him, presumably) banking union with a resolution fund and a deposit insurance fund to put an end to the quiet bank runs before they turn into panic. [ZeroHedge]

However, there is no such fund (although national funds exist and theoretically these could be partly or even completely pooled).

Euro-wide bank deposit insurance needs euro-wide bank oversight. Without it, all kinds of perverse incentives are created. The fund would be a commons, and countries would like their banks to fish in this commons first, creating a 'tragedy of the commons' in which everyone tries to eat out of it in fear that others won't leave anything for them.

Spanish Bank 'bailout' through the ECB
Well, that was what the Spanish authorities wanted, in a backdoor way described by The Economist:

Hence talk this week of giving Bankia Spanish sovereign bonds in return for equity, which it could then swap for cash from the European Central Bank

This draw the ire of the ECB. From their twitter account(!):

Contrary to media reports published today, the European Central Bank (ECB) has not been consulted and has not expressed a position on plans by the Spanish authorities to recapitalise a major Spanish bank. The ECB stands ready to give advice on the development of such plans.

Here is Luis Garicano from the London School of Economics take on that:

It is dangerous to play chicken when you are driving a Seat and the ECB is driving a tank

This has no chance, we think.

Spanish Bank bailout through the EFSF/ESM
There are quite a few in favor of this option. The European Commission is one. French Prime Minister Pierre Moscovici is another. It's also the preferred option of the Spanish themselves, avoiding the stigma and loss of control if they as sovereign have to go to the EFSF, with its conditionality's attached, having to go through the same rather humiliating procedure as the Greeks, Irish and Portuguese.

However, "Nein!" That's what the Germans think of it.

But at 6% and a bit, Spanish yields aren't yet at unsustainable levels, although that can change in a matter of hours.

Bond purchases by the ECB
Since the ECB has not bought any bonds for 12 weeks, they're not likely to start anytime soon. Here is Mario Draghi, the ECB president:

I don't think it would be right for the ECB to fill other institutions' lack of action [Bloomberg]

However, two types of conditions might spur them on:

  • As a reward for good behavior of politicians. The ECB wants to keep the pressure on the politicians to deliver (on austerity, structural reforms, working towards a banking union, etc.)
  • In case of emergency (with rates spiraling out of control in some part of the euro zone)

The combination of these two conditions will be an incentive to act.

The Germans are against it on principle, but they're simply in a minority on the ECB board.

The level of effectiveness is high. It is frustrating that nowhere in the world would bond purchases by a central bank have such an impact on the markets and, more importantly, on the economic conditions, as in the euro zone.

Spanish bailout through the EFSF/ESM
That's possible. It's the desired option for the Germans, they don't want the ECB to bailout the Spanish banks, they don't want the ECB to buy up Spanish bonds, they don't even want the EFSF to finance Spanish banks, that leaves only one option, the EFSF bailing out Spain itself.

As we noted already, the Spanish authorities want to spare themselves the humiliation and strict conditionality of such a move. Strictly speaking, there isn't (yet) an urgent need. Spain's total public debt stood at 68.5% of GDP last year, rising to 79.8% this year (as the economy and tax receipts are shrinking). Here are the debt projections from the Spanish government:

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Add in the bank recapitalization needs and the dire situation of the regions, and it's another story. However, Spain is so reluctant to go to the EFSF that they'll try their luck on the markets on Thursday:

Spain will try to raise money on credit markets on Thursday days after it said it was all but blocked from them.
Spain will try to raise $2bn (£1.3bn, 1.6bn euros) in bonds in a test of market confidence in its ability to pay.[BBC]

Could be an interesting day, Thursday (we're writing this Wednesday evening).

A fudge
From Reuters:

While Berlin remains firm in its rejection of Spain's calls for Europe's rescue funds to lend directly to its banks, the officials said that if Madrid put in a formal aid request, funds could flow without it submitting to the kind of strict reform program agreed for Greece, Portugal and Ireland.

Instead, Spain would only have to agree to new conditions tied to the reform of its banking sector. Berlin is also exploring the possibility of funneling aid to Spain's bank rescue fund FROB to reinforce the message that it is the country's banks and not its public finances which are at the root of its problems.

Obviously the markets bought this story, rallying 2%+ on the back of it on Wednesday. This is pretty credible, because the Greek elections are looming large, since there is little anyone can do to influence the outcome of that, it's best to put out the fire (at least for now) that is at least controllable in principle.

So we think 'the fudge' will have it. It's in the interest of all concerned. To end this article, there are a few more things that have been discussed by policy makers.

To the great irritation of the Germans, the new French president Hollande tried to put this back on the agenda, knowing full well that it wouldn't fly with the Germans at all.

Eurobonds do have the advantage that they would instantly solve the euro crisis. As a whole, the euro zone's public deficit and debt is smaller than those of Japan, the US, or the UK. The problem is that it is awkwardly distributed, and the euro triggers all kinds of counterproductive mechanisms. As there is no exchange rate risk, capital flows from where it is urgently needed (the periphery) to where it is abundant (the center), leaving peripheral banks and sovereign debt exposed.

Countries most in need (the periphery again) can't print money, can't devalue, can't stop the capital outflow. These are mostly a systemic characteristic, pertaining to the design of the euro zone. Which is why eurobonds would instantly solve these problems. But apart from Germany having to pay higher interest rates on their sovereign debt, it creates a free rider problem. Countries can simply externalize much of the cost of loose policies on others.

So there is no chance of this happening anytime soon. The Germans aren't going to lend their credit card to others, it's as simple as that. And who can blame them? Only in case they have a strong say in the budgetary policies of others might they consider this, but that's 5-10 years down the road, if ever.

ECB Rate cuts
The ECB could cut rates, but they won't, and they didn't. These presently stand at 1%, but we don't think cutting them in half will make much of a difference, if any. Yet, something is better than nothing. Interbank rates are low as a result of the long-term loans to banks. The ECB is also likely to keep some bullets left in case of acute crisis emerging (like Greece election turning sour).

Barclays apparently think this is on the cards. Interesting. The previous two installments were quite effective, at least for half a year or so. Peripheral banks (and quite a few banks from the center as well) have funding problems, as lending exceed deposits by a large amount and the capital markets are closed to many banks. With bank debt maturing, this can create acute problems. Ask Dexia.

The LTRO loans, 3 year 1% loans (against collateral) solved this problem and it opened the way for banks in Spain and Italy to buy their sovereign debt, getting rates down. Works wonders in good times, but if rates start rising the bonds turn sour in the books of the banks, creating something of a vicious cycle. Here is The Telegraph:

Those banks in Italy and Spain that used the money to play the Sarkozy redemption trade by purchasing sovereign debt - some with ten times leverage - are in serious trouble. Today's spike in Italian yields shows that they are running out of LTRO money to keep the game.

It ties the bank and sovereign dynamic ever closer, so we don't see this as likely unless the crisis becomes very acute.

Coordinated central bank moves
We think there is a high probability that the central banks will move rather massively should the Greek elections produce a result that make a Greek exit from the euro quite likely. We also think that this is what's holding the markets up, as there really isn't much, if any, positive news out there.

However, before we get too enthused, we might want to consider:

"I'm leery of any rescue operation," says Charlie Smith, Chief Investment Officer at Fort Pitt Capital Group in the attached video. "Central banks can really only do one thing, and that is buffer the collapse. They don't engender risk taking but they can keep the system from failing completely for an extended period of time." [Yahoo]

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.