European officials' ability to reduce the tail risks appears to have been quite successful. And they have achieved this without spending a single penny. Yet the tension between the interests of the creditors and the interests of the debtors has not been resolved.
This is clear the case in Greece. Officials, including senior German officials are longer seeking a Greek exit. The IMF has weighed in to support giving Greece more time. The creditors, led by Germany, are not simply rolling over. German Finance Minister Schaeuble has made a counter-offer.
A tranche payment by the end of next month seems likely, otherwise a default, which would hit the official creditors harder than the private sector, would seem inevitable. Schaeuble proposes setting up an escrow account and funding it with the aid.
The fund would only be used to service the country's debt. The disbursement of aid would not help Greece in any other way to ease the pressure to cut spending and raise taxes. The benefit of Germany's proposal is that it would insulate Greece's domestic pressures so as to minimize its destabilizing influences on Europe and the "will they/won't they" get the tranche payment dynamic. Yet it also rips the veneer off the circuit of capital by which the Troika agrees to make tranche payments, which in turn will be used to re-pay the very same Troika of course, it is easy for the IMF to call for official sector involvement in restructuring Greece's debt, because it has recused itself from the haircut (loss) that would imply.
In addition to Greece, there has been a change in sentiment toward Spain. This is reflected in the more than 280 bp decline in its generic two-year yield since late July. The 10-year yield is off about 185 bp in the same period and at 5.42%, it is near 6-month lows.
Yet the situation on the ground is deteriorating. Look at what was reported today. Spain house prices fell 2.4% in Q3 from Q2. This represents a modest acceleration of the decline in house prices which are off 9.3% from a year ago. Until house prices stabilize, it is hard to envision the end of the financial crisis there.
Separately, even if not unrelated, the Bank of Spain reported that Spanish banks are experiencing rising bad loans. Initially, it had reported that bad loans were 9.3% of total loans in July, but due to reclassification of 9.3 bln euros of loans, this percentage was revised up to 10.1%. The bad loan ratio rose further to a new record of 10.5% in August. August was the seventeenth consecutive monthly increase.
Bank loans fell 1.1% in August from July's and 5% on a year-over-year basis. Deposits fell just as fast as bank loans in August from July, but the year-over-year decline is a steeper 8.7%. The contracting loan book and the increase in bad loans compound the challenges of the sector, which also means the sovereign challenges.
The bad loans amount to 178 bln euros and rising. The bad-bank that is being set up to warehouse and re-sell the toxic assets will have about 90 bln euros and the backstop already promised from Europe is 100 bln euros (of which Spanish officials have suggested only around 2/3 will be needed).
Spain (like France) is able to project meeting fiscal targets in 2013 with the help of what appears to be optimistic growth assumptions. Officially Spain is forecasting a 0.5% contraction next year. The IMF says it will be nearly three-times larger (-1.3%). The Bloomberg consensus is for a 1.4% contraction after contracting about 1.5% this year.
The euro has approached a band of resistance seen in the $1.3140-70 area. It is trading well within yesterday's ranges. There does not seem to be a compelling technical sign that a top is at hand. The bulls still look comfortable. A break of $1.3060 may been needed to encourage profit-taking ahead of the weekend.