At the time of writing the first warnings of a possible buyers’ strike for US Treasury bonds are sending a discomforting signal to Fed Chairman Bernanke that QE may not be the panacea that he had thought it would be. At the same time, it may be his good fortune, in the near term, that the troubles on the other side of the Atlantic, which seem to lurch from one financial mishap to another, will keep a bid under dollar denominated government bonds as there is even less appetite for those denominated in the second most traded global currency – the euro.
Increasingly Dysfunctional Bond Markets in the Eurozone
Perhaps not unique in this regard, given the “support” being provided to asset classes in general by many central bankers, expressly by Fed Chairman Bernanke, it is feasible to argue that there is no "real" price discovery mechanism functioning at present for EZ peripheral debt. There is a de facto buyers’ strike, and, without the purchases by the ECB under its SPM program, one can only hazard a guess as to the prices that many issues – both sovereign and private bonds and structured instruments – would be fetching were true price discovery be allowed to prevail.
Laurence Mutkin from Morgan Stanley has summarized the situation rather aptly as follows:
Peripheral government bonds…while still being government bonds in name, no longer offer the advantages of a government bond – safety, liquidity, low volatility and a negative correlation with risky assets… Hence, investors running a traditional government portfolio are exiting those markets. In short, peripheral government bonds have become an asset class in search of a new investor base.
But most recently we now need to go beyond the peripherals and look at the European core. If the problem was confined to the PIIGS nations that would be serious enough for capital markets but on December 6th yields on 10-year German bonds briefly rose above their US Treasury counterparts. That is not typical and rather disquieting. Based on historical data it turns out that US bonds had higher yields for 70 per cent of the last decade and 74 per cent of the last five years. If there is one development which could turn the PIIGS fiasco into a full blown systemic crisis it would be the occurrence of a kind of Gresham’s Law, where the “bad” debts of the EZ peripherals tarnish the creditworthiness of the core countries of Europe and specifically that of Germany.
I commented on this phenomenon in an article entitled “How much does Germany love the Euro?”:
A problem… which will almost certainly lessen the appetite for further political/fiscal integration of the EZ is that the 10 year bund yield keeps moving higher and is approaching the yield on the equivalent UST (U.S. Treasury Bond). This remarkable phenomenon will not go down well with German policy makers or their electorates and may hasten the day when the consensus view within Germany is to return to the Deutschemark.
A poll conducted at the beginning of December by a major German TV network found that almost 60% of Germans would now like to see Germany abandon the euro and return to their much loved former currency. For the technocrats in Brussels this may well be, to use a wonderful American expression, where the rubber meets the road.
It has been observed by some that European Union officials never miss an opportunity to miss an opportunity. The events of the last few weeks which have seen the Irish government humiliated, an almost complete lack of liquidity in the private and sovereign bond markets for European issuers, and a renewed attack by short sellers on the euro accompanied by a ratcheting up of the rates chargeable under CDS and other swap agreements, have still not been adequately addressed. The EZ mess gets messier and there is, in my estimation, a strong presumption that things could spiral out of control, causing a nasty threat to the global financial system.
Is an EMU Failure Inevitable?
Just how seriously should the potential break down of the EMU and the demise or re-organization of the euro currency be taken? In the remainder of this article I shall provide reasons why I believe that the attempts to change the underlying architecture of the EMU are likely to fail. These inherent flaws in the EMU system are as much to do with the hubris and market naivete of the system’s architects as they are to do with the likely reactions – which will be visceral – when politicians seek a mandate from their constituents on a way of “fixing” the big problem with a big (but unacceptable) solution for greater “fiscal and political integration.”
Stated at its most simple level, none of the actions that have been taken by the ECB and the eurozone states has so far remedied the problems with the peripheral states or Club O’Med states (the addition of the O’Med to Club allows the inclusion of Ireland along with the other PIGS). All that has happened to date (as of mid December) are a series of disjointed and piecemeal initiatives designed like band aids to stop the bleeding within a body or system which could well be on the verge of cardiac arrest. The so called rescue packages for Greece and Ireland have crippled those economies with even more debt, with interest burdens that are on disadvantageous terms, and for which there are two choices – either many years of financial servitude for their populations, or a process of default and re-structuring, just the mention of which sends EZ leaders into paroxysms of rage and denial.
The major flaws in the EMU and the procedural shortcomings of the EZ management system have been only too obvious since the Irish have had to air their dirty linen in full view of the world’s financial media and analysts. But even more revealing has been the extent to which the German government appears to be resolved (?), to prevail on the view that eventually there must be burden sharing or haircuts for the senior creditors of the major European banks. While this eminently sensible idea continues to be propounded by German politicians (at least most of the time they seem to have this view), the rest of the EZ and of course the Federal Reserve, Bank of England and other central banks shudder at the thought that they too would most likely be implicated in another bail out of their respective banking systems. Yet again the policy makers will be prompted to remind us that given such a systemic threat we have no choice but to bail out these TBTF banks; these are, of course, the usual suspects who never saw an opportunity to lend money (up until late 2007), especially if it came with a AAA rating from a CRA (Credit Rating Agency), that they did not like.
Are the EZ's Problem Global and Systemic?
The lack of resolve on the issue of how to allow insolvent, but totally inter-connected, banks to fail within a mechanism for re-structuring all stakeholders, including the claims of senior debt holders, is now the glaring weakness of the EZ and its interface with the global banking system.
Just how inter-connected and fragile the web of EZ sovereign and private credits are can be appreciated from how the metaphors regarding the messy state of affairs are getting ever more graphical. This one from a Bloomberg article captures the flavor:
It also should be noted that European banks had $509 billion in claims against Ireland at the end of June according to the Bank for International Settlements.
The problem for the Irish state is that banking guarantee two years ago inextricably merged the country’s banking problems with the sovereign,” said Brian Lucey, associate professor of finance at Trinity College, Dublin. “It’s an omelette that is impossible to un-scramble at this stage.
One final indication of the repercussions of the intermingling of public and private balance sheets within the EZ, and how the first and foremost criterion for investors in any peripheral European debt should be the state of the sovereign nation’s finances, is brought out in an interesting piece from FT Alphaville. The following is taken from an article which appeared in June 2010 (after the Greek crisis but preceding the full blown Irish debacle by several weeks) and which highlights how the linkage between sovereign credits and private banking credits are so closely entangled that they effectively can not be separated:
This (grim) sovereign-bank loop is one that’s finally increasingly being picked up by markets — particularly in Spain. To wit, the rolling correlation between five-year CDS on Spanish banks (BBVA and Santander) and that on the Spanish sovereign below, from Deutsche Bank.
It’s inching towards the 100 per cent mark, implying the market is beginning to view the two sectors as one and the same.
(Click to enlarge)
As the graph above illustrates, even in June 2010 the correlation (as expressed by the more meaningful normalized beta values) was at or close to its maximum. For those paying attention to such extreme correlations, it should not have been a surprise when the Irish government’s 100% guarantee to its insolvent banking system effectively “bankrupted” the nation.
Deficiencies of the European Financial Stability Facility (EFSF)
The mechanism which the EZ is using to finance part of its rescue facilities (along with IMF facilities) for member states that are having difficulties (i.e. they are close to being, if not already, insolvent) is structured as an SPV. The table below shows the commitments that are required to be underwritten for this special purpose vehicle, from each of the 16 member states which use the euro currency, and these are in accordance with their capital contributions to the European Central Bank (ECB). The bottom line shows a total fund of euros 440 billion and the key percentages are really those for Germany and France at 27% and 20% respectively.
|Member State||Capital Commitment Euros (in billions)||Percentage of Total|
|Federal Republic of Germany||119,390.07||27.1%|
|Kingdom of Spain||52,352.51||11.9%|
|Kingdom of the Netherlands||25,143.58||5.7%|
|Kingdom of Belgium||15,292.18||3.5%|
|Republic of Austria||12,241.43||2.8%|
|Republic of Finland||7,905.20||1.8%|
|Republic of Slovenia||2,072.92||0.5%|
|Grand Duchy of Luxembourg||1,101.39||0.3%|
|Republic of Cyprus||863.09||0.2%|
|Republic of Malta||398.44||0.1%|
|Total Guarantee Commitments||440,000.00||100%|
The EFSF legal framework is arcane and designed with “credit enhancement” features according to its prospectus, which may help to explain (although these matters often defy explanation) why the three major credit ratings agencies back in the summer of 2010 attached a AAA rating to the EFSF as an issuer. On reflection the awarding of this rating (one cannot help recall the similar ratings given to CDO sub prime creations) is remarkable given that the Greek crisis should surely have raised a question about the validity of relying on the Hellenic Republic being able to underwrite its E12 bn commitment, and the uncertainty, even back then, surrounding the financial wherewithal of states such as Ireland and Portgual, should surely have raised serious concerns for the CRAs as to the credit worthiness of this vehicle. Nonetheless the EFSF mechanism, which would be relying on nations being bailed out to contribute to their own bail outs!, was promoted heavily by key European policy makers as providing a safety net under the EMU and designed to end speculative attacks against the euro currency.
The EFSF has a termination clause which sees the mechanism being wound up by the end of June 2013 and, from a contractual stance, the underwriters do not incur obligations which are joint and several. Both of these features should have raised further concerns to the CRAs. Firstly to put a time limit on the need for this vehicle seems imprudently optimistic given the long term and structural nature of the deficits of the peripheral states, and also raises the question of how do lenders deal with rollover risk. Secondly, the last provision is important since it provides, at least on a strict interpretation, that the commitment of Germany to supporting the mechanism is confined to its 27% shown in the table. The problem that makes many in Germany uncomfortable, to put it bluntly, is that if most of its “partners” in this club turn out to be financial basket cases, and there is any default risk attached to the issuances of EFSF bonds, this could jeopardize the much cherished AAA rating of the German Republic.
Three states, Germany, along with France and the Netherlands, the other key AAA sovereigns at present, represent more than half of the contributions required to underwrite the EFSF bonds which are currently in the process of being issued to cover the first tranche of funds being made to Ireland.
Once one removes the contributions of the actual and potentially troubled states, that may themselves need to be bailed out by the EFSF, the table looks quite a lot different. The size of the fund has shrunk to E278 billion (in fact due to other consequences of the legal framework the original headline amount for the table above of E440 bn was always more like a 350 bn in actual usable funds) and the top three contributors, currently with AAA ratings are actually obligated to provide almost 85% of the total funding required.
|Member State||Capital Commitment Euros (in billions)||Percentage of Total|
|Federal Republic of Germany||119,390.07||42.9%|
|Kingdom of the Netherlands||25,143.58||9.0%|
|Kingdom of Belgium||15,292.18||5.5%|
|Republic of Austria||12,241.43||4.4%|
|Republic of Finland||7,905.20||2.8%|
|Republic of Slovenia||2,072.92||0.7%|
|Grand Duchy of Luxembourg||1,101.39||0.4%|
|Republic of Cyprus||863.09||0.3%|
|Republic of Malta||398.44||0.1%|
|Kingdom of Spain||0.0%|
|Total Guarantee Commitments||278,437.29||100%|
The limitations of the EFSF have become only too apparent to those at the sharp end of the EZ crisis i.e. the TBTF "private" sector banks and those pension funds and insurance companies that own these bonds. The challenge of valuing their existing holdings of both sovereign and private sector issues, and also contemplating purchases in the future is not for the faint hearted. More precisely the real risk is that markets are doing what they do best – and should be doing – which is to test the robustness and resolve of various pledges that are made by issuers of any security. During the peak days of the Irish rescue negotiations CDS rates blew out and the spread between the government bonds of Spain, Italy, Portugal, Greece and even Belgium reached levels never previously seen since the EMU was introduced.
During the last few days while the negotiations were taking place in Dublin, the euro broke briefly below the pivotal $1.30 level, and sovereign CDS rates kept breaking records. The magnitude of the crisis was sufficient to bring forth some dramatic utterances from alarmed EU officials including the Union’s president Herman Van Rompuy, who it is worth mentioning is not a publicly elected official but an appointee of the Brussels parliament. Mr. van Rompuy was quoted in several news reports as follows:
The European Union won’t survive if it fails to overcome a debt crisis plaguing the single currency area.
We all have to work together in order to survive with the eurozone, because if we don’t survive with the eurozone we will not survive with the European Union. But I’m very confident we will overcome this.
Van Rompuy said in a speech in Brussels hours from an assembly of euro finance ministers with Ireland and Portugal each teetering on the brink:
We’re in a survival crisis.
Since the Irish government agreed to the rescue package and during early December, the ECB has been actively buying bonds of Ireland and Portugal and this has at least “stabilized” matters to the extent that betting against these sovereigns was no longer a one way bet. The approach of the year end also means that a lot of institutions are closing their books for the year and the euro bond market is effectively closed until January. Whether this will either dissuade or encourage traders to conduct raids against the euro and cause further widening of bond spreads and CDS rates again before next year will become clearer as we head towards the end of 2010.
But the chance to articulate a deeper solution to the ongoing crisis has still not been forthcoming. Rather we have seen more of the same and what has become characteristic of the daily pronouncements from EZ leaders. The first part of their rhetoric is the constant denials of the need for any further bailouts, but this is quickly followed up by their reassurances that the EZ can cope with another bailout for (say) Portugal.
There has been an acknowledgment by key EZ officials that the EFSF is insufficiently funded, there has even been the flotation of the idea of an E-Bond which would essentially be like a US Treasury Bond but issued by an ECB which, formally at present has none of the powers of a federally constituted central bank. The ECB’s Jean Claude Trichet has also ruled out (at least for the time being) any Euro style QE, and with numerous policy makers admitting that at present there is not a structural solution to the EZ’s problem, a two day meeting on December 6/7 was convened in Brussels to try to make progress on a new architecture – the European Stability Mechanism (ESM). However, as always the meetings were inconsequential, and perhaps not so much a wasted opportunity, as a reminder that there really may be no viable solution for “fixing” the ultimately flawed currency union.
The Visceral and the Cerebral
From their inception, the EMU and EZ have been examples of overly abstruse technocratic design, and built on the kind of consensus requirements of the EU itself – which, in many respects are woefully ill prepared for governing and solving problems in a real world consisting of an heterogeneous collection of often fractious European states, with a visceral history of disharmony. In the case of the EZ this lack of “fit for purpose” is particularly acute since it highlights that the financial engineers behind the EZ framework failed to take into account fundamental features of capital markets. The shortcomings of their architectural endeavors have now been exposed to the real world where things go wrong, investors become anxious and sell in attacks of panic and moments of great illiquidity, and where politicians come under pressure from their electorates because things have not turned out the way that they said they would.
For its first eight years or so the euro was widely welcomed as it allowed the citizens of the peripheral states to borrow money far more cheaply, since they were under the umbrella of some of the most stable sovereigns (especially Germany), than they could ever have borrowed in their own currencies and having to rely on their own country’s credit profiles. But since the banking crisis of 2008, in a reminder of the slogan “It’s the economy stupid” it has to be said that there is strong anecdotal evidence that many of the EZ citizens would rather see the back of the euro currency and a return to their previous domestic currencies. Despite the obvious financial dislocations that would be created by several countries exiting the EZ, the visceral may well prevail over the cerebral in the longer term.
Essentially there is a major cognitive conflict between truly global capital markets where financial flows can cross borders without showing any passports or hindrance, when a hedge fund in London with investors from Miami or Qatar could hold the largest net long position in government paper from Indonesia, on the one hand, and the antiquated system of nation states, sovereign risk and the nature of the “guarantees” being provided for specific regions of the global economy. Financial technocrats have yet to deal with the “gap” between the world of spreadsheets and algorithms and the world where the average citizen pays little attention to finance until it begins to encroach on visceral and primordial prejudices.
During the crisis in H2, 2008 there was quite a lot of hostility expressed in the US to the notion that TARP monies could be used to benefit global banks such as Deutsche Bank –which may be domiciled in Germany but is effectively a global bank. Why did this arise? The simple but powerful answer is – when you use taxpayers’ money it is to be expected that visceral and atavistic energies will be released.
As it turns out, and following the FIA request to the Federal Reserve where it was required to release information about the recipients of emergency funding in 2008, it is now apparent that amongst the beneficiaries were major non-US domiciled banks and even some offshore hedge funds.
There has been a lot of criticism from various German and French politicians and other eurocrats that the markets have been displaying irrational behavior and “have it in for the euro”. Once again, when stripped down to the bone, these kinds of statements do not present the parties expressing them in a good light, but they need to be understood as the utterances of individuals coming from cultures which are highly competitive and which have had a troubled history.
Part of this resentment is tinged with a certain hostility (and perhaps envy) toward the pre-eminence of “Anglo Saxon finance” (whatever that means!) with London and New York clearly outranking Paris and Frankfurt as financial hubs. Again to pursue the more emotive side of this envy and anger at the Anglo Saxon axis, there is considerable antagonism expressed by many continental bankers at what they perceive as financial engineers in London and New York embodying the “Wild West” of modern finance. However, one of the hardest things for such critics to explain is how and why some of the largest purchasers of questionable structured products were banks within their own domiciles. Furthermore to accuse traders in markets as being subject to bouts of irrational behavior is like complaining that your national football team should have won the game because they played more skillfully. The height of folly and hubris of the technocratic mindset would be to imagine that these bouts of non-rational behavior can be eliminated by clever regulators and regulations.
The same kinds of strongly visceral responses are pervasive in the EZ crisis. Why should the German electorate agree to a new EZ architecture which would include, among other devices leading to more “integration,” provision for fiscal transfers, and where amongst the recipients would be Greek citizens who can retire in their early fifties on a state pension? West Germans had to extend considerable generosity to twenty million fellow countrymen/women in 1990 after the Berlin Wall was removed and the old GDR was absorbed into the new German Federation. The fiscal transfers and re-structuring based upon accepting the old East German mark at parity with the old Deutschemark, while it was portrayed (correctly) as an exciting re-unification by German leaders, for a lot of ordinary German citizens there was a lot of disgruntlement about the drop in living standards and increased taxes that were involved in the process.
To expect German voters to elect politicians who would consent to treaty changes within the EU which would allow fiscal transfers to the peripherals would be as far removed from the real world as is the belief that an enlarged EFSF or revamped ESM is going to solve the structural flaws in the EMU.
The term “uncertainty” is being used increasingly amongst practitioners in Eurobond financing and the world of structured finance. There is a lot of discussion about arcane matters such as the percentages required to trigger collective action clauses and the nature of preferred creditor status. However the continuing use of the term “uncertainty” puts me in mind of another term which has been used to describe the aftermath of the bursting of the Japanese real estate/equities bubble of the 1980s which is “zombie.” A zombie financial system is one in which uncertainty is omnipresent as participants continue to deny that there really is a problem and try to find comfort in pretend and extend stratagems which will hopefully make insolvency problems go away.
In conclusion and to enlarge the context, for the fiscal problems of the US are not that dissimilar in many respects to those being seen in much of Europe, there is a real question mark as to how long we can all continue to kick the can down the road and believe that in the long run we will muddle through without dealing with our demons.