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Has Europe Been Rescued?

Well those European bureaucrats and those long the Euro and European credit sure hope so. The PSI may have 'reduced' Greece's officially reported debt by 53.5% but if one took a look at the amount they owed to the Troika and EFSF, plus those gnarly government guarantees for banks with extremely weak credit positions, the event risk isn't completely over for the sovereign. And that's just Greece, a country which GDP constitutes just 3% (and soon to be lowered) of European output. Joe sixpack has most certainly bought into the news, as proliferated by the MSM. The lack of critical news articles has led the innocent and unconscious mind to perceive that the European debt crisis has eclipsed and that we'll be seeing some sunlight after the haze. European and American bank credit and equity have stabilized at the least and been even ebullient (for TBTF American banks). This is all rubbish. Taking the issue at face value can be dangerous and probably pretty dumb.

The numbers are telling but the bureaucrats are lying. Most recently the entire Spanish curve rose by quite abit, with the belly of the curve underperforming the most. The crossover of the 10s Bonos over the 10s BTPs proved to be a death cross. But why has Spain taken such a blow when its yields were trading below those of Italy's for a good time last year? One is that Spain has slightly more than twice the reported debt of Italy. Spanish banks are more undercapitalized than the stronger Italian banks. Spanish banks with better credit ratings can raise capital from the ECB without having the government to guarantee the loans. Unfortunately fro Spain, relatively weak banks litter the scene forcing the government to guarantee lots of loans. Credit risk is essentially transferred to the government. While I think Spain prefers this over direct lending to the banks, this is very unsustainable. This angst over recapitalization has probably been the main driver of Spanish yields. Spain however has more tactfully structured its debt to make good use of the LTRO loans. Its weighted average maturity of debt stands around 3.3 years and 48% of which falls under the LTRO's 3-year maximum tenure. Spain seems to have locked in rates better than the other sovereigns; they probably share similar concerns warranting higher future yields. There is something to respect about Spain though. Not too long ago they defied orders by the IMF to lower their deficit to around 5% (I don't remember but I don't care either). Regardless, it was a draconian challenge that cannot be achieved (such promises are all in the name of bluffing at the poker table) and Spain rejected this demand. So whether or not they get funding from the Troika if things deteriorate in unknown.

The ECB's LTRO is totally underutilized. Yes, there is that notion that the money is acting as a buffer for future losses and recapitalization programs but heck, almost €800bn are sloshing around in ECB short term deposits. These ARE banks, and their main purpose is to LEND and INVEST. It seems the crisis has got the worse of them; their purpose incognito may have unknowingly morphed into staying alive and preventing the house of cards from falling, on themselves, on their sovereigns and on a grander scale, the EMU. The only 'beneficiaries' are the major FIs of the core (Germany, the Netherlands and probably France). The LTRO added strength to the thesis that the markets operated on nothing more primal than human psychology. Call it whatever you wish, market confidence or lack thereof is all there is to it. The sad but beautiful thing about this? Reality always catches up to psychology.

Italy, probably the heaviest sovereign (with €1650bn of debt), also faces its own problems. Italian banks have probably written down some of PIIGS debt and have mostly secured long term financing should anything snap in the future. Italy's crux is their profligate, mafia-styled government. Italian households are much less indebted than the EU's average. Unlike Spain, the government has shortened the duration of their debt. This isn't wise because unlike a fixed income fund which is a creditor, Italy is a debtor and it needs to lock in arguably modest rates now by issuing longer term debt. Italy will hence need to roll over its liabilities at unknown rates. Whether these rates are higher or lower than today's remains ambiguous; but I can probably make a bet on the upside. The biggest risk Italy poses is the sheer size of its debt. If it goes kaput, we'll know what chaos really means.

Then there is the potentially ugly problem of subordination. Simply put, in order of seniority: IMF>ECB>ESM>EFSF>Sovereigns/private super senior>private senior. This isn't a very dainty construct nor is it a very cool hierarchy. Succinctly, subordination hampers willful private funds from flowing into these FIs. In case you haven't known, the European interbank money market is dead; its function superseded by short and long term government/Troika loans. Now this subordination douche is slowly eradicating private existing and future bond holders. Now talk about free markets. On top of this most peripheral banks are short of free collateral. The ECB's LTRO has encumbered a good portion of free collateral. Are they sure they won't need additional lending in the future? Have all the banks written down bad sovereign and private sector debt? If Spain manage to arrange a PSI equivalent of a 50% haircut, that's €350bn worth of evaporated assets. With such weak capital structures and with a nascent equity market, further borrowings are guaranteed. This is part of the collateral problem I talked about previously. Lowering collateral standards and requirements won't solve much of the shortfall. And this is all assuming there are no impairments on collateral in lien. This can potentially be another AIG event where a liquidity squeeze subordinates all other problems. Then we can expect QE ad infinitium from the ECB, this time not under some arcane name but outright churning of the printing press. The Euro may hit parity in such an extreme case.

This is far from it, but from the facts I've presented, you decided whether Europe has been rescued.