Cracks Beginning to Appear?
Guest Post by Macro Story.
In two previous posts (Europe Behind The Scenes Part 1 and Part 2 found here) I discussed that behind the scenes financial markets and thus the global economy was experiencing stress. On the surface the iceberg may not be much of a concern but below it is often formidable.
A few developments this evening point towards the first real stresses beyond the control of the current EFSF “plan” including the plan itself.
Portugal Bank Run
M1 money supply (physical money such as coins and currency) fell at an annualized rate of 21% over the past six months. That is a massive flight of capital from banks. These IMF imposed budget goals are a moving target. Six months ago Portugal needed X. Today they need X plus all the capital leaving the bank’s front door. Full story can be found here.
If Portugal is dealing with this problem you can be assured Ireland is as well. But why would it be limited to Ireland? What about Spain, Greece and Italy as well? I’ve said a number of times. People are bigger than the system. A bank run is such proof.
The first US casualty of the sovereign debt crisis is apparently as close to bankruptcy as one can get. What the implications are for the financial markets are unclear until the event happens. It will be interesting to see who else has similar sovereign debt risk and exposure to MF. Will the CDS market work in this case?
The “plan” announced (remember no details, those will come later) has a few big flaws in it.
First flaw is the reality that Greece bonds will be cut in half yet the EFSF bonds will guarantee only 20%. No investor is going to buy a Spanish or Italian bond with a 20% guarantee knowing that they cannot insure with CDS and certainly will face a potential 50% loss like Greek holders. So the EU takes 200 billion Euros assumes 5 fold leverage (20% insurance) and gets 1 trillion euros. The reality is 200 billion euros will be leveraged 2 times or 400 billion euros.
Second flaw, let’s assume I bought an Italian bond over the summer. Now all of a sudden new bonds are issued with a 20% first loss guarantee. Why wouldn’t I sell my existing bond and buy one of these new and improved offerings? The value of these non EFSF insured bonds will fall. What implications will that have from a collateral standpoint? Will investors facing capital losses with the non insured bonds be driven out of the market?
And the biggest flaw of them all. What if Portugal and or Ireland needs extra help or asks for some form of debt forgiveness. That 200 billion euros left from the EFSF will disappear leaving nothing to leverage. Spain and Italy will be on their own yet again and this time the ECB cannot buy debt on the secondary market.
A reader said it best. Thursday’s price action in many ways was like the knee jerk reaction right after a Fed meeting. Friday may be more telling of what investors think of this plan and hopefully when the algos are not in a one way stampede.