Guest post by Peter Tchir of TF Market Advisors.
Profits not “Costs” from the Bailout. For all the talk about how much the bailouts are “costing” Germany and other countries, they have so far been very profitable.
Minimal Cash Outflows
In the early days, the countries did provide some funds. They may also have to provide the IMF with money (though the IMF also seems to be able borrow
rather than demand actual funds). Since then, the ECB and EFSF have largely provided the funds. So in spite of all the talk about the “cost” of
bailouts, the structure has allowed the money to go to Spain, Italy, Greece, Portugal, and Ireland with minimal cash out the door.
Merkel managed impressing investors on Friday. The question is, what is next? Spiegel on Merkel’s dilemma going forward.
Merkel launched her counterattack on Friday afternoon. In a post-summit press conference, she said one first has to sort things out after such a long night, and she tried to counter the impression that she had been out-maneuvered by Italian Prime Minister Mario Monti and Spanish Prime Minister Mariano Rajoy.
Merkel underscored that she had pressed to make sure that the rules of the ESM were adhered to. She said she had successfully defended the ESM’s preferred creditor status and that only a single exception would be made, for Spain. Likewise, she noted that, if at all, the ESM would only provide direct assistance to private banks after a long process of setting up a banking supervision mechanism, and that Germany would have several opportunities to exercise its veto during this process.
With the Greek weekend coming up, let’s brush up the definitions of the fancy ESM and the EFSF. From TF Market Advisors.
There is so much confusion about the ESM or EFSF funding costs. How it works, how it affects countries, etc. Here is how it works.
€1 Billion of EFSF Borrowing
The EFSF sells bonds to the market. They have already issued €109 billion of bonds, so they are a meaningful issuer and buyers at this stage understand how it works. The bonds are backed by “guarantees” from member countries with an “overcollateralization factor”.
The key is that for every €1 billion of bonds issued, you get a billion of guarantees from useful countries. Yes, Spain and Italy are included. Yes, technically if Spain or Italy receive money it is circular, but ultimately they are pretty irrelevant. Investors buy EFSF bonds and are getting paid more than if they invested in France directly – the weakest of the high quality guarantors. If you invested €1 billion split among the 5 best issuers in this ratio, you would expect to earn 1.01%. By investing in EFSF you get 1.82% and yet your risk is more than covered by those top 5. Yes, there is a risk that they don’t come in on their guarantees, but at same time you are getting almost double the spread of investing in countries outright and pick up the throwaway guarantees for free.
So now you can see how EFSF funds, how irrelevant Spain and Italy are too it, and that it is likely sustainable when it is so much cheaper than direct investments in the top countries (especially if people don’t think there will be an FX event in Europe).
Classical conditioning (also Pavlovian conditioning or respondent con- ditioning) is a form of learning in which one stimulus, the conditioned stimulus or CS, comes to signal the occurrence of a second stimulus, the unconditioned stimulus or US. The US is usually a biologically significant stimulus such as food or pain that elicits a response from the start; this is called the un- conditioned response or UR. The CS usually produces no particular response at first, but after conditioning it elicits the conditioned response or CR. Classical conditioning differs from operant or instrumental conditioning, in which behavior emitted by the organism is strengthened or weakened by its conse- quences (e.g. reward or punishment).
Conditioning is usually done by pairing the two stimuli, as in Pavlov’s classic experi- ments. Pavlov presented dogs with a ringing bell (CS) followed by food (US). The food (US) elicited salivation (UR), and after repeated bell-food pairings the bell also caused the dogs to salivate (CR).
In short, by associating the sound of a ringing bell with the appearance of food, Pavlov condi- tioned dogs to salivate merely at the sound of the bell.
Peter Tchir of TF Market Advisors on the Spanish bail out.
Change of Attitude or One More Last Minute Plea Bargain?
On a standalone basis, the deal announced yesterday does relatively little for Europe. It once again looks like a last ditch attempt to cobble together something to appease the markets. It relies on ESM which hasn’t yet been set up. It lends to the FROB rather than to Spain or capitalizing banks directly, creating some potential confusion. The plan, under the most positive interpretations, is reasonably meaningful to Spain, and under the worst execution, may do virtually nothing even in Spain.
The key is whether there has been a shift in attitude in Europe. Is this different than prior plans and is this only the first of many steps? The ECB was extremely dovish in words if not action last week. This plan does seem to bend over backwards to fit within the existing treaties and yet offer the most flexibility possible. If this is all we get, the rally, if there is one, will be short lived. If this is just the beginning of a series of actions such as
- Renegotiating Greek Austerity Package
- Working with Ireland, Portugal, and Greece to restructure existing programs
- Project and/or Redemption Bonds
- New LTRO, Renewed SMP, or Rate Cuts
- Global Policy Intervention with the PBOC and Fed leading the way
then we may yet be at the early stages of a liquidity and money printing and “growth” rally. It too will likely fail, but that will take time.
Market thoughts by Peter Tchir of TF Market Advisors.
So the EC wants the ECB to bypass the EFSF and use the ESM to recap EU banks? That was the rumor that shifted global stock markets by 1% in a matter of minutes?
The ESM is not yet up and running. There was talk that it would be done by June or July of this year, but in typical EU fashion I don’t think much progress has been made towards that promise. So right now the EU is stuck with EFSF and the potential to set up the ESM.
The EFSF actually has a lot of powers. I’m not sure exactly why it is such a big deal if the EFSF (or ESM) invests directly in banks or lends money to countries to invest in banks. In theory the countries could lose on their bank investment but pay back EFSF loans? That is a possibility but it would seem more and more likely that if the bank rescues fail the sovereign is dead anyways, so the market might be reacting too much to that distinction.
The bigger problem is that the EFSF is not well set up to leverage itself. The EFSF is technically the entity that could be buying bonds in the secondary market. It is supposed to have taken over that role from the ECB, yet it hasn’t done that. Why not? It is possible that they haven’t figured out a good way to leverage the EFSF and therefore would get minimal bang for the euro by buying bonds in the secondary market without leverage. The same issues apply to its role in the primary markets. Yes, the EFSF can intervene in the primary markets, but again, had very convoluted leverage schemes, which would never work.
The problem isn’t so much what the EFSF is allowed to do, it is how constrained it is in terms of leverage and access to funding. There is almost nothing that can be done about how EFSF is set up at this stage, nor should there be. That messed up entity should be put out of its misery.
As we have been arguing for over a year, a Greek default is inevitable. The question is how to perform it. With the Troika, IMF, ECB, EFSF etc involved, things are rather complex. Peter Tchir gives some color on the subject.
Europe continues to fight the wrong battle, and continues to spread contagion risk.
It is clear that Greece has had a solvency issue now for over 2 years. The ECB and Troika chose to treat it as a liquidity problem. Maybe, they could have argued that in early 2010, but by the summer of 2011 it was obvious to any credit observer that the problem was solvency, yet they continued to treat it as one of liquidity. That is scary because if they feel to see the problem correctly now, they will fail miserably. Not only is the problem clearly solvency, but now forced currency conversion has been added to the mix. Any “solution” from the EU must now address that risk, and it is not the same as solvency. Programs that can protect against solvency may do nothing for the redenomination risk.
Not only did Europe fail to address the problems, but in spite of convincing themselves that all these programs prevented contagion risk, they actually ensured contagion risk. That contagion risk, that they forced on themselves is now coming back to haunt them, and must be carefully addressed in any policy “solutions”.
Two Years of Bad Policy Have Created a Situation Like No Other
There is a lot of talk about what a Greek exit would or wouldn’t look like. People are comparing it to other defaults and currency devaluations. They are wrong. Greece is now unique in that almost all of the debt is owed to institutions that normally step in after devaluation. Greece is also unique in that it is leaving a currency union that is already fragile, and being the first to leave will open the floodgate of speculation as to what other countries will leave.
Market comments by Peter Tchir of TF Market Advisors.
The ECB will be the driver as it is the only entity in Europe that can make money appear and lend to “banking” entities with wide latitude. The EIB is suddenly stepping up its involvement. Look for “infrastructure” projects to be announced throughout Europe. There will be a focus on the countries in trouble, but also project given to the smaller countries that have been taken along for the ride. It won’t be a big amount, but it will be targeted to create immediate jobs and economic activity – ie, growth. The EIB can borrow from the ECB as far as I can tell and has the added advantage that figuring out who is on the hook for EIB losses, if any, is even more difficult than some of the other programs.
The EFSF may or may not get a banking license, but the ESM definitely will. This negates the need to tap the bond market for money, which is good, because that does cannibalize funds that could otherwise go to sovereign and corporate bond purchases. It also makes it easier to leverage. It ensures that the ECB will be the fulcrum of any future problem, as it is the mechanism that losses spread from the weakest countries to the strongest. But arguing that it won’t really work and that it causes more problems down the road than it resolves won’t stop the market from being happy, at least for a little while, especially in combination with other projects.
A lot of this is being done to prepare for a possible Greek exit. It is clear that Europe now realizes exactly what we have been saying since the elections – that Europe is not ready for a Greek exit in any shape of form at this stage, and Europe would be hurt more than Greece because all of the interconnectivity of commerce and more importantly, lending to Greece.
The ECB is also working on some form of deposit insurance. If that has some form of conversion protection, it would be truly useful, and shocking. If it only protects against default, it is less useful as depositors are pulling money from banks out of fear of conversion more than fear of default. The EU was fighting a solvency issue with liquidity and now runs the risk of fighting a forced conversion risk with solvency measures. Any form of deposit insurance would be beneficial, but to be truly long term meaningful, it has to protect against redenomination.
Guest post by Azizonomics.
So let’s assume Greece is going to leave the Eurozone and suffer the consequences of default, exit, capital controls, a deposit freeze, the drachmatization of euro claims, and depreciation.
It’s going to be a painful time for the Greek people. But what about for Greece’s highly-leveraged creditors, who must now bite the bullet of a disorderly default? Surely the ramifications of a Greek exit will be worse for the international financial system?
J.P. Morgan — fresh from putting an LTCM alumnus in charge of a $70 trillion derivatives book (good luck with that) — is upping the fear about Europe and its impact on global finance:
The main direct losses correspond to the €240bn of Greek debt in official hands (EU/IMF), to €130bn of Eurosystem’s exposure to Greece via TARGET2 and a potential loss of around €25bn for European banks. This is the cross-border claims (i.e. not matched by local liabilities) that European banks (mostly French) have on Greece’s public and non-bank private sector. These immediate losses add up to €400bn. This is a big amount but let’s assume that, as several people suggested this week, these immediate/direct losses are manageable. What are the indirect consequences of a Greek exit for the rest?
The wildcard is obviously contagion to Spain or Italy? Could a Greek exit create a capital and deposit flight from Spain and Italy which becomes difficult to contain? It is admittedly true that European policymakers have tried over the past year to convince markets that Greece is a special case and its problems are rather unique. We see little evidence that their efforts have paid off.
The steady selling of Spanish and Italian government bonds by non-domestic investors over the past nine months (€200bn for Italy and €80bn for Spain) suggests that markets see Greece more as a precedent for other peripherals rather than a special case. And it is not only the €800bn of Italian and Spanish government bonds still held by non-domestic investors that are likely at risk. It is also the €500bn of Italian and Spanish bank and corporate bonds and the €300bn of quoted Italian and Spanish shares held by nonresidents. And the numbers balloon if one starts looking beyond portfolio/quoted assets. Of course, the €1.4tr of Italian and €1.6tr of Spanish bank domestic deposits is the elephant in the room which a Greek exit and the introduction of capital controls by Greece has the potential to destabilize.
A multi-trillion € shock — far bigger than the fallout from Lehman — has the potential to trigger a default cascade wherein busted leveraged Greek creditors themselves end up in a fire sale to raise collateral as they struggle to maintain cash flow, and face the prospect of downgrades and margin calls and may themselves default on their obligations, setting off a cascade of illiquidity and default. Very simply, such an event has the potential to dwarf 2008 and 1929, and possibly even bring the entire global financial system to a juddering halt (just as Paulson fear-mongered in 2008).
Big US banks are set to return money to shareholders after the Federal Reserve released the results of “stress tests” on 19 financial groups showing that all but four – including Citigroup – had passed the exercise. Results of the test, which were rushed out two days early after the Fed said it was concerned about information leaking, sparked a rally in US bank stocks. The S&P financials index rose 3.9 per cent and is now more than 18 per cent higher for the year, withJPMorgan Chase, Wells Fargo and Bank of America leading the way. Citigroup rose 6.3 per cent before the market close, but fell close to 4 per cent after hours as it became clear the bank had failed. http://www.ft.com/intl/cms/s/0/c3496718-6d41-11e1-b6ff-00144feab49a.html#axzz1osZsMnZW
The US Federal Reserve kept policy on hold and gave a more optimistic outlook for the economy, in a statement that gave no hint further monetary easing is on its way. In the crucial line of its regular post-meeting statement released on Tuesday, the rate-setting Federal Open Market Committee upgraded its expectation for the pace of growth in coming quarters to “moderate”, stronger than the “modest” speed it expected in January. http://www.ft.com/intl/cms/s/0/fc009ad6-6d32-11e1-ab1a-00144feab49a.html#axzz1osZsMnZW
The UK chancellor aims to launch an “Osborne bond” – a 100-year debt issue or even a perpetual gilt that never matures – to take advantage of the country’shistorically low interest rates. The plan echoes similar bonds issued to finance debts after the 18th century South Sea Bubble and the first world war. George Osborne will say in next week’s Budget that he wants to “lock in” the benefits of Britain’s low borrowing costs, which he says reflect market confidence in his fiscal plans http://www.ft.com/intl/cms/s/0/8300b436-6d3c-11e1-b6ff-00144feab49a.html#axzz1osZsMnZW