AMERICAN FUTURE

From the Financial Times:

After months of denials by Spanish leaders that the country needed a bailout, it fell to Luis de Guindos, the economy minister, to declare in Madrid on Saturday that “the government of Spain declares its intention to request European financing” for its banking system.

– http://www.ft.com/intl/cms/s/0/b4deeb3a-b256-11e1-99ff-00144feabdc0.html#axzz1x2Eim5lB:

The formal request by Spain to the EU is expected before June 21, when Eurozone finance ministers meet in Luxembourg and after a detailed report is issued by two government-appointed advisers on the banks’ capital needs.

The amount? Up to 100 billion euros ($125 billion). From a statement issued by Jean-Claude Juncker, Luxembourg’s Prime Minister and head of the Eurogroup of finance ministers:

“The loan amount must cover estimated capital requirements with an additional safety margin, estimated as summing up to EUR 100 billion in total.”

– http://www.consilium.europa.eu/uedocs/cms_Data/docs/pressdata/en/ecofin/130778.pdf

The bailout will come either from the Eurozone’s temporary bailout fund (the European Financial Stability Facility) or, as soon as it is operational in July, the permanent rescue vehicle (the European Stability Mechanism).

According to the FT, the bailout funds will be channeled through the Spanish government’s Fund for Ordinary Bank Restructuruing (FROB), which will then inject the funds into the banks, shoring-up their capital positions.

Here’s the critical point (again from the FT):

“Because FROB is part of the Spanish government, bailout loans would still be on Madrid’s sovereign books and the government would bear ultimate responsibility for repayment.”

This means that the bailout will cause the Spanish government’s debt-to-GDP ratio to increase. If recent history is a guide, the increase in this ratio will result in higher interest rates on future Spanish government bond offerings. In my view, then, the bailout is nothing more than a band-aid that will stop the current bleeding but worsen the infection.

Market participants will be well aware that agreement on this bailout mechanism means that the Spanish government failed to secure a deal in which the bailout funds would directly inject capital into Spanish banks, thereby avoiding an addition to government’s debt.

According to the Wall Street Journal , de Guindos said

“The Spanish government is determined to do its best to protect the stability of the euro” and added that the conditions attached to the loans “will be imposed to banks, not to Spanish society, nor to its fiscal or economic policy.”

– http://online.wsj.com/article/SB10001424052702303753904577456044240154190.html?mod=WSJ_hps_LEFTTopStories

This strikes me as wishful thinking, at best, or delusional, at worst.

Those with the gold make the rules. Within the eurozone, Germany has the gold. Why change the rules when the status quo is just fine?

If you’re trying to understand why Germany is dead-set against eurobonds and other porposed solutions to the eurozone crisis, look no further than this:

The starkly contrasting economic trajectories of countries inside the eurozone were highlighted on Tuesday as Germany reported unemployment at 20-year lows while Spanish jobless figures rose for the fifth consecutive month.

The number of Spanish jobseekers rose to 4.42m, while Germany’s jobless count fell to 2.976m. Another measure, based on household surveys, puts Spanish seasonally adjusted unemployment at 5.4m, nearly 23 per cent of the workforce. The comparable German figure decreased to 6.8 per cent in December from 6.9 per cent the prior month.
And this:

The German car makers’ association said on Tuesday that 3.2m new cars had been registered in Germany in 2011, 9 per cent more than the year before, with domestic brands beating foreign rivals.

In greater detail, here’s the German employment situation:

German unemployment dropped markedly in December, bringing the number of out-of-work in the eurozone’s largest economy to a 20-year low . . . Unemployment fell by 22,000 in an unusually warm month, rendering an adjusted jobless rate of 6.8 per cent, down from 6.9 per cent in November.

German companies are profiting from solid order books, with demand for their goods increasingly coming from domestic consumers and companies as well as foreign ones.

Economists said the positive labour-market trend could continue over the next few months as companies were still willing to take on more staff – carmaker Audi said it would hire about 1,200 extra workers in Germany this year.

Other manufacturing companies were said to have shortened their traditional Christmas production break to work off their order backlog, and numerous sectors have been reporting many open positions in the past months.

But in Spain it’s austerity, not employment, that’s growing:

The . . . government has already announced €15bn of emergency public spending cuts and tax rises after announcing that the 2011 budget deficit could exceed 8 per cent of gross domestic product – two percentage points higher than the 6 per cent target agreed by the previous Socialist government with the EU.

The employment ministry statistics show that the jobless total has more than doubled since mid-2007 . . .

Evidently, the Germans have convinced themselves that their economy isn’t dependent on the economic health of the other members of the eurozone. If and when the Germans begin to listen to the advice of others, it will be a signal that the Merkel government has started to anticipate an economic slowdown.

Earlier this month, the European Central Bank announced an emergency loan program known as “longer-term refinancing operations,” or LTROs. The program will become operational tomorrow (Wednesday). The Financial Times says that the ECB expects strong demand for the loans, which will be available in “unlimited” quantities.

The purpose of the program, which enables banks to avail themselves of three-year loans at extremely favorable interest rates, is to ease the severe strains in the eurozone’s financial system. If demand for the loans is strong, it should reduce the likelihood that banks will substantially shrink their balance sheets (by selling assets and reducing new loans to their customers) to meet their funding needs (which are especially large in early 2012). The hope, then, is that the LTRO will improve the economic performance of countries in the eurozone. It’s important to note, however, that this provision of additional liquidity doesn’t attack the eurozone’s fundamental problem: severe and persistent balance-of-payment imbalances among its members.

The funding problem that the LTRO is aimed to ease is having a contagion effect. Asset sales by European banks have put pressure on securitized mortgage prices in the U.S. Instead of selling distressed assets in their home markets, the banks are selling assets elsewhere (as encouraged by their governments).

In combination with the sharp drop in Spanish short-term interest rates that took place today, the imminent start of the LTRO program may be responsible for the sharp rally in the U.S. equity markets. If demand is as strong as the ECB expects, contagion fears could ease, allowing for a short-term bounce in the stocks of financial institutions holding mortgage-backed securities.

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A Financial Times video explains the workings of the eurozone’s financial plumbing and how it might leak if one or more countries exit from the currency union’s membership. The hard-copy is here.

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Excerpts from an FT editorial:

Europe’s economic prospects are deteriorating frighteningly fast, and the world outlook is darkening in step with the Old World’s woes. Unless the world’s leaders manage to pull together soon, we should brace ourselves for a second phase of the credit crisis that will be even worse than the first.

[...] A credit crunch is gaining force, and Europe’s economy grinding to a halt because of it. This is making the twin crises – bank and sovereign – harder to resolve and is hitting emerging economies whose credit is drying up and whose export markets are withering. If the ECB cannot stimulate growth, governments must do so, and fast.

Today the whole world badly needs Europe to grow. Long-term growth and rebalancing are sine qua non for overcoming the debt crisis, but short-term recovery is a greater priority. Austerity by those who must should now be compensated by stimulus from those who can.

My sentiments, exactly.

Round 2 of Reactions to the EU Summit (and some other stuff)

The consensus:

The title of the FT’s editorial — “Europe fails to reach summit” — says it all:

It should have been the climax to Europe’s thriller, a summit that would kill off the sovereign debt crisis with a salvo of confidence-restoring measures. But, apart from Britain’sdramatic exit, last week’s European summit was entirely predictable in its inconclusiveness.

To be fair, it is good news that even modest steps were taken towards closer fiscal integration. But the real, comprehensive fiscal union needed to restore faith in the euro, as opposed to a few new rules, remains elusive.

More urgently, the deal that was struck does nothing to resolve the immediate crisis. Moves to bolster the International Monetary Fund and hints of more support next year for Europe’s two bail-out vehicles are neither big enough nor fast enough to deal with the titanic task of funding peripheral countries’ debt until confidence returns.

Hopes in the existence of a big bazooka proved misplaced. Mario Draghi, European Central Bank president, on Thursday quashed hopes that he would launch an unlimited bond-buying programme to help indebted sovereigns, as European rules do not allow this.

Now there is the suggestion that the ECB has a cunning plan to give the bazooka to Europe’s banks, which will be lent bags of cheap money, with which to buy their own countries’ debt.

The argument is tempting. Friday’s summit declared that there will be no more haircuts on sovereign debt. So if banks can get three-year ECB money at 1 per cent and buy Italian bonds at 6 per cent, this could help cut debt costs while bringing seemingly risk-free returns. This is not contrary to European rules and it could be in both parties’ interests. If the sovereigns go, Europe’s banks are front line victims.

However, there are many reasons to be wary of such a solution, not least because it fools no one. The ECB would in effect be funding sovereign debt through Europe’s banks. This is hardly in the spirit of the European treaty. Second, shareholders might rightly question why banks, which have been shedding periphery bonds despite having had the arbitrage opportunity for some time now, were suddenly scooping them up. Most importantly, if the current crisis was sparked by the link between sovereign and bank risk, does it make sense to intensify that link? Right now there may be no alternative to save the euro. But it amounts to little more than sleight of hand in a crisis where clarity and resolve would do much more to restore confidence.

Unsurprisingly, the FT’s Wolfgang Munchau agrees:

. . . the decision to set up a fiscal union outside the European treaties will do nothing whatsoever to resolve the eurozone crisis . . . this is not something you would wish to do outside European treaties. The existing treaties form the legal basis for all policy co-ordination of monetary union. It gets very messy when you try to circumvent them.

[...] A fiscal union set up outside the European treaty would face severe legal and practical limitations. Unless a trick is found, it cannot make recourse to the resources and institutions of the EU. Nor can it issue eurozone bonds. The only conceivable counterparty for a eurozone bond is the EU itself.

More important even, a fiscal union created through a legal trapdoor would not help solve the crisis. The eurozone is facing a generalised loss of confidence. Investors no longer trust its crisis management, the solidarity of its citizens, even the ability to conduct sensible economic policies. The EU is not going to restore confidence through legal gimmickry that will face numerous court challenges.

Leaders should have admitted on Friday that the summit had simply failed, or perhaps have given it a few more days. Negotiations might have produced a compromise. With the fake pretence of another treaty, that is no longer possible.

Remember what everybody said a week ago? To solve the crisis, the eurozone requires, in the long run, a fiscal union with a prospect of a eurozone bond and, in the short run, unlimited sovereign bond market support by the European Central Bank. What we now have is no treaty change, no eurozone bond and no increase either in the rescue fund or in ECB support.

Policy changes the ECB announced last week will help banks directly and governments indirectly. But the EU fell short on every element of a comprehensive deal. On Friday, investors reacted positively to what was sold to them as a “fiscal compact”. But once the implications of a separate treaty are understood, I fear disillusionment will set in.

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The rating agencies are equally unimpressed.

In its Weekly Credit Outlook, Moody’s says that “Pressure Remains on Euro Area Sovereigns in Absence of Decisive Initiatives” and “European Bank Recapitalization Plan Is Credit Positive, but Encourages Deleveraging”:

Pressure Remains . . .

. . . the [EU summit] communiqué reflects the continuing tension between euro area leaders’ recognition of the need to increase support for fiscally weaker countries and the significant opposition within stronger countries to doing so. Amid the increasing pressure on euro area authorities to act quickly to restore credit market confidence, the constraints they face are also rising. The longer that remains the case, the greater the risk of adverse economic conditions that would add to the already sizeable challenges facing the authorities’ coordination and debt reduction efforts.

As a result, the communiqué does not change our view that the crisis is in a critical, and volatile, stage, with sovereign and bank debt markets prone to acute dislocation which policymakers will find increasingly hard to contain. While our central scenario remains that the euro area will be preserved without further widespread defaults, shocks likely to materialise even under this ‘positive’ scenario carry negative credit and rating implications in the coming months. And the longer the incremental approach to policy persists, the greater the likelihood of more severe scenarios, including those involving multiple defaults by euro area countries and those additionally involving exits from the euro area.The credit implications of these and further measures likely to be announced in coming weeks require careful consideration against the backdrop of decelerating regional economic activity, fragile banking systems, partly dysfunctional credit markets, and the varying degree of success of country-specific measures aimed at structural change and fiscal consolidation. But in the absence of credit market conditions stabilising, the system remains prone to further shocks which would likely lead to selective rating changes. More broadly, in the absence of any decisive policy initiatives that stabilise credit market conditions effectively, our intention as announced in November is to revisit the level and dispersion of ratings during the first quarter of 2012.

European Bank Recapitalization . . .

Additional capital is credit positive as it enables banks to cope with increased stress. However, there is a risk that tighter capital requirements will encourage further deleveraging, thereby increasing the risk of a credit crunch and additional impairments.

The establishment of a sovereign exposure buffer follows criticism that the EBA’s stress test earlier this year inadequately reflected the true value of, and impairments in, banks’ sovereign exposures. Disclosures in banks’ interim statements also point to inadequate evaluation and provisioning and, in some cases, a failure to comply with international accounting standards.

[...] Supervisors are not simply seeking to achieve higher capital ratios, but also higher capital. Nevertheless, the incentive for banks to deleverage remains high and will only be exacerbated by higher capital requirements. More fundamentally, higher capital buffers cannot address the underlying cause of the disruption to the funding markets which is the sovereign debt crisis.

Fitch says that the “Summit Does Little To Ease Pressure on Eurozone Sovereign Debt”:

After the latest EU crisis meeting it is clear that politicians are responding to the eurozone sovereign debt crisis through incremental improvements. It seems that a “comprehensive solution” to the current crisis is not on offer.

This Summit demonstrated strong political support for the euro, and that its members are putting in place the institutional and policy framework for a more viable eurozone and ultimately greater fiscal union. But taking the gradualist approach imposes additional economic and financial costs compared with an immediate comprehensive solution. It means the crisis will continue at varying levels of intensity throughout 2012 and probably beyond, until the region is able to sustain broad economic recovery.

In the short term we predict a significant economic downturn across the region. The eurozone faces intense market pressure, which is triggering loss of business and consumer confidence, and weak industrial activity and retail sales. Our forecast of 0.4% eurozone GDP growth next year and 1.2% in 2013 would be significantly higher if there was a comprehensive solution to the crisis. The lack of a comprehensive solution has increased short-term pressure on eurozone sovereign credit profiles and ratings.

The latest EU Summit, like others before it, has resulted in some positive developments. There is an extra EUR200bn of funding for the IMF, the ESM has been brought forward, and there has been policy change on private-sector involvement in any future sovereign crisis. As with all Summits there is execution risk.

The extra resources for the IMF are welcome but it is not clear how and under what circumstances they would be deployed. The move away from requiring private-sector involvement (PSI) as a condition for ESM programmes is clearly positive for bondholders. The European Commission said it will “strictly adhere to the well established IMF principles and practices.” PSI has been a feature of past IMF programmes, but the Fund sets out to attract private capital to sovereigns and can be expected to use PSI as a last rather than a first resort.

Separately, the ECB also announced changes to its repo schemes that will aid bank liquidity, such as three-year liquidity lines and looser collateral requirements for structured finance. This could be positive for eurozone sovereigns if it eases pressure on them to introduce or re-activate bank debt guarantee schemes.

The Summit’s conclusions show a longer-term desire to move towards some form of fiscal integration in return for enforced fiscal prudence. We believe that most of the vulnerable eurozone countries are already implementing aggressive austerity programmes, and some are already changing their national constitutions. It is too early to judge how effective the fiscal compact will be due to the uncertainty regarding how it will be implemented.

We still believe the ECB, either directly through its sovereign bond purchase programme or indirectly by allowing the EFSF/ESM to access its balance sheet, is the only truly credible “firewall” against liquidity and even solvency crises in Europe.

Hopes that the ECB would step up its actions in support of its sovereign shareholders as a quid pro quo for institutional and legal changes that gave the ECB greater confidence in the long-run commitment of eurozone governments to fiscal discipline appear to have been misplaced.

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Lurking in the background, according to the Wall Street Journal, is an old nemesis: credit default swaps, which have been used in copious quantities by European banks:

Dozens of banks across Europe have sold large quantities of insurance to other banks and investors that protects against the risk of ailing countries defaulting on their debts, the latest illustration of the extensive financial entanglements among the continent’s banks and governments.

New data released last week by European banking regulators suggest the risks of banks suffering losses tied to European government bonds could be higher and more widespread than previously realized.

The numbers show European banks have sold a total of €178 billion ($238 billion) worth of insurance policies, in the form of financial derivatives known as credit-default swaps, on bonds issued by the financially struggling Greek, Irish, Italian, Portuguese and Spanish governments. If those bonds default, as some investors fear they might, banks could be on the hook for making large payments to the holders of the swaps.

The banks have at least partly insulated themselves from such potential losses by buying large quantities—roughly €169 billion worth—of credit-default swaps tied to the same bonds, apparently in large part from other European banks, according to European Banking Authority data.

Some analysts and investors say they had assumed that sovereign credit-default swaps, known as CDS, were primarily sold by giant global investment banks in the U.K., France and Germany, as well as in the U.S. Those banks sell the swaps to big corporate clients and other banks and institutions.

But the new EBA data show a surprising breadth of large and small European banks—at least 38 of them—have sold instruments that protect against potential losses on Greek, Irish, Italian, Portuguese and Spanish government bonds.

Of the total protection that European banks have written on government bonds in Europe’s five most-stressed countries, nearly one-third originated from German banks.

The diverse array of banks in the sovereign CDS market means that risks can spread more quickly through the financial system. It also means it is harder to predict how losses would ricochet among institutions and countries, analysts say.

The banks and some analysts argue that the industry’s actual exposure is far less than the €178 billion of swaps they have sold because the banks have purchased €169 billion in similar protection from other sources, which can offset the exposure. Many of Deutsche Bank’s purchases and sales of CDSs, for example, are with the same counterparties, with whom the German bank has legally enforceable netting agreements in place.

But some experts say it is risky to assume that all banks’ CDS transactions neatly cancel each other out.

“Netting is all very well provided that you trust your counterparty,” said Jon Peace, a Nomura Securities banking analyst. But in a crisis situation, “what you thought was net could tend toward your gross exposures” because certain sellers of the default insurance could themselves go bust.

For example, two of Italy’s biggest banks, UniCredit SpA and Banca Monte dei Paschi di Siena SpA, have sold a total of about €5.3 billion of protection against the risk of an Italian sovereign default, according to the new EBA data. The problem is that, in a default scenario, both banks likely would be in trouble themselves due to their huge holdings of Italian government bonds and the fact that their businesses are largely concentrated in Italy.

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While the Organisation for Economic Co-operation and Development (OECD) hasn’t issued a statement setting forth its view of the results of the EU summit, the Financial Times reports that it “will warn in its latest borrowing outlook, due to be published this month, that financial stresses are likely to continue with the “animal spirits” of the markets – their unpredictable nature – a threat to the stability of many governments that need to refinance debt.”

For the foreseeable future it will be a “great challenge” for a wide range of OECD countries to raise large volumes in the private markets, with so-called rollover risk a big problem for the stability of many governments and economies.

Rollover risk is the threat of a country not being able to refinance or rollover its debt, forcing it either to turn to the European Central Bank in the case of eurozone countries or to seek emergency bail-outs, which happened to Greece, Ireland and Portugal. The OECD says the gross borrowing needs of OECD governments is expected to reach $10.4tr in 2011 and will increase to $10.5tr next year – a $1tr increase on 2007 and almost twice as much as in 2005. This highlights the risks for even the most advanced economies that in many cases, such as Italy and Spain, are close to being shut out of the private markets.

While borrowing was higher in 2009 and 2010, the risks are greater than ever because of rising borrowing costs in turbulent, unpredictable markets.

The OECD says that the share of short-term debt issuance in the OECD area remains at 44 per cent, much higher than before the global financial crisis in 2007. This, according to some investors, is a problem as it means governments have to refinance, sometimes as often as every month, rather than being able to lock in more debt for the longer term that helps stabilise public finances.

The OECD also warns that a big problem is the loss of the so-called risk-free status of many sovereigns, such as Italy and Spain, and possibly even France and Austria. The latter two have triple A credit ratings but investors no longer consider them risk-free.

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Contagion from the eurozone crisis appears to be spreading to emerging markets: Indian industrial production dropped by 5.1 percent in October. From the Financial Times:

“The data are way worse than we were expecting,” said A Prasanna, economist at ICICI securities in Mumbai. “Usually output is lower during the months of October and November as there are fewer working days due to the festival season but a 5.1 per cent drop is significantly more than we predicted,” he added.

Manufacturing output, which represents about 76 per cent of industrial production, dropped 6 per cent in October, compared with a year ago and capital goods production, which is considered to be a key barometer of investment sentiment in the country, fell 25.5 per cent. Meanwhile, mining production was down 7.2 per cent, as a series of scandals in the sector and continued uncertainty over the outcome of a long-awaited mining bill hurt the industry.

From the online Wall Street Journal at 11pm:

• EU Banks Struggle to Lure Deposits

Several large Italian and Spanish banks recently reported double-digit percentage declines in deposits from corporate and other institutional clients, although their overall deposit levels fell more modestly, as lenders hold a greater share of retail deposits. The deposit base at Spanish banks dropped by €48 billion ($64.8 billion), or 2%, in the third quarter, according to the Bank of Spain.

The deposit outflows come as emergency borrowings by banks from the European Central Bank soared to their highest level in more than two years Tuesday, with the ECB allotting €247.2 billion in seven-day funds to banks, a jump from the previous 2011 high of €230.3 billion.

Meanwhile, banks in countries like Spain, Portugal and Italy are scrambling to retain existing customers and attract new ones by dangling ever-higher interest rates on deposits, making it more expensive for banks to finance themselves affordably.

[...] To be sure, analysts say that overall, European banks still have hundreds of billions of euros of deposits, many of them from individual customers who tend to be reluctant to switch bank accounts. The lenders also can turn to financial lifelines from the European Central Bank, posting government bonds and other assets as collateral.

But if the drought continues, it could pose a threat. European banks face a wave of maturing debt next year—up to €800 billion, by some analyst estimates. If banks can’t replace those funds by selling bonds or gathering new deposits, they will need to compensate by cutting lending. The situation is worrying regulators, policy makers and investors. Some officials have called for European governments to band together to guarantee new long-term bank debt, but senior finance officials from European countries rejected the idea at a meeting last week, according to people familiar with the discussions.

[...] Deposit levels at five of Spain’s top six banks declined in the third quarter, while five of Italy’s largest lenders also reported declines, according to a report by analysts at Citigroup . . . Spain and Italy’s largest banks each reported declines of at least 10% in the quarter that ended Sept. 30.

With deposits simultaneously becoming scarcer and more valuable as a funding source, some banks are entering into a sort of arms race. They are jacking up the interest rates they are offering on deposits and venturing into other European countries in the hunt for new customers. Even though the ECB is keeping its key interest rate at the historically low level of 1.25%, banks in Portugal, Spain and Italy are routinely offering to pay customers more than 4% annually for deposits.

• Europe’s Smart Money Votes With Its Feet

In Italy, nonretail customers withdrew €56 billion in the three months to the end of September, a fall of 12%. Intesa Sanpaolo and UniCredit saw corporate deposits decline by 16% and 10%, respectively, according to Citigroup research. Similarly, in Spain, nonretail deposits fell by 20% in the third quarter, with Santander and BBVA losing 10% and 11%, respectively. Even the French banks weren’t immune: Société Générale and BNP Paribas saw their corporate-deposit balances fall by 7% and 6%, respectively.

[...] if the trend in deposits continues, it will add to the pressure on banks to deleverage. Euro-zone banks are likely to cut up to €2.5 trillion of assets, equivalent to 5% of their total assets, as they struggle to meet new regulatory rules, reckons Morgan Stanley. Much of this can likely be achieved by cutting international operations and investment-banking activities. But as banks try to pass on higher funding costs, lending to core domestic economies could suffer, worsening the debt crisis.

• Santander Raises Cash With  Chile Stake Sale

Banco Santander SA is preparing to sell a nearly 8% stake in its Chilean business, the latest in a string of moves in which the Spanish bank is raising concerns among investors.

The move in Chile comes as Santander, widely viewed by many investors and analysts as one of Europe’s strongest lenders, also has unveiled plans to sell 8% of its Brazilian unit; the deals could raise a total of about $3.5 billion. It also sold a slice of its U.S. auto-loan unit last month for about $1 billion and made a recent offer to exchange some of its outstanding bonds, raising about €600 million ($809 million). The goal is to strengthen the Spanish bank’s capital cushions.

The efforts highlight how Santander and other European banks are scrambling to raise capital without taking steps such as reducing dividend payments or selling new shares at distressed prices.

[...] the terms and timing of Santander’s moves are raising eyebrows in the investment community. Analysts have expressed surprise that the bank is selling chunks of two of its prized Latin American businesses. And the bank’s debt-exchange plan, intended to drum up less than €1 billion in fresh capital, is on such unfavorable terms that it prompted a group of British insurance companies that are some of the major holders of this debt to band together to complain.

• Big Selloff Hits Europe Bond Markets

The Spanish Treasury was forced to pay a euro-era record 5.11% yield on three-month Treasury bills at auction, more than double the rate paid at last month’s auction. By way of comparison, to access the short-term debt market Spain now must pay more than Greece paid at its last three-month auction a week ago.

[...] The spike in yields fanned fears that the country will find it unsustainable to raise funds in the market if the trend persists. The result underscored concerns that more financially weakened euro-zone governments may soon be priced out of the capital markets.

The cost of insuring European government debt against default using credit-default swaps shot up to record levels as concerns about the euro-zone debt crisis and U.S. deficit-reduction plans continue to spook market participants and subdue activity in the European primary bond market. Default insurance on French, Belgian and Spanish debt leapt above record closing levels Tuesday as bond yields in the region climbed.

French bond yields also spiked sharply in a sign that the debt crisis was continuing to spread to larger, top-rated countries. A continued rise in French bond yields would put the country’s coveted triple-A rating in peril and risk derailing efforts to contain tensions.

• EU Warns Greece on Bailout

The European Union has warned Greece that unless political leaders give written pledges they will back agreed reforms, an €8 billion ($10.79 billion) loan payment won’t be given and the country will run out of money in about 20 days, Greek and euro-zone officials said Tuesday.

• Pressure on Merkel Amplifies

Ms. Merkel on Tuesday stressed that joint debt issuance isn’t the right response now. “The discussion of euro bonds in the midst of the crisis is inappropriate,” she said.

Germany has never categorically ruled out the joint issuance of bonds by the euro’s 17 national governments, known as euro bonds. But Berlin insists that before euro members collectively raise financing on the open market, they must create rules that force each country to exercise fiscal discipline—or pay a heavy price.

However, many analysts say Ms. Merkel may no longer have the luxury of time to wait for euro-zone economies to heal before working on long-term changes Germany believes are needed to prevent such a crisis from recurring.

[...] Many lawmakers in Ms. Merkel’s ruling center-right coalition are deeply skeptical about joint euro-zone liability for debts, which they fear would reduce pressure for southern European countries to rein in government spending. “The moment we let up the pressure, those countries that have such problems will become complacent,” German Finance Minister Wolfgang Schäuble said Tuesday.

In addition to being a hard sell to Germany’s lawmakers and voters, euro bonds may require amending the country’s constitution, requiring a broad consensus among political parties in the euro zone’s biggest member.

This post is a veritable potpourri of worries. Be warned.

With the landslide victory of Mariano Rajoy’s center-right Popular party, the government of the Spanish Socialists has become the fifth victim (after Ireland, Portugal, Greece and Italy) of the eurozone crisis. As have the leaders of the other recently-installed governments, Mr. Rajoy has promised to enforce budgetary austerity.

No matter. Despite the Popular party’s victory, yields on Spanish sovereign debt rose today; the ten-year bond yield reached 6.6 percent. Yields on the sovereign debt of other “peripheral eurozone” countries also jumped, as did the yields on “core” countries debt.

Undoubtedly, a report from Nomura — “Currency risk in a Eurozone break-up — Legal Aspects” contributed to today’s indigestion in the eurozone bond markets. The report deals with a subject — “redomination risk” — that has evidently not previously been on market participants’ radar screens: not knowing which euros will stay euros.

It is now obvious that the widespread electoral success of parties committed to fiscal rectitude isn’t sufficient to ameliorate, much less bring to a halt, the crisis by improving investor confidence. That this has become self-evident further undermines confidence, as what was once thought to be a solution has turned out not to be. More than ever, all eyes are turned toward the European Central Bank, with the hope that the ECB will, at long last, overcome its reticence and become the eurozone’s lender of last resort. As yet, there’s no evidence whatsoever that the ECB will undertake what would be an about-face of epic proportions; last Friday, the ECB’s president said that the crisis required a political solution and that the ECB wouldn’t bailout anybody. This situation will persist unless and until Germany performs its about face. But that isn’t happening; if anything, the Germans are digging in their heels.

No wonder, then, that commentaries on the crisis are becoming increasingly strident and downright panicky.

Wolfgang Munchau, writing in the Financial Times, uses the words “insane” and “depression”:

The consensus view in Brussels and Berlin is that the crisis can be solved by technocratic governments imposing structural reform and austerity. That proposition is, in my view, insane . . . We have gone way beyond the point at which this crisis is solvable by standard instruments of economic policy. The survival of the euro will now depend on whether Ms Merkel or Mr Draghi, or both, will blink.

This may yet happen, but not right away. The ECB is facing more formidable legal constraints than those who call for an intervention acknowledge. The bank is technically allowed to engage in secondary bond market purchases, but not with the aim of helping governments incur deficits or roll over debt. Article 123 of the Treaty for the Functioning of the European Union says the ECB shall give no overdrafts to governments. Clearly, the euro was sold on the grounds that the ECB would never do what it is being asked to now. Such a law is testimony to a lack of realism, especially given what we know about the history of financial crises.

[...] The eurozone has already entered a recession, driven by three factors, each serious on its own and lethal in combination: a slowdown of the global economy; pro-cyclical fiscal austerity programmes; and a much larger than expected deleveraging of the financial sector. If present policy prevailed, the eurozone would be in danger of falling into a depression.

[...] In present market conditions, a leveraged EFSF is unrealistic. So how long can this policy vacuum be sustained? So far, the speed of the crisis has exceeded the speed of the political response. The next political turning point will come at the European Council meeting in December, which will need to decide something more substantial than previous summits.

If that does not happen, we will be getting closer to the point where member states – confronted with an unsustainable funding position – could rationally conclude that the political and financial costs of staying in the eurozone may well exceed the costs of an exit. This is not a proposition anybody would want to test. Once the eurozone goes down that road, it will not come out of this crisis in one piece.

The moment will arrive, probably sooner rather than later, when Mr Draghi and Ms Merkel will have to blink simultaneously. The odds of that happening are neither low nor high. They are indeterminate. It is the worst kind of uncertainty imaginable.

George Soros describes the current situation as “a perfect vicious circle”:

From ft.com/alphaville:

Chew over this morsel of bad news, from ING: (Emphasis ours)

The economic recovery in Spain has ground to a complete halt. According to first estimates by INE, Spanish real GDP was unchanged in the third quarter (0.8% YoY), after growing a modest 0.2% QoQ in the second quarter. The outcome was less bad than had been suggested by lead indicators such as the purchasing managers’ indices, but bang in line with the initial estimate of the Bank of Spain. No expenditure breakdown is available at this stage, but we suspect that a positive contribution from net exports was offset by a further contraction in domestic demand.

A Spanish economic siesta recession should now be priced in, reckons ING:

Looking ahead, we fear that the Spanish economy might slip into recession soon – perhaps as soon as the current fourth quarter. Our base case scenario envisages no economic growth in 2012. The worsening economic outlook poses significant risks to Spain’s fiscal consolidation efforts. Indeed, Spain’s budget deficit targets (2011: 6.0% of GDP; 2012: 4.4%) are based on growth assumptions of 1.3% this year and 2.3% in 2012, which seem overly optimistic.

If PP-leader Mariano Rajoy indeed wins next week’s elections – as seems overwhelmingly likely given the polls – his new government will probably have to take extra austerity measures if they are to stand any chance of meeting the deficit goal. Alternatively, and probably more sensible from an economic growth perspective, fiscal targets might have to be relaxed somewhat.

Investors have taken note, with the yield on Spain’s 10 year rising in recent days, via Reuters:

There’s more evidence of an incipient eurozone recession. From Markit:



The data was collected between October 12 and 24 — before the confidence-eroding Greek referendum announcement.

Further detail:

Conditions in the Eurozone manufacturing sector continued to weaken in October. At 47.1, down from 48.5 in September, the final Markit Eurozone Manufacturing PMI fell to its lowest level since July 2009 and below the flash estimate of 47.3. The PMI has remained below the neutral mark of 50.0 for three months. Signs of weakness are becoming increasingly apparent in the core nations, while the periphery remains mired in recession. German manufacturing, one of the main drivers of the earlier Eurozone recovery, saw its PMI indicate contraction for the first time since September 2009. Rates of decline were the fastest for 27 months in both Austria and the Netherlands, while France signalled deterioration for the third month in a row. Rates of contraction accelerated sharply in Greece and Italy, with the performance of Italy deteriorating significantly compared with the previous month.

New orders declined at Eurozone manufacturers for the fifth month running, and at the fastest pace since May 2009. The sharpest reductions were seen in Greece, Italy and Spain. Weak domestic market conditions and the deteriorating global economic backdrop were the main factors underlying reduced new order inflows.

New export business fell at the quickest pace since June 2009. All of the nations covered by the survey saw new export orders decline, with rates of contraction accelerating in every country except Ireland and the Netherlands. Worryingly, Germany reported the sharpest reduction, as new export orders fell to the greatest extent since mid-2009.

On Italy:

Signalling a marked deterioration in the health of the Italian manufacturing sector in October, the seasonally adjusted Markit/ADACI  Purchasing Managers’ Index dipped from 48.3 in September to 43.3. This was the lowest PMI reading since June 2009, and the third successive posting below the neutral mark of 50.0. October’s decline in overall business conditions primarily reflected a steep drop in new business received compared with the previous month. New orders from both domestic and foreign-based clients were down markedly since September, with the latter centred on weaker European demand. Consequently, manufacturers cut output levels at the fastest rate since April 2009.

On Spain:

The seasonally adjusted Markit Purchasing Managers’ Index posted 43.9 in October, to signal a broadly similar deterioration in operating conditions as seen in September (43.7). The PMI has now posted below 50.0 for six months in a row. Spanish manufacturing production decreased sharply again in October, extending the current period of reduction to six months. Where output decreased, this was mainly linked to falling new orders.

On Greece:

The headline Markit Greece Purchasing Managers’ Index read 40.5 in October, down from 43.2  in September, signalling the fourth sharpest deterioration in the operating conditions of Greek manufacturing firms in the survey’s twelve-and-a-half year history.

“Like a bolt out of the blue”

– a senior EU official reacting to Greece’s announcement of a referendum on the EU bail-out

The party’s over: Greek government calls for a referendum on the EU bailout . . . Eurozone jobless hits a euro-era peak . . . Italian yields soar . . . Bank of Spain warns further austerity measures may be necessary . . . OECD cuts growth projections

Financial Times

• “Greece calls referendum on EU bail-out“

Prime Minister Papandreou made the pledge on Monday night.

“We have faith in our citizens, we believe in their judgement and therefore in their decision. All the country’s political forces should support the [bail-out] agreement. The citizens will do the same once they are fully informed.”

Needless to say, the alarm bells are ringing in Brussels, Paris and Berlin.

While he did not set a specific date for the vote, the FT suggests it will probably be held in January, when Greek bondholders are expected to sign up for a voluntary 50 per cent haircut currently being negotiated with the International Institute of Finance, wrapping up the new bail-out package. One Athens banker said: “This is a worrying decision by the prime minister. It could derail the whole process even before it’s properly started.”

The premier also announced a vote of confidence in his government would be held later this week to endorse the referendum proposal. That vote would follow a three-day debate on Greece’s worsening economic and social problems.

• “Eurozone jobless at euro era peak“

Seasonally adjusted unemployment in the 17-country bloc rose to 16.2m in September, 188,000 higher than in August and the highest since comparable data started in the late 1990s, reported Eurostat, the European Union’s statistical office. It was the biggest monthly rise in two years. In September, eurozone unemployment was equivalent to 10.2 per cent of the labour force – the same as in June last year but otherwise the highest since June 1998.

Wall Street Journal

• “Italian Yields Soar as Summit Enthusiasm Fizzles Out“

Italian bonds are getting pulverised Monday. The five-year Italian bond yield is trading at 5.95%, the highest it has ever been since the inception of the euro. The 10-year yield has climbed above the psychologically important 6% level, a level that in the past portended a sharp slide in government bond prices of other fiscally frail countries.

OECD

• Press Briefing on the Economic Outlook and Policy Requirements for the G20 Economies

The OECD slashed its growth forecasts to show the eurozone economy expanding by only 0.3 per cent in 2012, assuming there is no sudden crisis. In June, it had forecast 2 per cent growth. Failure to restore confidence and a repeat of the financial turmoil seen in recent years could see some large OECD economies contracting by as much as 5 per cent by the first half of 2013, it added.

Bank of Spain

• Economic Bulletin

As the year has unfolded, the Spanish economy has progressively weakened following the subdued recovery on which it had embarked in 2010. On Quarterly National Accounts (QNA) figures, the quarter-on-quarter rate of GDP growth slowed in Q2 to 0.2 %, placing the year-on-year rate at 0.7 %. Behind this lies an acceleration in the decline in national demand (-0.4 % in terms of the quarter-on-quarter rate), offset only in part by the improved contribution (to 0.6 pp) of net external demand to output. The information available for Q3 suggests this pattern of weakening continued mid-year, against a background marked by the worsening euro area sovereign debt crisis. Estimates made on the basis of the as yet partial and incomplete conjunctural information indicate that GDP is expected to have posted a quarter-on-quarter rate of change of zero in Q3, placing its year-on-year rate at 0.7 %.

The weakness of domestic demand and of activity has affected the rate of reduction of the fiscal imbalance. On the revenue side, the information available on tax takings to September shared by central government and regional and local government, on one hand, and the Social Security system, on the other, indicates that the growth of tax revenue is below the budgetary projection . . . if the budget outturn data for the coming months were to indicate the possibility of these risks materialising, further measures would forcibly have to be adopted in keeping with the unconditional nature of the commitment assumed by the government to comply with the fiscal targets, and in light of the close monitoring to which public finances will be subject during the current sovereign debt crisis.

I’ll be gathering reactions for the rest of the day. Check back here periodically for additions.

The Guardian

• “Eurozone debt deal reaction — as it happened“

World Bank president Robert Zoellick said:

It’s a very welcome and an important step because we have seen the ripple effects. I compliment the leaders of the European Union for facing and making difficult decisions. Of course problems like this can’t be solved by waving a magic wand, and the implementation of the three core elements will require follow through to ensure that with the market reactions, the banks can function more effectively and to ensure that euro zone countries are able to roll over their debt.

I’m hopeful that this first important step will lay the foundation for a broader approach that will focus on helping the world economy resume growth, overcome joblessness, and support the innovations so we can get the world economy back on track.

Canadian Prime Minister Stephen Harper said:

I see as positive steps, the actions taken by our European friends just a few hours ago,” Harper said in the Australian city of Perth, where he will attend a summit of Commonwealth country leaders.

Of course, we still await the elaboration of further details and successful implementation, as we approach the G20 summit (next month).

UK Chancellor of the Exchequer George Osborne said:

We are not going to contribute to the eurozone bailout, but we are members of the IMF … We aren’t turning our backs on the IMF. The agreement last night did not say the IMF was going to put additional resources into the eurozone.

We will only contribute to resources that are available to all members of the IMF around the world, we will not contribute to a fund that is hypothecated, that is directly linked to the eurozone.

We are not going to contribute to a special purpose vehicle that is set up to attract sovereign wealth funds or the Chinese government – in other words, people with large surpluses. We’ve got a large deficit.

Holger Schmieding, chief economist at Berenberg, Germany’s biggest private bank, said:

The deal tries to fix the mistakes eurozone leaders had made in July. At the time, they had agreed to restructure Greek debt without putting up a firewall to protect Italy against contagion risks. This time, the focus was very much on Italy. The fact that there is an enhanced deal is a positive.

Leveraging the EFSF up to €1tn yields an impressive amount of money. However, we are not convinced that – in case of a severe crisis – a first-loss insurance on sovereign bonds of 20-25% would really be sufficient to entice investors to buy newly issued Italian bonds, especially in the wake of a 50% haircut on Greek debt.

In our view, the role which the ECB will or will not play remains crucial. Without ECB support, the chances of this deal putting an end to the euro debt crisis now are probably below 50%. If the ECB were to signal a willingness to act as a backstop of ultimate resort by buying bonds, the chances that the deal could put an end to the euro debt crisis would be well above 50%. The summit statement leaves the role for the ECB’s bond purchasing open.

Many details still need to be fixed, including details of the 50% debt relief for Greece (by the end of the year) and of the two precise leverage options for the EFSF (by early November).

At the 3/4 November G20 summit in Cannes, international support through the IMF and direct contributions from emerging markets can be discussed.

In the short-term, continued austerity and bank deleveraging may have negative effects on the euro area economy. However, Europe continues on the path to fiscal rebalancing and is staying ahead of the other advanced economies in this respect.

Simon Lewis, chief executive of the Association for Financial Markets in Europe said:

The recapitalising of Europe’s banks will not in itself solve the sovereign debt crisis. However, this plan is set within a timeframe that should enable them to determine how best to strengthen their capital positions in ways that treat all stakeholders fairly and allow the banks to fulfil their role in supporting Europe’s economic recovery.

Alan James, strategist at Barclays Capital, said:

The results of the summit appear to provide a framework that can offer a degree of stabilisation over the medium term if efficiently implemented, but without significant positive surprises relative to market expectations. The details and timetable for implementation of most measures remains vague.

While the official statement suggests the leveraging mechanisms could potentially multiply the firepower of the EFSF by four to five times, the efficacy of the structure is far from certain. On Greece, it remains unclear whether the €30bn from member states is new money, while even if this process is completed without further detail, there is still potential for it to be designated as a default trigger event, albeit today’s agreement appear to have reduced this probability somewhat.

On bank recapitalisation, most of the €76bn estimated need outside of Greece is likely to come from the private sector, with Spain already indicating it does not expect state aid to be required. The initial market reaction of modest relief appears appropriate, in our view, but an extended normalisation rally is far from certain without more details on implementation.

El Pais (English edition)

• “Spanish banks at ease with new European capital demands“

Spain’s big banks on Thursday ruled out having to tap the markets to meet the new European-wide solvency requirements being imposed.

The European Banking Authority (EBA) late Wednesday calculated Spanish banks would require an additional 26.161 billion euros to meet the new core capital ratio of nine percent of risk-weighted assets they will need to pass the stress test to be carried out by the EBA in June of next year.

The tests will include the premise of a writedown in the value of Spanish government bonds held by the banks in their books of under three percent. According to EBA calculations, marking the value of sovereign debt in the portfolios of Spanish banks will cost them 6.29 billion euros.

Of the total required of Spanish lenders, 82 percent correspond to Spain’s two biggest banks, Santander and BBVA.

Local banks, which reckon the figure they require is only 13.5 billion euros once convertible bond issues and other adjustments are included, have informed the National Securities Commission (CNMV) that they rule out capital increases or state funding to meet the new requirements. They believe they can do so by generating additional capital internally from their earnings by June of next year.

Economy Minister Elena Salgado said the banks have the capacity to obtain funds for recapitalization on their own and do not need help from the state. “Of course, state funding is available, but the banks are going to do everything possible not to have to ask for it.” Salgado was following the same line taken earlier Thursday by Prime Minister José Luis Rodríguez Zapatero.

The Bank of Spain also issued the same message. “Bearing in mind that the figures published by the EBA are provisional, with the final calculations only available around the middle of November when the definitive figures for capital and exposure to sovereign debt as of the end of September are available, from the information offered by the banks it can be seen that they intend to meet the indicated requirements though their own ability to generate capital, with the understanding it will not be necessary for the public sector to take stakes in them,” the central bank said in a statement posted on its website.

Santander and other lenders also said they can meet the new requirements without changing their dividend policies.

Reuters

• “Italians, Greeks skeptical over euro zone rescue plan“

A deal struck by euro zone leaders on Thursday to contain the region’s dangerous debt crisis was greeted skeptically in the two countries most in the firing line, Greece and Italy, with some saying politicians were dreaming.

Italian Prime Minister Silvio Berlusconi submitted an ambitious set of reforms intended to boost growth and cut debt as part of the deal, but analysts questioned the ability of his fractious coalition to implement the plan.

In Greece, opposition politicians and citizens feared further painful belt-tightening and years of recession, showing little enthusiasm for a plan for banks and insurers to accept a 50 percent loss on their Greek government bonds.

Berlusconi’s pledges include raising the retirement age and making it easier for firms to lay off staff but few expect a scandal-ridden government with a poor track record of pushing through reforms to be able to do so while battling for survival.

“It’s hard to believe that yesterday’s intentions can really be transformed into the biggest plan of market reforms Italy has ever put on paper,” Antonio Polito wrote in the Corriere della Sera daily, pointing to coalition tensions and lack of faith in the government.

An editorial in the left-leaning La Repubblica daily described the plan as a “book of dreams.”

In a sign of the challenges Berlusconi faces, Italy’s biggest trade union CGIL responded by pledging to fight the reform plans and called on smaller unions to unite against “targeted attacks” on Italian workers.

“We’re ready to propose unified action,” CGIL secretary Susanna Camusso told La Repubblica.

The Institute of International Finance (IIF)

• Statements by Dr. Ackermann and Mr. Dallara on behalf of the IIF on the new Greek agreement

Dr. Josef Ackermann, Chairman of the Board of Directors of the Institute of International Finance and Chairman of the Management Board and the Group Executive Committee of Deutsche Bank AG, today confirmed his full support for the voluntary agreement reached last night between Euro Area leaders and the IIF on a new Greek debt deal.

Dr. Ackermann stated: “We are very pleased with the agreement reached. It was appropriate for all parties to move on the July 21 decisions in light of the changed circumstances. The Greek economy has weakened considerably since that time and the different parties are taking additional difficult measures to lay the basis for stabilization and renewed growth. European leaders are also doing more, and as all parties have recognized that not only the future of Greece but the future of Europe was at stake. The outcome is a good one for Greece, Europe and the investors, and we look forward to its early implementation.”

Mr. Charles Dallara, IIF Managing Director, said, “This voluntary substantial reduction in Greek debt by the private sector, along with additional official support, provides an historical opportunity for Greece to revitalize its economy and reap the benefits of the difficult measures the Greek people have undertaken. We look forward to work with the Greek and European authorities to translate this framework into a concrete agreement that can deliver an early reduction in Greece’s debt and place it squarely on a path toward debt sustainability. Throughout the process we have enjoyed strong support from the IIF’s Board of Directors and from many leaders of other financial institutions.”

Wall Street Journal (no links)

• “Europe’s Not-So-Grand Plan”

Previous Grand Plans unraveled within days under the glare of market scrutiny; the best hope is that this deal buys a little more time . . . The euro zone is gambling the market will judge the sum of the parts to be greater than the whole. But there is no new money on the table, while the crucial issue of who will bear the losses of the debt crisis has still not fully been answered. That may not matter so long as Ireland, Portugal, Italy and Spain’s difficulties can continue to be treated as problems of liquidity not solvency. But that requires an urgent revival in confidence and economic growth: That may be asking too much of this deal.

• “European Banks Look to Reassure on Capital Needs”

Spanish, French and Italian banks need around €50 billion in fresh capital . . . several large banks from the countries early Thursday said they won’t have to turn to shareholders for the money, and analysts affirmed that many banks should be able to accrue capital by retaining earnings and disposing of assets.

EU banks supervisor the European Banking Authority said around 70 banks in the 27-country bloc must add roughly €106.4 billion to their capital reserves to reflect price declines in the Greek and other sovereign debt they hold, and to generally bolster capital held against their assets. Final shortfall estimates will be released next month and banks will have until the end of the year to tell domestic regulators how they plan to come up with the money.

Bank have until the end of June 2012 to improve their ratios. Many have previously said they won’t turn to shareholders, but will instead retain earnings, pursue asset sales and otherwise shrink their balance sheets. The EBA stressed, though, that banks will be limited in the deleveraging they can do, for example by cutting off business lending, in order to protect the broader economy. Banks needing new capital will also be expected to withhold dividends and bonuses, the EBA said.

Financial Times

• “EU reaches agreement on Greek bonds“

[European leaders] agreed to increase the firepower of their €440bn bail-out fund by providing “risk insurance” to new bonds issued by struggling eurozone countries – a scheme designed for potential use in Italy – but they did not specify the amount of losses that would be covered by the insurance.

Both Ms Merkel and Nicolas Sarkozy, the French president, said it would increase the size of the fund “four or five times”, but a final number could not be calculated because it was unclear how much money was left in the fund. Most analysts estimate about €250bn will remain after the second Greek bail-out, putting the fund’s new firepower at more than €1,000bn.

Although the details of the deal as outlined by both European leaders and the Institute of International Finance remained vague, officials said that €30bn of the €130bn in the government bail-out money would go to so-called “sweeteners” for a future bond-swap, which would be completed by January.

Charles Dallara, the IIF managing director who served as the bondholders’ chief negotiator in Brussels, said in a statement that the net present value of bondholders’ losses had not yet been determined. He added that his consortium would need to continue to work with authorities “to develop a concrete voluntary agreement”.

“The specific terms and conditions of the voluntary [haircuts] will be agreed by all relevant parties in the coming period and implemented with immediacy and force,” Mr Dallara said.

Some elements of the package appeared to be based on optimistic assumptions. Under the terms of the deal, Greece agreed to put €15bn it aims to raise from a vast privatisation programme back into the European Financial Stability Facility, the eurozone’s €440bn rescue fund. International monitors have already acknowledged that Greece will struggle to raise the €50bn in privatisation cash it promised earlier this year, but the €15bn is supposed to come on top of previous commitments.

• Wolfgang Munchau, “Half measures and wishful thinking do not a solution make“

The deal with the Institute of International Finance is for a “voluntary” 50 per cent haircut on Greek debt on behalf of their member banks . . . I do not believe this is going to work. First, the agreement with the IIF is not binding on the banks. The IIF has yet to deliver the voluntary participation. Many banks would be better off if the haircut was involuntary, given their offsetting positions in credit default swaps. The whole point of a CDS is to ensure creditors against an involuntary default. By agreeing a voluntary deal, the insurance will not kick in. In other words, there is a significant probability that we will end up with an involuntary agreement – which is precisely the outcome the eurozone governments, except perhaps a small group of northern countries, had sought to avoid.

On the EFSF, the leaders reached political agreement to leverage it up to about €1,000bn. Herman van Rompuy, the president of the European Council, made a revealing comment following the meeting when he said that banks have been doing this forever. Why should governments not do so as well?

The reason is simple. Banks can only do this because central banks and governments act as ultimate guarantors of the financial system. There exists an implicit insurance of unlimited liability. In the case of the European financial stability facility the very opposite is the case: there is an explicit insurance of limited liability. Germany wants its exposure capped to a maximum of €210bn. I doubt that global investors will rush into the tranches of the special purpose vehicle through which the eurozone wants to leverage the EFSF. I struggle to see how this structure can lead to a significant and sustained fall in bond spreads.

Leveraging can work, but only if the eurozone were willing to provide an unlimited backstop. This would be either in the form of an explicit lender-of-last-resort guarantee by the European Central Bank, or through a eurobond – or ideally both.

Now that is something I would consider to be a comprehensive agreement. It may yet happen, but not for a long time. The crisis, meanwhile, continues.

• Gavyn Davies, “EMU summit leaves €1,000 billion to be raised“

The deal does not, and was not intended to, have any effect on the core problems facing the eurozone. There is still an urgent need to restore growth to economies which are hamstrung by uncompetitive business sectors, and continuous fiscal tightening. Recession still looms, especially in the southern economies.

What the deal is intended to provide is adequate medium term financing for sovereigns and banks which have been facing urgent liquidity problems. On that, it is notable that the summit has not really raised any new money, apart from an increase in the private sector’s write-down of Greek debt by some €80bn.

All of the remaining “new” money, including €106bn to recapitalise the banks and over €800bn to be added to the firepower of the EFSF through leverage, has yet to be raised from the private sector, from sovereign lenders outside the eurozone, and conceivably from the ECB.

There is no guarantee that this can be done. The eventual out-turn of this summit will depend on whether this missing €1,000bn can actually be raised.

. . . the Greek headache has not been definitively solved, and probably will not be until there is a significant write-down of official debt.

There will now be an anguished debate on whether this restructuring can be described as “voluntary”, and whether a default will be declared in the CDS market. The euro summiteers, who frequently announce that water can flow uphill, claim that it is indeed voluntary. Common sense says that it is not.

The attention of the markets will now turn to two main issues: whether new money can be raised from China and other sovereigns outside the eurozone; and how the ECB behaves under the new leadership of Mario Draghi.

• FT Alphaville, “So. Many. Bailout questions“

First, the Greek debt deal:

1) Greece’s debt will remain 120 per cent of GDP a decade hence, even under the 50 per cent bondholder haircut. (As the debt sustainability analysis by the Troika warned.) Does that look like a safe number to you? Say, providing a good buffer to any external shocks that Greece might face over that period? Does it look like it rules out subsequent bondholder haircuts?

2) The huge disparity between haircuts and actual debt reduction is a creature of Greece’s reliance on official loans (plus the ECB’s getting made whole on its Greek bond holdings). This deal will chuck another €100bn on the fire. Again, if a subsequent debt reduction is needed, we’re getting to the point of either completely wiping out bondholders, or official lenders have to write down.

3) Official sources will also provide €30bn of credit enhancement to bondholders in the debt swap. We don’t know what this really boils down to, and probably won’t for some weeks. It might be that EFSF collateral attached to the restructured Greek debt is offered, purely because that’s how the first swap proposal worked (and, it appears, banks really wanted it again this time round). Of course there were proposals yesterday to give bondholders cash upfront. We strongly desire to know about other possible features that we just don’t know about so far, such as the legal status of the new bonds (would they be governed under English law?).

4) How is Greece going to raise more money from privatisations? A further €15bn is targeted in the new agreement, but this is coming after the Troika already took a strange, fingers-in-ears-la-la-la approach to what is already acknowledged to be a difficult task of raising €50bn.

Four points in, and hopefully you can see that a) very critical details remain to be decided, and b) the room for manoeuvre on Greek debt might actually be decreasing with this new offer. That is, a subsequent haircut might be harder to execute (even if debt levels are still high enough to argue that it should happen).

5) Let’s get the inevitable Greek CDS question out of the way. What are the bondholders going to do, and what’s the ISDA determination committee going to determine? [Here are a couple of possibilities.] Assuming everyone agrees that the haircuts are sufficiently voluntary not to trigger a credit event — what does that mean for sovereign CDS? And indeed, for bond yields, as we pondered last week.

What we really need is evidence of whether, or how, Greece might “punish” and bind bondholders who don’t take part in the swap — providing crucial evidence for the ISDA committee. This could be anything: a clear statement of intent to service the new bonds over unrestructured debt, exit consents by the participating bondholders which bind the holdouts in some way. Again, more detail is needed. Doubtless however, a few lawyers must be leafing through the ISDA definitions for credit events this morning…

On to our second set of questions — the EFSF part of last night’s deal.

6) Is China going to stump up for the EFSF SPV? Sarkozy is calling Hu Jintao at midday on Thursday to speak to him about this, and Klaus Regling, the head of the EFSF, is travelling to China on Friday. But even if China agrees, there could be some complications.

7) How will the EFSF bond insurance plan pan out, particularly in terms of existing bondholders? Last night’s statement said that “providing credit enhancement to new debt” would be included. What form of enhancement in particular? The statement mentions investors can “purchase” insurance. This is very sketchy but this seems to exclude Spain or Italy buying collateral off the EFSF (a la Brady bonds) and handing them over to investors as a free gift with every bond issue. Rather, it sounds like investors buy credit protection. To put it all another way, it sounds like the EFSF sells protection (or “CDS”).

How likely is it that we’ll see the level of fiscal integration alluded to in the agreement? A commitment to “consultation of the Commission and other euro area Member State before the adoption of any major fiscal or economic policy reform plans with potential spillover effects,” sounds like a big deal, and a sign of some determination to get at the root of the problem (or, one of them) by really deepening fiscal integration.

Or, it could just be aspirational hot air.

The Economist

• “No Big Bazooka: Europe’s leaders have agreed on how to prop up the euro. For now“

But is it a good deal? This was, after all, the third “comprehensive solution” devised by the euro zone so far this year. With each “unprecedented” effort, the problem has only worsened (see chart 1). Sadly, this latest deal promises to be no more enduring. At best, it will buy time before the next round of panic. At worst, it may push the euro zone into catastrophe.

The next paragraph from the Economist refers to the following from the Euro Summit Statement:

“The Private Sector Involvement (PSI) has a vital role in establishing the sustainability of the Greek debt. Therefore we welcome the current discussion between Greece and its private investors to find a solution for a deeper PSI. Together with an ambitious reform programme for the Greek economy, the PSI should secure the decline of the Greek debt to GDP ratio with an objective of reaching 120% by 2020. To this end we invite Greece, private investors and all parties concerned to develop a voluntary bond exchange with a nominal discount of 50% on notional Greek debt held by private investors. The Euro zone Member States would contribute to the PSI package up to 30 bn euro. On that basis, the official sector stands ready to provide additional programme financing of up to 100 bn euro until 2014, including the required recapitalisation of Greek banks. The new programme should be agreed by the end of 2011 and the exchange of bonds should be implemented at the beginning of 2012. We call on the IMF to continue to contribute to the financing of the new Greek programme.” [My emphasis]

The bond exchange is billed as “voluntary”, but it is not clear that the International Swaps and Derivatives Association (ISDA), a trade body, will agree. If it judges that a “credit event” has taken place, then payouts will be triggered on credit-default swaps (CDSs), insurance contracts against default on government bonds. This is something that the governments and the ECB had been determined to avoid, fearing it would lead to financial catastrophe, rather as the bankruptcy of Lehman Brothers did in 2008. There is no clarity about who the biggest issuers of default insurance on Greece are. The net exposure on Greek CDSs is thought to be less than €4 billion, though this is likely to be unevenly distributed, with some banks big winners and others big losers.

The ISDA today updated its Greek Sovereign Debt Q&A:

“The determination of whether the Eurozone deal with regard to Greece is a credit event under CDS documentation will be made by ISDA’s EMEA Determinations Committee when the proposal is formally signed, and if a market participant requests a ruling from the DC. Based on what we know it appears from preliminary news reports that the bond restructuring is voluntary and not binding on all bondholders. As such, it does not appear to be likely that the restructuring will trigger payments under existing CDS contracts. In addition, it is important to note that the restructuring proposal is not yet at the stage at which the ISDA Determinations Committee would be likely to accept a request to determine whether a credit event has occurred. “

Bankrupting the banks?

Even if the euro zone succeeds in avoiding CDS payouts, this could prove a Pyrrhic victory. If losing half the face value of a bond does not amount to a default, what does? Undermining the value of CDS insurance could deeply distort the market. If banks or other investors lose faith in their ability to hedge risks, they will be tempted to cut back on risk or demand higher yields. So, perversely, sparing a CDS payout on Greece could push up the borrowing costs of other countries.

That said, the danger of contagion is real. If holders of Greek bonds can incur losses on what they once thought were safe investments, what of holders of Italian or Spanish debt? The initial deal on Greek debt in July was followed in August by the dumping of Italian and Spanish government bonds.

One of the obvious channels of contagion is the banking system. So the 27 governments of the EU—both in and out of the euro zone—agreed to force banks to take on more capital to reduce the risk of collapse. The new recapitalisation package will oblige banks to reach a minimum core Tier-1 capital ratio of 9% (somewhat higher than current requirements) by the middle of next year, after recalculating the value of their bond holdings at market prices. That would mean writedowns of Italian and Spanish bonds and gains on German and British ones. This will push much of the burden of raising new capital onto Spanish and Italian banks while leaving British and German ones largely unscathed.

The criteria are suspiciously kind to France. Its banks have been battered in the markets in recent months, and the government is alarmed by the prospect of losing its AAA credit rating. The recapitalisation will be reckoned according to bond prices on September 30th, when French ten-year bonds were still yielding 2.6%. Since then the price has fallen, and the same bonds are now yielding 3.1%. In all, banks will have to come up with €106 billion in extra capital. That sounds like a lot, yet it is at the lower end of many estimates, largely because it will not include a “stressed” scenario that models the impact of a recession. That may be a mistake, given the slowdown in Europe’s economy.

A far bigger mistake is in the plan’s timetable. Banks are being given almost nine months to reach the targets, ostensibly to allow them to raise capital themselves through cutting dividends or bonuses and selling shares. Yet few investors are willing to buy bank shares, cheap as they may seem, given the perceived risks of a series of sovereign defaults in Europe. This means that the burden would fall first on national governments and then on the increasingly stretched resources of the European Financial Stability Facility (EFSF), Europe’s main bail-out fund.

Given too much time, moreover, there is the risk that banks will, in fact, shrink their balance-sheets to bolster their capital ratios. Their first strategy will be to trim economically essential but capital-intensive businesses such as trade finance or lending to small businesses. Huw van Steenis, an analyst at Morgan Stanley, reckons that European banks may go on a “crash diet” and cut their balance-sheets by as much as €2 trillion by the end of next year. They may also sell government bonds of peripheral countries, worsening the bond-buyers’ strike that afflicts Italy and Spain.

Capital is only one issue facing banks. A second is their own ability to borrow. The ECB can step in for short-term funding, but long-term markets are frozen. European banks have, to all intents and purposes, been unable to issue bonds since the start of July. Governments could reopen the market by guaranteeing bonds issued by banks, but they are wary of putting their own public finances at risk; this was the path that led to Ireland’s ruin. In any case, few investors would trust guarantees from Italy or Spain.

Debased sovereigns

All this suggests that an essential part of shoring up Europe’s banks is to restore faith in government bonds. That means protecting countries, such as Italy and Spain, that are solvent but have lost the confidence of bond investors. Even fundamentally solvent countries can quickly go bust if their borrowing costs rise too fast.

This is where the EFSF comes in. It was designed to protect smaller peripheral states. European policymakers insisted it should have a gold-plated AAA credit rating, lowering its costs but limiting its capacity. It is now too small to shield the bigger economies. The EFSF can lend €440 billion (see chart 2). But given its commitments to Ireland, Portugal, Greece and, perhaps, the recapitalisation of the banks, it may have as little as €200 billion for future contingencies. And yet in the next three years Italy and Spain will have to refinance about €1 trillion-worth of bonds, not counting additional borrowing to finance their deficits.

Countries guaranteeing the EFSF’s funds do not want to increase their burden, not least because some cannot afford to do so. France’s AAA rating is already at risk. What is more, France and the EFSF are like tottering drunks holding one another up. If France is downgraded, the EFSF will be close behind.

How to conjure a bigger EFSF without more taxpayers’ money? The answer is “leveraging” through financial engineering of the sort that helped cause the global crisis in the first place. “If you want leverage, you can always find it,” says one senior policymaker disdainfully. “Just get two or three investment bankers in a room.” Herman Van Rompuy, the president of the European Council, who chaired the summit, sounds even more cavalier. For centuries, he says, banks have taken deposits and used them to multiply money.

The favoured option is to get the EFSF to insure government bonds, acting, in effect, as the issuer of the much-maligned credit-default swap. By guaranteeing to take, say, the first 20% of any loss on government bonds, the EFSF could, in theory, support €1 trillion-worth of Italian and Spanish debt.

A second option is to set up SPVs, or Special Purpose Vehicles. These would seek to attract funds from private investors or sovereign-wealth funds in Asia and the Middle East, again by offering to take the first losses in sovereign defaults. In effect they would be creating something that looks a lot like the collateralised-debt obligations (CDOs) that became infamous during the subprime crisis. How much leverage each vehicle would take on, and which countries they might apply to, are questions that still have to be resolved over the next few months.

Many wonder why any investor would put money into such vehicles when they can buy bonds directly at a discount or get the insured version. One reason may be that the direct-insurance version may breach “negative pledge clauses” in contracts governing some bonds. These prohibit countries from doing anything that would set holders of new classes of debt above those of the old.

A difficulty with the leverage scheme is that those insuring the debt of euro-zone issuers would themselves be grievously weakened if a neighbour defaulted. How credible can their insurance policy be? “We have really struggled to find investors who want to buy the ‘part-insured’ government bonds, for fear the insurance is so highly correlated to the risk,” says a banker.

An even bigger problem is that levers can work both ways. Leverage may enlarge the size of the fund, but it can also concentrate greater risk onto the sovereigns that guarantee it. If the EFSF were simply to buy the debt of a vulnerable country such as Italy, it would expect to get back more than half of the money even if there were a default with a relatively high haircut of, say, 40%. If, on the other hand, it promised to cover the first 20% of losses on the bonds, then a haircut of just 20% on the value of the insured bonds could wipe out all the money pledged by the EFSF as insurance. So instead of assuaging market fears, leveraging may yet become a mechanism that transmits panic and weakens the sovereigns, above all France. That is why, in practice, the EFSF could probably support Spain or perhaps even Italy, but not both.

Debtor, save yourself

The new weapons for the euro zone come with a political price: closer monitoring of national budgets and economic policies, particularly in the case of states that need the greatest help. After a dressing-down from Mrs Merkel and Mr Sarkozy at the first summit, Italy’s prime minister, Silvio Berlusconi, came back with a long letter setting out his promises to reform the economy (see Charlemagne). In December European leaders will consider whether they need to change the EU’s treaties to allow more integration. And there is pressure for greater harmonisation of taxes. But even if a re-engineering of the euro zone is possible, such measures are for the longer term, to avoid a repetition of the crisis in the future. The priority must be to deal with the present.

The euro’s crisis boils down to this: national treasuries do not have enough spare cash both to guarantee outstanding debt and maintain their own credit ratings. Even mighty Germany cannot stand alone behind the whole euro zone.

Some hope that more money can be found from non-European creditor countries, such as China, by convincing them to invest in SPVs. Or perhaps the IMF could do more, particularly if China increases its contribution to the fund. But even if the Chinese were game, this raises a serious political question: does the euro zone want to be so obviously in hock to China just as it is fretting about Chinese firms buying up European ones? “If the Chinese are going to chuck money into an SPV or the IMF there will be a price,” says a European diplomat. “The Chinese want two things: one is greater voting rights in the IMF, the other is market-economy status.” Such status, which is granted by the EU, would make it harder for the trading block to impose anti-dumping duties on imports from China.

There is a better answer: use the unlimited liquidity that only the ECB can provide by dint of its power to print money. The ECB could credibly stand ready to buy debt of a country like Italy. As such, it would be treating a sovereign almost as it would a bank suffering a run. The danger is that this will stoke inflation. Germany, in particular, has a deep aversion to anything that looks like printing money, an orthodoxy forged in the experience of the Weimar Republic’s hyperinflation.

The ECB guards its independence, but has not entirely kept to these rules; it has already gone into the markets to buy distressed bonds, ostensibly to ensure that a country’s bond yields do not stray too far from the interest rates the bank sets. Having seen off France’s attempt to get the ECB to lend to sovereigns indirectly, through the EFSF, Germany removed even a passing exhortation for the ECB to keep buying bonds from the summit communiqué. “We have no demands and we have nothing to request,” said Mr Van Rompuy.

In private, though, most hope the ECB will not withdraw from bond-buying. Its incoming president, Mario Draghi, who takes over from Jean-Claude Trichet on November 1st, has signalled his willingness to buy bonds to ensure the transmission of monetary policy. “The blanket prohibition against directly lending to governments is a complete idiocy,” says Willem Buiter, chief economist at Citigroup, and a former member of the Bank of England’s monetary-policy committee. “That is what central banks do. Just because it can be mismanaged does not mean you have to throw the tool away. You can drown in water, but it does not mean you cannot have a glass when you are thirsty.”