Troika to extend the unsustainable Greek debt by decades

The Euorzone leadership remains uneasy with the third bailout of Greece. This unease can be seen in the recent delay to the start of the negotiations, with the Troika staff in Athens siting "technical issues". The actual reason has to do with the fact that Greece's creditors have yet to reach an agreement among themselves. Apparently some Eurozone nations are still pushing for additional requirements that go beyond the austerity measures the Greek parliament recently passed.

The challenges surrounding the new bailout are severe. The intrusive nature of reform enforcement by the creditors is likely to worsen the already intense animosity in Greece toward the Troika institutions.

Bloomberg: - Previous memorandums committing Greece to enforce reforms on everything from the rules of bank recapitalizations to evaluating the “impact of the changes in milk pasteurization and sale procedures,” have prompted dissenters to claim that Greece has turned into a “debt colony.” Creditors argue that changes are necessary to stabilize the country’s finances and set it on course to sustainable growth.

Furthermore, the negotiations will once again be taking place "under the gun" as the next payment to the ECB of over €3bn is due on August 20th.

Assuming the deal will be completed in August as the can gets kicked much further down the road, Greece is being set up for a massive maturity wall, with little chance of principal repayment. And any form of debt principal forgiveness is off the table.

Natixis: - [Greek debt forgiveness] is unlikely to come about given the opposition of many Member States (Germany notably), the position of the Eurogroup over this issue (“nominal haircuts on the debt cannot be undertaken”) and the legal obstacle (measure would be in breach of Treaty). Under these conditions, this leaves one option, namely a re-profiling of Greek debt without touching the principal.

Out of the EUR82bn-EUR86bn lent by the ESM, part could be applied to repurchase the debt held by the ECB and to repay early the IMF (which in total would represent EUR25bn). [It] follows that the financing requirement of the Greek State, assuming there is a 20-year grace period and repayments are spread over 40 years, would correspond to the primary balances and repayments of principal and interest in respect of market debt held by private creditors (i.e. TBills, GGB PSI, new GGB and debt issued under foreign law)

According to Natixis here is what the liability term structure is expected to look like after the completion of this third bailout. How Troika lenders can possibly get comfortable leaving a small nation with this type of a debt profile is unfathomable. And yet, this is the most likely outcome of the upcoming negotiations.

Source: Natixis

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Spanish property crisis will require Ireland-style banking system recapitalization

Ireland dealt fairly quickly with its property market bubble by effectively and forcefully nationalizing and recapitalizing its banking sector. They clearly still have a serious problem on their hands, but the nation has been aggressive in addressing the issue of distressed real estate loans. In contrast, Spain's banking system is nowhere close to fully recognizing the full extent of the problem. Not facing the problem however is not going to make it go away.

Reuters: "Banks are not recognising all of their risk. Many of their debtors are property companies with negative equity who can't even pay the interest on their debt," Fernando R. Rodriguez de Acuna, chairman of the consultancy, told Reuters by telephone.

There are at least 21,000 "zombie [property developers] companies" in Spain that owe banks 126 billion euros, Rodriguez said, basing his estimates on recent data from Spanish mercantile records.

He said the banks were covered for only 67.5 percent of that risk, leaving 40 billion euros of exposure if all the companies filed for bankruptcy.

The fate of the banks is being watched by international investors who fear Spain may be forced to apply for aid as the euro zone debt crisis enters its third year.

One of the issues the banks are dealing with is poor recovery levels on distressed property loans. Recoveries are considerably lower than anticipated.

FT: Repossessed properties in Spain are selling for about half their original value and are likely to continue to fall in value, according to a new report, underlining the parlous state of the real estate market in Europe’s fourth-largest economy. Valuations on properties that were bundled up in securitisation deals and later repossessed are also significantly lower than data from the official housing price index suggest, according to a report from rating agency Fitch due to be published on Thursday.
...
Carlos Masip, Madrid-based director at Fitch, said: “If we view the market today we believe that there will continue to be a downward pressure on property prices. Home prices are still unaffordable for many when compared to income levels, there is a short supply of credit and a huge overhang of unsold properties.”

As discussed earlier, the amount of "recognized" bad debt has spiked. But this is thought to be only a part of  the total delinquencies the banking system will be facing soon.

Spain's banking system bad loans (Source: WSJ)

Just to give some perspective on the level of Spain's property crisis, consider the following chart showing housing prices over time in real terms compared to the Eurozone as a whole and to the US. Looking at the chart, consider the fact that the bulk of the loans on the books today were extended during the 2004 to 2009 period - right in the middle of the bubble. That's when the collateral was valued. This is why the recovery levels are so low and continue to decline.

Source: IMF

Spain will have no choice but to recapitalize the banking system as Ireland did a couple of years ago. But to do so the nation will need help from the Eurozone/IMF (as Ireland did). Unlike Ireland however, Spain's massive banking sector capital requirements will threaten to push the Eurozone the limit.

CNBC: ... economists believe that Spanish banks will have to turn to the euro zone's rescue fund, the European Financial Stability Facility (EFSF), for help in covering losses caused by a property market crash which has yet to end.

Likewise, investors are fretting about how Rajoy's center-right government can enforce deep austerity while reviving a recession-bound economy at the same time.

"They're going to need EFSF money to recapitalize the banking sector," said Carsten Brzeski, a senior economist at ING in Brussels. "I think we'll only see a real end to the Spanish misery if the real estate market stabilizes."

SoberLook.com

EFSF used to recapitalize the ECB on Greek debt loss

It looks like the ECB has caved in under the pressure to take a haircut on Greek debt. But only to a point. The central bank is not willing to take a loss, so it will transfer the bonds at cost to the EFSF.

WSJ: The idea is for the ECB, in effect, to exchange the Greek bonds it holds for bonds of the European Financial Stability Facility, the euro zone's temporary bailout fund. The ECB will hold the highly rated EFSF bonds on its balance sheet in place of the Greek bonds it bought as part of its Securities Market Program.

Apparently this exchange won't take place until the deal with the Greek bond holders is finalized. It means that the public sector is in fact taking a haircut, but rather than having the losses at the ECB, they are being taken at the EFSF (assuming the fund is not going to try subordinating the private holders.) The EFSF will not participate in the negotiations - it will be a passive participant in the bond exchange. In effect the EFSF is being used to recapitalize the ECB.

Update: Please see Comments below for an update/clarification from Blankfiend

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The ghosts of eurozone solutions (or lack thereof) haunt the markets

The quotes out of Europe continue to rapidly swing financial markets. The mere mention of a solution that may or may not see the light of day, or a comment about not using a solution that may not even be on the table to begin with creates market reactions that are often violent.

Bloomberg: Germany rejected proposals to combine the current and permanent euro-area rescue funds as Chancellor Angela Merkel’s government said divisions may prevent agreement on a debt-crisis strategy among all 27 European Union states this week.

The fact that Germany is not willing to combine the two "rescue" funds EFSF and ESM was enough to not only widen Spanish bond spreads (reversing Monday's tightening), but to move equity markets around the world.

Spain 5yr spread to Germany (Bloomberg)

Again, some form of a solution has been priced in, and the markets will react violently to a disappointment - real or not.

SoberLook.com

The euro-zone: we want it all

The summit meeting in Brussels this week has an aggressive agenda and will focus on 3 items:

1. IMF backed by a loan from the ECB to purchase Italian and Spanish bonds in the primary market (effectively a political cover for the ECB to keep purchasing sovereign bonds): EUR100 - EUR200 
2. Fiscal discipline to be embedded in amendments to European treaties.  This is effectively a euro-zone "stability union" as prescribed by Germany and France.
3. Leveraging of the EFSF x2 or x3 - not clear where the funding will come from 

The markets are now pricing in at least one, possibly two of these items being implemented soon, particularly the IMF structure. Spanish spreads have come in sharply:

Spain 5yr spread to Germany (Bloomberg)

Much is riding on this summit meeting as the euro-zone bond crisis is starting to make its way into the real economy.  Spanish PMI has taken a significant downturn.

In the next 6 months Italy will need to roll $276 bn of bonds and Spain $150 bn. That means should the summit fail to achieve its goals this Friday (and the "track record" isn't great), the sovereign bond sell-off will be rapid and violent. Global equity markets would follow.

SoberLook.com

The EFSF Leverage Bazooka

There is big talk emanating from Europe about the "bazooka" solution to the crisis. It's the talk the Europeans learned from the US. Let's leverage the European Financial Security Facility (EFSF). Start with EUR 200 billion and leverage it say five times to obtain a trillion euros of buying power. voila! Magic.

Except it doesn't work this way. To obtain leverage you need lenders. And yes, these lenders would be in a more secure position because EFSF will be responsible for the first say 20% of losses (the equity tranche). But no matter how you slice it, you still need 1 trillion euros from somewhere. When a similar transaction was done in the US (TALF), the US Treasury was the first loss and the Fed was the lender. The money ultimately came from the same source. The Treasury could not have done this without the Fed even if they did proved the first loss protection. But that is in fact what the eurozone has been proposing.

Initially it was thought that if first-loss is insured, investors will come in droves. Reality however is quite different. Who could be a potential lender in this facility? Maybe China will come in for some amount, although they have not indicated they would do so. Maybe the IMF will lend a small slice, although the US will object to that because of substantial exposure to IMF. It is unlikely that the US Congress during an election year would agree to participate in the eurozone bailout. That leaves the European Central Bank (ECB). The ECB does not have a trillion euros and would need to "print it" (the way the Fed did during QE2).

There is little chance however that Germany will allow such an assault on the euro just to bail out what they perceive to be their "less industrious" neighbors. Because of German austerity programs and the integration of East Germany, the current generation of Germans is thought to have a lower standard of living than their parents. And now they are asked to reduce their standard of living further in order to help their southern neighbors? Nevertheless the ECB remains the only viable option and Germany the only obstacle to implementing this. The pressure is building.

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