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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Another delay from the ECB and the "revised" Eurozone chain of events

What a surprise. The ECB is now signaling it will delay the periphery bond purchases that everyone is waiting for.

Bloomberg: - European Central Bank President Mario Draghi may wait until Germany’s Constitutional Court rules on the legality of Europe’s permanent bailout fund before unveiling full details of his plan to buy government bonds, two central bank officials said.

With the court set to rule on Sept. 12, investors looking for Draghi to announce a definitive purchase program at his Sept. 6 press conference might be disappointed, according to the officials, who spoke on condition of anonymity because the deliberations are not public. The program is still being worked on and staff may not be able to finalize it by then, said the officials, who are familiar with thinking on the ECB Governing Council. An ECB spokesman in Frankfurt declined to comment.

Is this the excuse they are coming up with? Germany’s Constitutional Court is widely expected to approve the ESM, even if it decides to attach some strings to ESM's implementation. But now the ECB's decision is somehow tied to that approval? The reality is that there simply is no agreement on the asset purchase plan. The detail has not been worked out and the ECB is buying time.

Bloomberg: - While Draghi is likely to give a progress report on the bond plan after the Sept. 6 rate decision, the ultimate design of the ECB’s program may depend on the uncertainty over the permanent bailout fund being resolved, so the officials said it makes sense to wait for the German ESM court ruling.

Full details of the ECB’s plan could be a month away, they said. While the Bundesbank opposes ECB bond purchases, it expects to be outvoted, one of the officials said.

Here is JPMorgan's take on the delay:

JPM: - We regard [waiting for German Constitutional Court decision] as something of a smokescreen. Very few think there is a high probability that the German Constitutional Court will deem the ESM unconstitutional and prevent its progress into law at this stage. While the Court may express some misgivings about the legislation and suggest modifications as it is put into practise, it is most unlikely to be blocked. We would not expect the ECB to delay its actions on the basis on what remains a low probability event at this stage. Rather, we would expect them to take the German Government at its word that it can deliver on the political undertakings it has made, until it discovers otherwise.

The “excuse” of the ruling on September 12 only has any substance to the extent that [the ECB is not ready with the asset purchase plan] is true – that work on the design of the plan is incomplete. The idea that work “is not complete” may also be a euphemism for the fact agreement on the contours of the policy is proving elusive. Even allowing for the summer break in August, an institution with the resources of the ECB has the ability to complete the technical issues in policy design over the period between meetings if it is minded too. Draghi has already “played for time” once with his sketch of policies still to be designed at the last meeting. Ultimately, we suspect Draghi and others at the ECB will recognise that continued delay in finalising its policy decisions contributes to the sense that opinion on the Governing Council is deeply divided, and hence its commitment to any policy intervening in markets will not run deep. That, in turn, could undermine the effectiveness of policy interventions themselves.

How many times have we seen this scenario play out? The Eurozone leadership declares that it has the ultimate solution that ends up failing at the implementation stage. This certainly feels like one of those situations. Here is the "revised" chain of Eurozone events (discussed earlier).

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From Euro Area Summit to the periphery "bridge loan" - a quick recap of major events in the Eurozone

The news from the Eurozone continues to dominate markets' direction. Yet the information from the area has been incredibly confusing, even for many who reside in the EU. The mass media has not made things easier by jumping from one event to another, often without connecting these events together. We've gotten numerous requests to try to clarify some of the key events that have taken place just in the last couple of months and what they mean for the euro area going forward.

Here is a highly simplified overview using basic diagrams. Solid lines indicate what actually transpired, while dashed lines show expectations at the time.

June 2012:

Between escalating risks of the Spanish banking system failure and Mario Monti's efforts to stabilize Italy's government funding costs, pressure was mounting on the Eurozone to take immediate action. Spain and Italy had somewhat diverging needs, but they came together to ask the Eurozone "core" to come to a decision.

And with the brand new Socialist government in France lead by Hollande, Monti and Rajoy found a new ally. Hollande heralded a shift in the balance of power in the Eurozone (as predicted back in January). Together the three were able to pressure Germany into a new compromise. They reached a broad agreement to centralize bank regulation, provide bailout funds to Spain's banks, and most importantly give the European Stability Mechanism (ESM) the ability to buy periphery bonds in a "flexible manner" and allow the bailout vehicle to rescue banks directly. This was a broad agreement with no visible path to implementation. But as we know from 2011, the devil of the Eurozone multiple proposed solutions has always been in the detail, which was entirely missing by the conclusion of the Euro Area Summit.

July 2012 (first 3 weeks):

It didn't take long for the markets to become disillusioned in the agreement reached at the summit as the implementation got bogged down in the black hole of the EU bureaucracy. The existing Eurozone structures were never set up to decisively deal with rapidly changing market pressures. Spanish yields and spreads hit new records and it became obvious that Spain is now shut out of the capital markets. What's more, due to a change in collateral rules at the ECB, the Spanish banking system (which itself is in the process of receiving a bailout) would not be able to come to the government's rescue as it did in the past. And a Eurozone-wide rescue of Spain was out of the question as it would dwarf that of Ireland, Greece, and Portugal.

Last two weeks:

Once the leadership came to the conclusion that the markets won't wait for the new "empowered" ESM - which is not close to being set up, it was time to find some way to "bridge" to the ESM event. In leveraged finance, bankers use what's called "bridge loans" (short-term loans) to provide financing to a company until it is able to bring a bond deal (or even an IPO) into the market. The Eurozone needed one of those and the ECB became the only available option. At this stage, given how desperate the situation has become, the ECB was no longer acting as an "independent" central bank.  Instead it was drafted to help hold off the crisis until the euro are institutions put in place the ESM "solution". Using the ECB to only tackle the short end of the curve was a new compromise with Germany that would provide this "bridge loan" to the periphery without taking on long term risk.

Bloomberg: - Members of German Chancellor Angela Merkel’s coalition parties signaled they won’t stand in the way of European Central Bank chief Mario Draghi’s plan to buy government bonds.

The envisaged move to purchase troubled euro states’ [short term] government bonds is “a wise middle way” to solve the region’s debt crisis, Elmar Brok, a European Parliament lawmaker and executive-committee member of Merkel’s Christian Democratic Union party, told Deutschlandfunk radio today.

Germany knows that once the ESM is in place, they can control the bond-buying process (to avoid taking "excessive" risks) via their veto power. In the mean time Draghi was brought in to "save the day" (without the full knowledge of some other ECB central bankers) .

So what happens now? The ECB will try to quickly implement a backstop program to keep short term periphery rates low to allow Spain and Italy to roll short-term paper, creating a low cost "bridge loan". In the mean time the Eurozone bureaucratic machine will try to implement the ESM structure as envisaged at the Euro Area Summit. But as the area recession deepens, the implementation becomes a race against time and more market volatility is inevitable.

SoberLook.com

Monti's race against time

Italy’s Prime Minister Mario Monti is in a race against time. He needs to secure government funding via a pan-Eurozone bond buying program before Italy's economic conditions deteriorate further.

Bloomberg/BW: - Italy’s Prime Minister Mario Monti is pressing his European counterparts to sign on to collective action to fight the financial crisis, trying to bridge a north- south divide in the euro area for help to lower borrowing costs.

Monti, who is due in Helsinki today for talks with Finnish Prime Minister Jyrki Katainen, is seeking to capitalize on a pledge by European Central Bank chief Mario Draghi to do whatever it takes to defend the euro. Bundesbank President Jens Weidmann said the ECB shouldn’t exceed its inflation-fighting mandate, according to an article published on the German central bank’s website today.

He has a reason to move quickly. The onset of Italy's deep recession may damage the nation's fiscal conditions as tax revenues decline. Without a backstop from the Eurozone (ESM and ECB) it may become increasingly difficult to roll government debt. With over €100bn of bonds to roll this year alone, this backstop becomes critical. And the latest economic indicators from Italy are showing a further deterioration.

Manufacturing PMI (source: Markit)

Source: DB

Markit: - "July saw the recession in the Italian manufacturing sector extend to a year. Moreover, the downturn was shown to have deepened as the PMI sank to its lowest level in three months, primarily reflecting a sharper reduction in staffing levels. A solid and accelerated decrease in stocks of purchases also dragged the headline index lower, and suggested that firms had grown more concerned about cash flow and were not anticipating a rise in production requirements in the near term."

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ESM armed with a banking license - the ultimate bailout "bazooka"

Should the ESM, the Eurozone's permanent bailout facility, be granted a banking license? Apparently some within the ECB believe that it should.

Bloomberg: - European Central Bank council member Ewald Nowotny said there are arguments in favor of giving Europe’s rescue fund a banking license, reviving the debate on bolstering its firepower as leaders face the prospect of a full-scale Spanish bailout.

“I think there are pro arguments for this,” Nowotny, who heads Austria’s central bank, said in an interview in his office in Vienna yesterday. “There are also other arguments, but I would see this as an ongoing discussion,” he said, adding he’s “not aware of specific discussions within the ECB at this point.”

It's a powerful concept because being a bank, the ESM could tap the ECB's unlimited lending facilities to leverage its holdings of sovereign paper. By granting the ESM a banking license, it can effectively buy Spanish and Italian bonds "on margin", with the ECB being the margin provider. This entity would wield buying power several times larger than the Eurozone's original ESM commitment, making it the ultimate bailout "bazooka".

So far Mario Draghi had not been supportive of the idea - at least officially.

Bloomberg: - ...ECB President Mario Draghi said on May 24 that such a move amounts to the central bank financing governments, which is prohibited by European Union law...

The issue of EU laws is a major one, but it's not without a precedent. As the Bloomberg article points out, "publicly-owned credit institutions such as the European Investment Bank (EIB) are exempt". In fact the EIB has been involved in buying government debt of Eurozone nations for some time, even ending up stuck with some Greek bonds (see this post).

Bloomberg: - The EIB, which was founded in 1958 and is owned by the member states of the EU, was granted access to ECB refinancing in July 2009. Nowotny said the fact that the ESM has missed a July deadline to become operational is a “weakness that has to be overcome.”

However there is a political problem with this scenario. The ESM now has a €500bn cap on total debt purchases. That means no matter what leverage is available to the entity, it can only purchase bonds of up to the amount of the cap. An increase in its buying power would require (among other things) Germany's approval. And with the elections coming up in Germany next year, the chances of German politicians agreeing to this increase are quite low.

Barclays Capital: - From a political perspective and in view of the German national elections scheduled for September 2013, we do not see much of a chance that the German government would agree to another increase in the ceiling until then, or to more fundamental changes implying the mutualisation of national, public debt. This constraint may be relaxed if the crisis picks up pace rapidly and moves into the core.

Nevertheless the rumors of the ESM being armed with a banking license are flying (and even moving the "risk" markets on Friday).

CNBC: - Reports (vague rumors) that ECB head Mario Draghi may have reached out to Bundesbank head Jens Weidmann moved the Dow more than a hundred points in the middle of Friday's trading day.

It certainly wouldn't be surprising that they talk, but the rumor mill threw in a rich tidbit: that they had discussed giving the EU's permanent bailout fund (the ESM) a banking license.

The danger of course is that after this buildup, the "bazooka" and other expectations from the Eurozone may not materialize. Without a decisive follow-through, the "risk" markets may retrace their recent gains and then some. After all when it comes to the Eurozone crisis, the EU leadership has a knack of over-promising and under-delivering.

SoberLook.com

The EU summit euphoria drowned by European bureaucracy

As discussed last week, the market "euphoria" associated with the outcome of the EU summit was premature. Once the practical realities of what was actually accomplished sunk in, a great deal of the risk asset rally was reversed.

Even the relatively simple agreement to hand over Eurozone-wide bank regulation to the ECB turns out to be not so simple.

WSJ: - Some officials in the European Commission—the EU executive that will be an important architect of the plan—and some national banking authorities, have their doubts about concentrating this power in the ECB, said Mujtaba Rahman, an analyst with Eurasia Group in New York. Even ECB officials don't have a common position on whether bank supervision is an appropriate role for the central bank.

The effort of recapitalizing Spain's banks has been stalled because no central mechanism currently exists to perform such a recapitalization. The ESM was designed to provide lending to governments, not make equity investments in banks. Plus the ESM is not even fully set up yet.

WSJ: - The trickiest questions surround the plan to directly recapitalize banks. The issue is how to convert a fund created by governments to provide loans to other governments into one that may also provide equity finance for banks. One idea officials say was discussed at the summit—the possibility of quickly creating a special entity to stand between the bailout funds and the banks that would absorb losses on the investment—was dismissed as being unacceptable to Germany and others.

And all that talk about the ESM being empowered to buy sovereign bonds in the secondary market was, well, just big talk. Not only would a nation need to apply for this "bailout" buying program and not only would Germany be able to overrule this action, but now the ECB will need to give its approval as well. This is European bureaucracy at its best.

Bloomberg: - The European Central Bank will need to recommend that that the euro region’s rescue fund buys a country’s bonds before securities can be purchased, European Union Economic and Monetary Affairs Commissioner Olli Rehn told the newspaper Corriere della Sera.

Once a country requests that the fund buys its bonds to try to bring down borrowing costs, granting permission “will depend on the analysis of the recommendations of the ECB and other conditions,” Rehn told the Italian newspaper in an interview.

SoberLook.com

Despite the summit agreement, it will be a while before the ESM is authorized to buy Italian bonds. Germany still holds the key.

On Friday Angela Merkel got the Bundestag approval she was seeking. Germany approved the Fiscal Compact and the ESM. Germany views the Fiscal Compact as a way to enforce austerity in the periphery countries.

FT: - ... the Bundestag passed the fiscal compact with 491 of 608 votes cast and the ESM with 493 of 604 votes, giving Ms Merkel a comfortable two-thirds majority which she needed for passage of each bill.

This vote was already planned and had nothing to do with the summit. But Merkel had to defend her decision to concede on direct bank bailouts and the use of the ESM to buy sovereign paper. Her argument is that the ESM has by no means been given a blanket bailout authority.

FT: - “There will be conditionality,” she added. A country such as Italy would have to apply for market intervention and sign a memorandum of understanding based on the European Commission’s recommendations before bond-buying would be approved in the primary market.

It basically means that nations will sill need to apply for a bailout just as they had to do prior to the summit. The stigma associated with the process will still be there. The difference is that the mechanism for such bailouts would assure a (supposedly) rapid approval and a direct response. But the Germans can still "veto" potential actions by the ESM going forward.

And Germany's unease with the summit agreement is already visible. The opposition politicians are unhappy about both the direct bank bailouts and the sovereign paper purchases.

FT: - The opposition Social Democrats earlier summoned Wolfgang Schäuble, finance minister, to attend an emergency meeting of the Bundestag’s powerful budget committee, with senior lawmaker Carsten Schneider demanding he explain Ms Merkel’s “180-degree about-turn” from previously blocking direct cash injections.

Dissatisfaction was also voiced by members of Ms Merkel’s coalition, who worried she might have compromised her principle of giving aid only with tough conditions.

Wolfgang Bosbach, a lawmaker from Ms Merkel’s Christian Democratic Union and long-standing opponent of eurozone aid, said summit decisions about direct bank aid and readier help to lower sovereign-bond rates had seen Germany “finally and irrevocably” abandon the EU’s no bailout clause.

Clearly the Germans know their national exposure to the periphery will be increasing. And depending on the ECB's decision to ease policy next week, the risk to Bundesbank will increase as well. This is sure to make Germany's authorities uneasy about further bailout approvals.

There is also the issue of the German Constitutional Court that is looking into the ESM scheme. The approval could take weeks and could potentially be linked to a constitutional change or even a public referendum. And that would open a Pandora's box.

Reuters: - There is a chance it could link approval to a change in the constitution - which would require Germany's first national referendum in the post-war era. At the very least, experts say, the court could say approval for any future integration, beyond the ESM and fiscal compact, would require constitutional change.

Thus in spite of Mario Monti's apparent "victory" at the summit, there will be a great number of hoops to jump through before the ESM is actually ready to buy Italian bonds. Some of the risk asset rally we've had on Friday may therefore be reversed once market participants fully absorb this reality.

SoberLook.com

Germany's growing exposure

With the latest summit "agreement" (assuming it gets off the ground) Germany will continue to increase its exposure to the Eurozone periphery. The nation's exposure will grow via its share of the ESM as well as the ECB who will be buying Italian bonds. That's in addition to what is already committed via the EFSF and its share of the IMF. There are also large direct exposures via the bilateral loans pooled by the European Commission (such as loans to Greece). And then there is the exposure that the media doesn't like to talk about because of the ongoing "debate". It is the Bundesbank's TARGET2 exposure, which just hit a record of about €700bn.

Bundesbank's TARGET2 exposure (€bn)

So what does 700 billion really mean in the context of Bundesbank's balance sheet? The balance sheet has grown as the exposure increased, right? But the reality is that TARGET2 is becoming an increasingly dominant component of Bundesbank's balance sheet. Almost two thirds of the central bank's assets are now tied in this "debated" exposure. And as funds flow out of the periphery states, the proportion is only getting larger.

In fact it is beginning to dwarf all the other assets. So here is a question: if you were Jens Weidmann or the the Bundestag or Angela Merkel or the German public for that matter, and you were looking at the chart below of Bundesbank's assets, what would you think? But no need to worry because these are just accounting entries and as long as the Eurozone stays intact there is no risk.

SoberLook.com

Cornered by other Eurozone leaders, Merkel concedes

With Hollande supporting Italy and Spain, Germany has became isolated. "Merkozy" is no more. Worn down Merkel conceded, sending risk assets to a massive rally. Caught in a short squeeze, the euro rallied nearly 2 % this morning. But with all the hoopla, let's take a step back and see what exactly did Germany agree to in the middle of the night. Here are some highlights.

1. Spanish banks will be bailed out (€100bn) directly out of ESM/EFSF rather than going through the Spanish government. This will avoid increasing Spanish government debt.Amazingly only last week Merkel said she could never agree to direct lending to these banks because she would be unlikely to "get her money back".

2. The Spanish bank bailout will not subordinate the bond holders as was expected.

3. Perhaps the most important agreement was that the European Stability Mechanism (ESM) could buy government bonds to reduce periphery borrowing costs. The only official statement was that the ESM will be used to buy bonds in “in a flexible and efficient manner”. No further details for conditions on such purchases were provided. This is clearly a victory for Mario Monti, who's been pushing hard for this measure.

EURO AREA SUMMIT STATEMENT: - ... We affirm our strong commitment to do what is necessary to ensure the financial stability of the euro area, in particular by using the existing EFSF/ESM instruments in a flexible and efficient manner in order to stabilise markets for Member States ...

4. There is an agreement to set up a single banking supervisor in 2013.

That seems to be it. A few observations:

• As expected, there is no agreement on a "banking union" that would provide deposit insurance across the euro area.
• The ESM, having already committed €100bn to Spain's bank now only has €400bn of capital. Given the amount of debt the periphery nations will need to roll in the next couple of years, this is hardly credible. And the Eurozone leaders have not agreed on the details of how capital will be released. We all know how easily the leadership gets caught up bickering over the details.
• There will be pressure on the ECB to do what the ESM may be unable to do - expand the SMP program to buy more periphery bonds (so much for central bank independence). It already bought €220bn, but Monti and company will expect far more. That basically means QE.

Overal the market reaction may be premature. There is nothing final about these agreements and they do not get at the heart of the problems of run on banks and investors' ability to absorb more sovereign debt - particularly at the risk of subordination by ESM. There may also be significant backlash from German politicians and the public.

SoberLook.com

The Fiscal Compact is in trouble

In the US the public had little interest in the recent French elections. But as predicted here some months ago, Hollande's victory has shifted the balance of power in the Eurozone (which will have a significant impact on the global and the US markets). Some investors in the US should have paid more attention to this.

Today in support of Italy and Spain, Hollande is putting the Fiscal Compact (to which Sarkozy agreed late last year) on ice.

Bloomberg: - Hollande put French endorsement of a German-inspired deficit-control treaty on hold, and Italy and Spain withheld approval of a 120 billion-euro ($149 billion) growth-boosting package unless Germany authorizes steps to calm their bond markets.

By provoking an open breach with German Chancellor Angela Merkel, the new French leader overturned the austerity-first consensus that has dominated the debt-crisis response and risked fracturing the Berlin-Paris alliance that built the European Union and euro.

Monti will walk away from the Fiscal Compact unless the ESM and/or the ECB are used to buy Italian bonds. He is basically saying he's done all he can domestically, and now it's the Eurozone's turn to help him bring down borrowing costs. And Hollande is on board with that. However Germany, who has the most to lose by indirectly becoming the biggest owner of hundreds of billions of periphery bonds, is clearly opposed to this move. The Fiscal Compact is in danger of collapsing. Without it there is little hope of pulling out of the Eurozone crisis.

SoberLook.com

Eurozone policy actions vs. the iTraxx spread

The historical chart from Barclays Capital below overlays the timeline of the various Eurozone policy actions on top of the iTraxx Main spread. It's a good chronology of policy announcements and market stress periods. As a bit of background, iTraxx Main is a CDS index referencing 125 investment grade European corporations. It's quite liquid and tends to be a good representation of financial stress levels in Europe.

Source: Barclays Capital (click to enlarge)

The point Barclays is trying to make here is the declining level of confidence the markets now have in the policymakers' abilities to devise and implement effective lasting solutions. As many have pointed out, this lack of confidence has caused the time periods between each successive "positive" policy announcement and the next market "stress period" to become shorter.

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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

German people zero in on TARGET2 imbalances; may derail ESM increases

Let's for a moment continue with the topic of Google Search trends. One trend in particular indicates that the German people are becoming increasingly aware of and likely concerned with TARGET2 imbalances. The chart below shows a spike in global searches for the word "TARGET2". The bulk of those searches are coming from Germany, particularly from Hesse (likely dominated by searches out of Frankfurt).

Google search relative statistics for "TARGET2" 

The debate on the issue has sharpened as the public is becoming inpatient with the demands (at least from the German perspective) the currency union is placing on them. As one German newspaper points out, it is rare that an abstract ECB payment mechanism has attracted so much attention.

Frankfurter Allgemeine: Selten hat ein abstrakter Notenbankmechanismus in Deutschland so viel Aufmerksamkeit erregt wie die Target2-Salden des Eurosystems. Insbesondere Ifo-Präsident Hans-Werner Sinn schlägt Alarm. Ulrich Bindseil von der EZB widerspricht ihm fundamental.

The unease of the German people, many of whom perceive TARGET2 as a "backdoor" bailout, may end up derailing the Eurozone's ability to scale ESM to the desired levels.

MSN: Germany, however, has taken a tough public line on limiting public funds used for bailouts. A government official close to Chancellor Angela Merkel insisted on Sunday that there is already enough money pledged for the euro-zone's rescue fund, known as the European Stability Mechanism. Berlin has said it sees no need to combine the ESM with a temporary fund, the European Financial Stability Fund. "The German government's position is unchanged: we see no need to increase the upper limit of the ESM," said the official in Berlin.

SoberLook.com

Subordination by the ECB is a done deal

Well, it looks like the subordination of sovereign Eurozone debt held outside the ECB has become reality.

Bloomberg: The Frankfurt-based ECB is exchanging its Greek bonds for bonds of an identical structure and nominal value, the only difference being that they would be exempt from so-called collective action clauses, the officials said late yesterday on condition of anonymity. One said the bonds have a face value of about 50 billion euros ($65 billion). An ECB spokesman declined to comment. Giorgios Zanias, chairman of the Council of Economic Advisors to the Greek Finance Ministry, didn’t respond to calls to his mobile phone.

The only thing right now that distinguishes the Greek bonds held by the ECB from the rest of the bonds is a different ID number on the certificates. But a much greater distinction will appear should the Greek government - via a legislative action - impose "collective action clauses" on the bonds NOT held by the ECB. Now the universe of bonds to be written down by some 70% is smaller and the existing bond holders can force the holdouts to accept the deal. But only the non-ECB bonds will be exchanged with such a large haircut. The ECB's holdings have effectively become a senior claim.

It is now clear that some institutions in the Eurozone are indeed "more equal than others". At stake is not simply the €50bn face value of Greek bonds. It is some €220bn of other Eurozone sovereign bonds held by the ECB (and other debt it is yet to purchase or take in as collateral) that have become de facto senior to any bonds held outside the central bank. The Greek bond exchange by the ECB has established a precedent. Now the more bonds the ECB buys the more subordinated the other holders become.

Typically corporate bond holders are concerned that incremental debt that is pari passu with their holding or worse yet senior to them is issued by the company, pushing their claim down in size, priority, or both. Many bond indentures limit or even prohibit such additional debt encumbrance. Now imagine that investing in sovereign debt will now require constant monitoring of the size of the ECB's holdings to see just how subordinated the non-ECB portion of the claim is. The bigger the portion the ECB holds, the greater the risk on the non-ECB bonds, and potentially the higher the yields as well. Yet after all this, the ECB will still need to figure out how to deal with the new Greek bonds it now holds. It is a poor policy decision by the ECB and will have negative repercussions for sovereign debt markets in Europe even before the subordination by the ESM becomes a major issue.

WSJ: Some policymakers are also afraid the plan could alienate investors. The head of Germany's Bundesbank, Jens Weidmann, voted against the proposal, according to a person familiar with the matter.

"It has always been slightly implicit that the ECB wouldn't be treated like other bondholders. Now it's explicit that they will be super-senior to everyone else," noted Lyn Graham-Taylor, a fixed income strategist at Rabobank International.

Richard Kelly, head of European rates and foreign exchange research at TD Securities, also points out that if the ECB is seen buying government bonds at times of stress, yields on these bonds may actually rise.

"If the ECB is in the market buying bonds, with the subordination of investors to the central bank, the actual losses will be distributed over a smaller pool of bonds, giving investors even larger losses."

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ESM, just like the IMF, will force bond holder subordination

Looking through the statement made by Standard and Poors on Friday, one paragraph stands out.

Standard and Poor's: As we noted previously, we expect eurozone policymakers will accord ESM de-facto preferred creditor status in the event of a eurozone sovereign default. We believe that the prospect of subordination to a large creditor, which would have a key role in any future debt rescheduling, would make a lasting contribution to the rise in long-term government bond yields of lower-rated eurozone sovereigns and may reduce their future market access.

This statement points at the crux of the issues faced by the eurozone bondholders - the risk of becomig subordinated.  But wait, wasn't the concept of "subordination" off the table in the last round of discussions?

It is not easy to assess exactly what is the latest agreement, given the numerous iterations of various negotiations in the eurozone. One thing that has always been clear is that Germany viewed any support provided by the (yet to be formed) European Stability Mechanism (ESM) to a member state of the eurozone as requiring private investor "participation".  In their view private investors had to agree to some form of a "haircut" before ESM provides a loan to a troubled state or take further losses in a default before any losses accrued to ESM. That concept is often described as "private investor subordination".

Reuters (May 25th, 2011): "We have decided on a long-term euro mechanism. And for Germany it is of existential importance that it foresees private sector participation in the event countries are judged insolvent," Merkel told a party conference of her Christian Democrats (CDU) in Berlin.

And the idea of private investor participation was indeed written into the original ESM proposal.

The ESM Term Sheet: An adequate and proportionate form of private-sector involvement will be expected in all cases where financial assistance is received by the beneficiary State. The nature and extent of this involvement will be determined on a case-bycase basis and will depend on the outcome of a debt sustainability analysis, in line with IMF practice, and on potential implications for euro-area financial stability.

Since then, Merkel kept bringing up this concept of "IMF practice" or "IMF rules". So what does it mean to have the ESM consistent with IMF practice?  Let's take Ireland as an example. There is no question that the current holders of Irish government bonds have become subordinated to the IMF.

ISDA: On 18 January 2011 the first drawdown (5.8B EUR) of the IMF loan to the Republic of Ireland occurred (see http://debates.oireachtas.ie/dail/2011/01/20/00067.asp under Point 78). The IMF certainly enjoys de facto preferential creditor status in accordance with its status as an International Financial Institution and the IMF has claimed preferential creditor status with regards to their loan to the Republic of Ireland – see the press conference transcript (http://www.imf.org/external/np/tr/2010/tr120210.htm) and the pg 100 of the IMF report (http://www.imf.org/external/pubs/ft/scr/2010/cr10366.pdf).

In the event that the Republic of Ireland is unable to meet its financial obligations at some point in the future no one denies that the IMF loan will be repaid first or that bondholders will not receive scheduled payments if the IMF loan is in arrears. From a practical perspective the existing Irish bonds have become subordinated to the IMF loan.

ESM in its original form can not buy bonds in the secondary market and has limited ability to participate in the primary markets. It's only approach would be to provide loans to sovereign governments in a fashion similar to IMF and become senior to the bond holders.

This version of ESM is certainly not giving sovereign bond investors a great deal of confidence. Imagine a scenario where Italian bond auctions fail. ESM would step in with a loan to Italy with a prerequisite that existing bond holders take a haircut negotiated with the Italian government in a debt restructuring process.  Now if you are one of those bond holders, you would be facing the Italian government and the ESM backed by Germany and France.  What are your chances of getting a fair deal? We see how well negotiations are playing out in Greece, even with investors agreeing to a 50% haircut and no ISM involvement.

As Europe came close to the brink in autumn of last year, it became clear that the "IMF approach" for ESM needs to change.  After a set of rapid fire negotiations between France and Germany it looked like Germany will indeed capitulate.

The Guardian (Dec 5th): In a major concession from Merkel in what was otherwise a German-inspired package, the leaders agreed that private investors in eurozone debt would not be forced to accept losses in the event of a default, with the exception of the case of Greece, where "haircuts" for the banks and private investors in Greek debt were agreed last July.

In an unexpected move, Berlin and Paris also called for the eurozone permanent bailout fund, the European stability mechanism, to be launched next year rather than in 2013 as previously planned. The Franco-German package is to be turned into a formal joint proposal to be handed to Herman Van Rompuy of Belgium, who is chairing the EU summit on Thursday and Friday. It falls to him to twist arms, and to get the rest of the EU and eurozone to support the package.

The talk was that the facility would only cover newly issued bonds of the eurozone members. Nevertheless ESM now looked more like a true bailout fund, a bazooka, rather than another IMF. The French Prime Minister Francois Fillon went on television the day after to say that "a decision was made by Merkel and Sarkozy that was critical, yet wasn’t sufficiently explained ... Germany agreed to give up the participation of the private sector, private investors, in case of sovereign debt restructuring.”  That's clear enough.  But German officials fired back the same day:

Bloomberg (Dec 6th): Germany rejected comments by French Prime Minister Francois Fillon that Chancellor Angela Merkel agreed to drop demands on investors to accept losses in any sovereign default, saying that International Monetary Fund rules will ensure private-sector involvement.

“We only made it clear that the kind of [private investor participation] you had with Greece is an extreme case that won’t be repeated,” Steffen Seibert, Merkel’s chief spokesman, said by text message late yesterday. So-called collective action clauses “will stay, so the investors will only encounter risks in Europe that they already know from everywhere else in the world.”

By "everywhere else in the world" Germany was insinuating that even after the new treaty, the ESM facility will not be taking a haircut side by side with the bond holders in case of a default, and instead operate like the IMF. But with the news of a potential new eurozone treaty, the markets had since shrugged off this comment, as Italian and Spanish bond markets stabilized.  The recent noise around negotiations with Greece has also drowned out any unresolved problems with ESM. That is until the S&P downgrade raised the issue again. As the structure of the new eurozone treaty emerges in the months to come, the ESM true status will become more clear.  But for now we are back at square one with ESM following the "IMF rules", which clearly (as in the case of Ireland) lead us to the concept of creditor subordination.


SoberLook.com

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.

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The France-Germany eurozone proposal - crib notes

The flow of information coming out of Europe has been fairly confusing, particularly when the media reports it in chunks, often not connecting the dots. For the sake of clarity, let's try to summarize the latest agreements between France and Germany that are meant to set the stage for the "new" euro-zone.  We have 8 key points:

1.  France and Germany explicitly ruled out the concept of a Eurozone Bond. This is unfortunate because in the long-term some form of combined debt issuance may help stability.

2.  The latest structure is a modification of the EU treaty to incorporate stricter rules for fiscal discipline. The issue as to who actually signs up still remains. If countries such as the UK choose to stay out, so be it. Rather than signing up the 27 EU states, they will just get going with the 17 euro-zone members. Then others can come in later as they wish.

3.  The fiscal discipline rules would set a hard limit of 3% deficit to GDP. Sanctions would apply based on the European Commission recommendation and would be waived only via the majority vote of member states.

4.  The constitution of each member state would be required to have a balanced budget built in. The European Court of Justice would opine on each state's constitutional requirements to balance the budget in order to determine if such requirement meets the new treaty standard. This part seems incredibly difficult to implement and may bring up sovereignty issues.  There may be significant internal political opposition within some member nations.

5.  European Stability Mechanism (ESM) becomes the main fund structure to provide support for member state bonds. Going forward any member state's new bonds would be the responsibility of that state and the ESM. Private investors holding the bonds would be senior to the ESM and would NOT need to take a haircut as long as ESM is able to cover the principal. The Greece situation would not be repeated, even though Germany originally insisted on a provision that would put private investors on the hook for potential losses alongside with the ESM.

6.  The ESM would be governed via 85% majority vote rather than unanimously as is currently the case. The goal is to avoid a single member from holding back the process.

7.  France and Germany will leave the ECB alone when it comes to its contribution to fighting the crisis. This is where it gets vague because the proposed loan to IMF remains a big question.

8.  Members will hold monthly meetings to address the standardization of labor and social welfare laws (which is meant to "help" other states achieve what Germany has done) as well as to deal with the inevitable euro-zone recession.

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