European Summit - Something for Bulls and Bears
By Fred Copper
July 3, 2012
The European summit outcome was fascinating; it had something for everyone, both bulls and bears. The net result was a positive surprise with at least one major concession by Germany. In concurrent news, three of the four semifinalists in the Euro 2012 soccer tournament were PIGS (Portugal, Italy, Greece and Spain) and the other was Germany. Spain won the competition on Sunday, symbolic of the PIGS’ power within Europe — it isn’t all about Germany.
Returning to the summit, what did they announce?
1. Bailout funds can lend directly to banks. By not forcing the bank bailout obligation onto sovereign balance sheets, this helps to break the connection between the banks and sovereigns. The market is assuming that required bank bailout funds will ultimately be obligations of the government (which then drives down the value of the sovereign debt held on bank balance sheets in a vicious cycle). This announcement reduces that risk. Spanish 10-year bond yields fell 60 basis points on the day. This is a major concession by Germany. While the distinction between the two has been blurred of late, banks are far riskier than sovereigns (banks fail more frequently than countries), so German/European taxpayer money is now being exposed to much greater risk of loss. An interesting point of clarification will be the terms of how the money is injected. Thus far, taxpayers have suffered tremendously in these situations relative to existing equity and bondholders due to governments underpricing their injections. This would be an opportunity for officials to make existing stake-holders suffer the full warranted burden — The Full Cost of Their Risk Taking.
2. Reduced conditionality for loans to Spanish banks. Admittedly, we aren’t exactly sure what this means as details thus far are scarce. This may just be a rehash of the initial announcement that bank bailout conditions are to be imposed on the banks themselves and not the sovereign state.
3. Announcement that bailout funds will not be super-senior. There is nothing new here as they are merely reiterating that European Financial Stability Facility (EFSF) loans are not given explicit senior status, which is known (though markets still evaluate the loans as if they are super-senior). Loans transferred from EFSF to European Stability Mechanism (ESM) will not be super-senior. However, ESM loans still will be.
What didn’t they announce?
1. No new funding. Existing bailout packages are the same size.
2. No immediate bond buying using bailout vehicles in secondary market. That was a silly idea to begin with as bailout vehicles are not nearly big enough to keep borrowing costs down. Markets would have seen official buying, stepped out of the way, and then driven rates right back up as soon as official buying was done, leaving the bailout funds with an almost immediate and guaranteed mark to market loss on their holdings.
These events are a net positive, particularly the direct bank capital infusions. The Summit, combined with Germany’s passage of the fiscal compact and permanent bailout fund, have lowered “stress” levels on our risk monitor. Over the month, Credit Default Swaps (CDS) have shown the most improvement, particularly in Portugal and Ireland. Ireland CDS are now just above those in Spain. Spanish and Italian 10-year bond yields are back close to levels seen earlier in the month.
The real and lasting impact of this summit however is going to be the changing dynamic among the politicians. With the election of Hollande in France, the new troika of Hollande, Monti in Italy, and Rajoy in Spain, are forming an alliance against Merkel in Germany, espousing far easier terms in exchange for funding. Previously French President Sarkozy was aligned with Merkel, giving them unquestioned domination over decisions impacting the region.
Spain, Italy and France combined are far bigger than Germany in terms of Gross Domestic Product (GDP) though less so in terms of available borrowing capacity. Merrkel is now fairly isolated in enforcing the policy of fiscal austerity. The growth pact that was assumed to be the showcase announcement of this summit was put at risk due to a threatened boycott by Monti and Rajoy who were demanding better terms, both of which demonstrate the growing power of the austerity opposition. The austerity first and last approach was not working and doomed to fail, so a forced retreat on that path is encouraging. Germany is a strong economy in a good fiscal condition; therefore it will be the one that has to pay for all of these bailouts. They have been willing to do this because it can impose conditions, such as labor reforms, on the governments getting the bailouts. We may have reached a turning point where Germany doesn’t have the support it needs from the other countries to keep imposing these conditions. This in turn could lead Germany to decide it isn’t going to pay anymore. This is going to be the key variable to watch. No new money was put on the table. That is key. Huge concessions were made, but stopped at the bright line of no incremental funds. At some point, the existing bailout pie can’t be divided any further and much tougher choices will have to be made.
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