by Peter Tchir, TF Market Advisors
Last week’s firewall headlines devolved into a “mine is bigger than yours” argument, as official headlines touted the highest possible number, and any reasonable analysis showed that the available money had only increased from €300 billion to €500 billion. Far less than the official headlines and any analysis of how the EU cobbles together €500 billion leaves serious doubts about it ever being achieved (Spain and Italy are expected to contribute 30% of that amount, which doesn’t make sense since they are potential users of the firewall). See here for a more detailed analysis of the “unused” firewall money and where it comes from.
What hasn’t been discussed much, is how useful is the firewall? What did the €300 billion already spent accomplish?
At best, the firewall helps the markets, but does little for the real economy, and at worst, it hurts the economy by avoiding hard decisions and shifts risks and costs from the private sector who made the original bad decisions, to the taxpayers.
Greece, Portugal, and Ireland received €300 billion of firewall money or commitments already. What has that done?
Greece defaulted on its private sector debt. The new Greek private sector debt trades at 20% of face value, a level that is lower than the old Greek bonds ever go to – think about that – the New “restructured” Greek debt, trades at lower prices than the old debt ever did – hardly the sign of a good restructuring. The economy is in shambles and has done nothing but deteriorate while the “firewall” was put in place. The firewall in Greece did nothing to help the Greek economy, delaying the inevitable default made the economy worse, and Greece still has the same amount of debt outstanding (in part because the taxpayers have recapitalized the banks), so now they just owe that money to different (more powerful) entities so their bargaining position is even weaker. A sad state of affairs and not a ringing endorsement of why anyone would want “firewall” money.
Portugal has not yet defaulted on its debt, but while accepting firewall money, they have also been busy at work letting the governments guarantee bonds issued by banks, so the banks can stay alive. Just like in Greece, the first restructuring will leave Portuguese debt burden unchanged, it will just replace who they owe it to, and force the taxpayers into capitalizing the banks that have now completely developed a parasitic relationship with the country. While Portuguese bonds benefitted substantially from LTRO and more promises that no PSI in Portugal would occur, both the 5 year and 10 year bonds have been weak the past few days, and still trade at prices 70 and 60 respectively, that indicate that restructuring is still to come. The main hope for those bond investors is that somehow, they get paid out and the public sector takes the risk – as sad as that seems for taxpayers, it doesn’t seem impossible that that is what the EU would decide to do.
Of all the countries that have received “firewall” or “bailout” money so far, Ireland seems the closest to turning the corner. The 10 year bond yields less than 7% and there is real talk about improvement in the Irish economy. Having said that, they are already re-negotiating their payment schedule for their bank recapitalizations. Yes, Ireland had actually been relatively okay until they threw taxpayer money at the banks without realizing what a deep dark hole they had gotten themselves into. In all 3 of these countries, it is the state support for banks that is making the crisis worse, or in the case of Ireland, sparked the crisis. The other issue with Ireland is that it is the smallest of the 3 countries that have needed help. With only €121 billion of “official” government debt (all the guaranteed debt, hidden derivative debt, commitments of support, etc., are not readily available), it is much smaller than even Portugal with €171 “official” government debt. One of our themes has been that smaller markets are easier to manipulate and the central bankers and politicians can hide problems longer there since the capital they are willing to throw at covering up the problems is disproportionately large. I’m not saying that is happening in Ireland, but I would also be careful about reading too much into their bond yields, as the size of the market makes it much easier to manipulate.
So of the €300 billion spent already to “firewall” or contain Europe, it is hard to see what has been achieved. Greece’s default, and bank recapitalization caused Greece to demand more firewall money. As Portugal seems destined to head down the same path, they too will need more money and will take a solid bit out of that remaining €500 billion, when they convert bank losses into taxpayer loans. Ireland seems most likely to be able to avoid needing more money, yet, having said that, they are re-negotiating terms of their existing bailout. Hardly a successful use of €300 billion (not including IMF money).
The politicians will argue that they bought time. That they have “saved” the banking sector. That is the best they can come up with, that by delaying they made the default in Greece less problematic, and that by saving the banks, they make the future better. I have argued all along that a default would not be catastrophic – the politicians didn’t do it when I first suggested – May 2010, but once they did allow the default to occur, it was far less painful than they would have led you to expect. I have argued that keeping dead banks alive does little for future growth, while making the problems bigger. I’m not the only one to say that, but I think Yalman Onaran’s “Zombie Banks” does a great job showing that time and again, the desire of politicians to delay the recognition of problems, particularly for banks, means the final tab for society will be much higher. The examples of this happening time and again are frightening (and recent), yet here we are trying to implement the same flawed policies.
How would the firewall work if Spain needed money?
It is great to talk about the “firewall” and just how big it is, but what happens if Spain starts to deteriorate. The likely scenario would be that Spanish bond yields start climbing. Let’s say that the 5 year bond gets to 5.0% and the 10 year gets to 5.75%. They are currently at 4.1% and 5.33% so this move would represent a serious shift in concern, but still be nowhere close to the worst levels seen in November (or pre LTRO – maybe Europe should switch from calling this 2012 AD, to 1 ALTRO?).
The first line of defense would be some ECB Secondary Market Programme (SMP) purchases. The ECB would go into the market to buy bonds. Given the problems the ECB’s holdings of Greek bonds caused (full payment and separate laws), the EU may choose to use EFSF or ESM money to buy the bonds. These entities are set up to work with the ECB, to buy bonds in the secondary market. With all that has gone on, I believe that the ECB will direct the purchases, but won’t use their own balance sheet. So any purchases will subtract from the remaining firewall. It also means that Spain will be guaranteeing some portion of the money being spent to buy Spanish bonds. For small size, say €20 billion or less, Spain will probably not opt to “step out”. With all the overcollateralization built into the guarantees, versus funded amount, there will be political pressure for Spain to remain part of the bailout team, in spite of the ludicrously circular nature of that. The argument will be that “secondary market purchases” are temporary, etc. The market will buy into that at first.
So the Doika (EFSF & ESM) will buy bonds. Initially this will scare the “speculators” who are short, and encourage the “investors” who will buy some bonds to participate in the potential short squeeze rally. The fact that many of the “speculators” are the same hedge funds that become “investors” will be ignored. We will see a rapid improvement in yields as dealers won’t fight the Doika, and fast money may even try to jump on the band wagon. The rally will likely be short lived, and not too dramatic, as LTRO has already been priced in, and shorts aren’t as prevalent in the past, and this round of weakness has been caused by fast money being caught long and overestimating the longevity of LTRO, rather than a “bear raid” on the country.
So let’s say after the SMP, Spanish yields drift back to 4.50% for the 5 year, and 5.25% for the 10 year. What has been accomplished? What was actually done for Spain?
Did Spanish borrowing costs decline? No. The price of secondary market debt doesn’t affect Spain’s current budget. Spain is obligated to pay the coupons agreed to when bonds are issued, the secondary market does not affect existing interest payments that Spain is due to make. It might help control the cost of Spain’s new issues, but the country is already issuing almost 70% of their debt with maturities of 2015 or less, so keeping long term yields artificially low doesn’t have much of an impact there either. Then why do it?
In theory, all borrowing in Spain will be benchmarked against sovereign debt. So banks who borrow money for 5 years will pay a spread to 5 year Spanish yields. Companies that borrow will also pay a spread over the 5 year sovereign rate. So in theory controlling the 5 year sovereign rate affects all Spanish companies that borrow money for 5 years. The same thing goes for the 10 year yields. That is great in theory because typically banks and countries are creating new debt every day at a faster pace than the country is creating debt, so you effectively “leverage” the SMP money, because keeping the sovereign debt yields low, means all the companies in the country can borrow at a lower yield. That might work in a “normal” environment, but we have moved so far past “normal” that it is laughable to believe this transmission works. It obviously didn’t work in Greece, and hasn’t worked in Portugal, so why ignore that? In Spain (and Italy) banks have become addicted to ECB funding. They have grown addicted to issuing bonds to themselves, getting a guarantee from the country, and then taking those bonds to the central bank to get money. They aren’t consistently issuing bonds to the public where the benchmark sovereign yield matters. More than that, they have shifted their borrowing to ever shorter maturities. The banks are borrowing more and more short term and they are definitely NOT lending money long term. They are lending to companies long term, if at all. The whole lending dynamic in the countries has broken down, so assuming traditional monetary policies work in this environment is just flawed.
So, other than calming the markets, at least temporarily, barely anything is done for the country, the banks, or the companies in Spain.
It might keep the cost of “hispabonds” down. These are bonds that would be issued by regions, but come with a government guarantee. On the other hand, these bonds might be the worst idea yet to come out of Spain. All the existing ways of hiding debt – off-market derivatives, verbal guarantees, private side-letter guarantees, commitments to EFSF/ESM where not all commitments are used, have the benefit of being difficult to find, or to convince people that they have a real impact on the creditworthiness of the nation itself. Hispabonds will attract attention to the fact that Spain is really issuing these bonds because the regions are in worse shape than the country. It will be hard to convince people otherwise, as these bonds will be right out there in the open where anyone can see them. Once the “guarantees don’t count” mantra has been breached, the potential floodgates of concern open up. How big is Spain debt, really? Not the “official” number, which is attractive, but the real debtload? It is high, and growing quickly, and likely unsustainable.
But anyways, what is that would cause SMP to fail to hold. Bad economic data? Ever increasing unemployemt? Failure to implement austerity? Civil unrest? Failure of a caja? Hispabonds? Revelations of secret debt? The list of potential catalysts is large. All it takes is for one thing, and the market that is still positioned long can resume its sell-off quickly. Remember, post LTRO, the banks are about as long as they can get and have to post collateral on mark to market losses on bonds they posted as LTRO collateral. Foreign banks will remain reluctant to extend capital, since Greece showed that restructurings are based on what is politically expedient, and not what the rule of law was at the time you bought your bonds.
This weakness causes bonds to spike higher again, this time reaching 5.5% for the 5 year and 6% for the 10 year. We see higher yields and a flatter curve as the market, caught long, realizes the last effort by the fire brigade failed to be sustainable. Nervousness is creeping into the market.
This is likely where the politicians make things worse rather than better. Some will start trotting out the “leveraged” EFSF/ESM concept. A non-starter, that may spark a brief rally by the naïve who think it can work, only to be followed by more selling pressure as markets get nervous that Europe is heading back to the clueless stage. The ECB will confirm that no new LTRO is planned – since yields aren’t really that bad, and they too can see that LTRO is a double edged sword. Renewed calls for austerity and dissention in Germany will add further concern. People like myself, will legitimately show just how much debt Spain is obligated to pay, and now more investors will start to pay attention. They will see that the guarantees are real. By this time another €50 billion in firewall money will likely have been spent (€20-30 billion on Spanish SMP and some to Portugal and Italy as Spain isn’t deteriorating in a vacuum). Rumors of law changes will abound. Rumors that Spain is preparing to default on non-Spanish held Spanish bonds will occur. There will be denials, but prudent foreign investors will be very fearful of getting involved in a deteriorating situation.
Long before the firewall money is spent, the outcome will come down to the ECB, France, and Germany.
What does the fire brigade do here? It really is tricky. At this stage, how do you stop the decline? Buying more Spanish bonds and Italian bonds? That will help, but not like the prior round, because now “speculators” who have been eyeing the horrific balance sheets of the caja’s, the regions, and the countries, will find ways to be short. Spanish sovereign bonds may respond to more Troika purchases, but CDS will remain well bid. Spanish bank and corporate debt that is beyond the maturity of LTRO will be attacked, not so much as a spread to sovereign bet, but one that sovereign yields will eventually spike. The regions will become desperate for Hispabonds at exactly the time the market won’t buy them. Although I believe Spanish yields will be worse than Italian yields at this stage, the Italian bond market will also be under pressure. Guilt by association if nothing else, but sadly it is more than just guilt by association, in spite of recent progress, Italy has a lot of problems of its own, none of which is helped by increasing problems in Spain – the correlation is real.
What happens if Spain “steps out”? If Spain decides it needs significant money to bail-out its cajas, regions, banks, and itself, then they will have to step-out. That greatly increases the burden on Germany, France, and Italy. Will they have the political will to take over Spain’s commitments? Remember, even ESM is only partially paid in capital, so ESM and EFSF will be issuing guaranteed bonds into a market, that is experiencing growing concern with Spain and Italy. Asides from the political will, does Italy have the economic capacity to step up its commitments if Spain “steps out”? Does Spain “stepping out” create real risk that Italy too has to “step out”, leaving virtually the entire firewall up to Germany and France? I think it does. It is hard to see plausible scenarios where Italy can honor its commitments without getting dragged down. They might not need to tap the firewall, but they may no longer be able to support it.
At this stage, all eyes will turn to the IMF and the ECB. I continue to believe that the IMF is the most constrained. Partly, their money is coming from reluctant donors, and partly because they do seem to do the most unbiased critical analysis of the situation (I’m sure what they discuss internally is far more morbid, than the already dire predictions they occasionally leak for public consumption). So it comes down to the ECB. The ECB will likely treat ESM as a bank or find some other way to fund programs so that these bizarre entities don’t have to rely on real markets for money. Why ever rely on real markets for risk assessment and pricing when you have the power to print and sustain economically unviable positions far longer than anyone ever thought?
This will be the key. It will once again fall to the ECB to come up with programs that “fix” things. Or at least give the can another good kick. Can they? The ECB will have to print. For the first time, it will become clear to everyone that if Germany and France can’t sustain the EFSF/ESM, then they can’t contain the ECB’s potential risk either. The commitment of France and Germany to the ECB is joint and several, as opposed to the EFSF/ESM where each has exposure that is capped. That risk will start to scare some sensible people. Politicians will likely bring out the “if we don’t help them, we all die, scenario” but the reality, as throughout the entire crisis, will be that “helping” them ensure you all die down the road, rather than having just some serious injuries now. Also, there will be a growing number of people, who may finally be listened to, that effectively argue that restructuring now, taking the losses and restarting with a sustainable system is the way to go. They will only have to point to Greece and Portugal to make their point, and they will be able to clearly demonstrate that Spain’s roll in the bailout of those countries, only hurt Spain. Too much of the bailout money goes to banks and insurance companies and not enough goes to fixing sovereign debt problems, or killing the banks that need to be killed so that others can survive. Yes, we hear the trickle down argument, that hurting bank share prices, or the portfolios of insurance companies hurts the little guy, but after 5 years of trying that in the U.S. and Europe, maybe it is time to test the theory. Most banks will not default if they have to take big hits on sovereign debt.
I for one, would like to see a much different approach to dealing with the crisis then has occurred so far, but in any case, this is where we likely get. It will all come down to the ECB, with the backing of France and Germany deciding to go all in, or PSI (default) on a large scale. But in either case, the €500 billion of unallocated money is just a myth and this problem will hit a critical point long before much more money is drawn down.
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