The Crisis Eats Its Way Into The Core

November 16th, 2011 | Author Pater Tenebrarum
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Timber!

What happened on Tuesday in the euro area's sovereign debt and associated markets has probably set alarm bells ringing everywhere. Considering yet another day of widespread carnage in euro area sovereign debt, it was almost comical to see the US stock market rising following comments by the Fed's über-dove Charles Evans in a TV interview about his proclivity to vote for more money printing. This is 'news' why exactly?

Of course the crisis in the euro area isn't really news anymore either. Alas, a new, and potentially decisive (perhaps fatal) facet has made a speedy entrance over recent weeks and has become decidedly more manifest this week.

First we had reports that the EFSF could not even sell € 3 billion in bonds, after cutting down the originally planned offer size from € 5 billion when it became clear it couldn't possibly get bids for that much. Remember, that's supposed to be the euro area's 'bailout bazooka'. Right now it looks more like a water pistol. A small one.

The Telegraph reported that in order to cover up the failure of the auction, the EFSF bought its own bonds, something the bureaucrats overseeing the fund immediately denied. The problem with their denial is that there's no explanation how they actually moved the entire amount, since apparently there weren't bids for € 3 billion.

When the EFSF made its first bond sale over a year ago, it was ten times oversubscribed. At the time investors evidently still believed the bailout would work. These bonds have performed rather atrociously ever since, as opinions on the workability of the fund have slowly but surely changed. Right now there is a problem rearing its head that may well condemn the 'new enlarged' EFSF to the DOA status we have assigned to it right after it was born. The fund's AAA rating crucially depends on the ratings of its major backers, one of which is France. Unfortunately for France, its fate is tied at the hip with Italy's, due to the fact that French banks are actually the biggest holders of Italian debt. We have pointed this problem out before: it is likely not possible for France to retain its AAA rating if the government decides to backstop the big banks, as it may eventually feel forced to do. French banks in toto hold assets worth almost 400% of the country's GDP (a little less now, since they are busy shedding assets as fast as they can).

Considering Tuesday's moves in CDS on France and the move in OAT yields, the markets no longer think an AAA rating is appropriate for France (as an aside, if you were wondering what the acronym stand for, it is 'obligations assimilables du tresor', which denotes long term bonds). The spread of French over German yields has rocketed to a record high.

In fact, it appears as though Germany will soon be the last man standing in euro-land, as new highs have been recorded in CDS and yields all over the show. Even bonds that were heretofore somewhat mysteriously considered 'safe haven' bonds like those issued by Austria's government are beginning to crumble at astonishing speed. Austria's politicians were apparently alarmed enough by this development that they decided to bring forward legislation on a constitutional 'debt brake', including the demand that the 'Länder' (provinces) and municipalities run balanced budgets from 2017 onward (file under 'pipe dream').

We must reiterate on this occasion that we are not only finally seeing a crisis of the modern-day welfare states, but underlying it, a crisis of the fractionally reserved banking system. In spite of the fact that the ECB has now advanced almost € 1 trillion in 'emergency liquidity' to euro area banks, i.e., almost an entire enlarged EFSF worth of money from thin air, the banks continue to flounder.



Man overboard: the spread of French OATs over German bunds goes ballistic – click for higher resolution.

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Euro Area Banks: Eurocracy Scores Own Goal

The euro area's biggest banks are facing a multifaceted problem. Not only are their holdings of euro-area sovereign bonds (ex Germany) losing value day after day, they are still lugging around gigantic amounts of toxic assets from the burst US real estate bubble (see our previous missive on this, scroll to the bottom of the post for the numbers), in addition to those that have been amassed in Europe's various housing bubbles, all of which have burst as well. If all of this stuff were marked to market – which it should be mentioned isn't even possible for the whole lot, since there simply is no longer a market for some of it – many of these banks would likely be insolvent.

Given the sudden realization a few weeks ago that euro area banks are short of capital and that the EBA's (European Banking Authority) previous 'stress tests' were largely a farce (the allegedly 'best capitalized bank in Europe' was Dexia according to the EBA – that's really all one needs to know about these tests), the EU has decided to apply more strict criteria to assess the health of banks and force them to raise far more capital than originally envisaged.

As the same time the eurocracy has done everything it could to lose what credibility it once may have possessed by means of a string of rather strange interventions (such as the ban on 'naked CDS' trading enacted by the EU parliament this week) and by issuing promises it could not possibly keep. First and foremost among those promises were the ones related to the Greek debt situation.

Initially banks and other investors were told that there would be 'no haircuts' at all for Greek debt. The ECB specifically was vociferous in its insistence on this point. This was later revised to a '21% haircut' – but at the time it was also made clear that only private investors would be subjected to it. Public holders of claims against the Greek government, from the IMF to the ECB to the EFSF were and are exempted. The math on this never really worked, since by that time a lot of Greek debt had already made its way onto public balance sheets. So a few short months later, the haircut was increased to 50%.

We have always argued that those who made bad investments should bear responsibility for the losses incurred. However, creating two classes of creditors was a big mistake. It was an even bigger mistake to change the terms of the agreement twice in mid flight. To add insult to injury, these haircuts were deemed 'voluntary' in order to avoid a triggering of CDS contracts – with the entirely predictable consequence that some bond holders felt they could no longer properly hedge their risk and thus should better sell euro area sovereign bonds as quickly as possible.

Finally, the banks had no longer any reason to believe the latest string of promises issued by the eurocrats. The major promise of the most recent emergency summit was that Greece would be 'fire-walled' and that no other government debt in euro-land would be subjected to similar treatment. Not surprisingly, bank managers at this point are thinking 'Fool me once….'.

Moreover, the banks were told that the tough new capital rules should preferably be achieved by tapping the private sector. Should this not work, then banks would be eligible for government or EFSF bailouts, which would obviously come with a great many strings attached (one of which is 'no more bonuses', which has an effect on bankers that is the equivalent of sprinkling holy water on Beelzebub).

The reaction of the bankers was entirely predictable. More shareholder dilution at stock prices that have declined to multi-year lows? Forget it. Taking money from Papa State in exchange for being dictated to even more? No way. So what is left? Only one thing: shrink those bloated balance sheets by selling assets – those that can be sold that is. No-one's going to buy some CDO stuffed with US sub-prime debt or similar garbage. Oh, and remember, there's a sovereign debt crisis in euro-land, which has called forth a lone bidder in the markets in possession of unlimited funds – the ECB. The banks see this as a marvelous opportunity to de-risk and shrink their balance sheets: Sold to you, Mario!

One wonders what their asset quality will be like when all is said and done. The average euro-land bank will probably shrink back to its core of unsaleable crap plus a few pompous marbled buildings.

We conclude that the eurocracy has an unsurpassed capacity at shooting itself into the foot. It doesn't even need an adversary, it is perfectly capable of shredding the euro-area all by itself.

We are actually somewhat astonished to learn that the latest nutty idea of financial markets commissar Michel Barnier, namely to 'ban credit ratings' on wobbly sovereigns, has met with enough bureaucratic resistance yesterday to be torpedoed before it could become policy. As the Irish Times reports, this time he was stopped by his fellow commissars, although the remainder of his plans was kept in place:

“PLANS TO ban sovereign credit ratings in “exceptional circumstancesâ€