After another weekend on headlines coming out of Europe stock futures are up nicely and credit, while better, isn’t performing quite as well and sovereign debt yields are up across the board. After a quick glance at the credit markets and the headlines, it seems once again that equities have gotten ahead of themselves.
The market seems happy that the governments of France, Belgium, and Luxembourg were able to come together and form a plan for Dexia SA. From a “plays well with other children” standpoint this deal gets a gold star. Away from that, everything about the situation should scare investors. First and foremost, not only did this bank pass the “un-stress tests” of just a few weeks ago, but it was relatively off the radar screen. The CDS market was well aware of problems with Dexia and led the way, but outside of that, many people seemed caught by surprise how quickly Dexia ran into trouble. I would be more concerned that few people saw this coming than with the fact that they cobbled together a temporary solution.
The solution itself has some problems. If “contagion” is the spread of risk, then the fact that €100 billion of new financing support is being provided by governments deserves some scrutiny. More debt is being shifted onto the non-PIIGS countries. This may provide temporary relief for the Dexia problem, but doesn’t help anything longer term and in fact it just complicates the situation and makes it harder for these countries to respond to future problems.
Selling off some assets is a good thing. That part of the solution makes perfect sense, though it would have been good to see some assets being sold to private institutions instead of some quasi-government institutions like Caisse des Depots et Consignations and La Banque Postale. The cynical side of me says these sales are just designed to bury and hide rather than fix problems.
I am looking forward to seeing what the “bad assets” are. A lot of the headlines make it appear as though all of the bad assets are PIIGS bonds. Did they really have that much exposure to Greece? For all the talk about Italy’s problem, Italian 5 year bonds are trading at almost 99% of par. Hardly seems like a “bad asset”. Are the bad assets more likely CDS written on tranches of synthetic CDO’s or other arcane trades? Is that why so little focus is being placed on what the bad assets are and why the complex set of sales to companies that have the potential to assume OTC derivative trades? We don’t know yet, because the details are there, but if we are jumping through all these hoops to put some Italian and Spanish bonds into a “bad” bank, then someone was just too stupid to see the easy solution was to sell bonds. Since no one is that stupid, I think the bad assets will be more complex and more varied than the current headlines suggest. That could focus attention on other banks or sectors of the market that will limit the benefit of this bailout.
Speaking of sectors that investors haven’t been talking about, and I have to admit I didn’t really know there was a French Municipal Bond Market. I don’t know how big this sector is, or what shape it is in, but when an obscure market only becomes highlighted because a poorly followed bank falls apart in a short period of time, it is probably worth digging into and not relegating to the background.
On a final note, I still haven’t seen a good story on why this happened so quickly. For Bear Stearns or Lehman or AIG there was a pretty clear chain of events. There was often even a specific catalyst. For Dexia, I am still left questioning how badly run was their liability management that the problem could cascade out of control so quickly, or is the rush to save Dexia as much a function of governments wanting to keep some things buried? Maybe that is over the top, but the timeline for this restructuring, and the participants all seem a bit off to me.
At the weak end of Europe we have the PIIGS. At the strong end we have the dynamic duo of France and Germany. What about the rest, the “throw away” or “taken for granted” countries, of Netherlands, Austria, Finland, Slovakia, Slovenia, Cypress, Estonia, Luxembourg and Malta. As hard as I tried I couldn’t think of a good acronym with the letters A, F, S, S, C, E, L, M. A good acronym might help get these countries get the respect they deserve, but all I can see with these letters is a bunch of easy to use, but low scoring, Scrabble tiles. Maybe that is what they are. None of them on their own are particularly useful to the solution, but with the existing construct, they are all important. They are all important and beginning to show signs that they don’t want to be caught in the middle.
Finland has demanded collateral. Slovakia may vote no to extending the EFSF program. The Der Spiegel interview with Richard Sulik (the leader of a minority party there) is well worth a read. In summary, he says that the EFSF is not what Slovakia “signed up for” when it entered the Eurozone. That the current path being taken is far from the original principle’s and hurts countries such as his, that have taken the pain to right their finances.
I suspect that as plans for EFSF V3.5 start hitting the tape over the next few days, more of these countries will walk away. Nothing about their participation in the Euro forces them to play these games, and if anything, some clauses about supporting other country’s debt, specifically ban what is going on. The likely outcome is that any solution will be a strictly German/France one at the sovereign debt level, and a national one on the bank level.
As the markets bask in the glow of yet another joint announcement from the Sarkozy/Merkel travelling circus, I cannot help but think of that old nursery rhyme. “All the king’s men, and all the king’s horses, couldn’t put Humpty Dumpty together again”. As much as this weekend’s announcement re-iterates their agreements and is taken by the bulls to signal that “Europe really gets it” now, it does nothing to demonstrate that they can ACTUALLY fix it. Clearly the king tried hard to fix Humpty, just because you try hard doesn’t mean you will succeed. Just because Sarkozy and Merkel finally sound desperate, doesn’t mean they have the ability to fix it. They may have waited too long. No matter how hard they try, it may have gotten too far out of their control. It is also unlikely to work, because they are unlikely to actually do anything “out of the box” enough to work. They keep extending and changing existing plans that are now stretched too thin and haven’t really done anything to prevent the problems from growing anyways.
If they want to do something, they need to change their approach. Growing economies would be good, but since they really cannot do much to fix that immediately, they need a plan that gives everyone a couple of years of breathing room. As much as the Euro concept sounds good, it is breaking apart. The weak nations, that need the bailouts, really cannot be expected to provide funding. It is circular and just doesn’t work. The mid-tier countries do not have the same incentive to pull out all the stops to keep Europe going. They aren’t invited to the fancy weekend retreats but are expected to put up their capital when told to. That is already shows signs of breaking down and any new, bigger plan, should avoid requiring more involvement from these nations. It drags on the process and is becoming more likely to be voted down somewhere, causing a last minute scramble to do whatever plan there is, without those countries anyways. The ECB also needs to be willing to print money. A lot of it. If you aren’t willing to let any banks fail, then printing money has to be part of the solution.
What sort of a plan would scare me completely out of my shorts? Germany and France should announce the creation of a €500 billion funded program. Germany and France alone would fund this vehicle. The money would be there so that at any time, if a country was having difficulty rolling over maturing debt, or making a big coupon payment, they could tap this facility. No questions asked. No austerity measures, no Troika inspections, it is just there and available. Quickly, we can figure out how long that would last if none of the PIIGS were able to roll over any of their debt. That would be the minimum amount of breathing room created. With some ECB funding mechanisms in place, and some arm twisting at the bank level, they can probably ensure that at least Spain and Italy can roll over some of their debt, making this program good for at least 2 years. It has to be France and Germany (and maybe Netherlands) because the small countries can’t or won’t be able to participate, and it really makes no sense for even Italy or Spain to contribute cash to buy their own debt. It might be hard for France and Germany to ram this down the throats of their citizens, but it has the benefit of it might actually work, and has to be easier than getting 12 countries to approve it (seriously, the PIIGS will approve anything since they are the beneficiaries).
At the same time, each country would have to put into escrow, money that is available for bank recapitalization. It should have a set methodology for capital infusions – just ask Buffett what is fair. So banks would know how to tap capital and what the cost is. It should have a 3 month lifespan. Banks would have 3 months to tap that facility or they should not expect to receive government support in the future. 3 months is long enough, banks can go and shop that bid and see if they can do better from private investors or that they can decide they really don’t need the additional capital. There also have to be severe consequences to any country that later offers their banks capital. This has to be a one- time offer with a time limit, as otherwise, the banks will not bother, knowing that there is always bailout money to be had. Maybe all the gold or other similar assets of the countries needs to be held in a vault somewhere, so that it can be confiscated by other countries when a country violates the rule. Some form of collateral or ability to ensure a country is violated for breaking the rules might help the whole situation. Right now a country can flaunt the rules, and rather than being punished, they have a stronger seat at the negotiating table, because the other countries have nothing of value to threaten them with. A giant pool of collateral that can be taken away when obligations aren’t met would do a lot to sharpen the focus of the serial offenders.
While banks are deciding if they need capital, a massive effort has to be taken to remove OTC derivatives from their books. In an ideal world, 3 months should be enough to get virtually all of the trades into a clearing system. It is certainly enough, that if every bank spent every day, with a team of people focused on netting, we could get the gross notionals down dramatically, but a clearing solution is the best solution. Forcing the OTC derivative markets into clearing would reduce all these concerns that investors have about counterparty risk and off-balance sheet exposure. We should have learned the lesson after Bear Stearns. We should definitely have learned the lesson after Lehman. The volatility in the past 3 months is at least partially attributable to the failure to fix this problem. Regulators have been asleep at the switch for over 3 years, but it is in their power to fix this. If the banks need to raise money to provide collateral to the clearing corporations (one of many reasons that potentially banks have resisted this move), then let the ECB and FED provide special loans for the provision of collateral. If a bank cannot afford to trade the product in a regulated and cleared environment, then they shouldn’t be in the business. The strong banks would be rewarded and less competition could make up for more transparency.
On top of this, the willingness of the ECB to print money has to be there. There is too much debt and too little money available to pay for it. Printing money has to be part of their plan.
Do I think the “cure” may be worse than the “problem”? Yes, I remain convinced that allowing defaults now would be the best solution for the longer term. It would clear out the system and allow a proper rebuilding. On the other hand, after a year of half-baked plans that accomplish nothing, they might as well come up with something that really could work. Shed the political veneer and go for it. In the end, we will likely continue to bounce higher on plans of plans, and sell off as those plans don’t work, and the economies fail to rebound.
I am sure there are lots of flaws with some of the above ideas, but Europe needs to come up with something that is new and real. It has to address short term funding needs and bank capital and counterparty risk. Worrying about full participation of members or money to keep secondary market yields on 10 year bonds low are not addressing the problem and are unlikely to get approved in a timely manner.