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Oct 28 2011

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Irrational Exuberance About Europe

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Safer Now? Nope

So this is what makes world markets swoon?

If that is the case, “do I have a bridge for you….”

Global markets rocketed yesterday after news that the EU had cut a deal on its sovereign debt crisis.

The Dow up 340 points. NASDAQ up 3.3 percent. The S&P up 3.4 percent. NIKKEI up 2 percent, and the FTSE up a remarkable 4.1 percent.

Is the confidence and enthusiasm remotely justified?

You be the judge.

The first, and arguably most important part of the EU agreement dealt with Greek debt held by private lenders and insurers.  The private sector agreed to a  “voluntary” 50 percent reduction in their loan values to Greece.

The package will reduce Greek debt by 100 billion Euros overall, and provide relief to the Greek budget by reducing interest payments by five billion Euros each year.

The impact is expected to reduce Greek debt to GDP from 170 percent next year, to a high, but more manageable 120 percent in 2020; provided that economic conditions don’t continue to disintegrate.

Greek GDP is expected to contract 5.5 percent this year.

But as Robert Samuelson points out in today’s Washington Post, the European approach on Greek debt write downs is “Orwellian,” in that words have lost their ordinary meaning.

Here is S&P’s definition of default.  “We generally define a sovereign default as the failure to meet [the] interest or principal payments…contained in the original terms of the rated obligation.”

Pretty black and white in the case of Greece, yes?

But the “voluntary” write down by private lenders and insurers was necessary to avoid and official default, which would have had a contagion effect across southern Europe. Indeed, in order to get the agreement, Merkel, Sarkozy et.al., effectively threatened private bond holders that unless they agreed, 100 percent of their investments would be made worthless.

Are muggings and stick-ups now “voluntary” too?

But perhaps the EU leaders were too clever by half.

Will global investors see this as truly “voluntary” and continue the flow of investment into other sovereign debt in “at risk” countries? Or having seen the writing on the wall, will it have a chilling effect as investors begin to sell existing commitments – while they still can – and refrain from new investment?

We’ll see.

Next, the EU deal requires Euro banks to increase their core “tier-one capital” to 9 percent of assets.  So, as certain institutions are writing down their Greek debt, they must also now bulk up their reserves.

Consider the case of France, which is fighting to keep its AAA rating. French banks will have to take a $14 billion write-down on their Greek debt and simultaneously, raise their capital cushion by $12.5 billion.

The additional capital requirements are intended to buffer banks against potential future losses and thus reassure investors. The increase in core capital, EU wide, is equal to about $140 billion, spread out among 90 banks, two thirds of which are in Greece, Italy and Spain.

In placing the capital requirements however, the EU stipulated that banks could not sell assets to meet the new requirement, meaning that at least in the initial phase, these institutions have to attract capital from the private market.

Would you invest in Italian, Spanish or – hilariously – Greek banks at this time?

It is a strange call for action at this point in the European crisis.

By way of example, consider that when US banks were illiquid in 2008, it required the US government to intervene with a huge program that ultimately invested $245 billion in the banking sector to stabilize the market.

 In contrast, at a time of severe stress, the Europeans believe that private banks can raise 60 percent of the TARP totals from private sources by June 2012?

This is fanciful at best.

Third, the EU is trying to enhance the firepower of the European Financial Stability Fund (EFSF).

Just recently expanded to $600 billion, the fund is already inadequate in size to deal with the scope of European financial challenges, with only about $250 billion left in uncommitted resources.

As no EU nation has the political will to put more money into the fund (German voters say no, the French will lose their AAA rating if they did), EU discussion has been on how to leverage the fund. Two, complementary proposals are being pursued.

First, the EU plans on offering “first loss” insurance of up to 20 percent on new issues of sovereign debt by “at risk” countries such as Italy and Spain. The insurance would be designed to attract investors and keep yields on these debt issues from skyrocketing, as they have with Greece.

Second, the EU is exploring the creation of “Special Purpose Investment Vehicles” (SPIV) that would be “seeded” with EFSF funds to attract foreign investment for European sovereign debt issues. This would include cash rich, emerging market countries, such as Brazil, sovereign wealth funds, oil rich countries of the Gulf, and the titan of foreign asset reserves, China, which holds a mind boggling $3.2 trillion in hard currency reserves.

In a sign of its importance, the head of the EFSF was in Beijing yesterday.

But the “leveraging” of the EFSF in these two instances is problematic.

First, no one knows for sure if a partial insurance guarantee for sovereign debt would entice investors back to Euro bonds.  The same holds true for the “seeded” SPIVs.

Europe is hardly a seller’s market. Indeed, savvy investors could hardly do worse in waiting for the current crisis to run its course, and then rummage through the wreckage for prime assets at bargain basement prices.

It thus becomes an almost historic question regarding what financial and other incentives would be necessary to attract investment, particularly government investment.

The geo-political magnitude of the question is borne out by the reality that should China invest the $50-100 billion that has been notionally discussed, the Chinese would have more power over EU policy than Great Britain, an EU, but not Euro-zone member.

It would be the greatest change in world power since the collapse of the Soviet Union or perhaps the end of WWII.

Finally, having announced the deal, it seems to have escaped the consideration of analysts that nothing is yet set in stone.  There are glaring gaps in the EU plan, and difficult negotiations on all pillars of the blueprint.

But time is of the essence. Last week’s economic report shows the EU sliding into possible recession that will fundementally change fiscal assumptions that produced the Euro deal to begin with.

In addition, for all the fanfare and promise of the EU deal, the fundamentals on the continent have not changed.

That EFSF leveraging proposal only confirms the fact that there is not enough money in Europe to bailout Europe.

And that the core challenge for the EU is not confidence but their fundamental social contract.

Demographics and two generations of nanny-state ossification – where the government eats more than 50 percent of the GDP – have created a private marketplace that in insular and  uncompetitive.

It is this reality that has driven debt off the charts and which impending recession creates a mortal risk.

In the end, only robust and sustainable economic growth – not bailouts will restore Europe to solvency.

Nothing in the EU relief plan suggests that Europe has an answer to that challenge.

Which is why the celebration in world markets will likely be short lived.

 

 

 

 

 

 

 

 

 

 

 

 

 

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