The Mess in Europe
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The disconnect in Europe just gets worse and worse, as I sadly predicted at least a few years ago, and have made a big deal out of over the last year, with the very pointed note that a European banking crisis is the #1 monster in my worry closet. Today, within 15 minutes of each other, I ran across the following three notes, from Zero Hedge, the London Telegraph, and the Financial Times, with a quote from Bloomberg as well. Read them all. And then try and figure out how they can all get what they want. There are going to be tears and lots of them somewhere. Greek three-year rates are now at 21%. And so I decided to link these three short pieces into your Outside the Box this week. To kick things off, a few teaser quotes and observations:

“On Saturday Jurgen Stark, an executive board member of the ECB, warned that a restructuring of debt in any of the troubled eurozone countries could trigger a banking crisis even worse than that of 2008.

“‘A restructuring would be short-sighted and bring considerable drawbacks,’ he told ZDF, the German broadcaster. ‘In the worst case, the restructuring of a member state could overshadow the effects of the Lehman bankruptcy.’” (From the Telegraph, with more below.)

“There is ‘no painless way’ for countries that sought aid to reduce debt, while a restructuring may cut off the respective country from the financial markets for an unforeseeable time, Stark was quoted as saying. The only viable path for such countries is to ‘strictly push through reform programs and repay debt in full,’ the central banker was quoted as saying. Stark did not refer to a specific country.” (Bloomberg)

Let me repeat a phrase here: “The only viable path for such countries is to ‘strictly push through reform programs and repay debt in full.’”

But in a well-done column from Zero Hedge, which discusses a controversial Citibank report, we learn that, “In addition, no country with Debt/GDP ratio of more than 150% has ever avoided a default anyways. Why would Greece be different?” Athens has said it will also implement fiscal measures worth €26bn in an attempt to reduce the budget deficit to 1pc of GDP by 2015. The plans have sparked a fresh wave of anger in Greece and more threats of strikes and marches from trade unions.

But the Greeks are not the only ones who are unhappy. I wrote about the Finns last week. Now we jump to a marvelous Wolfgang Münchau piece from the Financial Times (www.ft.com), which gives us additional insight and points out that the Germans are getting rancorous. A quote from this must-read piece: “A premature Greek default would change everything. As would the failure by the EU and Portugal to agree a rescue package in time; or an escalation in the EU’s dispute with Ireland over corporate taxes; or a ratification failure of the ESM in the German, Finnish or Dutch parliaments; or a German veto for a top-up loan for Greece in 2012; or the refusal by the Greek parliament to accept the new austerity measures; or a realisation that the Spanish cajas are in much worse shape than recognised, and that Spain cannot raise sufficient capital.”

All this bodes for a great deal of volatility and uncertainty, which markets hate. This makes for a very interesting Outside the Box, and one you should ponder and that we will be visiting in the regular letter in the future. Gentle reader, this is important. Let’s jump right in.

Your keeping one eye on Europe 24/7 analyst,

John Mauldin, Editor
Outside the Box


The Mess in Europe

EU Poised for Greece Crisis Talks

A delegation of leading European and international monetary officials are planning a crisis summit in Athens in May amid growing fears that Greece may default on its sovereign debt.

Senior officials from the European Union, the European Central Bank and the International Monetary Fund are expected to make a "lightning visit" for two days to ensure Greece can meet plans to cut its deficit by €24bn (£21bn). The trip is being planned for May 9, although insiders said this could be brought forward to May 5.

George Papandreou, the Greek prime minister, and other Greek officials have this weekend strongly denied rumours that Greece may be forced to restructure its debt imminently – possibly as early as this weekend.

A year after Greece was forced to accept €110bn (£97bn) of financial aid from the EU and IMF, Greek government spokesman George Petalotis denied "the persisting international reports about a restructuring of the debt". George Papaconstantinou, the Greek finance minister, said that a restructuring or an extension of any of the €340bn national debt, which is set to hit 160pc of GDP by next year, was out of the question.

However, Greek news channels have continued to broadcast the rumours. The biggest network, Mega TV, on Saturday reported a government official saying that "in the worst of cases, a rearrangement rather than a restructuring will take place in the future, featuring an extension of the repayment period for the loan, as has been granted for other countries".

The influential newspaper To Vima reported that, in addition to the lengthening of deadlines for repayment instalments, Greece might seek a 30pc reduction in the debt itself. But it said such a decision might take "up to six months".

European officials are determined to avoid the need for Greece to change the terms of its debt repayments. On Saturday Jurgen Stark, an executive board member of the ECB, warned that a restructuring of debt in any of the troubled eurozone countries could trigger a banking crisis even worse than that of 2008.

"A restructuring would be short-sighted and bring considerable drawbacks," he told ZDF, the German broadcaster. "In the worst case, the restructuring of a member state could overshadow the effects of the Lehman bankruptcy."

Fears among the international community have been met with increasing anger in Greece. On Friday, Mr Papandreou lashed out at the credit rating agencies. In a piece posted on a Greek government website, the prime minister said the agencies were "seeking to shape our destiny and determine the future of our children".

Meanwhile, Greece's finance ministry has asked the local prosecutor to launch an investigation after a banker at Citigroup warned clients of the potential need for a debt-restructuring. In an email the Citi employee said: "There seems to be some increased noise over Gr[eek] debt restructuring as early as this Easter weekend."

Citigroup said: "We are co–operating with the authorities and do not consider there to have been any wrongdoing by Citi or its employees."

When the markets closed before the Easter weekend, Greek credit default swaps hit a record high of 1,335 basis points, up 53 points, pushing the annual cost of insuring £10m of the government's debt to more than £1.3m.

Last week the Greek government unveiled plans to raise €50bn over the next two years from a sale of national assets including palaces, marinas and beaches.

Athens has said it will also implement fiscal measures worth €26bn in an attempt to reduce the budget deficit to 1pc of GDP by 2015. The plans have sparked a fresh wave of anger in Greece and more threats of strikes and marches from trade unions.

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And now to Zero Hedge:

(From http://www.zerohedge.com/article/citi-expects-76-haircut-greek-debt-and-95-if-country-waits-4-years-debtgdp-ratio-back-down-6)

Citi Expects A 76% Haircut On Greek Debt (And 95% If Country Waits 4 Years) For Debt/GDP Ratio Back Down To 60%

Yesterday we learned that in borrowing a page right out of 2010, when the Greek government was mounting a full frontal assault against CDS traders everywhere (only for Eurostat to tell us that CDS traders had absolutely no impact on Greek solvency), Greece is once again scapegoating unrelated third parties for its problems. In this particular case Citi London trader Paul Moss, who is being interrogated by Interpol because of a recap email indicating Greece may, gasp, restructure (or, as it is known in enlightened circles, conduct a "liability management exercise"). Yet when Greece reads the following note by Citi's Stefan Nedialkov, it will most likely issue a cease and desist order in perpetuity against Vikram Pandit's bank. Nedialkov's summary (released one day after Moss' April 20 note): "If a 42% haircut is taken in addition to these measures, we estimate Debt/GDP falls to below 90% in 2013 and below 60% in 2020." The problem is that the market will likely give Greece at most a few months of breathing room in exchange for just a 90% debt/GDP reduction. If truly engaging in a liability exercise of some nature, Greece will likely pursue a permanently viable option. And as Nedialkov indicates, in order to achieve a far more credible 60% debt/GDP ratio, the country would need to take a 76% haircut now, or do nothing for five years, and eliminate a whopping 94% of its debt in 2015. Since the market is already expecting roughly a 50% haircut it remains to be seen just how much further bond prices will plummet, and how much bigger the ultimate impairment on Citi debt, and European banks, Greek pension funds and local bond investors, will ultimately be. One thing is certain: with Greek 2012 debt/GDP expected to peak at 159.4%, the country will restructure, and a a vast swath of insolvent European banks are about to see the tide go out.

Some more color from Citi, which is sure to get the Greek inquisition on the heels of Nedyalkov: "Citigroup said that no country with a debt-to-GDP ratio of over 150 percent has “ever avoided a default.” Greece’s austerity measures aren’t achieving the “desired results as quickly as hoped,” it said."

And some more:

In Figure 11, we illustrate the path of Debt/GDP under some of the above scenarios. Privatisation appears to be the most effective solution on its own, with the Debt/GDP ratio at c.150% in 2020 vs. 175% in the base-case scenario, according to our estimates. Better yet, all options (short of haircut) taken together would bring the ratio down to c.110% in 2020. And if a 42% haircut is taken in addition to these measures, we estimate Debt/GDP falls to below 90% in 2013 and below 60% in 2020.

Most disturbing is Citi's sensitivity on the type of haircut needed in order to bring total debt down even more: Cut 76% of the debt now (to get Debt/GDP to a healthy 60%), or wait until 2014... and impose a 95% haircut.

As for the debtholders, we believe that most have come to the conclusion that some sort of haircut is needed, especially as the austerity measures are not bringing in the desired results as quickly as hoped. At this point, debtholders would rationally want to minimise the amount of haircut taken. In Figure 13, we calculate the “incremental” haircuts debtholders would suffer if they were to wait a certain number of years from today. For example, to bring the Debt/GDP ratio down to 90% in 2011 would mean a 52% haircut, 63% haircut in 2012, 68% in 2013, 70% in 2014 and 70% in 2015. Hence, the marginal haircut (“damage”) from waiting longer diminishes quickly — this is in-line with the expected recovery in the primary government balance and the return of real GDP growth. Therefore, we see two rational strategies for debtholders:

Option 1 — “Act Now”: Insist on restructuring as soon as possible in order to avoid more haircutting in later years. The market (see Figure 14) seems to be voting for “Act Now”, or rather act within the next two to three years. The yield on the 3Y GGB is 21.1% compared to the 30Y yield of 9.6%.

Option 2 — “Pretend and Forget”: as the “haircut curve” starts to flatten out beyond year 2015, debtholders could close their eyes, help refinance maturing Greek debt, and hope that Greece slowly finds its way out. But this could be a long wait and may require concessions such as extending maturities. In addition, no country with Debt/GDP ratio of more than 150% has ever avoided a default anyways. Why would Greece be different?

As for the analysis of which European banks will suffer the biggest capital income in case of a 50-60% haircut, not surprisingly the list is topped off by France, Germany, Austria and Belgium. Here's to hoping (as the EU is currently doing) that these banks can easily digest the capitalization hit should "assets" have to be written down post a restructuring.

You can access a full 60-page copy of the Citi report at Zero Hedge or http://www.docstoc.com/docs/77754835/Citi-Barber-ians.

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And now on to Wolfgang Münchau in the Financial Times.

The eurozone’s quack solutions will be no cure

Published April 24 2011, 19:51

I was uncharacteristically optimistic last week, and had planned to end my informal series on eurozone crisis resolution with a benign scenario. The eurozone would survive in one piece; there would be no blood on the streets, just a once-and-for-all, albeit reluctant, bail-out, accompanied by a limited fiscal union. But as several readers have pointed out, my scenario is prone to a very large accident. I accept that point. Last week, we caught a glimpse of how such an accident may come about. My benign scenario looks a lot less certain today than it did a week ago.

The week began with the strong showing of two parties in the Finnish election, which are advocating a partial Portuguese debt default as a condition for a rescue package. The results triggered a renewed outbreak of the financial crisis, as eurozone spreads rose to near record levels once again.

The most disturbing news, however, was a revolt within Angela Merkel’s increasingly fragile coalition. It looks as though the German chancellor is on the verge of losing her majority over the domestic legislation of the European Stability Mechanism (ESM), the long-term financial umbrella for the eurozone. She may have to rely on the opposition to ratify the ESM, which may come at a heavy political cost. The Bundestag already postponed the vote on the ESM until the autumn, hoping to keep it clear from the controversial decision to pass the Portuguese rescue programme in May.

As opposition to the ESM mounted, German officials fell over themselves to be quoted by various newspapers pronouncing that a Greek restructuring was inevitable. Even Wolfgang Schäuble, finance minister, talked about the possibility of default. Some wily speculators unleashed the rumour that Greece would spring a surprise debt restructuring. The rumours prompted a criminal investigation. Another week in the eurozone’s debt crisis!

A monetary union is at a natural disadvantage when it comes to the handling of crises. There is no central government that takes decisions, which makes communications hard to control. What is less forgivable is the serial incompetence of the eurozone’s decision-makers, as exemplified by the perpetual eagerness to declare the crisis over the very second financial market pressure subsides. Not only do they know little about financial markets, they have surrounded themselves with policy advisers who know little too.

Their ignorance is an ideal breeding ground for quack solutions. One such is immediate default. German Christian Democrats and Finnish isolationists spent the last week trying to convince themselves that a Greek debt-restructuring would save them a lot of money.

That belief is premised on two false assumptions. The first is that a voluntary restructuring could solve the Greek debt problem. It can work in limited cases, but not when countries are insolvent. Greece, however, faces no short-term liquidity squeeze, because it is supported by the European Union and the International Monetary Fund. There is no need for any restructuring, voluntary or involuntary, right now. But Greece may need to impose a “haircut” in the future to ensure debt-sustainability. The ideal moment would be when the country achieves a primary surplus, probably in 2013.

The second wrong assumption is that the Greek banking sector would survive a restructuring unscathed. This is a conditional error. If you believe that a voluntary restructuring would be sufficient, then the Greek banking sector would indeed survive. But it would surely not survive a large and involuntary haircut. The European Central Bank would face a haircut on its direct investments of Greek government bonds, and, more importantly, much of the collateral posted by Greek banks would vanish. On my calculation, the cost of a Greek default to the German taxpayer alone would be at least €40bn ($58bn), including recapitalisation of the ECB. A bail-out would be cheaper.

A premature Greek default would change everything. As would the failure by the EU and Portugal to agree a rescue package in time; or an escalation in the EU’s dispute with Ireland over corporate taxes; or a ratification failure of the ESM in the German, Finnish or Dutch parliaments; or a German veto for a top-up loan for Greece in 2012; or the refusal by the Greek parliament to accept the new austerity measures; or a realisation that the Spanish cajas are in much worse shape than recognised, and that Spain cannot raise sufficient capital.

Then there is the downgrade threat for French sovereign bonds. I recall asking a French official about this, and getting the smug answer that the rating agencies could hardly downgrade France if they maintained a triple A rating for the US. That was before last week. By extension, France must also now be in danger. A downgrade would destroy the logic of the European financial stability facility. It is built on guarantees by the triple-A countries. Without France, the lending ceiling of the EFSF would melt down further.

The list of potential accidents is long, but they share a joint theme – serial political crisis mismanagement. We saw another glimpse of that last week. If we go down the route of premature default, and allow the True Finns and the true Germans to run the show, the eurozone as we know it will be finished.


Disclaimer

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

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Posted 04-25-2011 8:29 PM by John Mauldin
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