Europe at the Eleventh Hour…Again
10/28/2011 12:29 pm EST
The markets are either celebrating or are simply working off a giant short squeeze, but Europe’s challenges aren’t over yet, say Jim Fink of InvestingDaily.
It took European leaders until 3 a.m. Thursday morning, but they finally agreed to a three-pronged debt deal that delays the day of reckoning for Greece and the other PIIGS (Portugal, Italy, Ireland, and Spain). The three components of the deal are:
1. Greece-Specific Relief
Private banks—as represented by the Institute of International Finance—“voluntarily” agreed to forgive 50% of the € 200 billion in debt the Greek government owes them.
The banks’ resistance was broken by a threat “to move toward a scenario of total insolvency of Greece, which would have cost states a lot of money and which would have ruined the banks.”
Private debt forgiveness will reduce Greece’s current debt load of €340 billion by €100 billion. (Yes, I know that half of €340 billion is €170 billion, but the EU and the IMF are not forgiving any of their €140 billion in debt.)
Under the plan, Greece’s debt load is forecast to fall from its currently unmanageable 160% of GDP to a less heavy 120% of GDP by 2020. The European Union will ease Greece’s short-term solvency concerns by providing the Greek government with a new bailout loan of €100 billion.
Even after the news, Greek bonds were still trading at a 60% discount to par value, suggesting that investors did not think that a 50% haircut would be sufficient. Furthermore, the 120% of GDP debt estimate assumes that Greece’s economy will start growing again by a robust 3% per year by 2016, which may prove overly optimistic.
2. Recapitalization of European Banks
Europe’s big banks are required under the plan to increase their Tier 1 capital levels to 9% of total capital by the end of June 2012. Total capital needed: €106 billion, with banks in Spain and Italy responsible for raising nearly 40% of the total amount.
The EU is hoping this can be accomplished with private investor money, but European governments will likely take bank equity stakes themselves if private capital cannot be obtained. I would have preferred to see the EU pony up the new cash themselves right now and worry about obtaining private capital later, but c’est la vie.
3. Stronger European Financial Stability Facility (EFSF)
The EFSF’s current lending capacity of €440 billion has only €250 billion of available cash after the €190 billion worth of bailouts for Greece, Ireland, and Portugal are taken into account.
French President Sarkozy wanted to enlarge the EFSF’s lending capacity by giving it access to European Central Bank funds, but German Chancellor Merkel refused and, as always, weak France yielded to the stronger Germany.
Germany’s alternative plan—which was adopted—was to leverage the EFSF’s existing €250 billion by as much as fivefold, through the use of credit insurance guarantees and special purpose vehicles (SPVs). Insuring part of the government debt issued by weaklings like Spain and Italy will arguably reduce their cost of borrowing, which, in turn, will reduce their debt load.
But the insurance could actually have the opposite effect, because investors will start asking why the insurance is needed. Indeed, Italy’s ten-year bond remained at an uncomfortably high 5.8% yield even after the debt deal news was announced.
SPVs isolate a company’s highest-quality assets from lower-quality stuff, which reduce the cost of borrowing, increase investment rates of return, and make it easier to create asset-backed securities that can be sold for quick cash. The hope is that such SPVs will be attractive to outside investors—like China—who will provide extra investment capital if the perceived risk is low enough.
SPVs were at the heart of the Enron financial collapse, but who cares?
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Royal Dutch Shell Is Not Impressed
US stock indices skyrocketed more than 4% intraday on news of the European debt deal, but fell back at the end of the day on skepticism that the deal will actually cure Europe’s problems. Personally, I see the deal as just a stopgap measure that will only delay default.
Even if I’m wrong, many details of the agreement still need to be ironed out before it can actually be implemented. Time is of the essence, something that an “agreement in principle” does not provide.
Furthermore, the European debt deal does nothing to stimulate economic growth, which is the real crux of the issue. After the agreement was announced, Royal Dutch Shell CFO Simon Henry stated that the company was scaling back investments in the European Union because:
"Europe’s macroeconomic position can only recover and the sovereign debt crisis can only be addressed through underlying economic growth. We do not see the European Union creating the conditions for that, in fact quite the opposite."
European Economic Data Points Toward Recession
If you look at the most recent economic data, Europe’s economy is retracting.
The Eurozone’s purchasing manager’s index (PMI) for October sank for the third straight month, to 47.2, and manufacturing has been under the 50 level each of the past three months (services for two consecutive months). Anything under 50 means contraction.
According to Chris Williamson, chief economist at survey compiler Markit:
"Most indicators seem to suggest it is going to get worse, not better, in the coming months. So there is a significant chance of a contraction in the fourth quarter."
Many economists have concluded that a European recession is now inevitable, regardless of any European debt deal.
However, the mercurial stock market doesn’t seem to care about economic forecasts, and wants to rally based on whatever slim slivers of good news come out of Europe. No matter how trivial.