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Hey, euro, you've got two weeks to come up with a new, credible fix--the markets are starting to worry even about Germany
11/22/2011 8:30 am EST
In Frankfurt, the new president of the European Central Bank, pushing back against those Eurozone politicians who have pleaded for the bank to become the bond buyer of last resort, asked, “Where is the implementation of those long-standing decisions?” Why is the European Financial Stability Fund, the EuroZone’s bailout fund, still unable to intervene 18 months after it was established and four months after EuroZone leaders voted to expand the fund’s powers? The European Central Bank wouldn’t need to intervene in the bond markets, Draghi was saying, if EuroZone politicians would get the European Financial Stability Facility running.
Okay, reasonable question. The delay is unconscionable in the midst of a crisis like this. But no one who knows how quickly the technocrats in Brussels move expected that the rescue facility would be in action by now. The best guess back in July is that it would take until October or November to get all 17 members of the EuroZone to approve the changes and then until sometime in early 2012 to write the rules that would govern the facility’s new powers. And that’s approximately where we are now.
But calling on the European Financial Stability Facility NOW is scarily out of date. Can’t Draghi hear the dominos falling? By the time the facility is up and running it will be just about useless. The European Financial Stability Facility might have been a good idea 18 months ago but this crisis has left it far behind. It is no longer a serious player in the euro crisis—and if Draghi doesn’t realize this—if his speech in Frankfurt was anything more than an attempt to get EuroZone politicians off his back—then the European Central Bank really doesn’t understand just how serious the current stage of the crisis is. And that would indeed be scary since it would mean that the central bank doesn’t understand that it is the only player left with the power to stop this crisis short of financial chaos.
Why is the European Financial Stability Facility irrelevant to this stage in the crisis? Most criticism of the facility has argued that the 440 billion euro ($600 billion) rescue fund is too small for the job—even if the fund were able to get on with the job. (Which is why EuroZone leaders spent so much time in October trying to figure out a way to increase the facility’s fire power.)
But the real problem is in the structure of the fund as it was set up in May 2010 to “solve” the first Greek crisis. Because EuroZone governments were unwilling to put their real money at risk in the facility, EuroZone governments built a row of risk dominos. And once one domino falls it gets only more likely that the next will tumble too.
You see the facility was structured not as a pool of actual money but as a collection of guarantees from the 17 EuroZone member governments. With those guarantees behind it, the facility would be able to raise real money by selling bonds and since key guarantor countries such as Germany and France had AAA credit ratings, the European Financial Stability Facility got an AAA rating too from Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings. That meant that the facility could sell its bonds at a low interest rate and that financing the facility would be cheap for member governments.
Instead of transfers of actual cash from strong member governments, the facility transferred credit ratings from strong countries such as Germany to weak countries such as Ireland and Portugal.
But along with all the advantages of that arrangement for politicians who hoped they wouldn’t have to tell tax payers to actually take money out of their pockets to support the bonds of other EuroZone members, came some potential problems too that would become apparent as the crisis spread to pull in other countries.
It is only as the crisis has progressed—and maybe really only now that it threatens Italy and Spain—that is has become clear that setting up the European Financial Stability Facility in this way has been akin to setting up a row of dominos where the tipping of one domino threatens to take down the next and the next and, maybe finally, all the dominos.
In the initial structure of the facility Italy provided 18% of the guarantees, Spain 12%, France 20.5% and Germany 27%. Ireland and Portugal also provided their share of the group guarantee behind the facility.
Or at least they did until they needed their own rescues. When a country needs a rescue from the facility, it can’t provide part of the facility’s guarantees, and other countries have to pick up the slack. When Portugal and Ireland dropped out of the pool of guarantors, Italy’s share of the guarantee went up to 19%, Spain’s to 13%, France’s to 22%, and Germany’s to 29%.
Ireland and Portugal are small economies and their troubles didn’t create a huge surge in the guarantees from other EuroZone members. Italy and Spain are much bigger economies and if they need a rescue, the effect on the guarantees from other members would be considerably greater. France’s share of the guarantee would go up to 32% and Germany’s to 43%.
And, of course, that’s not the end of the dominos. The bond markets are starting to worry about Belgium. Standard & Poor’s has warned that France is getting over-extended and that it’s AAA rating might be in danger.
I can see two big effects from this process that make me worry about Mario Draghi’s seeming belief that the European Financial Stability Facility can be the vehicle for calming the financial markets.
First, the gradual concentration of guarantees in the hands of France and Germany—the two countries would account for 75% of the facility’s guarantees if Italy and Spain were to need rescue—has raised doubts about the facility’s bonds. At the November 7 auction of 3 billion euros of bonds for the Irish rescue, yields for the 10-year issue climbed to 3.591% and demand was barely over the 3 billion size of the issue. Yields weren’t hugely higher than they had been for the June 15 issue of 10-year bonds at 3.49% by the facility for Portugal (although Ireland is a much better economic risk at the moment than Portugal), but demand in the earlier auction had been much higher with bids of 8 billion euros when the auction size had been just 5 billion euros.
And second, the concentration—or actually the potential concentration—of guarantees has finally started to weigh on German bonds, up to this point the rock solid EuroZone asset.
While all eyes have been on the increasing yield spread between German 10-year bonds—called Bunds—and the debt of Italy, Spain, and most recently France as a sign that the financial markets are getting increasingly nervous about ending to those governments, something peculiar has been going on with German Bunds.
German Bunds now yield 0.2 percentage points more than 10-year Swedish government bonds. What’s the major difference between Sweden and Germany? Sweden doesn't use the euro and isn’t part of the EuroZone.
Even more peculiar the yield spread between German Bunds and United Kingdom gilts has been narrowing. Looking just at government finances that doesn’t make much sense. The current budget deficit in the United Kingdom is 8.8% of GDP while the Germany deficit is 1% or perhaps less. (The German government has just announced a tax cut since tax receipts have been running above forecast.) And Germany’s economy is growing faster than that of the U.K.
The only reason that I can think of for this narrowing of the yield spread between U.K. and German 10-year bonds is that the United Kingdom like Sweden doesn’t use the euro and isn’t part of the EuroZone. (Adding to that conclusion is the recent closing of the spread between German yields and those on the government debt of Denmark, another member of the European Union that doesn’t use the euro.)
S&P and other credit rating companies started to express doubts about France’s AAA rating once they added up all the French commitments to the European Financial Stability Facility, the bailout of Belgian-French financial company Dexia, and France’s potential need to support the big French banks that are so exposed to Greece and Italy.
Now a similar process seems to have begun with Germany. No credit rating company is questioning Germany’s AAA rating (If Germany isn’t AAA, what country is?) But the financial markets have started to add up Germany’s commitments and worry.
Germany’s commitment to the European Financial Stability Facility is 221 billion euros so far. The German central bank, the Bundesbank, is the main guarantor behind the bond-buying program of the European Central Bank. That’s another 180 billion euros. The European Central Bank now holds a lot of Greek, Italian, and Spanish debt. If that debt falls in value, it’s the member central banks that will ultimately be left holding the bag—and that means Germany.
The risks to Germany, the limits of Germany’s ability to support the European Financial Stability Facility, and hence of the power of the facility to address the crisis have just started to hit the consciousness of EuroZone leaders. Comments like that of Eurogroup head Jean-Claude Juncker on Wednesday are therefore still shocking. Juncker told a German newspaper that Germany is no longer a sound credit. “I think the level of German debt is worrying. Germany [with government debt of 82% of GDP] has higher debts than Spain,” he said.
All this is why I find Draghi’s remarks so baffling. Maybe it was just frustration with the pace at which political leaders in the Eurozone has moved during this crisis. I sure hope so. Surely, he can do the math and figure out what the markets know—that the dominos are falling, that Germany isn’t a credible backstop to the all the woes of the EuroZone, and that the European Financial Stability Facility has been left behind by events.
All this is scary. No doubt about it. If the crisis sucks in Germany, where they does it end?
But what’s needed right now in the EuroZone is a strong dose of reality delivered to Germany and the European Central Bank. Old solutions—even when those solutions date back only to July or October—won’t work. The core of the EuroZone isn’t somehow above the crisis. And time to fix this is getting very, very short.
I’d say we need some new credible ideas on the table before the December 9 summit of European leaders or things will get worse quickly.
I’ve been encouraged in the last few days by the rumors of weird deals that might be presented to the European Union summit on December 9 like the idea that the EuroZone could funnel rescue funding from the European Central Bank through the International Monetary Fund. Why that would be better than having the European Central Bank directly involved is beyond me. But I’m glad to see thinking of any sort directed at breaking the current deadlock in Europe.
This crisis could still get worse but it doesn’t have to.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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