Just when you think it might be over, the euro debt crisis enters a new more dangerous phase

01/17/2012 8:30 am EST


Jim Jubak

Founder and Editor, JubakPicks.com

We’ve seen this plot before.

Everything seems peaceful after Carrie pulls her house down on herself and her mother, but the film ends with a dream of Carrie’s hand reaching out from her grave to grab Sue’s ankle.

Kyle and Sarah think they’ve killed the Terminator but he emerges, reduced to a metal core, from the exploding gasoline tanker.

This time in “The Curse of the Euro” Mario Draghi, president of the European Central Bank, proclaims on January 19 that the threat of the euro debt crisis is receding and no longer threatens to sweep the EuroZone into chaos only to have the hand of the crisis reach up from the grave on January 13 to grab France, Italy, Spain and indeed the entire EuroZone.

Only this time the reality of the euro crisis has topped the imagination of Brian De Palma and James Cameron.

In “The Curse of the Euro” it’s not a solitary hand emerging from the grave or a single Terminator stalking out of the flames, but an escalation of all the danger that has come before.

On Friday, Standard & Poor’s downgraded the credit rating of nine EuroZone countries (see my post on the S&P downgrade http://jubakpicks.com/2012/01/13/france-and-austria-lose-aaa-ratings-still-aaa-rated-luxembourg-finland-and-the-netherlands-put-on-negative-credit-watch-by-sp/ ), AND Greece and its private creditors adjourned their meetings without an agreement that would prevent a Greek default in March, AND the European Central Bank warned that the proposed draft of the European fiscal discipline treaty was dangerously weak, AND the European Financial Stability Facility contemplated its own credit downgrade, which would leave it with even less money to rescue Greece, Portugal, and Ireland—let alone Italy, Spain, and France.

Wow!! And this story still isn’t over.

But I think we can take a stab at writing a final ending.

Okay, here’s the story as we left it on Friday.

By offering 489 billion euros ($616 billion) in new three-year loans to European banks in December, Mario Draghi, the new kid in town, had restored peace to the EuroZone, or so he announced on Monday, January 19. Yields on the benchmark 10-year Spanish bond had fallen to near 5% and on Italian bonds to near 6.5%. Investors had new confidence in the euro and in the sovereign debt of EuroZone countries.

That sense of peace lingered through Friday, January 13, when it collapsed under assault from multiple directions.

Standard & Poor’s downgraded AAA-rated France and Austria to AA+ and put AAA-rated Luxembourg, Finland, and the Netherlands on negative credit watch, a warning of an impending downgrade. S&P also issued two-notch downgrades to Italy (now BBB+), Spain (now A) and Portugal (now BB). That pushed Portugal’s rating to the junk bond category, territory already occupied by Greece (now rated C by S&P.)

At virtually the same time, Greece and its private creditors adjourned their talks without reaching an agreement on how big a haircut the creditors would accept on the value of their holdings of Greek bonds and what the yield would be on new bonds issued to replace current Greek bonds. In October EuroZone leaders put together a rescue package for Greece that was dependent on a voluntary 50% reduction in value of Greek debt. That 50% figure has been left in the dust by the continued deterioration of Greek finances.  Now a 60% haircut seems like a minimum and more would be desirable, but some private holders of Greek debt are balking at taking a bigger write-down, at least without a higher yield on the new bonds. The International Monetary Fund has said anything higher than 4% would make it impossible for Greece to stabilize its finances. Greece faces the need to repay 14.4 billion euros in bonds in March. Without a new rescue fund payment from the European Union, the European Central Bank, and the International Monetary Fund Greece won’t be able to make that payment. And without an agreement with creditors, those three institutions say they won’t cough up another euro.

That wasn’t the end of the news from Greece. Turns out the average Greek doesn't have much faith that this crisis will come out all right in the end so money is fleeing the Greek banking system. Greeks have pulled about 65 billion euros from the banking system over the last two years—or about one-third of total deposits. The October rescue package included 30 billion euros to help recapitalize Greek banks. That’s now about 10 billion short of what’s needed and the amount needed increases every day that uncertainty drives more deposits out of Greece.

This alone might be enough to make Draghi feel like he’s been drenched with a bucket of pig’s blood at the prom—but there’s more horror in the way that these events fit together.

After the downgrades to Portugal that country will need support from the European Financial Stability Facility, and after the downgrades to France, Italy, and Spain investors will need more reassurance that the theoretical backstop to these countries, that same European Financial Stability Facility, will be there to help. But whatever doubts there were about the adequacy of the facility before Friday’s downgrades, and there were plenty, just got more intense with those downgrades. Since the facility is structured as a set of guarantees from EuroZone countries—rather than as a pot of actual money—the amount of money that the facility can raise and the interest rate that it has to pay to raise that money is very sensitive to the credit ratings of the EuroZone countries. The downgrades to Austria and France call into doubt about 180 billion euros of guarantees to the facility from those two countries.

Before the downgrades the facility had about 250 billion euros left—after its support to Portugal and Ireland and the planned contribution to the Greek rescue plan—for backstopping Italy and Spain. That was terribly inadequate but with the Friday downgrades, the terribly inadequate has become even more so. And the size of the credibility gap between what would be needed to backstop Spain and Italy and what is actually available to backstop Spain and Italy will put upward pressure on the bond yields for both those countries.

Now you can imagine two very different reactions by the parties that have the power to actually intervene in this crisis—the European Central Bank and Germany—to Friday’s events. One possibility would be them to step up and say, Hey, we’ll do more to put this crisis to an end. The second possibility is for them to distance themselves and say, Hey, we’ve done enough and don’t expect more.

If you’ve been following this crisis, you know very well that only possibility #2 would be in character with these two players.

On the same day that S&P was announcing its downgrades the European Central Bank voiced its strong criticism of revisions to the draft of the fiscal discipline treaty that EuroZone nations had agreed to pursue back in early December. The revisions, which would allow heavily indebted nations to exceed budget deficit limits during an economic downturn would, the bank declared, amount to a escape clause that would make it too easy to get around the rules. The deficit limits, the central bank declared, should apply except in cases of natural disaster and any country running a deficit above the limit of 0.5% of GDP would be forced to bring its deficit within limits by an unspecified automatic mechanism.

Germany’s reaction to the downgrades from S&P was to emphasize that it would not raise its contribution to the European Financial Stability Facility, that the best solution to the limits of the facility would be to speed up the time table for getting a permanent backstop fund, the 500 billion euro European Stability Mechanism, into operation more quickly than the current June schedule, and, finally, to press ahead with the fiscal discipline treaty.

What happens now?

Either everything collapses quickly or the EuroZone puts off collapse until June or so. At which point, the hand of “The Curse of the Euro Crisis” thrusts out of the grave again.

Avoiding collapse will require

  • Negotiators for the fiscal discipline treaty getting a draft together in the next week or ten days in time to get the treaty ready for submission by the end of January deadline. Getting the treaty passed won’t be easy after that—opposition to the big transfer of budget power from national governments to the bureaucracy in Brussels has been growing. But the failure to even get a draft to the table on schedule would be a huge defeat for Germany and the European Central Bank

  • Greece and its private creditors must reach an agreement within the next month or so that will allow the International Monetary Fund, the European Union, and the European Central Bank to approve the next tranche of rescue cash in time for Greece to meet its March bond repayments. The agreement will have to be voluntary, by the extremely loose standards of the International Swaps and Derivatives Association; otherwise it would trigger the insurance features of credit default swaps and bond owners who had bought those derivatives as insurance against a Greek default would be able to collect. That would be fine for those who had bought such insurance but expensive for those who had sold it. Since no one knows how positions would net out and which banks and other financial institutions might be on the hook, the result would be a period of intense uncertainty as the accountants tried to match the two ends of all these deals.

  • The European Central Bank will have to step up its buying of Italian and Spanish bonds to prevent yields from climbing back near the 7% level that spooks financial markets. Spain and Italy face very large net refinancing in February.

  • Investors will have to buy the bonds of the European Financial Stability Facility at only modestly higher yields.

  • The markets will have to greet the next three-year offering by the European Central Bank in February with the same sense of relief that greeted the December offering. European banks are likely to add to the 489 billion euros they borrowed from the central bank in December. That month investors decided this was a good thing since it added needed liquidity to the banking system and removed fears of a liquidity crunch. In February investors will need to look past evidence that banks are borrowing and then quickly re-depositing the cash with the European Central Bank. Some might see that as a sign of how weak the EuroZone economies are and how afraid banks are. That attitude can’t become general or the central bank’s efforts will become a negative rather than a plus.

If all these things go right, the EuroZone will reach the end of January without a crisis and indeed might well finish the month with a sense of momentum and optimism. Look at all we’ve achieved, figures like Draghi and Germany’s Angela Merkel will say. The euro debt crisis might once again look like it was headed to an ending.

The problem is that this best-case scenario doesn’t actually defeat the euro debt crisis. Look at what will remain ready to resurface.

Deposits will continue to flow out of Greece and the Greek banking industry will require at least another 10 billion euros of recapitalization above what was in the October rescue deal

As the economy of Greece sinks further into recession, by April, I’d estimate, investors will see another round of projections from the International Monetary Fund saying that whatever deal struck by Greece and its creditors in January, wasn’t sufficient to put Greece on the path to sustainable debt.

Italy and Spain will confront a similar problem to that of Greece: as their economies shrink under the impact of recession, they will be forced to find even more budget cuts in order to retain even a pretense of meeting the budget deficit limits promised to the European Central Bank. The cuts are a necessity if financial markets are to be convinced to keep lending to Italy and Spain. But the problem of budget cuts slowing already slowing economies will become acute as the recession drags on and worsens.

The election schedule might be the trigger for the next stage in the euro crisis. Greece now looks likely to hold elections in April—rather than February—but the current caretaker government looks no more likely to win a later contest. The probable winner, the New Democracy Party, would be less committed to pushing austerity ad reforms than the current government. There’s a good chance that New Democracy would renege on promised reforms or refuse to meet new demands from Greece’s rescuers. The odds are high that one side of the other would walk away after the March refinancing is done.

And then, of course, there’s France where the S&P downgrade of the country’s AAA credit rating has done nothing to improve the electoral prospects of President Nicolas Sarkozy. The most likely winner in the elections that begin in April is Socialist Francois Hollande who is running against the current French-German policies on the euro debt crisis. (For more on the way the French election could change the politics of the euro see my post http://jubakpicks.com/2012/01/06/will-the-french-election-spell-the-end-of-the-euro-this-spring/

In other words as early as March but probably before June, the leaders of the EuroZone are likely to be facing the euro debt crisis again—and this time the discussion would center on a Greek default, the departure of Greece (and possibly other countries from the euro) and the shape (who’s in and who’s out) of a reconstituted EuroZone/European Union.

Investors could well see a period of calm in late January and into February. But it won’t be time to relax. I think “The Curse of the Euro” still has a few more plot twists to throw at us.

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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