While Top Bank Fiddles, Europe Burns

11/22/2011 8:00 am EST

Focus: GLOBAL

Jim Jubak

Founder and Editor, JubakPicks.com

The new head of the European Central Bank seems as reticent as other leaders, even as the crisis puts France and Germany at risk. It doesn’t have to spread—but will it?

Mario Draghi’s Friday speech at the European Banking Congress was the most depressing and frightening thing to come out of the European debt crisis since George Papandreou, then Greece’s prime minister, said "referendum" and scuttled October’s deal to rescue Greece.

In Frankfurt, Draghi—the new president of the European Central Bank—pushed back against Eurozone politicians who have pleaded for the bank to become the bond buyer of last resort. He asked, "Where is the implementation of those long-standing decisions?"

By that, he meant, why is the European Financial Stability Facility, the Eurozone’s bailout fund, still unable to intervene, 18 months after it was established and four months after Eurozone leaders voted to expand its 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.

OK, good question. The delay is unconscionable in the midst of a crisis. 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 was 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But calling on the European Financial Stability Facility now is scarily out of date.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 dominoes falling? By the time the facility is up and running, it will be just about useless.

A Fund That Falls Short
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 Eurozone crisis.

If Draghi doesn’t realize this—if his speech in Frankfurt was anything more than an attempt to get politicians off his back—then the European Central Bank 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 to do the job—even if the fund were able to get on with the job.

But the real problem is in the structure of the fund as it was set up in May 2010 to address the first Greek crisis. Because Eurozone governments were unwilling to put real money at risk in the facility, they built a row of risk dominoes. And once one domino falls, it only becomes 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.

Because 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, and Fitch. That meant that the facility could sell its bonds at a low interest rate, so 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 weaker countries such as Ireland and Portugal.

But with all the advantages of that arrangement for politicians—who didn’t want to tell taxpayers to take money out of their pockets to support the bonds of other Eurozone members—there were some potential problems. They would become apparent as the crisis spread to pull in other countries.

NEXT: Now the Dominoes Fall

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Now the Dominoes Fall
Only as the crisis has progressed—and maybe really only now that it threatens Italy and Spain—has it become clear that setting up the European Financial Stability Facility in this way was akin to setting up a row of dominoes, where the tipping of one domino threatens to take down the next and the next and, maybe finally, all of them.

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 a share of the group guarantee behind the facility.

Or at least they did until they needed 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 rescues, 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 dominoes. The bond markets are starting to worry about Belgium. Standard & Poor’s has warned that France is getting overextended, and that its AAA rating might be in danger.

Euro Ties Are Trouble
Two big effects from this process make me worry about 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 of bonds for the Irish rescue, yields for the ten-year issue climbed to 3.591%, and demand was barely over the size of the issue.

Yields weren’t hugely higher than they had been for the June 15 issue of ten-year bonds at 3.49% by the facility for Portugal—although Ireland is a much better economic risk at the moment than is Portugal. But demand in the earlier auction had been much higher, with bids of €8 billion when the auction size had been just €5 billion.

And second, the concentration—or actually, the potential concentration—of guarantees has 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 ten-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 lending to those governments, something peculiar has been going on with German bunds.

Bunds now yield 0.2 percentage points more than ten-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 UK gilts has been narrowing. Looking only at government finances, that doesn’t make much sense.

The current budget deficit in the United Kingdom is 8.8% of gross domestic product, 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 UK.

The only reason I can think of for this narrowing of the yield spread between UK and German ten-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 so far. The German central bank, the Bundesbank, is the main guarantor behind the bond-buying program of the European Central Bank. That’s an additional €180 billion.

The European Central Bank now holds a lot of Greek, Italian and Spanish debt. If that debt falls in value, member central banks will be left holding the bag—and that means Germany.

The risks to Germany, and the limits of Germany’s ability to support the European Financial Stability Facility—and, thus, of the power of the facility to address the crisis—have just begun to enter the consciousness of Eurozone leaders.

Comments like that of Eurogroup head Jean-Claude Juncker last week are therefore still shocking. Juncker told a German newspaper that Germany is no longer a sound credit risk. "I think the level of German debt is worrying. Germany (with government debt of 82% of GDP) has higher debts than Spain," he said.

NEXT: Why Won’t the ECB Act?

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Why Won’t the ECB Act?
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 have moved during this crisis. I sure hope so.

Surely he can do the math and figure out what the markets know—that the dominoes 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 pulls in Germany, where does it end?

What’s needed now in the Eurozone is a strong dose of reality delivered to Germany and the European Central Bank. Old solutions—even those dating back only to July or October—won’t work. The core of the Eurozone isn’t above the crisis. And time to fix this is getting very, very short.

I’ve been encouraged in the past 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, 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 here.

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