The market is relatively stable overnight and this morning. Yesterday we traded in fits and starts with brief moments of concern that Friday’s sell-off would continue and brief moments of hope that Europe was going to do something to fix the situation in Europe. Trading was on light volume and liquidity seemed low as gaps of five points on the S&P 500
seemed the norm.
With the UK shut for a second day due to the Queen’s diamond jubilee, there isn’t much of a read on credit markets in Europe. Spanish and Italian 10-year bond yields are better for the fifth day in a row in the case of Spain. Five-year yields are more mixed and CDS, without London, is effectively shut. Here in the US with futures hovering around fair value the credit indices are stable with IG18 1 wider and nearing the 130 level, but HY18 is finally outperforming and actually up an one-eighth of a point. High yield managed to squeak out a small win yesterday in ETF land with HYG
both up, and the
EMBI index had some real strength. This is in spite of continued outflows from the funds, though with the ETF’s now trading at less than a 1% discount we may see any arb driven activity slow.
Is the German Pot Calling the PIIGS Kettle Black?
We seem to get the daily barrage of messages and soundbites out of Germany demanding that countries stick to existing plans and that “austerity” is the only way forward. Germany continues to love to point the finger at the other countries; it accuses them of borrowing too much and says they need to suck it up and pay what they owe. For now we will ignore the fact that Germany itself was one of the first countries to break the Maastricht Treaty. What Germany seems to be forgetting is that it jeopardized its own credit quality. With bunds at record lows, this may not be obvious, but for the past two years, Germany has been throwing around guarantees and commitments like they mean nothing.
I have argued since the beginning that all these guarantees were dangerous. Guarantees are more dangerous than CDS since it is truly impossible to figure out how much debt has been guaranteed or how likely the guarantees are to be honored. Zerohedge and Mark Grant (among others) have done a lot of work on the true size of various countries’ obligations. Here is an estimate of what Spain's real indebtedness is
from Zerohedge. I don’t completely agree with the numbers, but the point is extremely valid. Looking at just the debt outstanding for these countries is very misleading. Some account of their off-balance sheet, unfunded commitments and obligations needs to be taken into account.
Which brings us to Germany. Germany is the ultimate backstop and seems to have forgotten that debt exists in two states.
Debt Is Either Repaid or It Isn’t
There are only two outcomes when you lend money. You either get repaid what you lent based on the original contract or you don’t. It doesn’t matter why you don’t get paid what you expected, whether it is because of forced redenomination, restructuring, or default. What matters is that you don’t get paid.
So while Germany is drawing a line in the sand, they seem to have forgotten the borrowers have two choices. Germany seems to be under the impression that no matter what they say or do these other countries will pay their debt. That Germany can cave in and let the other countries spend and grow and let the ECB provide immense liquidity and get paid. Or that Germany can remain firm on austerity and a deal is a deal rhetoric and still get paid back. But what if they are wrong?
What if at some point Greece, or worse, Spain or Italy finally say they have had enough of the finger pointing and blame game and are going to redenominated and stop certain payments altogether?
How Much Is Germany on the Hook for at the ECB?
If countries are leaving the euro and the ECB is no longer going to be their central bank, the bonds held by the ECB in the SMP portfolio will be hit. With over €200 billion of SMP bonds, a 40% loss due to redenomination seems reasonable. That is an €80 billion hit to the ECB. The ECB cannot handle a loss of that size without either printing massive amounts of money or making a capital call on the member states. It would be ironic and nonsensical to print money to fund the loss, since the ECB could have printed less money and not had the loss in first place. On the capital call side, obviously the PIIGS aren’t making it. I think a lot of the other smaller members may choose not to as well, since the ECB is joint and several. I’m not sure even France would participate. The uproar in France that Germany drove the situation to this point may be enough to get them to demand that Germany pick up the lion’s share of the tab?
Then what happens to all the bonds being held at the ECB via LTRO and other facilities? The ECB holds government bonds, they hold bank bonds guaranteed by the government, and may even hold bank bonds outright. They will need to make margin calls on these facilities. Will all the banks be able to meet the margin calls? No. The weakest banks have already used the LTRO more than other banks. They are extremely leveraged and have no money left to meet those margin calls. If any governments had provided guarantees on their debt, now would be a great time to revoke those. Why take more losses for a bank that’s going down, when you can change the law and jam the loss onto the ECB?
I find it hard to believe that the losses at the ECB won’t be at least €100 billion and could easily be more. The liabilities are joint and several but could fall heavily on Germany.
How Much Is Germany on the Hook for via the EFSF and EU and IMF?
The EFSF has €110 billion of debt outstanding. That money in theory has been lent out to various countries. The EFSF will have losses and I expect those losses would be greater as a percentage of notional than the ECB’s since more of the EFSF exposure is to Greece where the losses will be highest. In theory Germany is only obligated to make good on their “portion” of the debt. But if they do that, will other countries honor their commitments? I cannot imagine Spain and Italy will make payments on the debt that is outstanding even though they are guarantors, once they have gotten to the point of leaving the euro.
While Germany may decide to pay the ECB money regardless of the cost, it might be easier to let EFSF bond holders take losses rather than adding more debt and taking on more responsibility than they are legally obligated to pay. The EFSF bonds remain horribly overrated as they don’t account for how likely the guarantees are likely to be revoked or not paid when called upon. The EFSF will only make calls against guarantees once the situation has turned nasty, so the rating should reflect that. If you believe the countries are going to leave the EU, the EFSF bonds are a great short.
There are EU direct loans. More losses for Germany and France. There are costs of running the EU, to the extent one still exists. More of those expenses will have to be picked up by the remaining members (somehow it feels like there won’t be any remaining members once this process starts).
The IMF is likely to come out best in terms of any loss on existing holdings, partly because they have been more conservative in their lending practices, but mostly because the countries will need them to provide additional loans after they exit.
I almost forgot the European Investment Bank (EIB) and European Bank for Reconstruction and Development (EBRD). Hard to believe that this won’t create more demands for money from Germany? Possibly small, but the hits against Germany are starting to add up pretty quickly.
How Bad Will German Bank Losses Be?
The partially state owned bad bank, Commerzbank
had big write-downs in Greece. Hard to imagine that they avoided even taking bigger exposures in Spain and Italy. Then there are the German worse banks or landesbanks. They had some of the largest exposures to Greece. It would be simply shocking if they didn’t have even bigger exposures to Spain and Italy.
These banks had enough “capital” or government support to make it through the Greek PSI process, but can they withstand hits of 10-50% on their Spanish and Italian holdings? I highly doubt that without another huge infusion from the German government.
Then what about Deutsche Bank
(DB)? By far it is in the best shape, but maybe you remember they were the first bank that Spain provided verbal guarantees in respect of regional debt. Why would Spain possibly honor that guarantee when they are abandoning the euro and need all the money they can spare? What is Deutsche Bank going to do? Repossess Catalonia?
The PIIGS will all walk away from any guarantees they have made. That is even easier than stopping payment on bonds or forcing through a new currency. This will hit banks more than countries, but the losses may be so big that it makes it back up to the country level.
How bad is the Target2 hit?
I have read a decent amount on this and remain confused. At one end, are arguments that the risk is massively overstated and losses would be minimal. Frankly I have found those articles rely too much on the same hope that was evident during PSI, where ECB bonds get paid par, because that’s what they get. I think once countries are in full on exit mode, niceties like that will be thrown out the window. At the other extreme is arguments that the full size of Target2 balances would be at risk. Those articles honestly seem to be more realistic.
Target2 could cause more massive losses, and at the same time could force trade to grind to a halt. I think the trade disruptions in any case will be critical and the Target2 system breaking down would add to that problem.
Countries in Glass Houses Shouldn’t Throw Stones
No wonder Josef Ackermann came out in favor of more support for Europe. He has the good sense to see how bad this is. I have focused on Germany here since they alone seem to believe that they can push the situation to the brink, get paid, and have no trouble, but if the defaults start (whether payment defaults or currency redenomination) then France and the other countries will be hit hard. France has its own set of Dexia guarantees and who knows what exposure their banks have to Spain and Italy?
Editor's Note: For more from Peter Tchir, check out TF Market Advisors.