The Outlook For A European TARP
October 17,
2011
What Winston Churchill said about America, that it
can be counted on to do the right thing after it exhausts the other
alternatives, seems equally applicable to Europe. It is slowly but inexorably
moving toward its own version of TARP—the U.S. “toxic asset relief program”.
Rather than sub-prime mortgages and related derivatives, the toxic assets in
Europe are sovereign credits, which in some cases is a function of the
nationalization of private sector debt.
Although Slovakia provided some last minute drama,
policy makers and investors were already anticipating the approval of the
reforms of the European Financial Stabilization Fund (EFSF) and looking beyond,
toward implementation. The shift in the focus has helped spur a bout of
position-adjusting.
Euro
As illustrated by the net non-commercial positions
at the IMM, the short-term momentum and trend-following market had amassed a
large short euro position from late August through early October (the largest in
a little more than a year). For the better part of two weeks, the euro has been
trending higher as these shorts have been covered.
As noted in an earlier post, the euro-dollar
exchange rate is the most correlated (rolling 60-day, percent change) with the
S&P 500 as it (or its synthetic) has been since at least the early 1990s.
The euro-dollar exchange rate is also near its highest correlation, with 2-year
U.S.-German interest rate differentials as well. The Fed’s promise to keep rates
low until at least mid-2013 takes some volatility out of the U.S. 2-year yield,
so the spread has tended to be more a function of the German side of the
equation.
There are two main drivers of short-term German
interest rates. The first is economic data. The eurozone economy has slowed down
markedly from Q1, including the German economy. The unwinding of at least one of
this year’s two rate hikes is likely by the end of the year (we suspect December
when the new ECB President will have revised staff GDP and inflation forecasts
to guide the decision). This has arguably helped lower 2-year German rates.
The second force, investors’ embrace of Germany as a
safe haven, seems the stronger of the drivers. As the debt crisis increased in
intensity in September and early October, the demand for German paper grew. The
German 2-year fell to record lows in late September near 32 bp. During the bout
of position adjusting, the German yield has more than doubled and the premium it
offers over the U.S. has doubled from 20 bp to 40 bp.
There is scope for additional positioning in the
coming days, ahead of the October 23 EU summit. The next technical objectives
are found around the $1.4000-50 area. Given the extreme market positioning and
the right noises coming from European officials, the data stream suggests that
the world’s largest economy has accelerated since mid-year rather than slowed
further. This could propel the euro and overshoot these technical targets.
Europe’s Tarp
Germany and France appeared to have a “eureka
moment”. International pressure/criticism is mounting, investors and businesses
fear a financial apocalypse, a political backlash is evident in Germany
throughout the year in state elections, and the Socialists winning control of
the French Senate for the first time in the Fifth Republic. Merkel and Sarkozy
have promised a “durable” fix. Market participants are in effect buying the
rumor of new measures and could very well sell when it becomes news.
The incrementalism of European officials through the
crisis is partly institutional in nature. It is a congenital defect, but one
that made the birth possible in the first place. Eurozone members
surrender/abdicate monetary policy but have thought they maintained economic
sovereignty. This crisis is shattering that illusion. The kind of closure that
investors want is institutionally prohibited in the eurozone.
There are three key components of the “durable” and
comprehensive plan that Germany and France will likely present at the summit.
First, it needs to find a more sustainable solution for Greece. Second, it must
come to terms with the fact that some systemically important eurozone banks may
need to be recapitalized. Third, it will likely propose ways to bolster the EFSF
without members having to go back to parliaments to request more funds.
We have maintained consistently since the crisis
began what is now becoming clearer to officials: That bondholders would have to
eventually accept 50%-70% haircuts on Greek debt. The 21% haircut plan of July
21 was seen by many as only a partial down payment. Many, but not all, large
European banks wrote down their Greek exposures by 50%. Several of those banks
that provided reserves for 21% have come under more pressure recently. Some
press reports suggest that German banks are preparing for 60% haircuts.
The ECB is the single largest holder of Greek
government bonds. However, it refuses to participate in the “voluntary” scheme
to make investors share some of the burden of adjustment. This means that the
haircut needed in the private sector is actually larger the more that the ECB
owns.
In any event, European officials hope that the
larger haircut can re-establish a firewall around Greece and suggest that there
won’t be other sovereign debt restructurings. This is one of the Achilles'
Heels. If Greece can walk away from 50-70% of its debt, why shouldn’t Portugal
and Ireland, not to mention Belgium, Spain and Italy, not seek some relief?
The EFSF’s institutional successor is the European
Stability Mechanism (ESM), which was supposed to allow for orderly sovereign
debt restructuring. It is supposed to come online in the July 2013, but there is
movement among some eurozone officials to bring it forward by a year.
Recapitalizing Banks
If sovereign bond holders are going to “voluntarily”
take substantial losses to avoid a Lehman-like debacle, some assurances are
needed that banks will be recapitalized. How eurozone officials do this, given
the conflicting positions of key stakeholders, may be another Achilles' Heel and
prompt skepticism by the capital markets.
In the United States, banks appear to have been
largely told how much capital they were going to request from the Treasury,
which provided the same terms to everyone, the innocent and guilty, those that
may have needed a capital infusion and those that may not have. It directly
injected money into the banks, not by buying the distressed assets as initially
conceived, but providing permanent capital in a way that also protected
taxpayers. It avoided the ideological problem of the government having a vote on
the bank boards, by acquiring preferred shares and long-term warrants.
Lacking sufficient institutional mechanisms, Europe
is unlikely to duplicate the U.S. process and results. A greater burden is
likely to fall on the members of the eurozone themselves. Of the core members,
France is seen as in a particularly disadvantageous position relative to
Germany. This helps explain why as the bank recapitalization talk increased and
the euro appreciated and the basis swap (price of swapping euros for dollars)
fell to four week lows, the spread between German and French 10-year yields
widened to new EMU-era highs.
In fact, the correlation between the euro and the
10-year Germany-French spread has been inversely correlated (60-day rolling,
percentage change), since the Greek debt crisis first flared up in late 2009.
However, since early September inversion has become significantly less (from
-0.55 early September to -0.22 in mid-October).
The greater the breadth (number of systemically
important financial institutions covered) and depth (size of capital infusion)
and more European (federal) the backstop for eurozone banks, the better the
chances of success. European officials risk greater instability if a stigma is
attached to participation (which is the advantage of forcing all critical
institutions to partake). European officials also risk under-whelming the market
if the proverbial bazooka turns out to be a water gun and officials fail to
commit an overwhelming amount of resources. An ability to lift the burden from
strictly national finances risks exacerbating the credit pressures on countries
such as France.
EFSF
This is where the EFSF comes in. It can be used to
help countries recapitalize their banks. There are various approaches that have
been proposed, but the institutional and political constraints suggest that an
insurance model may very well be the path of least resistance. By partially
guaranteeing some part of new sovereign issuance, the EFSF would achieve the
leverage that is necessary to ramp up the 440 billion fund without requiring new
parliament votes.
The insurance model likely means that it will not be
able to buy sovereign bonds in the secondary market as some have proposed, which
would relieve the ECB of this unpleasant task. While some at the ECB may not be
pleased, its continued involvement is an important element of support the
financial system. Yet, paradoxically, the more success eurozone officials have
at next week’s summit and at the G20 meeting in early November, the less the
ECB’s purchases of sovereign bonds will be needed.
At the start of the debt crisis, there were powerful
voices in Europe that opposed a role for the IMF. Those voices were ultimately,
of course, outvoted and the IMF has played a significant role (and provided
roughly 1/3 of the capital in the aid programs). Some European officials now
seek an even greater role for the IMF.
The IMF’s Lagarde indicated last month that the
Fund’s $390 billion in current lending power was insufficient for the demands it
may face. Yet many key contributors are reluctant at this juncture to agree to a
new capital raising exercise by the IMF. This may change if and when new formal
requests for IMF programs are requested. Several of the large developing
countries reportedly are more interested than, say, the U.S. and U.K. and this
could lead to realignment of power within the IMF in the coming years.
Lastly, policy makers seem to believe that by
focusing on repairing the financial system, they will win back the confidence of
investors. Yet we suspect it will take more than that, while recognizing that it
is no simple task either. The real challenge is the underlying source of the
debt crisis, and one that remains un-addressed and off most radar screens:
Sustaining aggregate demand. Debt allowed aggregate demand to be sustained in
the face of weak wage and salary growth. What is going to replace it?
