Head Fake

The markets soared last week, in the aftermath of the European Summit, whereby the leaders of the Euro zone came to terms on how to deal with the on-going crisis. The problem was that no details were announced. The headlines focused on three major points. The first was the recapitalization of the European banks. The second was a “voluntary” 50% haircut for Greek bonds, and the third was the expansion of the European Stabilization Fund (EFSF) to €1 trillion. On the first point, the European Banking Authority (EBA) estimated the recapitalization at €106 billion, about a third of the original estimate. The lion share of the funds (52%) will be for the recapitalization of Greek and Spanish banks. The big surprise was that the large Spanish banks, particularly Santander, were not as solid as they advertised, and they would require huge capital injections. The other surprise was that the recapitalization of the French and German banks was going to be minimal, at €8 billion and €5.2 billion, respectively. This was very surprising, given the immense exposure of these two country’s banks to Greek sovereign bonds. Nevertheless, the failure to use mark-to-market accounting to address capitalization requirements means that bank regulators can be creative when concocting all possible scenarios to estimate adequate funding needs. Not surprisingly, the banks were pliant on the request to increase the Greek haircut to 50%. Many of the larger European financial institutions had already made provisions for such a scenario. At the same time, the European authorities were very accommodative on the recapitalization measures, allowing institutions to reduce the size of their balance sheets and liquidity facilities in order to meet capital requirements. Many financial institutions are also using swap operations with hedge funds and other asset managers to reduce their risk-weighted assets (RWA), thus allowing them to cosmetically improve their balance sheets. For the most part, regulators are looking the other way as banks use these sleight of hand operations. Therefore, it is not surprising that the banks were more than happy to accept a bigger haircut.

There was also lack of definition on the Greek haircut. The Greek delegation was not happy at all with the proposal, given that it will all but wipe out their banks. It is clear that the haircut will be voluntary, in order not to trigger a credit event—thus launching a tidal wave of Credit Default Swaps (CDS) claims. The larger haircut will include similar credit enhancements as the one that was announced at the end of July. This means that the Greek rescue package will be expanded to €130 billion. Despite the larger haircut, Athens will still be burdened with an unsustainable debt load of 120% of GDP. Surprisingly, there was no talk or discussion on how to make the Greek economy viable. On the contrary, statements issued by French President Nicolas Sarkozy revealed a great deal of frustration with the Greeks, and a suggestion that they did not merit being part of the Euro zone. Greece represents a huge question mark for the European Union. If it remains part of the Euro community, it is in for many years of fiscal austerity and wage deflation. If it will no longer be part of the group, it is in for a devastating economic and financial crisis, with an enormous potential for political and social unrest. Either way, the future is grim for Greece.

The details on the expansion of the EFSF were nebulous, at best. The leadership decided to increase the size of the fund four-fold, but it did not explain how it would do so. The €1 trillion figure that was batted around was just for headline effect. Even German Chancellor Angela Merkel admitted later in the day that she did not know what would be the ultimate size of the EFSF. It is not clear whether the fund will tap into the international capital markets, or convert itself into a bank so it can use the European Central Bank (ECB) liquidity facilities to fund itself. The markets rallied on the news, but it gave up some of the gains the next day. There are clear doubts about Italy’s future. Investors demanded a yield of 6.06% for Italian bonds during Friday’s auction. This was 65 bps higher than the previous auction and 200 bps higher than last year’s. With €300 billion worth of bonds to roll over during the next year and a government that is on the verge of collapse, the situation in Italy is untenable. Spain is not much better off. Despite the media fanfare about how it is doing everything right, Madrid cancelled the major privatizations that were in the pipeline and it will also miss its fiscal targets by a wide margin. Therefore, the European Summit was nothing more than a tremendous head fake, allowing the Eurocrats to buy a little more time. The problem is that the market is impatient and the day of reckoning is nigh.