The European Debt Crisis Redux

The half-life of solutions to Europe’s debt problem is getting ever shorter.

Recent hopes have relied on the ostensible success of the European Central Bank’s (“ECB”) LTRO – Long Term Refinancing Operation, more appropriately termed the Lourdes Treatment and Resuscitation Option. In December 2011 and February 2012, the ECB offered unlimited financing to European banks at 1% for 3 years replacing a previous 13-month program. Banks drew over Euro 1 trillion under the facility – Euro 489 billion in the first round and Euro 529.5 billion in the second. Participation amongst European banks was widespread, especially in the second round where around 800 banks used the facility.

The funds borrowed were used to purchase government bonds, retire or repay existing more expensive borrowings and surplus funds were redeposited with the ECB. The first entailed banks borrowing at 1% purchasing higher yielding sovereign debt, such as Spanish and Italian bonds that paid 5-6%. This allowed banks to earn profits from an officially sanctioned carry trade – known as the Sarko trade after the French President.

The LTRO provided finance for both beleaguered sovereigns and banks, which need to raise around Euro 1.9 trillion in 2012. It helped reduce interest rates for countries like Spain and Italy. It also helped banks covertly build-up capital, via the profits earned through the spread between the cost of ECB borrowings and the return available on sovereign bonds.

The LTRO was very clever, effectively monetising debt (printing money) without breaching European Treaties or the ECB’s charter.

The sheer weight of money – at one Euro 500 note per second it would take 63 ½ years to count Euro 1 trillion- proved successful. Financial market sentiment was overwhelmingly positive feeding a large rally in global stock markets and other risky assets.

As subsequent events have exposed, there were always reasons to be cautious.

The LTRO facility is for 3 years. It assumes that the conditions will normalise within that period. It is not clear what happens if that is not the case.

Economist Walter Bagehot advised that in a crisis central banks should lend freely but at a penalty rate and secured by good collateral. The ECB does not appear to have quite understood Bagehot’s commandment. The rate is below market rates, amounting to a subsidy to banks. The ECB and Euro-Zone central banks have loosened standards, agreeing to lend against all manner of collateral. In effect, the ECB is now functioning as a financial institution, assuming significant credit and interest rate risks on its loans.

If the European Financial Stability Fund (“EFSF”) was a Collateralised Debt Obligation, the ECB increasingly resembles a highly leveraged bank.

The ECB balance sheet is now around Euro 3 trillion, an increase of about 30 percent just since Mario Draghi took office in November 2012. It is supported by its own capital (scheduled to increase to Euro 10 billion) and the capital of Euro-Zone central banks (Euro 80 billion). This equates to a leverage of around 38 times.

Critically, the LTRO cannot address fundamental issues.

It does not reduce the level of debt in problem countries, merely finances them in the short-run. Europe is relying on its austerity program to reduce debt. As Greece demonstrated and Ireland, Portugal, Spain and Italy are demonstrating, massive fiscal tightening when combined with private sector reduction in debt merely puts the economy into recession. As public finances deteriorate rather than improve, it results in an increase not decrease in public debt.

Ultimately, it may be necessary to go Greek. Debt restructuring may be needed to achieve the required reduction in the public borrowings for many countries. Interestingly, financial markets price the risk of a Spanish debt restructuring at around 30-35%.

The LTRO does not improve the cost or availability of funding for the relevant countries beyond an immediate short term fix.

Government bond purchases financed by the LTRO artificially decreased the interest rates for countries, such as Spain and Italy. Unless additional rounds of LTRO are offered, interest rates are likely to return to market levels.

The real increase in liquidity available to support sovereign borrowings was lower than Euro 1 trillion. Perhaps only one third of the LTRO loans and maybe as little as Euro 115 billion were directed to this purpose. Banks used the bulk of funds to repay their own borrowings. As debt becomes due for repayment through the year, banks may need to sell sovereign bonds purchased with the funds drawn under the LTRO. Unless market conditions normalise and banks regain access to normal funding quickly, this will place increasing pressure on sovereign funding and its cost.

With European countries facing heavy refinancing programs in 2012 and beyond, the ability to raise funds at reasonable rates remains important. Existing bailout programs assume countries like Portugal and Ireland will be able to resume financing in money markets normally from 2013.

Events complicate the ongoing commercial financing of European banks and sovereigns. The need for collateral to support ECB funding makes other investors de facto subordinated lenders reducing their willingness to lend or increasing the cost. In the Greek restructuring, European Central Banks and official institutions were exempted by retrospective legislation from loss while other investors suffered 75% writedowns. This has reduced investor willingness to finance countries considered troubled.

European banks already have large exposures to sovereign debt, which has increased since the start of the LTRO. Spanish banks are thought to have purchased around Euro 90 billion, a jump of around 26% to Euro 220 billion. Italian banks are thought to have purchased Euro 50 billion, a jump of 31% to Euro 270 billion. A similar rise in government bond holdings has occurred in Portugal and Ireland.  As interest rates on these bonds have increased, buyers now have large unrealised mark-to-market losses on these holdings.

As with the sovereigns, the LTRO does not solve the longer term problems of the solvency or funding of the banks, which now remain heavily dependent on the largesse of the central banks. It is a government sponsored Ponzi scheme where weak banks are supporting weak sovereigns who in turn are standing behind the banks – a process which can be best described as two drowning people clinging to each other for mutual support.

The LTRO has not materially increased the supply of credit to individuals and businesses. The money is being used by banks to finance themselves as they reduce borrowings by selling off assets to reduce dependence on volatile funding markets. The LTRO does little to promote desperately needed economic growth in the Euro-Zone.

The initial euphoria faded as a number of concerns re-emerged, manifesting themselves in the form of increasing rates on Spanish and Italian debt which now hover around the key level of 6.00% per annum.

Increasingly poor economic growth figures from Europe pointed to a lack of growth and progress on debt reduction.

Attempts to reduce Spain’s deficit has proved problematic. Both Spain and Italy have deferred balancing their budget in the face of a deteriorating economic outlook. It is unclear which markets fear most -Spain and Italy not achieving its targets through savage spending cuts resulting in higher debt or achieving its target putting their economies into an even deeper recession and increasing debt.

The difficulties faced by both Spanish Prime Minister Mariano Rajoy and Italian Prime Minister Mario Monti in implementing labour reforms have highlighted the resistance to structural change. Increasing protests in many countries point to the political difficulty in implementing the agreed austerity measures.

The problems of the banking system have resurfaced. Spanish banks’ bad and doubtful debts have increased, as the Iberian property bubble deflates.

Increased reliance by Spanish and Italian banks on financing from central banks has heightened concern. Spanish bank borrowings from the ECB increased to over Euro 300 billion in March from Euro 170 billion in February. Lending to Spanish banks now accounts for nearly 30% of total ECB lending. Italian banks have also been heavy borrowers, a reminder of the linkage between banks and their sovereigns.

Reluctance to increase the inadequate European firewall sufficiently to deal with potential problems means policy options are limited. At around Euro 500 billion in available funds, the bailout fund is short of the Euro 1 trillion sought by the International Monetary Fund and G-20 or Euro 2-3 trillion thought necessary by financial markets. German leaders have repeated their unwillingness to increase the fund to the necessary size, arguing, probably correctly, that no firewall will be adequate.

Poorly judged and ill-timed comments by ECB President Draghi about the absence of need for further LTRO funding and planning for an exit drew attention to the fragility of the position and ongoing risks. The comments were driven by Bundesbank’s unease at the ECB’s policy. The market reaction forced Mario Draghi to retract comments about an early exit from emergency funding. As rates continue to rise, Benoit Coeure, the French ECB board member, promoted a new round of direct purchases of Spanish bonds to reduce yields.

The failure of the LTRO to decisively solve European problems is unsurprising. Confidential analyses prepared by European Union officials and distributed to ministers meeting at the Copenhagen meeting in March 2012 concluded that the Euro 1 trillion in loans was a “reprieve”, rather than a solution.

Rather than take the time afforded to move on other fronts, European leaders reverted to type. Spanish Finance Minister Luis de Guindos opined that: “We are convinced that Spain will no longer be a problem, especially for the Spanish, but also for the European Union”. It was eerily reminiscent of his predecessor Elena Salgado who almost exactly one year earlier on 11 April 2011 said: “I do not see any risk of contagion. We are totally out of this”.  The optimism was echoed by French President Nicolas Sarkozy who was confident that the Euro-Zone had “turned the page”. Italian Prime Minster Mario Monti stated that the “financial aspect” of the crisis had ended.

The European debt crisis is not over. Fundamental problems – debt levels, trade imbalances, problems of the banking sectors, required structural reforms, employment and economic growth – remain.

Beyond the German favoured remedy of asphyxiating austerity to either cure or kill the patient, Europe is rapidly running out of ideas and time to deal with the issues. As the real economy stalls and debt problems continue, the most likely policy actions may come from the ECB – an interest rate cut to near zero and further liquidity support, perhaps even full-scale quantitative easing. Bailout funds may be channelled to recapitalise Spanish banks, as a means of helping Spain without resort to a full-blown bailout package.

It is doubtful whether any of these steps will work.

European politicians and citizens want a quick return to a period Spaniards now refer to as cuando pensábamos que éramos ricos which translates to “when we thought we were rich”. Official policies and action are focused on deferring rather than dealing with the problem. Unfortunately, that means the inevitability of meeting the same problem somewhere down the road.

John Maynard Keynes observed in The Economic Consequences of the Peace that each action designed to bring closure to one crisis sows the seeds of greater economic, political and social problems. Europe is living the truth of that statement one day at a time.

10 Responses to "The European Debt Crisis Redux"

  1. Domenico   April 29, 2012 at 3:08 pm

    Great article. great site :))9

  2. LCR   April 29, 2012 at 9:02 pm

    It is said that children, in all their innocence, see more ideas from complexity then we give them credit. Often, they come up with rather "simple solutions" due to their ability to not be distracted by the clutter of data the adult mind must reckon with.

    "The LTRO facility is for 3 years. It assumes that the conditions will normalise within that period. It is not clear what happens if that is not the case."

    I can tell you that, as someone who understands BASIC debt principles and mathematics, with certainty, the following will happen:

    1. The EU will break up as the debt economies can not restructure under one currency. It is as sure as the Fed will destroy the US Dollar and Germany will stop mortgaging its future.
    2. The precious metals (silver and gold) will remains stores of value (money) as nation after nation devalues to keep exports alive.
    3. We will see mass starvation as the governments all over the world tax the people for revenue and there will be practically no money for compassionate charities to feed the homeless and poor.

    This is a guarantee, so people need to reconsider what they currently are exposed to in counter-party risk. All of Europe will suffer, if not Japan first. The US will implode later.

    • rodeneugen   April 30, 2012 at 7:21 am

      I wonder about the algorithm that brought you to these conclusions. In any case there is no need for mystification and no need to frighten people, if you want to do it, it is enough to speak about the Maya calendar and its prediction for December 2012, but do not do it in this forum i believe nobody will be frightened anyway.

      • LCR   April 30, 2012 at 7:37 pm

        Mystification? Are you kidding me? Frightening people? Are you frightened?

        The European Union and its Euro currency is a broken system from the outset, arranged by idealists without regard to human nature. Peripheral countries joined by hiding their debt and became enamored by the security of the currency. Leverage has been outrageous. If you have the time, read "The Tragedy of the Euro". History and the consequences of fiat currency is there for the eyes to see when not blinded by main stream media and neoclassical economists. I think you added nothing to in the forum to dispute my claims of catastrophe. Perhaps you could explain what plan B and C are in Europe. I would contend that LTRO to infinity is the plan, followed by revolution.

    • vrmcardoso   April 30, 2012 at 9:54 am

      Yes. And android dinosaurs, riding meteors, will rain down on the planet and kill us all with their laser farts.
      Got to love fatalists…

      • LCR   April 30, 2012 at 7:42 pm

        You may want to read about the Euro a little more prior to your dismissal. You too have added nothing to this conversation.

        • rodeneugen   April 30, 2012 at 11:43 pm

          Oh yes, now I got it, your algorithm you borrowed from Lenin “The end justifies the means”. Did you find already your follower, Mr. Stalin? If you are right, it is time to leave Europe, where destructive, self-imposed Gods, always found the way to mobilize the mobs for their cause, just to bring to them next day the worse atrocities and abuse of power, that with all the imagination of the humanity, nobody could even think of. Welcome to the gulags and the concentration camps. If you have to express yourself, why not sell some good lie about nice future? I hope that the mobs of today are much more sophisticated than you think, and will have the wisdom not to listen to this kind of revolutionary apocalyptic thoughts.

          • rodeneugen   May 1, 2012 at 12:05 am

            As to the subject itself, there are many ways prior to destructing the whole financial system and cooperation between the individual states, which was built gradually in the last 60 years and brought so much to Europe, just because some Greek politicians acted short sightly and without any responsibility.

            All this talk about human nature is repulsive. Who knows what is it human nature? Only self-imposed Gods. But even them, are successful only when historical turmoil brings an opportunity, and they exploit it without restrain.

          • LCR   May 1, 2012 at 7:54 am

            I am not selling anything. You will see the destruction (in Europe and the US) that debt economies must eventually go through when tapped out. It is well written in human history that savings and production expands an economy, something lacking in developed nations for a long time now. Spain has been financially ruined as was Greece. Nothing about modern technology changes the laws of basic mathematics and corrupt governments and banks can hide the numbers only so long. On this subject, the LTRO is a cover up. I don't know if there will be mass starvation where you live, but if you follow the historical context of these crisis, you can understand that this is not a random idea.

  3. george   May 5, 2012 at 9:29 am

    Satyajit. A suggestion for a future story. Most people do not realize the scope of the debt problem here in Canada where I live. For your information the following link will take you to a data table on the Statistics Canada (which is a Government of Canada agency) website which has a summary of the total credit market debt in Canada over the last 5 years. Please check out the 6th line from the bottom – Total funds raised equals total funds supplied, and how much this number is, and its rate of increase over the last 4 years.