Saturday, June 16, 2012


The economic crisis in Europe has reached a crossroads, from which in all probability there is no return. The past many months have been empty debate when the situation has further deteriorated.

Governments depend for their financing on the sovereign bond markets, where they can refinance existing debt, and raise new debt caused  by deficit spending. Today bond investors are shunning these sovereign bond markets as they see unacceptably high risk or are asking interest rates that are so high as to be unaffordable for governments with mountainous debt levels.The Greek bail out and the cram down of bond holders also added a new element of risk that any new money from the Bail out funds would have a preferred status, thus driving away even more  bond investors. In short the bond market has taken away from the politicians the control over the situation as regrettably was forseen by many observers for years.

A similar situation exists for weaker banks, which can no longer raise equity capital and long term bond financing. Thereafter they  turn to their governments for assistance, which as explained above,  they are no longer capable of providing. Such banks are also shut out of the interbank short term financing market, where banks lend to each other. The degree of mistrust between banks is so great, that instead of lending to each other, stronger banks park their cash with the ECB. The amounts involved are staggering, recently approaching   EUR 800 Billion. The cash starved banks can obtain finance from the ECB but only on presenting  valid security for these loans. We have now reached the stage that these banks have pledged virtually all their assets already, and can offer no security in exchange for more cash. The famous LTRO of EUR 700 Billion last year enabled weak banks access cash, but doomed them in the market, where their share price collapsed, as it was a flagrant proof of weakness. Also when the bank used the cash to buy their sovereign bonds, the market now knows the further losses they incurred. For all these reasons a further LTRO 2 looks very unattractive.

Thus we have reached the stage where both soverign countries and their major banks have reached the limit of their borrowing capacities when their actual borrowing requirement increases exponentially, and as explained above the EU and ECB interventions while creating a short term fix have made matters even worse.

Although this crisis has been many years in the making, historians may well come to regard the weekend of the French and Greek elections as the turning point.

Mr Hollande was elected on a platform of reducing retirement age, giving sweet deals to bureaucrats, increasing spending to generate growth, and using other people’s money to pay for it. This of course appealed so much to the French electorate that Mr Hollande a man who has never  held ministrerial office, has taken the reins in France’s most difficult hour. He looks set to consolidate the socialist party power in this weekend’s local elections.

Meanwhile in Greece, the polarisation in politics has cannibalised the centre left and right parties and is making way for irreconcilable extremes. Austerity has slashed living standards for the ordinary Greek citizen, while many abusive anomolies remain. In hospitals the situation is so desperate that Cancer patients are no longer getting medication and the most basic hospital supplies are either rationed or not available. Many state employees have simply not been paid, and private businesses are shuttering their premises.

There is an election this weekend and at this stage it is to be hoped that whatever the errors of the past the country remains governable and does not degenerate into anarchy.

The financial situation in Greece has been debated to death. The economy is contracting, while the tax revenues are dwindling. The monies handed over to Greece have essentially been recycled  to bail out of the insolvent banks in Northern Europe. Virtually nothing remains in Greece. When the Greeks do not wish to play the game of getting even more indebted,  it was even proposed to hand the cash directly to the banks and send the Greek government the bill.

In Spain the true situation is increasingly coming to the surface. Firstly Prime Minister Rajoy said that Spanish banks had no problems and did not need any financial assistance, secondly Bankia reported a profit and a few days announced  later a whacking multibillion loss. Then Mr Rajoy reaffirmed that the problem could be handled in Spain, and a few days later went cap in hand for a EUR 100 Billion bail out, for the banking sector only.

Informed sources estimate the banking bail out, to cover primarily real estate losses,  alone should be of the order of EUR 400 Billion Then there is the problem of spendthrift out of control regions, and the funding of the massive social security commitments of a country where youth unemployment is running at over 50%. Stopping the latter payments could lead very rapidly to serious social unrest.

Spain has  in addition substantial commitments to various EU solidarity funds and also to the ECB. Estimates of its true Debt/GDP ratio is closer to an unviable 120%, pre bank bail out, to which should be added the projected deficits for the coming years

This is reflected in Spain’s cost of 10 yr borrowing at around 7% in today’s market. This is reported as excessive, which is simply not true,  When Spain borrowed in Peseta’s, interest rates were  much higher, which curtailed the borrowings.. Debt levels are the real problem.

In Italy where the EU nominated  Mr Monti to became technocratic Prime Minister, the situation is equally grim. The debt/GDP is approximately 180% but at least Italy does not have a colossal real estate bubble. However their banks also have shaky balance sheets and the economy very weak.

Italy also has  significant contingent liabilites to EU solidarity funds.and also to the ECB.

The inherent risks are reflected in 10 yr borrowing costs only slightly lower than Spain

In the past the commitments and contingent liabilites were never really considered by Governments as cash liabilities as nobody foresaw that they would ever be used. This is rather like an insurance company not collecting a premium and never expecting to have a claim. Now however all the signs are that each and every one will be called to the full and there is absolutely no cash availaible to meet these demands.

Each country has  also realised that the sooner you get in line for a bail out, the better your chances of not being asked to contribute to another country’s bail out.

The quickest way to achieve this is to make sure one of the country’s too big to fail banks has a run on funds, a crashing share price and is on the edge of bankruptcy. At that point the Government will promise to bail out the bank and run cap in hand to the EU for funding, and announce oh by the way we also need cash for the other banks.

Spain has outmaneuvred Italy very effectively leaving Mr Monti fuming. When the Austrian finance minister suggested that Italy may be next, he furiously denied it. “Methinks he doth protest too much” – Shakespeare

We are also seeing Slovenia and Cyprus threatening to join the queue

What Monti does know is that with Greece, Portugal, Ireland, and Spain and potentially Slovenia and Cyprus out of the game the burden falls on those left standing. Italy on its own may just survive but is in no position to shoulder its share of the burden imposed by others.

Thereafter France with high Debt/GDP ratio, increasing deficit spending, massive EU  contingent liabilities, and  its domestic banks overcommitted to Spain, Italy and Greece, could go under overnight. Mrs Merkell has strongly criticised France today for its present policies as she rightly fears a situation where France, instead of being an ally becomes yet one more liability. 

There is  no way Germany virtually alone could redress the situation. The amounts of money required to rectify the situation are vast. Germany would have to take on massive debt burdens much higher interest costs and lower its standard of living to that of the EU average, while continuing to work much harder and being far more productive. This is a tough sell to a teutonic electorate, already  widely disliked by those they would help.

The extraordinary thing, never mentioned by the EU political elites, is that even if the slate were wiped clean, the imbalances which created this mess, differing productivity, same exchange rate, same interest rate for all, would create the problem all over again.

In summary, sovereign states have  run out of cash simultaneously  and cannot access the credit markets on acceptable terms for the amounts needed. The major banks with few exceptions are in the same situation.

The EU rescue mechanisms ESM/EFSF  meant to save individual states in difficulty are largely unfunded, and there is no legal and political agreement as to how the funds should be deployed. Even if totally funded  they are perhaps adequate to deal with Greece and Portugal,  but are completely completely overwhelmed by the scale of the problem posed by Spain, Italy et al.

This in financial parlace is “Contagion” but in reality  it simple arithmetic. These numbers have been known for years. The problem is that the philosophy of “extend and pretend “ so loved by politicians, has its limits.  Ultimately it transitions into “lie until you die”  which is where we are today.

The problem has never been Greece despite all one reads in the media, contagion has always been the problem. Contagion can only happen when all the others are only slightly stronger than the weakest link.

At some point very soon this festering situation has to explode and when it does Europe and probably the world will never be the same again. 

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