If You Owe 300 Billion, The Bank Has The Problem

Remember one of the many summits when the bank representative "agreed" on a 50% haircut for Greece? Basically the banker was called into a room by Mercozy and bullying into saying "oui" (he is French).  Of course, he doesn't have any power to enforce this on the other banks but why let that get in the way of a good story.

Fast forward to today, guess what, maybe not all banks agree to "pardon" 50% (not to mention that many debt holders are not even banks and do not partake in these negotiations).  

Adding insult to injury, guess who is a major holder of Greek debt?

The price for naive expectations goes to Der Spiegel's reporter who wrote:

The Greek economy was supposed to slowly make its way toward recovery, with austerity measures taking hold and the debt mountain finally showing signs of shrinkage.

If you haven't checked our Back To The Future Section, it is time.

As for Greece, I'd say some will give them the money they need in March no matter what they do.

Calling A Spade A Spade

For a realistic point of view, call the Germans.  This article in today's Der Spiegel gives not only a nice History of the debt problem (as with any complex subject it is necessarily incomplete) but also recognizes the need for a painful solution.  Unfortunately, it will probably fall on deaf ears.  As anyone who has dealt with a budget knows, one thing is to say "we need to save" and another one is to forgo those "necessary" expenditures.

What Crisis? Spain Borrows As Much As She Wants

For all his claims of orthodoxy and credibility, it seems like  Draghi has picked up where Trichet left off.  Remember the Greek treasury auctions? In this operations the Greek treasury borrows "in the market" at 4.5%.  In reality, the Greek treasury sells the bonds to the Greek banks who in turn get the cash from either the Greek Central Bank (they still function AND, contrary to popular belief, issue currency) or the ECB.  The purpose is to maintain the fiction that markets are still working (Greek bonds trade at rates that go from 50 to 100%).

Today, as he declares he is against indiscriminate buying of government bonds, Mr. Draghi is indeed buying most of the much celebrated Spanish auction in the "hope" (a favorite financial term) that others will believe Spanish bonds are a good investment.

How is this done? The European banks (presumably heavily represented by the Spanish cohort) buy the debt at the auction.  Then, they turn around and pledge the same bonds to the ECB for cash.  Here is an article that describes the operation.

The problem, however, is that this does nothing to improve Spain's competitiveness and/or stimulate growth.  The point, on the other hand, seems to be to keep the banks alive until, by virtue of some miracle, the economy begins to grow again.  With borrowing rates this high, it is unlikely.

Why The European Plans Do Not Work

As we are writing this, equity markets around the world are having a euphoric session allegedly on a new-new-new European solution to the debt problem.  In this case, multiple solutions are being announced or rather disseminated with the usual glib by the press.  For instance, the story that the IMF is about to lend $600 billion to Italy, which has now been repeated around the world, conveniently neglects to mention that the IMF does NOT currently have 600 billion to lend.  Not to mention that 600 billion is an enormous sum of money, and thus, would give governments pause before it is approved (as opposed to go from theory to fact over a weekend).  After all, the much touted EFSF (the European Stabilization Fund) failed to even raise $3 billion in its last attempt (eventually they completed the offering by lending to themselves!)

The reason these plans haven't worked and are unlikely to work in the future (we use unlikely instead of the categorical won't since it is hard to prove a future negative) is rather simple, they are all based on the fallacy that says that the so-called European debt problem is a temporary phenomenon.  Thus, according to this line of thought, all that we need is for confidence to come back.  If confidence comes back, other people (i.e. not the IMF, the ECB or the EFSF) will buy Italian, Spanish, Portuguese, and Greek debt moving the clock back to 2007 when all these governments financed their borrowings via private investors (another name for other people).

The question the politicians fail to ask themselves is: who are these private investors, why did they stop buying and how likely are they to come back? Contrary to popular belief, most government  financing is NOT obtained by direct loans but rather by selling securities (bonds) in the open market to, mostly, institutional investors as diverse as global money market, pension, wealth management and other mutual funds.  These investors buy government bonds because they are deemed to be safe and NOT because of their potential high returns.  In that sense, perversely, the higher the yields go the less attractive the bonds are.  In particular, once a credit is tainted (i.e. deemed not safe) the risk-averse money market fund is unlikely to buy it at any price.  This is what has been happening for some time to European bonds as these links illustrate:

Japan's Kokusai bond fund drops Italy, Spain, Belgium

U.S. Money Funds Reduce Spanish Bank Holdings; Overall Euro Exposure Remains Significant

U.S. Money Funds Reduced Lending to French Banks by 44% in September

This process is relentless and ongoing, however, it will not grab any headlines because most journalists and politicians fail to understand how the global market works.  In any case, you can rest assured that the combination of all these types of investor are much bigger than the IMF and the EFSF (if it ever gets off the ground) put together.  Furthermore, it is not necessarily the case that these people avoid Italian bonds because they believe Italy is about to go bankrupt.  In fact, most of them believe something will be done, however they do not want to take the risk just in case.

The conclusion is simple, it took years for non-Italian investors to believe that Italian government bonds  were safe, they may feel so again in the distant future but not now.

Why Worry About Spain?

As the Spanish election came and went without any reprieve from the financial markets (why did anyone expect anything different is still a puzzle to us) we are being bombarded by financial articles asking why the markets perceive Spain as risky as Italy given that the former's national debt, at 61% is much lower than the latter's comfortably over 100%.

For instance, look at what Der Spiegel says today:,

Still, Spain is not just another victim of the euro crisis. The country's relatively strict banking regulations allowed it to survive the international financial crisis with only light damage. And in the current debt crisis, the Spanish have been model students: With a national debt at some 61 percent of gross domestic product, Spain lies far below Greece (145 percent) and Italy (118 percent) -- but also comfortably below Germany (83 percent).
"Even panic-mongers can't find terrible stories to tell about Spain," says Nicolaus Heinen, an analyst at Deutsche Bank. "The level of national debt isn't critical and important reforms have been put in place." But none of that seems to have helped. "The markets are now punishing any country vulnerable to even a whiff of doubt about contagion," Heinen said.

Except Argentina went bankrupt with a debt to GDP of 55% and Japan has already crossed the 200% barrier while comfortably borrowing, in Yen, at less than 1% for 10 years (the lowest borrowing cost in the world).

Markets are complex mechanisms which journalists, politicians, and investors often oversimplify with disastrous consequences. The reasons why Spain may be riskier than it looks are not too obscure, however.  First, Spain still has a budget deficit of about 9% which means the debt keeps growing.  In addition, it is well known (at least in Spain) that the so-called cost cutting measures are mostly comprised of forced financing from government suppliers (i.e. the government doesn't pay their bills on time) and other accounting gimmicks.  Second, unlike Japan, Spain runs a structural current account deficit, which means they need foreign financing.  Foreigners can be notoriously fickle in their risk perceptions.  Last, but not least, Spain's total debt (i.e including non-public) is at the level of Italy's.  The 61% quoted on the article above accounts only for the debt of the Kingdom of Spain (excluding the bills they do not pay which are not counted anywhere) and ignores the debts of the Comunidades Autonomas and other politically connected entities, like the local banks.  Ireland was at one point the country with the lowest debt to GDP ratio in the eurozone until they decided to bailout the banks. 

As we have seen recently in Ireland, the UK and the US, when the crisis comes and the politicians have to decide between bailing out a locally relevant entity (a bank, a state, a car company, or a defense contractor) and respecting the promises made to the bondholders, many of whom are foreign and, thus, do not vote, the latter don't stand a chance.

Where Do They Think The Money Comes From?

Nobody talks about the European bailout fund anymore (EFSF).  Apparently, only two weeks after the "historical" meeting in Cannes, the Europeans seem to have given up their dreams of having their debts paid by the likes of China, India and Brazil.  After all, how fair would it be for a country like India, where many leave on less than $1 a day, to bailout rich Italy?

Or have they? Someone said that politicians never change, only voters do.  They don't want to fund the EFSF? No problem, we have the IMF.  Never mind that the IMF is supposed to intervene as a lender of last result to bridge liquidity gaps during a currency crisis (Europe does not have a liquidity but a solvency problem and there is no currency crisis at this point).  The objective, as with all of these plans, is to separate non-European taxpayers from their money, preferably without alerting them first.

Listen what the president of the World Bank said yesterday (full interview in the link above):

The U.S. administration, in discussions with lawmakers, “will want to make sure that actually the taxpayer isn’t doing a bailout of Europe,” Zoellick said. “And I think the mechanisms through the IMF and others certainly can do that.”

If the IMF lends money to Italy and Italy defaults, the U.S. taxpayer is on the hook for about 20% of the losses.  Mr. Zoellick, like a good politician, excludes the possibility of default in order to make his solution look risk-less, it is not.

If you think this sin is unique to the World Bank, you may also think again.  The current debate about ECB intervention is similar.  Those who need the bailout and/or those who will not be responsible for the losses are trying to convince the German leaders to force the ECB into financing Italy, Spain, and the others in violation of its own charter.  Why not? they say, the ECB can print money and buy the bonds.  Is that it? Yes, if it works.  However, if it doesn't...

Germany has reason to be cautious. In the event that Italian, Spanish and other bonds had to be written down the way that Greek bonds were, Berlin would have to pay the most to recapitalize the bank. That would be tantamount to a backdoor bailout, a transfer of money from German taxpayers to cover the debts of other states without parliamentary approval.

 The ECB is prohibited from financing governments directly because the Germans made that clause a condition of their participation in the Euro.  The Germans demanded that clause because they knew this day would come.  Whether or not they decide to pay the Spanish and Italian debts it is up to them.  However, it would be nice if they were first consulted by the politicians.  Unless, of course, the politicians don't believe in democracy.

More From Those European Free Markets

Italy borrowed 5B euros from the market today.  How? They sold 1 year bonds (called bills).  Although the identities of the buyers are not disclosed, it is a fair bet that most of the bonds where placed in Italy with the local banks who in turn get financing from the ECB.  Incidentally, if this mechanism seems familiar, it is because Spain did the same last week.

In addition to providing liquidity to the banks, the ECB also intervened in the market buying existing Italian debt.  Why doesn't the ECB buy the debt directly from Italy? Because their charter prohibits lending money to the governments directly.  So the banks lend the money (via bonds) and the ECB lends to the banks by buying the same bonds, or others.

In addition, it is interesting to see that the rate of 6.09% was higher than the 4.5% Greece paid when they placed their bills.  Naturally, the financial press continues to parade the myth that these rates are freely determined by buyers and sellers by continuing to report that the auctions are oversubscribed. 

The truth is that neither Italy, nor Spain, Greece, Ireland or Portugal have a free functioning debt market any longer.  Even if the auctions continued to be scheduled and reported the investors who used to buy these bonds are either too scared or bankrupt.

caveat emptor