Sunday, November 13, 2011

A Short History Of European Union

Gonzalo Lira has put together a somewhat simplistic guide to the crisis in Europe with a reference eventually as to how it will affect us in Europe. I don't think it can be cured with fifty billion Euros in quantitative easing nor do I think it will take very long at all for the contagion to spread to US banks. For the longest time I have expected failure in Greece because every "expert" ever interviewed based his/her predictions on Greece sorting out the mess and it has been patently clear forever that the Greek debt can't be straightened out. So crisis it must be.

In 1999, the Europeans implemented a common currency, the euro. They did it in order to improve trade between the eurozone nations, and thus bind the European countries closer together.

This new currency was centrally managed—that is, there was a single issuer of this new currency. Which of course makes sense: In the United States, you don’t have 50 states issuing currency—you just have the Federal Reserve, issuing dollars for the entire country.

Same with Europe: Thus the eurozone—the zone of countries that had the euro as their currency. This new currency was managed by the European Central Bank—the ECB—out in Frankfurt, Germany. The ECB’s primary concern—like all central banks—was making sure that the currency it was supervising did not lose value. That is, it made sure that inflation stayed below 2% per year.

However, just like in the U.S., though there was a central bank—in this case the ECB—each of the member states of this European Money Union (from where we get the acronym “EMU”)—could issue its own debt.

So far, so good: The euro was printed and managed by the ECB in Frankfurt. The individual countries—Spain, France, Germany, Holland—could each issue their own debt, and of course manage their own government budgets.

Now, the strongest economy in Europe is Germany’s. For our purposes, the reasons why of this don’t matter. What matters is, Germany’s cost of borrowing was the lowest of the eurozone.

This makes sense: If I make a million bucks a year, and borrow $10,000 for expenses and stuff, I’m going to get a pretty good interest rate from my credit card company or my bank. You know how lenders are: They lend you an umbrella when it’s sunny, then take it away when it rains. Since I don’t need to borrow the ten grand, all the lenders will trip over themselves to lend me money at extremely low rates, because they know I’m good for it. I won’t default on the debt.

Same with nations—and same with Germany: German debt was always cheap, in the 1%–3% range, because Germany was good for it. After all, it’s the fifth largest economy in the world, and the biggest within the eurozone, racking trade- and fiscal budget surpluses year after year. So who wouldn’t feel comfortable lending money to the Germans? Nobody—‘cause see the Germans? They pay up—always.

But here comes the problem: Banks felt very comfortable lending money cheaply to Germany. Germany was a member of the eurozone. Therefore, lenders assumed that the other countries in the eurozone were going to be as good a credit risk as Germany.

So the banks lent money to the other, weaker countries in the eurozone at the same rates of interest as they lent to Germany.

Yeah, I know: !!!

Imagine you have a great credit rating—so the bank gives your kid a $100,000 consumer line of credit, just because he happens to live in the same house as you do. The bank lends your kid the money because it says there’s a “tacit promise” that if your kid doesn’t pay back the money, you will.

Crazy, right? Right—but that is the core problem: Countries like Portugal, Italy, Ireland, Greece and Spain—countries whose initials spell out the acronym “PIIGS”—could go into debt at the same rates of interest as Germany, just because they shared the euro as a currency.

The economies of the PIIGS were not as sound as Germany’s—but the lenders treated them as if they were. Not only that, the lenders assumed that, if any country got into trouble—i.e., if any one of the PIIGS couldn’t pay back their loans—the eurozone as a whole would be good for the debt.

This was great for the PIIGS. Because it meant cheap and plentiful loans, with which they could go out and buy stuff.

So they did: The PIIGS went into debt—too much debt—while the banks gave them all the slack they needed. Which makes complete sense: If before 1999, these countries were borrowing at (say) 6% or more, and all of a sudden their cost of borrowing drops in half, what will they do? Go into debt!

Which is what they did—massively.

And what did these countries do with the debt? Create a false sense of prosperity!

This in a nutshell is what happened between 1999 and 2010, when the Greek crisis first erupted: During those “boom” years (which were really no more than junior going crazy with the credit card), the various countries of the eurozone went into massive debt, in order to both fund a social safety net, and cut taxes on their citizens.

In other words, something for nothing, bought and paid for with cheap debt. Kind of like America . . . —but that’s for another time.

Though they now don’t want to admit it, the Germans encouraged this over-indebtedness, by the way—as did the French. Why? Because with this false sense of prosperity, the over-indebted nations bought German and French goods and services. German and French banks were at the forefront of lending money to the PIIGS—which essentially made the whole scheme nothing more than vendor financing on a massive scale: I lend you money so that you can buy my products.

Just like a junkie setting up an addict, or a predatory credit card company giving you teaser rates, the Germans and the French—via their banks and government institutions—gave the weaker economies all the incentive in the world to go into massive debt, and then go out and buy German and French products.

It was bound to end in tears. As is happening now. It all goes to the issue that all these countries are over-indebted. And that overindebtedness is being reflected in the sovereign bond markets.

Let’s take a slight detour, to explain what this means.

What Are Bonds? What Are Yields? And Why Do They Matter?

A bond is a bit of paper that is traded, just like stocks. But unlike a stock, which is a piece of ownership in a company, a bond is essentially a promissory note: You lend me money, and I give you this piece of paper where I promise to pay you back. The bond has a face value, and an interest rate. The person who buys the bond at the market price collects the interest, and receives the principal of the bond on maturation. A person can own a bond, or sell it to someone else, just like a stock.

Corporations issue bonds, in order to finance factories, expansion, whathaveyou. And governments issue bonds, in order to finance various infrastructure projects, as well as their deficit spending.

With all bonds, there are three pieces you have to understand: There is the face-value of the bond, there is the interest that the bond pays, and then there’s the effective return-on-investment of the bond—which is known as the yield.

The yield of a bond is what everyone pays attention to. The yield on a bond is a percentage value: It is the interest rate of the bond, times the face value of the bond, divided by the current price of the bond. The yield is inversely affected by the price of the bond: The higher the price of the bond, the lower the yield, and vice versa.

So you see, it’s a seesaw: When the yield of the bond is going up, then the price of the bond is going down. When the yield is going down, then the price of the bond is going up.

Let’s see an example: Say I sell you a bond for €1,000, paying 5% interest per year. The bond is trading in the open markets at €900. So 5% times €1,000, divided by €900, equals 5.55%—the yield has widened, as they say in the biz. That is, the yield has gone up, since the price of the bond has gone down.

But say instead that the bond has risen in value, which of course can happen: Say the price is up to €1,100 per bond. So 5% (the original interest) time €1,000 (the face value), divided by €1,100 (the current price, gives us a yield of 4.54%. The bond’s yield is said to be narrowing.

Since bonds all have different conditions insofar as maturation, interest rate, etc., it is simpler and quicker to speak of changes in yield only: “The yield is rising” means that the price of the bond is going down.

Why is the price of a bond going down? Because investors think that the person who owes the debt—the bond issuer—is not necessarily good for the debt. That is, they think the debtor might default. So the owners of the bond sell it at a lower price, because they don’t want to have the risk of a default.

Why does a bond go up in price? Because the debtor might show signs that it won’t default—so the high yield makes it attractive for a buyer to pay more for the bond, thereby driving up the price, thus paradoxically lowering the yield of the bond.

So what does this mean for countries?

Well, when the yield of a government bond rises, it means that people are selling that country’s bonds. Take the above example of €1,000 bonds paying 5%. If the bonds are now at €900, the yield is at 5.55%, as per the above example.

Now, if the yield on that bond rises to 7%, what does that mean? It means that the bond is trading at distressed levels. Because for a €1,000 bond paying 5% interest to be yielding 7%, then the bond is trading in the €715 range. (The face-value price of €1,000 times 5% divided by a current price of €715 yields 7%.)

(By the way, this is a simplified version of calculating yields. In markets, often as not, the “yield” being referenced is the “yield-to-maturity” (YTM), which is a more complicated calculation. If you’re interested, check out this discussion, which explains it in relatively straightforward detail.)

So say you’re a government, and you have to fund €1 billion for a bridge. You will issue bonds to finance the bridge, bonds that will pay an interest of 5% a year. In order to raise those billion euros, you have to sell not a million €1,000 bonds—you have to sell 1,400,000 bonds with a face value of €1,000.

And therefore, you have to pay interest on 1,400,000 bonds, instead of 1,000,000 bonds. And when these bonds mature—that is, when they have to be paid off in full—the government won’t be paying out €1 billion in principal: They’ll be paying out €1.4 billion in principal, on what was supposed to be a €1 billion bridge. Because bonds are paid full face value on maturation.

Thus a government’s cost of borrowing has risen. And it’s all expressed in the yield.

That’s why yields matter. And unfortunately, rising yields is what’s been going on with European debt: They have risen massively—because investors think there is a less likelihood that the bonds will be paid back in full.

Why does this matter? Because these nations are all relying on deficit spending: They spend more money than they bring in. So they need to issue more debt, in order to pay off their obligations, such as salaries, pensions, medical care, not to mention pay off the interest on the previous bonds they’ve already issued.

So in this situation, a country can get to the point where its bonds are selling at such a discounted value that it cannot issue enough bonds to simultaneously pay off their obligations and allow them to continue to function at their current level.

That is, countries can get to the point of bankruptcy—depending on how high the yields on their bonds rise.

Now, About Greece

This is what happened to Greece: Its cost of borrowing rose so much that they no longer had the ability to raise the cash to pay off all their obligations.

So starting in April of 2010, the so-called Troika—the International Monetary Fund (IMF), the European Central Bank (ECB), and the European Commission (EC, the executive arm of the European Union)—structured a bailout package, which was eventually passed through in June.

The bailout package of course had some conditions, which the Greeks agreed to in order to get the money—and which they then promptly failed to live up to. (How am I not surprised . . .)

The details aren’t that important for the purposes of this discussion. What matters about the Greek Drama is two-fold:

• One, Greece is a small economy within the EMU—about 2% of the eurozone’s GDP—so therefore its debts, while massive, were all-in-all manageable.

• Two, the bailout of Greece was supposed to be swift and decisive, and act as a signal to the markets that the Troika would defend the eurozone, and not allow any of its members to go bankrupt. In other words, Greece was a firewall, to protect the other economies.

But the problem was, the Troika dithered.

Why did they dither? Because it became immediately clear that the only way to fix the Greek situation was by debt haircuts—and haircuts were impossible, because they would bankrupt the European banks. And the American ones too.

Let me explain.

Fear of a Credit Event

Part of any debt restructuring—be it a poor man’s bankruptcy, or the bankruptcy of a large corporation—is debt haircuts: That is, lenders get less than the 100% of the debt that they are owed.

Say I owe $10,000 to a car dealership for a new car I bought last year, and I go bankrupt. The dealer will get a percentage of the money I have left after everything (including the car) is liquidated. But they won’t get the full $10,000 that I owe them, obviously, because I’m bankrupt: I owe more than I have.

Same with nations: Greece owed more than they had—so Greece’s lenders were going to have to take a haircut. That is, they would have to take less money than they were owed.

This is what’s known as a “credit event”.

This was a problem.

If there was a haircut on Greek debt—a credit event—then the banks and insurance companies which held the debt (predominantly German and French banks) would have to write a loss on those loans. Huge losses. Losses bigger than their capital.

Thus these banks would go bankrupt, if there was a credit event in Greek debt.

Even if they didn’t go bankrupt, these financial institutions would have to sell off other bonds, in order to raise the cash to stave off bankruptcy.

This massive sell-off of sovereign bonds would have a contagion effect: In order to cover their Greek bond losses, banks would have to sell their Italian, Spanish and French bonds—at a loss—so as to raise the cash to stay solvent, which would in turn make Italian, Spanish and French debt toxic.

In other words, a domino effect.

Furthermore, American banks—which don’t own much in the way of PIIGS debt directly—have written a lot of insurance on those sovereign bonds: The famed credit default swaps (CDS). Bank of America especially has made a lot of money selling CDS’s on those debts in 2008, 2009 and 2010, as has JPMorgan.

If those sovereign bonds defaulted, those American banks would have to pay off these CDS’s—

—and thus they would go bankrupt too!

Everything is connected: A credit event in Greek bonds would trigger credit events in Italian, Spanish and eventually French bonds, which would bankrupt European banks as well as American banks—

—basically, a repeat of the 2008 Global Financial Crisis, only bigger, and without the happy ending.

This is why the Troika dithered. They talked tough, and they even put the gun to Greece’s head: Pass these austerity measures, or else no bailout money. But they never pulled the trigger and let Greece fail—because if they did, the European and American banking sector would collapse.

Since the Greek financial hole grew bigger between 2010 and 2011—because the Greek’s didn’t live up to most of their promises—a second bailout package had to be created.

Again—more dithering. This time, the dithering was because the Germans in particular feel that they are propping up spendthrift countries—and nobody likes to feel like the chump who’s paying for other people’s good times.

There is enormous political pressure on Merkel to not save Greece. The people pressuring Merkel don’t realize what will happen if Greece collapses.

So then last October 28, the Troika plus German Chancellor Angela Merkel and French President Nicolas Sarkozy finally came up with a “solution” to the Greek Drama.

I say “solution” in the loosest possible sense of the word: In the weeks previous to the Oct. 28 announcement, the Europeans had been going around the world, hat in hand, asking emerging markets—especially China—to fund their bailout facility. They had been politely refused—because they’re not stupid: They saw that the bailout facility—the famed European Financial Stability Facility (EFSF)—was just a lot of smoke and mirrors, essentially throwing good money after bad.

Through some clever accounting tricks and some not-so-clever baldfaced lies involving accounting standards, the Europeans managed to cobble together a workable EFSF which could give Greece and potentially one of the other PIIGS a lifeline.

But in order to show that they were “serious”, the Troika and Merkel and Sarkozy insisted that the Greeks agree to a serious of painful austerity measures.

The big news, however, was that this second bailout of Greece included haircuts on Greek debt. The advertised number on the Greek haircuts was fifty percent! (Though when you looked more closely at the details, it was more like 20%.) The Oct. 28 deal stipulated that the haircuts on the Greek debt would be voluntary—“voluntary” as opposed to “forced”, which would have triggered a credit event)—

—but then on the following Monday, Georgios Papandreou, the Prime Minister of Greece, threw a monkey wrench into the Rube Goldberg contraption that is the Second Greek Bailout Package:

G-Pap called for a popular referendum of the bailout!

All hell broke loose.

The eurocrats famously do not like going to the public to ask for their support—they like to dictate instead. Why? Because they consistently lose the popular vote, to the point where they no longer bother putting things up for a vote.

For Papandreou to put the austerity package to a popular referendum meant that it would likely not pass—because no citizenry likes to be asked if they want their government to give them less services and entitlements (duh!).

Therefore, the Troika suspended the €8 billion tranche of the first bailout package that the Greeks were supposed to get in November.

Without that tranche, Greece goes bankrupt on December 15.

So Papandreou backtracked on Thursday, November 3, and said that there would be no referendum.

But the damage was done: The bond markets got so freaked out that they started looking at the next weak link in the European chain.

So Now, We Have Italy

In mid October, Italian debt was yielding about 3.5%—very respectable. Italy, furthermore, has a very large debt, but it is far from insolvent: In fact its government regularly meets its budget with a bit of a surplus. Balance of trade is okay, growth is low but in line with the rest of Europe. And aside from periodice sex scandals, the Berlusconi government is fairly competent and efficient.

Overall, Italy is in pretty good shape.

But it needs more debt to pay off previous debts, and to shore up its economy, which is in a recession much like the rest of the world’s. It’s debt load is growing, but strictly because its government is spending to prop up the sagging Italian economy.

Nevertheless, after the Greek fiasco, the bond markets turned on Italy.

On the Monday after the Greek Week (Nov. 7), Italian yields rose from their 5% level—then spiked on Wednesday to above 7.6%, which is potentially catastrophic. Why catastrophic? Because at those levels, no advanced economy can finance itself—not to mention the fact that certain derivatives require that yields stay below certain thresholds. If they remain above certain yield numbers for a set period of time, they are considered credit events—which triggers CDS’s, which lead to bank bankruptcies.

So those yields have to go down now—fast.

This crisis in Italy has led Silvio Berlusconi to announce his resignation, which will likely calm the markets—for a bit. What strikes me is the inanity of the eurocrats’ response. They come up with vague and flimsy packages, and a lot of flowery rhetoric—you should have just heard Sarkozy, after the Oct. 28 deal, going all French Literature on the thing.

But the Europeans don’t seem to understand that they have a nuclear weapon at their disposal—which they refuse to use.

And that nuclear weapon in the European Central Bank.

Fear of Monetization

The easiest way to fix this entire debt situation would be for the European Central Bank to simply print up money, and go out and buy enough Greek and Italian debt to bring down their yields.

It wouldn’t even have to be very much—a mere €50 billion would do the trick. The fear that the markets would have of being caught on the wrong side of a trade against the ECB would be enough to keep the markets docile and quiet.

I’m not saying this is a best solution to the current situation—or even a solution at all. However, you cannot make sound economic policy on the fly, as you react to a crisis. You have to stabilize the patient, before you give him the treatment—not operate him for liver cancer while he’s still bleeding from a gunshot wound to the leg.

Having the ECB come in and decisely calm the markets—like the Swiss National Bank did a month ago—would be the best way to get the European house in order, and then implement the structural reforms and austerity measures that everyone agrees need to be implemented.

But the ECB isn’t stabilizing the patient. Why? Because the Germans are greedy.

See, if the ECB does a European version of Quantitative Easing, the Germans are afraid that their currency will weaken—which they do not want, because they are a creditor nation. If the euro’s value erodes, then Germany will have lost some purchasing power.

They are so afraid of the euro weakening—and thus the Germans losing a bit of their surplus—that they are making the other economies in the eurozone crash.

The Germans do not seem to understand that, if the nations of Europe go down, there will be no buyers for their goods and services—so they will suffer too.

Thus the ECB sits there, while this Greek problem becomes now an Italian problem—

—and soon a French problem: The yields of French bonds are rising precipitously, and already one French bank, Credit Agricole, is in trouble over the Greek Drama. It’s only a matter of time before the big French banks start tumbling—and then France itself—unless the bond markets are calmed.

So What’s Going To Happen?

What’s going to happen is—best case—the Germans come to their senses, and the ECB starts buying up European sovereign debt, calming the markets. Greece and a couple of other small and/or weak eurozone countries exit the European Monetary Union, go back to local currencies, devalue, and then rebuild their economies; say Greece, Portugal, Spain and maybe Italy. And finally, austerity measures are imposed, fiscal budgets are put on a sounder footing, and things right themselves in a few years.

Worst case? Italy gets really sick, and then France falls as well, leading to the eventual break-up of the whole eurozone, with Germany, Austria, Holland, Finland and Belgium maintaining the euro as their currency.

This would not be a good thing for those countries, by the way: If the union between France and Germany breaks, the non-eurozone countries would be poor—so they would not be able to buy the goods and services of the rump-eurozone countries.

So all the countries would lose, if there is a break up of the monetary union.

Unfortunately, at this time, the worst case seems the likely case.

No comments: