Friday, September 23, 2011

Europe: No one left to lie to

“Europe” has exhausted its credibility with the credit markets. The corrosion began in the Anglosphere, where there is very little investment in the “European idea” (see: euroscepticism). Over time disbelief has slowly spread not only around the world, but more recently into the heart of Europe itself.

Why is this? I would advance three reasons: (1) Europe has no leadership. (2) Credit market participants can do arithmetic. (3) Every statement issued by the European authorities has been not only a lie, but a conscious lie, and has been proven to be such.

Who runs Europe? The Council? The Commission? France? Germany? The ECB? It’s like asking who runs MLB, or FIFA. Nobody. How can a political entity with no authoritative spokesman have any credibility?

When Greece, Portugal and Ireland lose capital market access, and when Spain and Italy appear in danger of losing access, it is difficult to say with any credibility “Nothing to see here folks; move along”. Anyone with calculator can plot how long it will take for these countries to run out of euros, given the scale of their maturing debt and their ongoing budget deficits. (Yes, countries with balanced budgets can still go bankrupt if they can’t refinance their maturing debt.)

The European party line for the last two years has been: “We have everything under control. This is Europe. Default by a eurozone member is unthinkable, so don’t think about it or, God forbid, talk about it.” OK, so that means that in the end, Europe will bail out the South, right?
Except that (1) this doesn’t apply to Southern banks; and (2) further sovereign bailouts will include “private sector participation”.

This means that “Europe” does not guarantee the PIIGS’s banks, and that there is no risk of a sovereign default, aside from “private sector participation”.

If “Europe” had the courage to tell the truth, they would say that “We will help the PIIGS and their banks, but we expect you (the bondholder) to help out too.” In other words, there is considerable credit risk with respect to the PIIGS and their banks. Which is why credit is being withdrawn and why credit spreads are rising to the point that Italy and Spain are steadily losing market access.

Europe must choose now, not next month, whether they will protect the bondholder in PIIGS sovereign and bank debt or whether they won’t. If they will, they need to publish a credible plan, such as a massively expanded EFSM with joint and several guarantees and a AAA rating from Moody’s and S&P. Or, if not, they must publish a credible scheme to recapitalize the Northern banks in the event of massive Southern defaults.

In the absence of a credible bailout plan, and in the absence of emergency recaps of BNP, SoGen, Credit Agricole, and the Landesbanken, why would any Credit Committee refrain from ordering a steady reduction in concentration limits for every bank in the eurozone?

The PIIGS problem is no longer central. What is happening now is systemic:  a run on the eurozone’s banking system that could make Lehman look like a slip-and-fall. This run must be met with two tools at once: (1) unlimited euro and dollar liquidity from the ECB so that liquidity is not an issue; and (2) a massive shock-and-awe recapitalization in order to facilitate an eventual return to the credit markets.

There are two ways to achieve this. The easiest is to simultaneously recapitalize the banks while stating that, if further capital is needed, it will be forthcoming (i.e., an implicit state guarantee). The other (currently popular) way is to contribute enough capital to allow re-entry while piously stating that this is the “last bailout”. This approach requires an enormous amount of capital in order to be remotely credible. From the FT:

The EU internal markets commissioner, Michel Barnier, said the 16 banks that nearly failed the stress tests “are judged to be fragile and must also be strengthened further. We want the recapitalisation for these banks to be by private means. The era of bailing out banks must end.”
Very helpful, M. Barnier.

Now that “Europe” has lost all credibility in the credit markets, further Wizard of Oz-like statements will prove not merely useless, but frightening. ("They have no clue!")
The time for soothing statements has passed, and the time for decisive and credible action is rapidly running out. 
My prediction? Catastrophe, of course. My best analogy to what is going on in Brussels today is the Imperial Cabinet in the summer of 1945. Denying the obvious, awaiting the inevitable.

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