Andrew B. Busch Global Currency & Public Policy Strategist BMO Capital Markets

On October 26th, the members of the Euro Zone agreed to three major structures to reduce credit stress within the union.  First, there was an agreement to increase the losses to private sector Greek bondholders from 21% to 50%.  Second, there was an agreement on the need for bank recapitalizations of 108 billion EUR.  Third, there was agreement to expand the size of the bailout facility to enhance its ability to cover larger nations.  All are important and all are related.  Let’s review the structures to gauge if they will be successful and to gauge what additional measures need to be taken to contain the crisis.

Greece was the initial infection for the European debt crisis and therefore resolving this country’s issues were seen as critical for containing the problem.  Clearly, this was a nation that needed a severe restructuring of not only its fiscal spending, but also its economy.  With one out of five workers employed by the government, the public-private balance was out of balance and encouraged the electorate to vote for legislation favorable to government spending.  With the economy contracting 7.4% in 2010 and expected to contract 5.5% in 2011, the country’s tax receipts continue to shrink and their ability to service their debt has decreased significantly.  Greece has a debt-to-GDP level of 145% and their tax revenues can support less than a third of that load.  In July, Euro zone members agreed to a 109 billion EUR loan to Greece as well as a voluntary (to avoid triggering CDS) private sector 21% cut to face value of Greek bonds.

Clearly, this reduction in debt load was not enough to set Greece on a sustainable fiscal path.  At that time, the markets were pricing Greek bonds at only a 30-40 of face value and reflected what they believed was sustainable.  In October, the Euro zone nations acted again to reduce the 21% haircut to 50% for private sector bondholders.  While this is closer to a level they can support, the problem is that cut is only for the private sector holders and it will only reduce the debt-to-GDP levels to 120% by 2020.  Greece needs to have this level reduced to 60% for a true sustainable debt load.  Therefore in the medium term, the Greek issue will not be resolved by further austerity measures or by a new Greek government.  It must restructure its debt with losses for all bond holders, both private and public including the ECB.

With this in mind, the progression of the European debt crisis has been that the contagion moved from the periphery countries into the core countries into banking system.  It’s this third stage of infection that has expanded the crisis into an acute stage which had to be addressed expeditiously.  Sadly, the debt crisis has been dragging on since November of 2009 and through 13 meetings of European leaders to no resolution.  This has exacerbated the downward spiral of confidence leading to US money market funds not extending credit to European banks and creating a potential funding crisis.  It didn’t help when the EBA (European Banking Authority) did a stress test recently that gave Dexia a passing grade only to see the bank collapse and have to be broken up.  The IMF has calculated that European banks need to raise E200 billion to plug a hole in bank balance sheets created by sovereign debt write-downs with other estimates as high as E275 billion.  Unfortunately, the October Euro zone agreement was underwhelming in that it asked Europe’s big banks to find only 108billion EUR infresh capital by June 2012 to strengthen the banking system.  The EBA ran new stress tests and this higher level of capital would make lenders to reach a 9% threshold for their tier one capital ratios.  Europe missed their opportunity to shore up their banking system quickly and take a major step towards providing certainty to investors over the entire banking system.

One of the unintended consequences of simultaneously putting the Greek bond haircuts on the private sector and asking banks to recapitalize is forcing owners of all sovereign European debt to sell.  With only the private sector bondholders taking the Greek haircut and the haircut not reducing the debt-to-GDP down enough, the perception is that more will be needed and it will fall on the private sector.  This encourages bondholders to sell now or take more losses.  Also, this structure may be used on other nations like Ireland, Portugal, Spain or Italy and further encourages selling of those nations’ debt.  Finally, banks can raise their tier one capital ratios by either issuing more stock or by reducing the assets on their balance sheets.  With stock prices already extremely low, issuing stock is not only dilutive, but won’t raise capital very efficiently and therefore will not likely be done.  However, banks will be incented to reduce their balance sheets by selling assets like sovereign debt and by reducing their lending.  Both of these outcomes are negative for European growth (and tax receipts) and for prices of sovereign debt.

Finally, the expansion of the European Financial Stability Fund or EFSF is seen as critical for dealing with the contagion that has now engulfed Italy.  The European Financial Stability Fund has been underfunded since its inception due to constraints over the AAA ratings of the bonds it issues to fund itself.  The original lending facility was under E250 billion, but was just boosted to E440 billion under the July 21st agreement.  With Italy now sucked into the vortex of the downward debt spiral, this fund needed to be expanded to be able to cope with the size of Italy’s debt at around E1.8 trillion.  As we learned from the 2008 US crisis, there are numerous structures that can be used to expand lending and help foster confidence in the financial system (ex. TALF).  The October 26th Euro zone agreement focused on two leveraged paths that are intertwined: a special purpose investment vehicle(SPIV) and an insurance model. The SPIV would be mandates to invest in sovereign bonds of a country in both the primary and secondary markets.  The insurance model appears to be able to absorb first proportion of losses incurred by the SPIV up to 20%.  Both structures were deemed necessary, but both structures could “statistically increase member states’ gross debt” and thereby also potentially create conditions for a member country downgrade.  The goal was to eventually boos the EFSF lending by approximately E1 trillion.

The concept was to have the EFSF buy the bonds of Italy at auction and thereby significantly reduce Rome’s borrowing costs.  To raise capital, the EFSF would issue bonds and have these insured up to 20% of first losses.  However, the capital markets appetite for these types of bonds has shrunk due to the volatility in the markets.  This means that the leverage for the EFSF would need to be reduced to increase the insurance component to 30% to incent investors to buy these bonds.  The new EFSF structure is expected to be in place by the end of November, but remains a question mark until the final structure is presented.

Given the state of the Greek bailout and the form of the private sector haircuts, the inadequate bank recapitalizations and the still unformed, levered EFSF fund, it should surprise no one that the October relief rally in risk assets has stalled and volatility has remained.  There are many unanswered questions that need to be resolved and structures that need to be concretely put in place to create the conditions for a stable and sustainable European fiscal environment.  Going forward, this translates into continued uncertainty for the financial markets.  However, the fact that Europe has moved this far is a welcome sign and bodes well for containing the debt disease to allow enough time for a cure.

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