What happened on Tuesday in the euro area's sovereign debt and associated markets has probably set alarm bells ringing everywhere. Considering yet another day of widespread carnage in euro area sovereign debt, it was almost comical to see the US stock market rising following comments by the Fed's über-dove Charles Evans in a TV interview about his proclivity to vote for more money printing. This is 'news' why exactly?

Of course the crisis in the euro area isn't really news anymore either. Alas, a new, and potentially decisive (perhaps fatal) facet has made a speedy entrance over recent weeks and has become decidedly more manifest this week.

First we had reports that the EFSF could not even sell € 3 billion in bonds, after cutting down the originally planned offer size from € 5 billion when it became clear it couldn't possibly get bids for that much. Remember, that's supposed to be the euro area's 'bailout bazooka'. Right now it looks more like a water pistol. A small one.

The Telegraph reported that in order to cover up the failure of the auction, the EFSF bought its own bonds, something the bureaucrats overseeing the fund immediately denied. The problem with their denial is that there's no explanation how they actually moved the entire amount, since apparently there weren't bids for € 3 billion.

When the EFSF made its first bond sale over a year ago, it was ten times oversubscribed. At the time investors evidently still believed the bailout would work. These bonds have performed rather atrociously ever since, as opinions on the workability of the fund have slowly but surely changed. Right now there is a problem rearing its head that may well condemn the 'new enlarged' EFSF to the DOA status we have assigned to it right after it was born. The fund's AAA rating crucially depends on the ratings of its major backers, one of which is France. Unfortunately for France, its fate is tied at the hip with Italy's, due to the fact that French banks are actually the biggest holders of Italian debt. We have pointed this problem out before: it is likely not possible for France to retain its AAA rating if the government decides to backstop the big banks, as it may eventually feel forced to do. French banks in toto hold assets worth almost 400% of the country's GDP (a little less now, since they are busy shedding assets as fast as they can).

Considering Tuesday's moves in CDS on France and the move in OAT yields, the markets no longer think an AAA rating is appropriate for France (as an aside, if you were wondering what the acronym stand for, it is 'obligations assimilables du tresor', which denotes long term bonds). The spread of French over German yields has rocketed to a record high.

In fact, it appears as though Germany will soon be the last man standing in euro-land, as new highs have been recorded in CDS and yields all over the show. Even bonds that were heretofore somewhat mysteriously considered 'safe haven' bonds like those issued by Austria's government are beginning to crumble at astonishing speed. Austria's politicians were apparently alarmed enough by this development that they decided to bring forward legislation on a constitutional 'debt brake', including the demand that the 'Länder' (provinces) and municipalities run balanced budgets from 2017 onward (file under 'pipe dream').

We must reiterate on this occasion that we are not only finally seeing a crisis of the modern-day welfare states, but underlying it, a crisis of the fractionally reserved banking system. In spite of the fact that the ECB has now advanced almost € 1 trillion in 'emergency liquidity' to euro area banks, i.e., almost an entire enlarged EFSF worth of money from thin air, the banks continue to flounder.



Man overboard: the spread of French OATs over German bunds goes ballistic – click for higher resolution.



Euro Area Banks: Eurocracy Scores Own Goal

The euro area's biggest banks are facing a multifaceted problem. Not only are their holdings of euro-area sovereign bonds  (ex Germany) losing value day after day, they are still lugging around gigantic amounts of toxic assets from the burst US real estate bubble (see our previous missive on this, scroll to the bottom of the post for the numbers), in addition to those that have been amassed in Europe's various housing bubbles, all of which have burst as well. If all of this stuff were marked to market – which it should be mentioned isn't even possible for the whole lot, since there simply is no longer a market for some of it – many of these banks would likely be insolvent.

Given the sudden realization a few weeks ago that euro area banks are short of capital and that the EBA's (European Banking Authority) previous 'stress tests' were largely a farce (the allegedly 'best capitalized bank in Europe' was Dexia according to the EBA – that's really all one needs to know about these tests), the EU has decided to apply more strict criteria to assess the health of banks and force them to raise far more capital than originally envisaged.

As the same time the eurocracy has done everything it could to lose what credibility it once may have possessed by means of a string of rather strange interventions (such as the ban on 'naked CDS' trading enacted by the EU parliament this week) and by issuing promises it could not possibly keep. First and foremost among those promises were the ones related to the Greek debt situation.

Initially banks and other investors were told that there would be 'no haircuts' at all for Greek debt. The ECB specifically was vociferous in its insistence on this point. This was later revised to a '21% haircut' – but at the time it was also made clear that only private investors would be subjected to it. Public holders of claims against the Greek government, from the IMF to the ECB to the EFSF were and are exempted. The math on this never really worked, since by that time a lot of Greek debt had already made its way onto public balance sheets. So a few short months later, the haircut was increased to 50%.

We have always argued that those who made bad investments should bear responsibility for the losses incurred. However, creating two classes of creditors was a big mistake. It was an even bigger mistake to change the terms of the agreement  twice in mid flight. To add insult to injury, these haircuts were deemed 'voluntary' in order to avoid a triggering of CDS contracts – with the entirely predictable consequence that some bond holders felt they could no longer properly hedge their risk and thus should better sell euro area sovereign bonds as quickly as possible.

Finally, the banks had no longer any reason to believe the latest string of promises issued by the eurocrats. The major promise of the most recent emergency summit was that Greece would be 'fire-walled' and that no other government debt in euro-land would be subjected to similar treatment. Not surprisingly, bank managers at this point are thinking 'Fool me once….'.

Moreover, the banks were told that the tough new capital rules should preferably be achieved by tapping the private sector. Should this not work, then banks would be eligible for government or EFSF bailouts, which would obviously come with a great many strings attached (one of which is 'no more bonuses', which has an effect on bankers that is the equivalent of sprinkling  holy water on Beelzebub).

The reaction of the bankers was entirely predictable. More shareholder dilution at stock prices that have declined to multi-year lows? Forget it. Taking money from Papa State in exchange for being dictated to even more? No way. So what is left? Only one thing: shrink those bloated balance sheets by selling assets – those that can be sold that is. No-one's going to buy some CDO stuffed with US sub-prime debt or similar garbage.  Oh, and remember, there's a sovereign debt crisis in euro-land, which has called forth a lone bidder in the markets in possession of unlimited funds – the ECB. The banks see this as a marvelous opportunity to de-risk and shrink their balance sheets: Sold to you, Mario!

One wonders what their asset quality will be like when all is said and done. The average euro-land bank will probably shrink back to its core of unsaleable crap plus a few pompous marbled buildings.

We conclude that the eurocracy has an unsurpassed capacity at shooting itself into the foot. It doesn't even need an adversary, it is perfectly capable of shredding the euro-area all by itself.

We are actually somewhat astonished to learn that the latest nutty idea of financial markets commissar Michel Barnier, namely to 'ban credit ratings' on wobbly sovereigns, has met with enough bureaucratic resistance yesterday to be torpedoed before it could become policy. As the Irish Times reports, this time he was stopped by his fellow commissars, although the remainder of his plans was kept in place:

“PLANS TO ban sovereign credit ratings in “exceptional circumstances” have been shelved by Europe’s top financial regulator after he came under pressure to climb down on the controversial measure to rein in the agencies that issue the assessments of national financial strength.

Michel Barnier, the European internal market commissioner, admitted that he had to bow to objections from his fellow European Union commissioners but insisted the power to suspend ratings was never “the main measure” in his reform package.

Although Mr Barnier still unveiled proposals to aggressively transform the business model and methods of the big rating agencies, the last-minute decision to order more “technical work” on suspension represents a significant political blow.

Yet, despite the amendments, rating agencies remain deeply concerned by planned requirements for issuers of financial securities and bonds to rotate agencies, and rules that give regulators the power to “pre-approve” analysis methods.

“We strongly believe that the commission proposal is damaging for the credit markets,” said Michel Madelain, Moody’s chief operating officer.”

A bullet was dodged here: Barnier's wide-ranging plans to shoot any and all messengers he can find are already doing more than enough damage. Contrary to the beliefs apparently held by populist euro area politicians, the crisis is not the fault of 'speculators', it is the fault of the fiscally incontinent governments these politicians lead.

Speculators are in fact doing us a great service by uncovering the system's fault-lines by means of reassessing the merits of dodgy debt and forcing governments to react. The correct reaction is not to 'ban speculation' as has just been done with CDS trading (the ban is supposed to become active in a year's time, but markets are forward looking with regards to that), the proper reaction is to make the debt less dodgy by cutting spending.

Readers may recall that we have discussed the problems arising from these interventions on several occasions. So has the WSJ yesterday


To Print or Not To Print …

We noted yesterday that recent personnel changes at the ECB and hints from Germany's politicians at the CDU congress indicate that a move to weaken the ECB's resistance to guaranteeing all government debt in the euro area may be underway(likely on a 'just in case' basis, but still).

However, we would point readers to the fact that the president of Germany's Bundesbank (BuBa) remains implacably opposed to this idea. An interesting portrait of Jens Weidmann has just appeared in Germany's news magazine Der Spiegel, an English language version of which can be seen here: 'Germany's Central Bank Against the World'.

If after reading this you are convinced Weidmann will never ever alter his stance, you are probably right. An interesting tidbit is that he is convinced that  letting the ECB off the leash would actually do far more harm than good, as then the one institution that still has some credibility in the euro area will end up compromised, while the fiscal offender governments will lose the incentive they now have to adopt reforms.

Interestingly, Germany's public, its most prominent economists and its commercial banking establishment are all backing Weidmann's views.

So if there really is a 'plan B' regarding the disposition of the ECB's printing press, then it will have to happen over the dead body of Weidmann, metaphorically speaking.

Weidmann continues in the tradition of the BuBa, which was always marked by fierce independence and resistance to the wishes of the politicians of the day. Politicians are of course always in favor of easy money, an idea that is anathema to the BuBa. 

Financial Quake Reaches Hungary

Below is a weekly chart of the euro against the Hungarian forint  that kind of speaks for itself. You have to be in really deep trouble if your currency collapses against the euro of all things.

The forint has now plunged below its 2008/9 lows, which is quite a feat. Government bond yields are also rising sharply, but are still a good distance away from their GFC highs, when the ECB had to come to Hungary's aid with a liquidity injection and the IMF granted an emergency loan as well.



Forint per euro, weekly – click for higher resolution.


Unfortunately one of the euro-areas six AAA rated nations – namely Austria – is not only bordering Italy, but also Hungary and Slovenia (which we have previously noted is in grave trouble as well all of a sudden). A common border is per se not a reason for concern, but as one might imagine, Austria's commercial and banking ties to all these countries are strong. Hungary's government led by Victor Orban has become known for its capricious and dirigiste policies, one of which was to shift the losses from CHF denominated mortgage loans from borrowers to lenders – causing Austria's Erstebank to report a huge loss (we have chronicled the storied history of this loss and the resulting capital requirements in these pages not too long ago; as far as losses go, this one went on an astonishing growth trajectory in a very short time period).

Hungary's growing problems have now been noticed by the financial press. The WSJ reports:

“Hungary's central bank sounded the alarm on Tuesday as international investors continued to dump Hungarian assets amid concerns over the country's economic management and over the impact of the euro crisis on its banks and sovereign rating.

The National Bank of Hungary's monetary policy council warned that the drop in the country's currency, the forint, escalates the risk of inflation, and said official interest rates may have to be increased to reverse the trend. The central bank blamed the run on its currency on the threat of recession in the euro-zone and the effects that is having on neighboring countries that don't use the euro.

The official warning over capital flight extended the forint's sharp declines to near-record lows, as speculation grew that Hungary's strong banking ties with the euro zone made it most vulnerable among Eastern European economies.

Hungarian stocks tumbled and government borrowing costs soared as investors demanded higher premiums for Hungarian government bonds. Hungary paid a painfully high yield of 6.71% on Tuesday to sell 40 billion forints ($172.55 million) of three-month Treasury bills at auction. The cost of insuring against debt defaults continued to march higher.

Economists were reminded of Hungary's financial near-collapse in 2008, when only the arrival of emergency aid from the International Monetary Fund prevented its crisis from spreading to other emerging markets in the region.

"Hungary is once again at the epicenter of attention among emerging-market bond investors following a number of unorthodox and controversial policy choices made by the new administration," said Michail Diamantopoulos, an emerging-market portfolio manager at Investec Asset Management.

Since it took the helm in spring 2010, the Hungarian government has introduced a number of one-time measures to fill holes in the budget while economic growth accelerates. Such steps include temporary "crisis" taxes imposed on the telecommunications, energy, retail and financial sectors; nationalization of the mandatory pension funds; and, this September, a plan that allows households to repay in a lump sum at discount rates mortgages denominated in foreign currencies.”


(emphasis added)

Let us say the budding crisis in Hungary is not entirely unexpected, but it sure comes at an inopportune moment.



Hungary's 10 year government bond yield, short term. About to overtake Ireland's as it were – click for higher resolution.



Hungary's 10 year government bond yield, long term. This shows that things are not yet as bad as they were at the height of the GFC in early 2009, but once these moves get going, they have a tendency to become 'non-linear' very quickly – click for higher resolution.



Euro Area Credit Market (Massacre) Charts

Below is our customary collection of CDS prices, bond yields, euro basis swaps and several other charts. Both charts and price scales are color coded. Prices are as of Tuesday's close.

It was an across-the-board massacre on Tuesday. It is no exaggeration to state that the debt crisis has never been closer to getting completely out of hand. A little over two weeks ago we thought that there was perhaps a small chance for things to calm down again for a while, but we were clearly mistaken.

Since then, things have gone from bad to worse in what seems an unseemly hurry. As the title of today's post indicates, the crisis is now eating away at the viability of the 'core', with only very few euro area sovereigns remaining above the market's suspicion. 

Truth be told, not all of them deserve it, alas, the market has been quite diligent in winnowing the undeserving from the ranks.



5 year CDS on Portugal, Italy, Greece and Spain – CDS on Italy and Spain both have reached new highs once again – click for higher resolution.



5 year CDS on France, Belgium, Ireland and Japan – CDS on France and Belgium are now 'going vertical' – click for higher resolution.



A separate chart breaking out CDS on French debt. From an Elliott Wave standpoint we would guess that this is a third wave – the 'recognition wave'. What is being recognized is that France's credit rating is probably toast – click for higher resolution.



5 year CDS on Bulgaria, Croatia, Hungary and Austria – big one day jumps higher across the board once again, especially in CDS on Austria (up 20 basis points or roughly 10% on the day) – click for higher resolution.



5 year CDS on Latvia, Lithuania, Slovenia and Slovakia  – also moving higher again, if at a somewhat slower pace – click for higher resolution.



5 year CDS on Romania, Poland,  Slovakia and Estonia – Estonia is the best of these in absolute terms, but in relative terms it is now seeing the fastest rise of this quartet – click for higher resolution.



Three month, one year and five year euro basis swaps – these look like they will break  support at any moment – click for higher resolution.



Our proprietary unweighted index of 5 year CDS on eight major European banks (BBVA, Banca Monte dei Paschi di Siena, Societe Generale, BNP Paribas, Deutsche Bank, UBS, Intesa Sanpaolo and Unicredito) – say hello to a new all time high in this index, on account of a huge one day jump of almost 30 basis points – click for higher resolution.



10 year government bond yields of Italy, Greece, Portugal and Spain – Italian yields back above 7%, Spanish yields at a new high – click for higher resolution.



10 year government bond yield of Austria, the 9 year government bond yield of Ireland, UK Gilts and the Greek 2 year note.  The jump in Austrian bond yields has gone from 'remarkable' to 'striking' to 'scary' in the space of one week. Greek yields continue their bizarre journey toward absurdity – click for higher resolution.



5 year CDS on the two Austrian banks Erstebank and Raiffeisen continue to break higher with some vigor as well. These are indexed, absolute values are currently 344 basis points for Erstebank and 353 for Raiffeisen – click for higher resolution.



10 year government bond yield of Belgium – this is also beginning to look precarious – click for higher resolution.



10 year government bond yield of Belgium, weekly. Here it should be noted that in 2008, these yields reflected a 'price premium' or 'inflation premium'. Currently all they are reflecting is a 'risk premium', i.e. the market perception of growing default risk – click for higher resolution.



The 10 year bond yield of France. This looks pretty worrisome as well – click for higher resolution.



10 year bond yield of France, long term. If it is to come down again, now's the time. Should this trendline break, a move to the next level of lateral resistance becomes highly likely – click for higher resolution.



Italy's 10/2 year spread, long term. Once again approaching inversion – click for higher resolution.



Portugal's 10/2 inversion once again widens a little – click for higher resolution.


Inflation adjusted yields show that inflation expectations are now falling faster in the euro area than in the US – click for higher resolution.



5 year CDS on Australia's 'Big Four' banks – bouncing again – click for higher resolution.




The structure of the decision making bodies of the ECB. Jürgen Stark is about to be replaced by Jörg Asmussen (the chief economist is traditionally a German), the replacement for Lorenzo Bini Smaghi (who is leaving due to the new president being an Italian as well) has yet to be determined, but will most likely be a Frenchman – click for higher resolution.





Regarding Belgium, here is a famous (in Belgium, anyway) song from better, more lighthearted times:



Potverdekke! by Mr. John.



Jens Weidmann's name meanwhile reminds one of the German archaic term for 'hunter', which is 'Waidmann'. Even today, hunters greet each other by saying 'Waidmann's Heil!'

Ironically, there is a song called Waidmann's Heil by the German metal band Rammstein, the chorus of which goes 'Die Kreatur Muss Sterben' ('the creature must die'). This is probably what every politician below 47 degrees North latitude in Europe is currently secretly thinking when contemplating Weidmann.

We doubt he will do them the favor, but he may eventually be outvoted.



Rammstein, Waidmann's Heil (sounds appropriately apocalyptic as well).



Lastly, here is another Spiegel article we would recommend to our readers, dealing with the German government's plans to transfer more power to Brussels (as discussed yesterday), which will necessitate that the German constitution be altered – which in turn will likely require a referendum.



Charts by: Bloomberg, M&G Investments, Portfolio.hu, Der Spiegel



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6 Responses to “The Crisis Eats Its Way Into The Core”

  • jimmyjames:

    Very true, in the free banking systems of the past, even though they practiced fractional reserve banking, the booms were never getting out of hand the way they do now

    Maybe the credit driven booms were always semi contained because the 12-1 reserve requirements held FRB in check-until Greenspan allowed the use of Sweeps-which effectively manipulated the reserve requirements?


    • Sweeps clearly contributed greatly to the late 90’s boom and the acceleration in money supply growth observed at the time. I have discussed this point extensively in the past. Sweeps have essentially done away with reserve requirements altogether. That is also why it was possible for bank reserves at the Fed to hold relatively steady over the ’95-2007 period, while the money supply expanded by leaps and bounds.

  • uneasy:

    If I was Angie I would push for everything that requires a referendum.
    1. She will be reelected.
    2. The consequences wouldnt be her fault.

    She is not dumb.(Maybe evil)

  • Let Us Have Peace:

    “We must reiterate on this occasion that we are not only finally seeing a crisis of the modern-day welfare states, but underlying it, a crisis of the fractionally reserved banking system.”

    The crisis of the fractionally reserved banking system begins as soon as reserves cease to be specie or specie-backed currency. There is nothing in the history of free banking – either in Scotland in the 18th century or the U.S. throughout most of the 19th century – to suggest that fractional reserve lending by private banks can lead to the kind of sovereign credit gluttony that has produced the inflation of the last century.

    This may be a useless debate over semantics. In a “system” (sic) where legal tender is itself an IOU of the government, there are no reserves for private banks that are not themselves an extension of the sovereign’s own finances – as Pater reminds us so wonderfully each day.

    • Very true, in the free banking systems of the past, even though they practiced fractional reserve banking, the booms were never getting out of hand the way they do now. Plus, it was crystal clear that once the bust struck, the money supply would simply shrink back to the specie backing, and that was that. Malinvestments were quickly liquidated and a sound foundation for the economy was quickly reestablished. No interference by busybody bureaucrats by fiscal and/or monetary means got in the way.
      What we have today is by comparison truly monstrous….

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