Now that the temporary “stability” mechanism is slowly getting its final form in the aftermath of the euro summit after serious of failures, it’s good to look at the different elements. Btw, I hope you have enjoyed the stability these mechanisms have brought to you and the hopium rally that last total of few days and is coming apart with vengeance today.
Key decisions were the 50 per cent haircuts for private investors, leveraging the rest of the EFSF assets up to 1 trillion euros and bank recapitalizations. However, there are also plenty of words about firepower, structural reforms, restoring trust and stability and consolidating fiscal policies amongst EU countries. Moreover, Greece has recently received their next heroine dose.
Here are official statements.
At this point I’d like to quote one of my superior officers in the military. He used to say that “Why should we change something that has never worked?” And he was quite proud of that statement.
Equivalently, Barroso & Co. also seems to be truly proud of what it has achieved here. After all, it is totally plausible that the cause of the problem works as the best cure for the same problem, that taking on more debt fixes the problem, which is the excess amount of debt and repeating what has failed numerous of times simply makes it more likely to work the next time.
At least there is somewhat clear admission that banks are severely under-capitalized and that Greece will not pay back what it cannot pay back. However, that is where the good ends. I am somewhat horrified by the use of the word “firepower” because the last thing I want someone with complete lack of economic understanding to do is to leverage up my tax euros and use it as his personal war chest in manipulating financial market for political purposes. Secondly, it is truly perplexing that EU would come up with one of the most complex credit products ever and apply leverage when most of these types have been complaining banks doing this in the build-up to the financial crisis.
There are sensible actions that should be undertaken immediately that are not in any way included in the statements by the EU. The actions should be carried out at national level where applicable. These include forcing banks to prudentially mark all assets to market values, resolving troubled banks and if they cannot survive as solvent institutions they must be liquidated, terminating employment of incompetent employees at EU and ECB starting with Barroso, unequivocally denying banks all access to taxpayer money, enforcing zero inflation rate policy, enforcing the stability and growth agreement and many others, but most importantly rule of law must be followed without exception.
On that last point, it is sad to point out that of course all these bailout actions have been against the law as the Lisbon Treaty stipulates that:
(ex Article 103 TEC)
1. The Union shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.
In my humble opinion bailout of country after country does not even remotely qualify as a “joint execution of a specific project”, because otherwise the whole article would be meaningless and the bailouts are not even joint projects because they exclude non-euro countries.
And since the purpose of the EFSF is to allow Greece and other bankrupt countries to run excessive deficits without the need to balance budgets immediately, it is comforting to know that that is also against the law as the Lisbon Treaty stipulates that:
(ex Article 104 TEC)
1. Member States shall avoid excessive government deficits.
And then there is the growth and stability pack. Remember that? Deficits should be below 3 per cent of GDP and public debt below 60 per cent of GDP, otherwise you get punished. Barroso & Co. is even loudly proposing that fiscal discipline should be restored and strictly followed. Given that you might think that EU and the euro zone countries have followed these principles in the past. You would be wrong, because the minute large countries started breaking the rules, they decided that they don’t have to follow the rules. We are paying the price now.
There are plenty of other examples, but these should suffice.
EBA stress test 2.5
The first thing about these stress tests is that why should anyone care after two utter failures? After the previous figures came out, I said they would fail and I suppose this latest set of figures from EBA acts as a formal acknowledgement by them that their work was a failure and that I was right.
Onto the new figures
Once again there is no explanation on why their previous stress tests did not work and there also appears to be no consequences for the failures. This time they are going for 9 per cent Tier 1 capital after sovereign debt write-offs, which starts to be more reasonable capital buffer. The shortfall is now about 106 billion (final sum to be announced after Q3 results), which has to be acquired by the end of June 2012. The interesting part about this is that it goes beyond and against what Basel III has proposed. It is going to be interesting to see what will eventually be legislated. However, this 9 per cent Tier 1 Capital is not enough. I am expecting to see something like maximum 10-to-1 leverage based on prudentially marked-to-market assets and common equity and separation of deposit-taking institutions and the rest. Furthermore, the figures for French banks seem way too low. Put another way, these measures do not restore my trust at all.
Implications to sovereign CDS
The “voluntary” 50 per cent haircut on private bond holdings and the subsequent decision that this does not constitute a credit event has the interesting consequence that sovereign CDS will become useless, although ISDA claims otherwise. Why would an investor hedge sovereign bond exposure through CDS if it is highly likely that whenever there is an actual chance of sovereign credit event, it will be handled in a manner that will be deemed voluntary and not a credit event?
Considering the fact that the original 21 per cent haircut did not get the expected response, how could a 50 per cent haircut be deemed voluntary? Earlier I did say that EU might actually be doing something sensible by banning naked CDS positions but now something not so great is happening. It appears that going forward selling the cash instrument is the only way to hedge.
Here is the latest from ISDA:
Does the October 26 Eurozone deal for Greece qualify as a credit event?
The determination of whether the Eurozone deal with regard to Greece is a credit event under CDS documentation will be made by ISDA’s EMEA Determinations Committee when the proposal is formally signed, and if a market participant requests a ruling from the DC. Based on what we know from preliminary news reports, the Eurozone proposal is voluntary and not binding on all bondholders. As such, it does not appear to be likely that the deal will trigger payments under existing CDS contracts. In addition, it is important to note that available information for the Eurozone proposal is currently not sufficient for the ISDA Determinations Committee to accept a request to determine whether a credit event has occurred.
Yes, banks are voluntarily accepting the haircuts at gunpoint. Just like I learned in military that being forced to do something is just a one form of volunteering. This is not a done deal yet, but if it goes ahead like ISDA wants, sovereign CDS become useless.
The European Central Bank has been buying a lot of sovereign debt lately. The following is a chart of ECB’s weekly assets held for monetary policy purposes since summer 2009. ECB has luckily so far refrained from massive balance sheet expansion unlike the Fed.
Source: ECB weekly financial statements
However, the purchases that appear to be heading into one direction only are starting to go against the law as the statute of ECB stipulates that:
Operations with public entities
21.1. In accordance with Article 123 of the Treaty on the Functioning of the European Union, overdrafts or any other type of credit facility with the ECB or with the national central banks in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.
In addition, the sad thing about these ECB bailouts is that Trichet has repeatedly claimed in public that ECB will not be a lender-of-last resort to troubled countries and that ECB will not monetize sovereign debt and then the ECB goes and does that very thing the next day or later.
If the purpose of these EBC interventions has been to lower the rates on PIIGS’ bonds, they have failed; Italian 10-year just euro time time highs.
Transition into ESM
While the EFSF appears to be an ever-evolving bailout mechanism, it has the undisputed benefit that it is temporary. Unfortunately, the EFSF will be replace by the permanent ESM or European Stability Mechanism. The treaty creating the ESM was signed in July and it will replace the EFSF in July 2013, if national parliaments vote for it, while the EFSF is slowly wound down.
First, let’s look at the legal framework (here is the full treaty) for the ESM, which is quite draconian:
The purpose of the ESM shall be to mobilise funding and provide financial assistance, under strict economic policy conditionality, to the benefit of ESM Members which are experiencing or are threatened by severe financing problems, if indispensable to safeguard the financial stability of the euro area as a whole. For this purpose, the ESM shall be entitled to raise funds by issuing financial instruments or by entering into financial or other agreements or arrangements with ESM Members, financial institutions or other third parties.
The authorised capital stock shall be EUR 700 000 million.
ESM Members hereby irrevocably and unconditionally undertake to provide their contribution to the authorised capital stock, in accordance with their contribution key in Annex I. They shall meet all capital calls on a timely basis in accordance with the terms set out in this Treaty.
The Board of Governors may call in authorised unpaid capital at any time and set an appropriate period of time for its payment by the ESM Members.
The Board of Governors shall review regularly and at least every five years the maximum lending volume and the adequacy of the authorised capital stock of the ESM. It may decide to change the authorised capital stock and amend Article 8 and Annex II accordingly.
If an ESM Member fails to meet the required payment under a capital call made pursuant to Article 9(2) or (3), a revised increased capital call shall be made to all ESM Members with a view to ensuring that the ESM receives the total amount of paid-in capital needed.
During the transitional phase spanning the period from June 2013 until the complete run-down of the EFSF, the consolidated ESM and EFSF lending shall not exceed EUR 500 000 million, without prejudice to the regular review of the adequacy of the maximum lending volume in accordance with Article 10.
To summarize the above, ESM will have 700 billion in authorized capital which is can call from member states at any time. If Finland does not pay, Finland loses its voting rights and other countries must fill the gap. “Filling the gap” continues as long as only Germany is left to pay for everything, but it does not end there as this ESM will be able to increase the authorized capital without any input from national parliaments. ESM can also take as much debt as it wishes as there are no strict limits on capital structure. I would say that this is the final nail on the coffin of national sovereignty since this mechanism is permanent.
The ESM, its property, funding and assets, wherever located and by whomsoever held, shall enjoy immunity from every form of judicial process except to the extent that the ESM expressly waives its immunity for the purpose of any proceedings or by the terms of any contract, including the documentation of the funding instruments.
The property, funding and assets of the ESM shall, wherever located and by whomsoever held, be immune from search, requisition, confiscation, expropriation or any other form of seizure, taking or foreclosure by executive, judicial, administrative or legislative action.
The archives of the ESM and all documents belonging to the ESM or held by it, shall be inviolable.
The Members or former Members of the Board of Governors and of the Board of Directors and any other persons who work or have worked for or in connection with the ESM shall not disclose information that is subject to professional secrecy. They shall be required, even after their duties have ceased, not to disclose information of the kind covered by the obligation of professional secrecy.
In the interest of the ESM, the Chairperson of the Board of Governors, Governors, alternate Governors, Directors, alternate Directors, as well as the Managing Director and other staff members shall be immune from legal proceedings with respect to acts performed by them in their official capacity and shall enjoy inviolability in respect of their official papers and documents.
Within the scope of its official activities, the ESM, its assets, income, property and its operations and transactions authorised by this Treaty shall be exempt from all direct taxes.
If you are curious how exactly these conventions that governments can break the all they want are created, there is your proof. The above also explains how they are going to get away with intentional market manipulation while I would go to jail if I were to engage in similar activity.
If we want the illegality in government to stop and rule of law to be enforced, we but stop creating institutions that are above the law. It is not that hard concept to comprehend.
No real causes addressed in any way
It takes no expertise what so ever to paper over everything with more debt. Everyone knows it will bring a short-term relief to the liquidity problem, but once the cash infusion runs out we will be in the same hole with the exception that now it is deeper.
Equivalently, it takes just about zero expertise for the central banks to give unlimited free credit to banks and then claim they saved the economy when in reality they rewarded failure and looted those who had been acting responsibly.
The party is already ending, because since the deal was reached one primary dealer has gone bankrupt (How is that even possible?), Greece government is about to collapse and Italy sovereign debt is imploding.
Is any of this really surprising to anyone with even an ounce of common sense and basic understanding of elementary school mathematics?
On the positive side, Greece seems to be going back towards taking control of their own country, although markets are not liking the news.