Sunday, 9 October 2011

And the World holds its Breath


The latest instalment of the European debt crisis is going to hit the markets on Monday-Wednesday.

Sunday’s “orderly” decision on the Dexia bank bail-out, such a huge contrast to the sovereign debt crisis, nonetheless contains major collateral risks. Dexia, frozen out of credit markets, is really only the tip of the iceberg. European deposits at the ECB and Federal Reserve have reached record limits last seen before the 2008 Lehman collapse, a clear sign of the risks facing the banking sector. The ECB has also opened up repo funding in a major way this past week: it was not enough to provide the needed liquidity.

Among the collateral risks are a further ratings downgrade of Belgium, and a negative downgrade watch on France. Spain and Italy were both downgraded by Fitch on Friday. It seems very unlikely that France will avoid a downgrade going into 2012.

Also on Sunday, President Nicholas Sarkozy and Chancellor Angela Merkel met to resolve French-German differences over the role of the EFSF, which still has not been ratified and is still not operations (Slovakia and Malta are left; the indications are that Slovakia will approve). The main disappointment, however, is that there is still no clear plan. As Bloomberg reports:

“By the end of the month, we will have responded to the crisis issue and to the vision issue,” Sarkozy said. “We’re determined to do everything necessary to ensure the recapitalization of our banks,” Merkel said.

This plan should have been in effect in July 2011, or even earlier. Instead, it’s been continually kicked down the road. Absent real action, which I would quantify at a minimum of EUR 2 trillion in national, ECB and EFSF loan guarantees and bond purchases, it’s not going to work.

In the meantime, the inconclusive discussions of a greater haircut on Greek debt continue, backed by nearly every source. Yet no one has really modelled the numbers. In Greece, for instance, bank and social insurance fund recapitalisation will have to reach at least EUR 40 billion to avoid a banking sector melt-down. On the global scale, even a 50% haircut results in debt of about EUR 180 billion and annual interest costs of at least EUR 8.1 billion, which Greece probably cannot hope to sustain before 2013 at the earliest. How the EU banking sector will deal with a EUR 180 billion write-down, and the concomitant contagion that will hit most other markets, is entirely beyond me.

Robert Zoellick, President of the World Bank, was quoted by Reuters as stating that “there was a "total lack" of vision in Europe and Germany in particular needed to show more leadership.”

Dexia is only the tip of the iceberg: there are at least 12 other major banks in worse condition, vulnerable to the slightest moves in equity or liability valuation. Unless something is done soon, the domino may start falling far sooner than we think. That we are already in the greatest crisis since September 2008 is clear; what’s missing is any sort of confidence that Europe’s leaders will take the right measures quickly.


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© Philip Ammerman, 2011


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