The Never-Ending Story of European Debt. What Next?

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates.

(Written on Friday, 7/8) 

After weeks of negotiations it looks as if some temporary resolution to the Greek debt was found and the rating agencies seem to be onboard. The restructuring and rolling out of the debt will not be defined as a default, providing Greece access to another EUR 70 billion, which should enable debt payments to be made. German and French banks agreed to roll out any maturing payments until after 2014. Greece owes EUR 355 billion of which about 288 billion is owed to other European governments.

This week Portugal’s debt was downgraded to junk status. The yield on 10-year government bonds of both Portugal and Ireland traded at over 13 percent. Spanish 10-year bonds traded over 5 percent, while German bonds for the same maturity were at 2.85 percent. The disparity between the debt of different currencies that are all denominated in euros obviously puts a lot of stress on the euro system.

Today the market focus changed to the results of the next round of the European bank stress tests, due to be published on Friday. The Germans as well as  Draghi of Italy, who will take over from Trichet as head of the European Central Bank, said  their respective banks will all pass the stress tests. The market view of statements like this is at the least skeptical. Advance comments on the subject after what happened on the original round of stress test, where the criteria was softened to make sure most of the banks passed, only appears to be desperation and does nothing to buoy up credibility. And credibility is something the European financial system certainly lacks after a history of broken promises, hidden information and misleading guidance ever since the euro was formed.

I wrote an article at the beginning of the year on what a possible breakup of the euro would look like. Most of that piece was focused on sovereign debt and how much all the European governments had lent each other in the euro capital Ponsi-like scheme. We all know what happens when the money stops coming into such a scheme.

Friday’s bank stress test results should reveal how much recapitalizing some of the banks will need to meet the capital ratios that have recently been suggested would be adequate — whether they are the EU’s own ratios or the more stringent ones recently unveiled by the Bank of International Settlements.

Greece and Portugal’s debt problems are principally government driven. Of course, they do cascade down to the banks in those countries, but they started at the government level. In Ireland the problem was more bank-driven as it was in the UK, but in the UK the problem has been helped by government austerity programs that were put in place. Whether they are effective or not, only time will tell, but for now they are serving to boost credibility — a lesson Europe needs to learn.

Many questions arose today about Italian bank debt, which caused Draghi to make his comment.

I do not think the financial markets will allow the rolling out indefinitely of the combined euro zone debt obligations. The more the EU tries to postpone a real resolution, the more likely it is the financial markets will take on the EU establishment to correct matters and, of course, to make money.

In a refreshing piece of candor, ECB Head Trichet said after a meeting of the European Systemic Risk Board (yes they do have one) that the link between debt problems and banks “is the most serious threat to the financial stability in the European Union.”

Next week the foreign exchange markets and their relationship to risk on – risk off trading in the global markets will be subject to all news bites on the European bank stress test until Friday, when the results become known. After it has been announced there will be many questions asked about how credible the results are and then the market will attack the weakest part of the euro zone system.

(Written on Monday, 7/11, to reflect the weekend’s revelations) 

Italy put in place a ban on short selling this morning after talk of the EU not being able to agree how the Greek bail out would work, and talk of a partial default surfaced. The result is basically a run on Italy. The Italian debt load is 1.6 trillion euros, significantly larger than that of Ireland, Greece and Portugal. The Italian debt to GDP level is the second highest behind Greece at 119 percent of GDP as at the end of 2010.  In this morning’s trading, 2-year Italian government debt was sold off effectively raising the yield from 3.5 percent to 4.08 percent, its highet level since 2008. With the market now focused on Italy, it is estimated that if the debt is sold off in a similar fashion as happened with Greece, Portugal and Ireland, the 10-year yield will reach 7 percent within three months. Seven percent was the level at which the other three countries had to resort to a bail out. The European finance ministers are in the sights of the market as they meet today.

As Italian debt came under attack, the yield on Spanish 10-year debt rose to 6 percent, its highest level since 1998. As the yields of the PIIGS bonds rises, the German bund yields have fallen as investors run to them as the European safe haven. The yield on the 2-year bund fell to 1.34 percent, below the European Central Bank’s benchmark interest rate of 1.5 percent for the first time since January. As a point of reference the yield on the Greek two year money is 31.21 percent.

A couple of months ago the European Stability Mechanism, which takes effect in 2013 and makes EUR700 billion available, to in theory stop any contagion such as is happening today, it is obviously too little too late.

Credit default swaps for Italy and Spain hit an all-time high this morning.

The European problems are epitomized by today’s call by Michael Barnier, head of the European Commission based in Brussels, who called upon the rating agencies to reveal the analysis used when they downgrade European countries. He said that the rating agencies actions are just exacerbating Europe’s problems. He has a point, of course, but the solution is to fix the problem not point the finger at someone else (unless the intention is to deflect attention from the real problem). The downgrading of Greece raised its borrowing cost from 142.8 percent of GDP last year to about 158 percent this year and increased Portugal’s borrowing cost from 93 percent of GDP to about 102 percent.

As you can see from the different facts in the section I wrote on Friday and the section written today, the moving parts of the whole European story are changing very rapidly.

The outcome I think will have to mean at some point the restructuring of the euro from that outlined in the Maastricht Treaty which constitutes the original rules under which the euro structure would work. In the last year its rules have been blown apart.

What are the odds of the euro at 1.2000 by year end? That would not be a dumb question if it were not for the sovereign funds that have been buying the currency every time it dips. They are one of the main reasons why the euro is at its current level. If the market stages a full on assault on the currency, the question is whether sovereign investors have the fortitude to hold their positions or whether they get squeezed. This will determine how far the euro can fall if the situation should worsen.