Euro Bailout Failure

5 ducats

Have so many ever been so enthusiastic over a plan to beg, borrow, and steal $1.5 trillion?

• Beg - Weaker European banks will have to raise over $100 billion in capital.
• Borrow - Eurozone will borrow $1.4 trillion to bailout future sovereign and bank defaults.
• Steal - Private investors lose 50% of their Greek bonds' face value (ok, "steal" is a bit strong).

Begging, borrowing, and stealing doesn't usually instill confidence. And it shouldn't. Piece by piece, here's why...
Greek bond 50% haircut:

1. Greek bonds held by the ECB and IMF don't get a haircut, so the Greek gov't didn't get half of all of their debt cut - only part of it. They still owe much more than 50%.
2. Greece's economy is still shrinking and it still runs a trade deficit, so they will continue to run a gov't budget deficit. They are going to default again.
3. The bank trade group agreed to the 50% cut as voluntary so that it wouldn't trigger a CDS default, but their decision doesn't bind the actual bond investors, and some probably won't volunteer.
4. The best reason to volunteer now is so that you haven't shot your wad early, before Greece defaults again, when you might get a bigger payout.
5. Nobody knows what the interest rate and term of the restructured bonds will be. Assume it will be very low and very long, so that the present value of the bonds will be much less than 50%. Looking for volunteers? (in truth there isn't that much Greek CDS out there).

 Banks Raise Capital:

1. The rule was created so that it scarcely touches German and French banks, funny how that works since they negotiated the deal.
2. Italian banks have to raise a lot of capital, but do private investors want to put money in banks in a stagnant economy, with a government that probably can't bail them out?
3. The goal is to hit a target capital as a percentage of assets. Instead of raising capital, they could sell assets - particularly the good ones that will sell for a high price, which leaves them with the crummy assets and makes the bank weaker in the long run.
4. A scarcity of bank capital will cause banks to lend less and lend more conservatively, which will contrain economic growth and ultimately make it harder for banks and governments to pay back their debt.
5. If banks sell many of their assets, and lend less, then that will generally lower the price of European assets and further undermine bank solvency.
6. If the value of sovereign bonds is used to determine bank capital adequacy, why would a bank now buy Italian and Spanish bonds that have a greater risk of falling in value? Sovereign bonds are now risky to banks even if they don't default.

Borrow €1.0 trillion ($1.4 trillion):

1. €1 trillion equals 45% of China's foreign reserves, but China's reserves aren't in Euro cash, but mostly in US Treasury and Agency debt. And although these are very liquid assets, you can't sell $1.4 trillion of anything without driving down your price a lot (unless the Fed wants to buy it).
2. No nation will guarantee the €1 trillion debt, Germany explicitly will not. 
3. Germany demanded that the ECB would not guarantee the debt either.
4. The Euro Emergency Stability Fund will take the first loss before any of the €1.0 in debt defaults, but the EFSF is backed by credit risks such as Italy and Spain, who are more likely to default than lend in an emergency.
5. Borrowing €1.0 trillion from China will increase demand for the Euro, causing it to rally and make the Eurozone trade deficit worse.
6. If the money is lent from within the Eurozone, then you are removing money that would otherwise be lent to someone else, which may constrain economic growth.
7. If the €1.0 debt is perceived as safer than some individual Eurozone members, then individual Eurozone members may not be able to sell their own bonds to refinance their debt - which means that they would be forced to tap the leveraged emergency fund.

If I'm China, here's what I think:

1. If this loan is so important, why won't the borrowing nations' guarantee it?
2. If this loan is so important, why won't they let their own bank guarantee it?
3. If this loan is so important, why did they send the French guy rather than the German?
4. Why should I risk the value of my US investment portfolio?

Then I offer the Frenchman some sage words, some spare change, and a pat on the head. Give them maybe one year's worth of their Eurozone trade surplus - about €140 billion, since it is natural to recycle trade supluses back into the importer's debt.