Sunday, November 20, 2011

End of the euro, Sunday edition

Charlemagne Prize winner German Chancellor Angela "Odoacer" Merkel is recalling previous German attitudes in her approach to the European bank crisis, using it to turn one European government after another into collection agents for big banks.

The caption is a quotation from Prince Otto von Bismarck, "Wir Deutsche fürchten Gott aber sonst nichts in der Welt." ("We Germans fear God but nothing else in the world.")

This is a good symbol of what Angie Odoacer thinks she's doing with her "impoverish the people of Europe" austerity policy that she's turned the EU into a club for enforcing. That ugly snake could represent what Bismarck thought of the menace of democracy. But the snake's fangs may be sharper and longer than they look. And that armor may be pretty darn thin.

EU President José Manuel Barroso is trying to talk Merkel into accepting some variety of eurobonds, which would allow other eurozone countries to borrow against Germany's credit (to oversimplify a bit). (Cerstin Gammelin, Brüssel Barroso lockt Merkel mit neuem Plan für Euro-Bonds Süddeutsche Zeitung 20.11.2011)

Angie's partner in the destruction of the EU, French President Nicolas Sarkozy, is finally pushing the idea that outgoing Spanish President Prime Minister Zapatero endorsed last week of having the European Central Bank (ECB) act as a lender of last resort for eurozone governments. That might actually provide a short-run solution, and could be pulled off without technically violating existing EU laws on the function of the ECB.

But it's probably too late. Angie and Nick, it appears, jumped the shark (passed a point of no return) with their late-October Greek rescue plan. Greece has to have a reduction of its principal on the debt, a writedown or "haircut", because Greece isn't going to be able to repay the current debt. That rescue package included a 50% "voluntary" writedown on the portion of the Greek bond debt owed to private banks.

But one of the reasons a Greek or Italian or Spanish default could have far-ranging effects of financial institutions in Europe and the US is the usage of credit-default swaps (CDS), a financial derivative that allows institutions to hedge their interest-rate risk. Matt Yglesias provides a readable summary of how CDS work in How The EU Killed The Sovereign Credit Default Swap Market And Why It Matters Think Progress 11/14/2011:

When you lend money to somebody, you bear a certain amount of risk that he won’t pay you back. In exchange, you earn interest. But maybe you’d like to bear a bit less risk and earn a slightly lower rate of return. You could just find someone else to lend money to, but there may not be demand for loans at exactly the risk/return point you’re looking for. Another alternative would be to hedge your risks through insurance. That’s the origin of the “credit default swap” concept, you take a position that pays off in the case of default. Then as with all other kinds of financial instruments, a secondary market develops and soon enough you have a whole different business in writing and trading CDS contracts alongside bonds.
And he describes the problem with the latest Greek bailout and CDS:

But a funny thing happened on the way to the partial Greek default in late October. European leaders proclaimed that banks were going to take a 50 percent haircut “voluntarily” even though the whole point of politicians getting together to make the deal was to underscore the non-voluntary nature of the restructuring. It was declared voluntary, however, precisely in order to protect institutions with CDS exposure. As a result of this, market participants no longer have confidence that sovereign credit default swaps mean what they’re supposed to mean, and the correlation of CDS rates to yields is plummeting.
If banks holding Greek bonds would voluntarily take a writedown ("haircut") of 50% on their holdings, the writedowns don't trigger the CDS, i.e., the CDS lenders dont' have to pay out. But in practice, that means that CDS on eurozone sovereign debt have lost much of their value.

But then, the latest Greek rescue plan isn't a done deal anyway, as Ed Harrison points out in Greek non-default deal not running smoothly Credit Writedowns 11/17/2011.

Still, the partial nullification of the value of the CDS against eurozone sovereign debt seems to have been a major factor in the increased pressure on basically all the eurozone countries last week except Germany.

It also raises a question about the health of the balance sheets of US and European banks. There doesn't seem to be anyone who actually knows what the total exposure of those banks to eurozone-sovereign-debt related CDS is. But it's almost certainly very big. If CDS payouts can be nullified by "voluntary" bank writedowns of debt, then just how much are any eurozone-sovereign-debt related CDS worth? How would the banks balance sheets looks if a realistic valuation of their CDS were done in regulatory stress tests?

Also on CDS, see:

Nick Dunbar, We Need to Talk About Sovereign Credit Default Swaps 10/31/2011

Council on Foreign Relations/Center for Geoeconomic Studies,
It's Time to Euthanize Sovereign CDSs 11/14/2011

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