Europe finally agreed on a solution to the Greek question, sort of. European leaders persuaded banks holding Greek debt to accept 50% haircuts and have given banks until next June to raise capital. Banks will raise capital from private sources if they are able and from government sources, if necessary. This is not, we repeat not, a Greek default. Greece is not haircutting investors. European banks are voluntarily accepting a 50% haircut. Investors not agreeing to a voluntary haircut will receive 100% of par for their Greek debt at maturity, if Greece is solvent at the time. Among those NOT participating in the haircut is the IMF. The result is not a 50% reduction in debt for Greece, but according to sources on the street, something closer to 20%.
I mentioned earlier in this piece that this was sort of a final solution. We say sort of because there are details which need to be worked out. For instance, European officials agreed to expand the size of the EFSF to $1.4 trillion, but there are no details as to who is adding what capital to the program. Banks have been told to recapitalize, from private sources if possible and from government sources if necessary. Specifics of how banks may be able to receive public recapitalization and what restrictions may be put on such banks (dividend cuts, pay restrictions, core asset, etc.) have yet to be worked out. The way it stands is that banks which are unable to raise sufficient capital in the open market must first tap their national governments and only approach the EFSF as a last resort. Banks have until June 2012 to recapitalize. No word of what action might be taken, should a bank run into difficulties prior to raising sufficient capital.
The threat of contagion persists. It is possible that public pressure could force the governments of Portugal, Spain and Italy to request haircuts of some degree. Given the size of the Spanish and, especially, the Italian government bond market, even small haircuts to the sovereign debt issued by the European periphery’s two largest members could significantly affect banks and necessitate even more capital raising.
The EU did win not-specific support for the expansion of the EFSF from both Japan and China. China’s Premier Hu Jintao told Chinese television that he hoped measures taken in Europe will stabilize markets.
Which banks might need recapitalization? The Wall Street Journal reported that British and Irish banks will probably not need recapitalizations. However, banks in Germany, France and remaining periphery nations will probably need additional capital. Bloomberg News is reporting that French Banks BNP Paribas and Societe Generale (the two largest banks in France) are hastening cuts in their trading books (believed to be a combined $1.5 trillion, to avoid having to raise capital. French banks have already scaled back dollar-funded lending operations for items such as aircraft. Now BNP Paribas and Societe Generale are reluctantly shrinking their trading and derivative businesses. One European fund manager told Bloomberg News:
“It’s a striking sin of pride. They all want to keep their rankings, but French banks risk not having the necessary capitalization.”
European banks may find it increasingly difficult to shed assets at anything close to their fair values. As one London analyst told Bloomberg News:
“Everybody is trying to reduce risk-weighted assets as soon as possible. They’ve already all started, but they’ll probably find it harder than expected because the environment is clearly getting tougher.”
When a crowd tries to escape from a burning building via one door, some people get burned.
Already the holes in the deal are letting light in. For one, this does nothing for Greece. Oh sure, it reduces the country’s debt load for awhile, but unless Greece stops its profligate ways, its debt load will rise. However, since Greece can only obtain financing from the EU, it will default. It is nearly impossible for Greece to avoid a default. The contagion then spreads to Portugal. If it ever makes it as far as Italy, watch out. Italy has the third largest government bond market in the world. Just a10% haircut on Italian debt would cause turmoil among European banks.
Europe is a mess. Officials do not know how to pay for the “solution” or even or how the haircuts will be acknowledged. Meanwhile Europe hurtles toward recession. The rescue is nothing of the sort. Greece may end up leaving the euro (but not the EU) and devalue its way out of its mess. It is Greece’s only hope.
The bond markets are already telling us the bloom is off the Greek rose. Italy had to pay higher interest rates with its 10-year yield topping 6.00% on Friday. Spreads of periphery debt widened versus German bunds and money flowed back into U.S. treasuries.
I would advise investors not to be sucked in by stock jockey pundits and look at the situation for what it is. The periphery is an unsustainable mess. Common and preferred dividends are likely going away for awhile. If you must invest in Europe, be at a senior level on corporate capital structures. If not, invest in the U.S., at least we can keep printing money. :o
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