Europe and Yogi Berra
David R. Kotok
July 2, 2012
“We affirm that it is imperative to break the vicious circle between banks and sovereigns.”
-Press Release, Euro area summit, June 29, 2012
European leaders have finally determined something that was apparent to everyone for years. Now comes the difficult part: how to implement a euro zone-wide banking system. Will sovereign countries give up their sovereignty and submit to a euro zone-wide authority? We shall see.
Meanwhile, in order to accomplish this agreement, Germany, under the leadership of Angela Merkel, achieved something she wanted without having to give up anything. Germany had previously insisted that the coming European Stability Mechanism (ESM) crisis-funding facility have seniority status relative to other sovereign debt claims. Germany’s allies in this position included other northern eurozone countries, like Finland. The southern countries had not agreed to this status since it would have created a market based pricing of their multi-tiered sovereign debt..
Merkel agreed to give up something she did not have in order to achieve the continuation of austerity requirements in the southern countries. She agreed not to press for the two tiered seniority pledge. In return, the ESM and the peripheral southern countries will be able to achieve the ESM’s role expansion. The ESM will be used to recapitalize banks.
A euro zone-wide banking system with a euro zone-wide deposit protection function and with a euro zone supervisory role by the European Central Bank (ECB) has been long sought. Those who have observed the creation of the euro zone knew that this had to come. What’s new is that it took a crisis to bring about a conceptual commitment. Moreover, it happened at 4:30am after 19 summit meetings.
Spain’s benchmark sovereign debt yield was again above 7%. This morning it is above 6%. Italy’s yield was rising. The weaker credits of the euro zone and the euro zone spreads were widening to the point where economies were structurally incapacitated. Cumberland Advisors tracks those spreads on its website; you can see the weekly update on the series at the following link: http://www.cumber.com/content/misc/EU_Contagion.pdf. BTW, track the French yields given the reports today by its national auditors.
Note that the Swiss sovereign debt yields have now been added as an additional chart in the stack. As we wrote in previous missives, the Swiss franc has become the de facto stabilizing currency for the euro zone. The government of Switzerland and the Swiss Central Bank has pegged the Swiss franc to the euro at a ratio of 1.2 to 1. Note how the spread between the German 10-year sovereign bond (the Bund) is 100 basis points relative to the Swiss franc-denominated 10-year sovereign bond. Watch this spread. It indicates the market driven estimate of the developing credit risk in Germany vs. Switzerland.
Implementation of a euro zone-wide banking structure, a so-called banking union, will unfold over the next few months. This theatre is bound to be entertaining and volatile.
While we are pleased to see that the leaders in the euro zone have finally reached a general framework for a banking union, we still do not see the framework developing for political union nor movement in the budgetary requirements that need to be closed in order for the bleeding of the euro zone to stop.
Over the weekend, reports, since the summit, showed that the economy of Spain continues to shrink. Other peripheral economies are doing the same. Deficits have not been reined back and spending has not been sufficiently reduced to close the expanding deficit problem.
On our website, the debt-to-GDP ratio is included along with credit ratings of the various sovereigns in Europe and the euro zone. Debt-GDP is not the only standard by which to measure creditworthiness, but it is one of them. If your debt is expanding faster than your economy is growing, your debt-GDP ratio is rising. If your interest rate is also rising, then the cost of finance for your government is rising even faster. That situation is made much worse when the economy is shrinking. Then, you have a shrinking denominator and a rising numerator; therefore, the ratio expands quite rapidly.
Markets are not dumb; they may overreact in pricing in both directions, but they are not perpetually dumb. Market agents know what happened in Greece. They watched the private sector crushed in the debt negotiations and reconfiguration. They decided not to lend to Greece anymore. They are worried about Portugal, which is why the Portuguese spreads have been wide, even as the government of Portugal is attempting to balance itself and meet its obligations. Markets punished Ireland. Market agents continue to question Italy and Spain.
Does the pledge of the ESM to recapitalize Spanish banks and other banks arrest the deterioration of the debt-GDP ratios? We think not. Does it assist the banks in a transition that will enable them to regain functionality? We think that is a possibility.
On a wholesale basis, bank runs have been occurring in European peripheral countries for many months now. The statistics demonstrate this. Those are wholesale runs; they do not show up on television as retail depositors standing in lines in front of banks. We have not seen a “Northern Rock”-type visual experience like the one in the UK several years ago. The reason bank runs have not been visible is that the sovereign governments and sovereign debt structures have been supplemented by a facility called the Emergency Liquidity Assistance (ELA) financing mechanism. That has prevented banks from running out of cash.
Will the newly constructed banking system and bank capital injection coming from the ESM augment ELA? Probably so. Will banks with additional capital be able to deal with some of their problem loans? Probably so. Will confidence be restored in banks so depositors do not move their monies out because of insecurity? That remains to be seen.
We would not keep our own euro-denominated deposits in any of the countries that have deteriorating credit and deteriorating economic positions. Why should we expect any other depositor to do so?
Barclay’s economist Julian Callow summarized his analysis as follows: “The key breakthrough at the Euro area summit was to pave the way for a banking union that would ultimately be backstopped by euro area collective funds, helping to break the link between sovereigns and national banking systems. The summit’s conclusions are another reminder that the complex economic, financial, fiscal and political challenges can be addressed only incrementally, with full attention to conditionality, accountability and sequencing.”
We believe Julian Callow has summarized it perfectly. The euro summit, the funding of the ESM, the use of it for capital injection purposes in the banking system is a positive step. To applaud it as a solution is to overreach. A step in the right direction is one thing; we have not reached the finish line in this saga of the reconstruction of the euro zone.
We close with best wishes to our clients, friends and readers for a happy celebration of the 4th of July. America’s birth and independence enables us to enjoy great freedom in this wonderful country called the United States. Despite our political protestations and differences, we continue to thrive and survive.
On an historical note that may offer guidance related to Europe, let us remember that the first attempt to form a national system failed in the United States. We then had to go through a process to formulate our constitution. We attempted to have a currency called the Continental Dollar, and we subsequently inflated away its value. We went through a system of currencies and monetary authorities that really were in the hands of the several states. We fought a civil war. We endured repeated banking and credit crises. After the crisis in 1907, we witnessed the inception of the Federal Reserve System. It became official in 1913. That first attempt at a Federal Reserve System had its own faults and frailties. The faults emerged in the Great Depression and in the subsequent activities of the Fed leading up to World War II. During the war, the Fed assisted the financing of the United States so it could fight the war. The newest form of American monetary structure went into effect in the early 1950’s, when the US Treasury and the Federal Reserve reached an accord and restructured the operations of the Federal Reserve System.
There is no reason for us to expect Europeans to do something in ten or fifteen years when it took us several centuries. They are in an early stage.
Here in America, we enjoy our great democracy and political freedom coupled with a federal monetary system. The Europeans are now attempting to obtain their version in the monetary and banking sphere.
Enjoy your 4th of July and celebrate the birthday of America. We may have difficulties and frailties in the United States, but it remains a wondrous place.
By the way, at Cumberland, we still have a cash reserve as of today. This “ain’t over till its over” said a great American. His name is Yogi Berra.
David R. Kotok, Chairman and Chief Investment Officer