Wednesday, June 6, 2012

Time to tighten the chin strap on the helmet folks: the Eurozone endgame is underway




So today was the biggest stock market rally in months and there were a lot of good reasons for it. Though the ECB left rates unchanged there was some hinting that in the event that things got worse that there could be some additional easing at the next meeting. Since virtually all the data coming out of Europe is negative this seems like a lock. Then there was speculation that the Fed itself might ease sparking a big rally in gold but when the Beige Book came out better than expected this afternoon gold fell off but the rally kept on. Indeed, the strongest part of the rally was in the final 15 mintues when the market exploded higher on strong volume. If you ask me the most powerful thing behind the rally today was the Reuters story about the EU preparing a package for the Spanish banks.

Now while there has been a lot of talk about Greece and the Greek restructuring and the new elections on June 17th which may result in the election of parties unfriendly to the austerity regime being elected and taking Greece out of the Eurozone, ground zero for the Euro-crisis as of now is the Spanish banking system. First of all, by far the most likely outcome is that the Greeks elect people who will maintain the agreements that have kept the country solvent. Even in the event that they don't most of the private sector creditors of Greece have already taken all the losses they are going to take in the event of a Greek default/Euro exit. The only people who will be hit by a default now are the ECB, the IMF and the EFSF all of which are ultimately backed by the Eurozone sovereigns or the world at large. As far as Greece goes the pain is over. The worst thing that would happen is that it would trigger contagion and maybe force Ireland and Portugal out as well but this is not too likely and in any case would probably not be fatal to the Euro project.

The same can not be said of the collapse of the Spanish banking system. Unlike the Greece and Portugal, Spain is a major economy in Europe and the Spanish banking system, at least at the top end, operates in the pan-European market and has close relationships with the other major banks in the Eurozone. As far as I am concerned the solvency issues in the Spanish banking system are by far the most important thing facing the Eurozone and this is because they are so large that if it becomes necessary for there to be a capital injection into the Spanish banking system the Spanish state is simply not large enough to do it. To give you a sense of what is involved the top two banks in Spain have balance sheets totally $2.45 trillion. Spanish GDP is $1.4 trillion. That is to say the top five banks in Spain have balance sheets about five times the size of the entire economy of Spain. It is estimated that the real estate losses on the balance sheets of the Spanish banking system amount to something on the order of $300 billion. That is a BIG BIG hole in the balance sheet of the financial system. Another thing to remember about Spain, and the whole of Europe for that matter, is that there is no such thing as the FDIC. If your bank goes under because it got smoked lending money to Brits to buy vacation homes in Marbella guess what fraction of your deposits are insured: zero. Yep, if your bank folds you get nothing. This means that once it dawn on people in Spain that there is this big hole in the financial system you will have an old school run on the banking system and someone is going to have to step in there and sort things out. The trouble is, the Spanish government isn't big enough to do it.

Now thanks to the magic of leverage and fractional reserve banking the total amount of equity that would have to be injected into the banking system to maintain its solvency is something more along the lines of $40-$80 billion but given that Spain is already borrowing at 600 basis points over Germany just to fund its regular deficit I think it is safe to say that there is no way in hell that it will be able to tap the capital markets for something that size in the event that they need to do so. Especially if the triggering event is a Greek or Portugese default which will cause a general abandonment of Eurozone sovereign paper for a while. So, like it or not, Spain is going to need outside help and the fact that some Eurocrats rang up Reuters and told them that they were hard at work on contingencies seems to have calmed the markets fear that the worst case scenario is off the table.

That said, personally I think this is just beginning. Spain has not asked for help, and the EU has made no official announcement. This is simply and off the record discussion that the EU is making plans to help Spain in the event that Spain needs the help. What will now commence is a very intricate dance whereby Spain will move in the direction of taking the aid. It helps that the EU seems to not want to make aid to the Spanish banking system contingent on additional reforms or on a generalize EU banking union but the Spanish government will still be reluctant to accept outside assistance if it can possibly avoid doing so. As a result it will be up to the markets to compel the Spanish to do so and I think the markets will probably oblige. So while today was a great day, I think there will be some more excitement to come.

That excitement will start tomorrow when the Spain tries to borrow $1-$2 billion in a debt auction. This will be interesting because it's very likely that today's announcement was driven by the Spanish claim on Tuesday that they were being shut out of the capital markets. Personally I'm not sure what will happen tomorrow. If the auction goes terribly will the markets assume that the Spain is going over a cliff and sell off or will they think that a rescue is now certain and rally. If the auction goes well will the markets assume that everything is OK and rally or will they think that the stage has been set for more wrangling between Spain and Germany and sell off. I really can't say. All I can say is that this is neither the beginning of the end nor the end of the beginning. It's just the beginning.  

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