Week in Review Part I: Europe, Washington and Wall Street

It was a week that saw German Chancellor Angela Merkel gaining acceptance in the Bundestag to lever up the European Financial Stability Facility (EFSF), or rescue fund, then all night negotiations on a plan to finally bail out Greece, increase the firepower of the 440bn euro EFSF, and a plan to recapitalize Europe’s banks. It was also a week when, aside from a stupendous global rally in stocks, French President Nicolas Sarkozy admitted the obvious: It was a mistake to admit Greece into the eurozone in the first place back in 2001.

“It was an error because Greece entered with false (economic) figures…it was not ready,” he said. Asked then if he had confidence Greece can emerge from the crisis, Sarkozy opined: “Yes…we have no other choice. We had to face up to all this. If the euro had exploded last night, all of Europe would have exploded.

If Greece had defaulted, there would have been a domino effect carrying everyone away…We took important decisions yesterday that avoided catastrophe.” It turns out that in terms of an outline, virtually everything I have been writing all this year in particular has come to pass; the needed plans to recapitalize the banks, reduce Greece’s debt, and the creation of a firewall around Italy and Spain, at least thus far in theory.

Improving Europe’s governance, a highly explosive issue still to come in future EU summits, threatens members’ sovereignty. Greece itself is the first victim as a set of advisers from the troika (International Monetary Fund, European Central Bank and European Commission) will be riding herd on Greece to ensure it meets its austerity objectives. The debates regarding other nations, and the ever-increasing power of Germany, promise to be titanic.

On the element of the Greek ‘haircut,’ not only is the reduction in Greece’s debt dependent on current bondholders buying in, but the actual bond-swap has not even begun to be negotiated. Details, details.

Plus, the recapitalization of the banks is not only at an amount far less than most thought was needed, but there are a myriad of issues behind the actual implementation. As I wrote a few weeks ago, the banks are to first look to raise capital internally (like through asset sales), then through private sector investors if the first step isn’t enough, then to their national governments and finally – as a last resort – to the EFSF.

But recall, France, which doesn’t want to lose its AAA-credit rating, is still hoping to eliminate the step where the banks go to their government. It’s unclear just what will happen after this week’s EU actions, though it seems inevitable France will indeed lose the AAA-rating regardless because of perceived future liabilities and that creates a whole new set of issues for the EFSF. Most agree that investors aren’t going to line up to put their money into a French bank, such as BNP Paribas or SocGen, and thus the government will need to bail them out with taxpayers’ money.

Then you have the European Banking Authority saying the banks can’t curtail business lending, but the EBA will ride herd on them to withhold dividends and bonuses to raise capital if the banks can’t raise it per the above. The whole issue of raising capital by June 2012, as mandated, of course means that business lending will be curtailed, so Europe’s small- and medium-sized businesses in particular face even more of a credit squeeze than they are already experiencing today. Yet it’s growth that the eurozone needs more than ever…and fast!

As to ring-fencing Italy and Spain, especially the former, again, the devil is in the details of the EFSF, as European officials hope that China, Japan and others come to the rescue, either through the stability facility or the IMF, which would then save the day. It’s about guarantees of all sorts with no one as yet understanding how they would work.

When it comes to Italy and its $1.9 trillion sovereign debt, ergo, too big to fail, it’s about a totally dysfunctional government that is literally coming to blows in parliament over hiking the retirement age to 67…by 2026! While Spain announced this week that unemployment there is officially at 21.5 percent; this as the nation’s banks keep ratcheting up the estimates for bad loans on the books because of the ongoing crash in the property market.

Oh, and as for the goal of reducing Greece’s debt-to-GDP ratio to 120 percent by 2020? This assumes, among other things, that their economy will be growing by 3 percent annually by 2016, even as the IMF says the country will contract by 5.5 percent this year and 2.5 percent in 2012 due to the crippling austerity measures.

So now it’s on to the G20 Summit in Cannes this coming Nov. 3-4. Further bombast and promises, while behind the scenes there will be more head-scratching as to just how the grandiose objectives are met. At least the latest Euro program not only bought some time, but in the short run the idea of a systemic crisis and a run on a major bank would seem to be off the table. For how long is the big question.

For those who naively think the Euro crisis has now been solved, on Friday, German Chancellor Angela Merkel said “it wouldn’t be over for at least a year.”
Various opinions on the Euro Fix….

Editorial / Financial Times
“In typical European fashion, a summit deal which seemed out of reach at midnight last night was triumphantly unveiled at 4 a.m. The deal does not, and was not intended to, have any effect on the core problems facing the eurozone. There is still an urgent need to restore growth to economies which are hamstrung by uncompetitive business sectors, and continuous fiscal tightening. Recession still looms, especially in the southern economies.
“What the deal is intended to provide is adequate medium term financing for sovereigns and banks which have been facing urgent liquidity problems. On that, it is notable that the summit has not really raised any new money, apart from an increase in the private sector’s write-down of Greek debt by some 80 billion euro.

“All of the remaining ‘new’ money, including 106bn euro to recapitalize the banks and over 800bn to be added to the firepower of the EFSF through leverage, has yet to be raised from the private sector, from sovereign lenders outside the eurozone, and conceivably from the ECB.

“There is no guarantee that this can be done. The eventual out-turn of this summit will depend on whether this missing 1,000bn euro can actually be raised.”

Editorial / Wall Street Journal

“(Europe’s) piecemeal approach is not going to cohere into a real or lasting solution if policy makers continue to ignore the underlying economic anemia that has afflicted the economies of Europe for decades. The patient has risen from his bed and not fallen down. This is one definition of progress.
“Thursday’s deal offers the sort of grab-bag familiar in Brussels. Greece gets another package of bailout loans, totaling 130bn euro in value. Various parts of the EU’s bailout machinery will be tweaked or boosted. But let’s climb across the deal plank by thin plank.
“The biggest accomplishment is the agreement to impose a voluntary 50 percent write-down on private holdings of Greek debt. This is progress for a Continent that dared not to breathe the word haircut only months ago.

“But that’s small consolation now that the European Central Bank, the International Monetary Fund and eurozone governments hold about 40 percent of all Greek debt, a figure that will only grow as privately held bonds mature. As long as these institutions refuse to take haircuts on their own Greek holdings, a private-sector haircut can only go so far toward reducing total debt….

“To prevent the write-down from tanking European banks, the deal provides for a raft of measures for bank recapitalization. One requires eurozone banks to achieve a 9 percent capital ratio for core Tier 1 capital by June 2012….Whether these new capital requirements will do much good remains to be seen. Still fresh in most memories is that Franco-Belgian lender Dexia fully met its own Tier 1 requirements before it went down earlier this month….
“That brings us to the summit’s last plank, an agreement to pump up the 440bn European Financial Stability Facility. Details of course will be negotiated later, but the bailout fund is now authorized to act as a bond insurer, guaranteeing first-losses up to an as-yet undecided amount on new issuance of euro-zone sovereign debt.

“The legal basis for this is dubious under the Rome Treaty, which explicitly forbids member states from guaranteeing each others’ debt…
“In short, everyone is bailing out everyone. The larger problem betrayed by yesterday’s agreement is that European leaders continue to act as if they are mainly dealing with a crisis of confidence, which can be restored with evermore far-reaching bailout schemes. Absent from this week’s communiqués are any new ideas for promoting the structural economic reforms – both at the periphery and at the center of the eurozone – that might create real confidence in the eurozone’s long-term economic prospects.”

Wolfgang Munchau / Financial Times

[On the goal of bringing Greece’s debt-to-GDP ratio down to 120 percent by 2020]
“The European Union has been consistently wrong in its economic forecasts for Greece. They misjudged the impact of austerity on economic growth and public sector deficits. This misjudgment is the reason why the voluntary bank haircut of 21 percent, agreed to in July, has now grown to 50 percent. What happens if the outlook were to deteriorate further? There is no sign yet of a turnaround….

“In the unlikely event that the banks come up with the money, and that Greece manages to hit a 120 percent debt-to-GDP level in 2020, it is far from clear that Greece can return to the capital markets even then….

“On the EFSF, the leaders reached political agreement to leverage it up to about 1,000bn. Herman van Rompuy, the president of the European Council, made a revealing comment following the meeting when he said that banks have been doing this forever. Why should governments not do so as well?

“The reason is simple. Banks can only do this because central banks and governments act as ultimate guarantors of the financial system. There exists an implicit insurance of unlimited liability. In the case of the European Financial Stability Facility the very opposite is the case: there is an explicit insurance of limited liability. Germany wants its exposure capped to a maximum of 210bn. I doubt that global investors will rush into the tranches of the special purpose vehicle through which the eurozone wants to leverage the EFSF. I struggle to see how this structure can lead to a significant and sustained fall in bond spreads.

“Leveraging can work, but only if the eurozone were willing to provide an unlimited backstop.”

Robert Samuelson / Washington Post

“There’s an Orwellian quality to Europe’s latest financial rescue. Words lose their ordinary meaning. Greece, for example, has clearly defaulted, but no one says so. In July, private lenders agreed ‘voluntarily’ to accept an estimated 21 percent reduction in their loans to Greece. Now that’s been pushed to 50 percent, and private lenders’ consent is still described as ‘voluntary.’ Well, it’s about as ‘voluntary as when one hands over one’s wallet in response to the choice of, ‘Your money or your life,’’ notes Douglas Elliott of the Brookings Institution.
“What constitutes a default? Here is Standard & Poor’s definition: ‘We generally define a sovereign default as the failure to meet [the] interest or principal payments … contained in the original terms of the rated obligation.’ Not much doubt there: A 50 percent ‘haircut’ wasn’t part of the original bonds. But for political and legal reasons, it’s inconvenient to declare a default. Instead, the Europeans call the write-down ‘private-sector involvement,’ or PSI. How reassuring.”

[Ed. On Friday, Fitch Ratings issued a statement: “The 50 percent nominal haircut on the proposed bond exchange would be viewed by the agency as a default event under the Distressed Debt Exchange criteria.” The International Swaps and Derivatives Association, whose market decisions are binding, hasn’t ruled on this yet.]

Mohamed El-Erian / PIMCO

“(The) feel good factor will only last if this is followed quickly by two other important developments.

“First, and most immediate, there is a long list of details that must be specified over the next few weeks to put into practice what was agreed to in Brussels. Many of these are technically very complex. Indeed, implementation may prove as tricky as the original negotiations, if not more so.
“How will the reduction of Greek debt actually be executed? Will the banks that need capital be able to find sufficient private funds to meet the new prudential targets? In the event that they do not, what conditions should be attached to the financing coming from taxpayers? How will the European Financial Stability Facility be levered? How will its funds be allocated among competing claims, including between stabilizing the old stock of debt and providing partial risk insurance for new issuance? And what roles will the European Central Bank and the International Monetary Fund play, as well as other countries?
“Second…Europe desperately needs an effective plan to boost employment and promote inclusive economic growth. Without this, it will be virtually impossible to stabilize the region’s sovereign debt markets, and counter fragilities in its banking system….

“Politicians also need to decide how they will strengthen the institutional underpinnings of the eurozone.”

Editorial / The Economist

“You can understand the self-congratulation. In the early hours of October 27th, after marathon talks, the leaders of the eurozone agreed on a ‘comprehensive package’ to dispel the crisis that has been plaguing the eurozone for almost two years. They boosted a fund designed to shore up the eurozone’s troubled sovereign borrowers, drafted a plan to restore Europe’s banks, radically cut Greece’s burden of debt, and set out some ways to put the governance of the euro on a proper footing. After a summer overshadowed by the threat of financial collapse, they had shown the markets who was boss.
“Yet in the light of day, the holes in the rescue plan are plain to see. The scheme is confused and unconvincing. Confused, because its financial engineering is too clever by half and vulnerable to unintended consequences. Unconvincing, because too many details are missing and the scheme at its core is not up to the job of safeguarding the euro.

“This is the eurozone’s third comprehensive package this year. It is unlikely to be its last.”

Washington and Wall Street

Stocks rocketed higher on Thursday thanks to a combination of the seemingly good news out of Europe, coupled with a report showing the U.S. economy grew at a 2.5% rate in the third quarter. This isn’t enough to put a dent in the unemployment rate, but it’s better than the 0.4% and 1.3% rates of the first two quarters this year and puts to bed, at least until next year, talk of a double-dip recession as classically defined. The figures though are pretty much irrelevant unless jobs are being created. It’s going to feel like a recession to many of us.

The reason the economy grew at such a clip, though, was due to increased consumer spending, even as real disposable income declined. So we dipped into our savings some and the savings rate fell. This trend won’t continue, though I’m guessing the Christmas season is a little better than expected. The brakes will come back on early next year, which is about when Europe could once again be a screaming issue, not that it won’t remain on the front page the balance of 2011. Italy, for example, has to roll over $400 billion in debt in 2012.

Just one other item on spending. Friday’s reading of personal income and consumption for September confirmed the GDP report’s findings. Personal income was up 0.1% for the month, while consumption rose 0.6%. Earlier in the week the government did report durable goods (big-ticket items) were up a solid 1.7% in September, ex- the volatile transportation sector.

On the earnings front, while over 70% of those reporting are beating expectations, this is a vastly overrated barometer these days with companies doing their best to tamp down expectations in order to more often than not pleasantly surprise, the better for one’s share price.

More important is the guidance and the accompanying statements on the outlook for business and on this, the last two weeks have shown a Corporate America that is decidedly mixed when looking at the next 6-12 months, as in many, such as Cummins Engine and 3M remain exceedingly cautious on the global picture, while others such as Caterpillar are optimistic.

As for the bipartisan ‘supercommittee’ that is supposed to come up with something heroic, like budget savings of $3 trillion that could begin to put a real dent in the federal deficit, as well as restore a huge amount of confidence to the business community, rather than the minimum $1.2 trillion they are charged with finding by Nov. 23, you can basically forget about our elected officials playing profiles in courage. It’s the same game-playing; Democrats don’t want to do anything significant with entitlements, and Republicans refuse to discuss revenue increases from personal or corporate taxes.

Lastly, a bit on China, which played no small part in the week’s equity rally. HSBC’s flash report on the manufacturing sector, the PMI, rose to 51.1 in October from September’s final reading of 49.9, 50.0 being the dividing line between contraction and expansion. With this one figure talk of a “hard landing” fell by the wayside. I have been steadfast in saying China would see a soft landing, but it’s a little too soon to declare victory on this one. If China’s GDP were to stay above 8.5% or so the next few quarters, though, it would be a huge boost to global confidence. It was also helpful this week to have Premier Wen Jiabao strongly hint that the government’s tightening policy is over and that it may be ready to relax credit controls to ensure employment growth. [I’m also going to learn a lot about the country’s economy with the coming earnings release of my large holding in Fujian province, sometime in the next two weeks.]