21 May, 2012, 14:52 Posted by Zarathustra
The events in Europe right now is essentially a slow-motion bank run (or “bank jog”) on various European banks in the periphery. Greece, for instance, have been losing deposits in their banks, while Spanish bank Bankia was rumoured to have massive among of deposits being withdrawn. And of course, in the days of modern banking with internet and other stuff, you don’t even need to see a massive queue outside a bank to know that there’s a bank run.
Disturbingly, what’s happening today in Europe reminds me of something happening more than 80 years ago, when bank failures triggered bank runs virtually in the whole of Europe, later bank holidays in hope to stop bank runs, capital control, and countries going off gold standard. Sure enough, by thinking about the event in 1931 by no means suggest that I think what happened then will surely happen in 2012. It is always, however, good to look at the history and see what we can learn from it.
We all knew that the Great Depression started in 1929. Perhaps lesser known is that one of the more dangerous legs of the slump during the the Great Depression did not start until 1931 when an Austrian Bank Credit Anstalt went bust.
At the time, it was the biggest bank of Austria. Its failure triggered a European banking crisis, with bank runs started first with Austrian banks, then with German banks.
In Liaquat Ahamed’s wonderful book Lords of Finance: The Bankers Who Broke the World, he wrote that while Austria was a small country with the GDP about one tenth of Germany’s, remarkably the failing on its biggest bank sent a massive shockwave to the whole of Europe, an ultimately to the world economy. While the big central bankers were trying to come up with rescue packages, without the experience of modern central banking, they came in too late, with too little money.
During the time of the Great Depression, it was the French which had the biggest gold reserve after the United States. At the time of Credit Anstalt’s failure, the French was apparently faring relatively well among European countries. And not surprisingly, politics was in play in their attempt to save themselves. France, although financially stronger among European great powers, they were not keen at all to save the Germans and Austrians (perhaps still quite keen to punish them for starting World War One). When the United States unilaterally forgo war debts from Europe for a year, which included German’s reparation, France was furious. Liaquat Ahamed quoted that the British Prime Minister at the time Ramsay MacDonald saying that “France has been playing its usual small minded and selfish fame over Hoover proposal…”, while the Bank of England Governor’s Montagu Norman said, according to Ahamed, that “Berlin was being ‘bled to death’ while the French and the Americans were busy arguing” (p. 413). And sure enough, when the German’s central bank Reichsbank asked Banque de France and the French government for help, that didn’t work. The French government offered some loan with conditions, which the Germans thought of that as “political blackmail”.
As the crisis worsened, Danatbank, at the time the second biggest bank in Germany, went bust some two months later after Credit Anstalt failed. On 13 July, it failed to open for business, triggering yet another wave of massive bank runs on every other German banks. With the banking crisis at its worst, a two-day bank holiday was imposed in German to prevent further drain in deposits. Later, banks in virtually the whole of Europe are closed.
Meanwhile, in London, the government is considering measures to reduce budget deficits even as the banking crisis hit Britain, partly because of UK’s banks exposure to Germany and other countries in the continental Europe, and the Bank of England was losing gold reserve, forcing the Bank to raise interest rate when it should not. The military’s salary would be cut in hope to plug the budget gap, but the some sailors in the Royal Navy became (predictably) very angry and essentially went on strike, an event which is now known as the Invergordon Mutiny. Not a particularly huge event, but enough to send a shockwave to the City of London with stock market crashed and a sterling crisis. In about a week after the Mutiny, Britain was forced out of the gold standard.
- European Banks Are Getting Pounded (mb50.wordpress.com)
- As First Greek CDS “Anstalt” Appears, A Question Emerges: Did Banks Not Square Off Margins? (zerohedge.com)
- Chinese Defaulting on Commodity Contracts (ritholtz.com)
- 18 Signs That The Banking Crisis In Europe Has Just Gone From Bad To Worse (raptureimminent.wordpress.com)
They argue that one euro will fall to just $1.20 within the next four months, compared to a current value around $1.34. What’s more, they think this estimate has downside risks.
Their analysis is predicated on a baseline scenario that EU leaders will put stop-gap measures in place in the near-term but will ultimately have to adopt large-scale QE to stave of the crisis in the medium term.
From their investor note:
In our central case, in which the ECB will be forced into a delayed and reactive large-scale QE, risk assets could trade better over time (assuming that the QE amount is sufficient). But it is likely to be seen as a change in the ECB reaction function, and hence we think EUR/USD would trade lower in the medium term. AUD, CAD and EM FX should perform quite well in this scenario.
We also expect ECB QE and although the immediate effect upon announcement of such measures may well be EUR bullish, large-scale monetization is likely to weigh negatively on the EUR in the medium term, hence providing an offsetting force to any USD negativity related to Fed QE3.
- NOMURA: The Euro Is Going To See A MASSIVE Drop In Value In The Next Four Months (businessinsider.com)
- Analysis: ECB’s Failure To Sterilize Bond Buys – Is It QE? (forexlive.com)
- The Pound rallied from a low just above 1.56 against the US Dollar Exchange Rate (torfx.com)
- Complete Summary Of What To Expect From Europe This Week (zerohedge.com)
- ForexLive European wrap: Euro shows a bit of backbone after S&P’s announcement…… (forexlive.com)
- S&P Threatens To Downgrade Euro Rescue Fund Amid Crisis Of ‘Governance’ In Euro Area (businessinsider.com)
This may be in Germany’s future.
Sean Pignatell of Cowen International just put out a new note calling peripheral European debt “completely uninvestable” and predicting the end of the eurozone unless the European Central Bank makes a commitment to “unconditional and unlimited” intervention in the sovereign bond market.
That’s because it is now impossible to hedge both currency and sovereign credit risk.
A combination of policy that allowed Greece to default (even “selectively”) and bond yields surpassing 3% mean that investors are no longer able to hedge the sovereign credit risk of the PIIGS. Even France, Pignatell writes, is nearing the end of that rope.
But now it’s even impossible to hedge currency risk. Here’s why:
The real answer is that it never could be but, until very recently, it didn’t need to be. And here we have to go back to that pivotal moment when Merkel and Sarkozy openly called Papandreou’s bluff and turned his ill-advised political manoeuvre (the bail-out referendum) into a vote on remaining in the Eurozone. One bad decision compounded by a catastrophic one. Pandora’s Box was opened and there will be no coming back from that one.
So, in one move we went from a position whereby currency risk for individual countries in the Eurozone could be hedged via Euros, to needing to be hedged in currencies that, as yet, do not exist.
With the very fabric of the euro monetary union in flux, there is only one solution that would avoid catastrophe:
Markets will continue to be volatile, and Eurozone sovereign spreads will have good days as well as bad. However, until the ECB fully commits, both unconditionally and without limit, then these bond spreads will continue to rise.
The mechanism by which others get sucked into the periphery is not dissimilar to a black hole; as the periphery’s problems grow, so does its pulling power, drawing more countries into its vortex, in turn increasing its force. Eventually, without a break up of the Eurozone, even Germany would get sucked in.
The International Swaps and Derivatives Association — responsible for determining when a credit event (that would trigger credit default swap payouts) occurs — just updated its Q&A on Greek sovereign debt to account for the newest changes to the private sector bond swap discussed last night.
Their prognosis? If the swap is indeed voluntary, then there won’t be a credit event, even with haircuts of 50%.
But the likelihood that most bondholders will agree to those kinds of losses without significant coersion is slim. Numbers on participation when that haircut was just 21% were at best around 85%, under the 90% Greece demanded.
The ISDA says it can’t make a final decision on whether or not there will be a credit event until a formal decision is made:
UPDATE OCTOBER 27: The determination of whether the Eurozone deal with regard to Greece is a credit event under CDS documentation will be made by ISDA’s EMEA Determinations Committee when the proposal is formally signed, and if a market participant requests a ruling from the DC. Based on what we know it appears from preliminary news reports that the bond restructuring is voluntary and not binding on all bondholders. As such, it does not appear to be likely that the restructuring will trigger payments under existing CDS contracts. In addition, it is important to note that the restructuring proposal is not yet at the stage at which the ISDA Determinations Committee would be likely to accept a request to determine whether a credit event has occurred.
Read their full Q&A on Greek sovereign debt here.
- How gross and net CDS notionals really work (ftalphaville.ft.com)
- Credit Event Or No Credit Event, This Will Get Messy (zerohedge.com)
- Barclays Explains Why A 50% Greek Haircut “Would Be Considered A Credit Event, Consequently Triggering CDS Contracts” (zerohedge.com)
- So. Many. Bailout questions (ftalphaville.ft.com)
- Farce Is Complete As ISDA Finds 50% “Haircut” Is Not A Credit Event (zerohedge.com)
- Who wants to be a Greek bond holdout? (ftalphaville.ft.com)
For the majority of a nerve-wracking summit that dragged on more than 10 hours, from 6 PM CET Wednesday to 4 AM CET Thursday morning, all attempts at progress to stem the crisis appeared to hit a wall.
But EU leaders finally made a breakthrough.
At 3:30 AM CET, we heard that they were closing talks with bank representatives on “voluntary” 50% haircuts on holdings of Greek bonds. Then we started hearing about leverage, and suddenly — at 4 AM CET (10 PM EST) — we finally got word of some agreement.
So here’s the rundown of what leaders decided (EU leaders were still pretty vague about all the numbers, however, citing estimates for most things):
- 50% haircuts on private holdings of Greek bonds through 2020. Evidently this will still be voluntary. It would cut Greece’s debt by €100 billion ($139 billion). German Chancellor Angela Merkel said EU leaders aim to see the credit swap take place in January.
- Leverage will increase the firepower of the European Financial Stability Facility by 4-5 times, to somewhere in the range of €1 trillion ($1.4 trillion).
- China and the IMF could play a huge role in the bailout. Not only has the IMF expressed interest in playing a role, French President Nicolas Sarkozy told reporters that he will call Chinese Premier Hu Jintao around midday tomorrow, presumably to discuss this.
- Greece will receive €130 billion ($180 billion) in fresh aid. We’re thinking this includes the nearly €110 billion ($150 billion) it was promised back in July.
- EU leaders believe Italy’s commitment to debt sustainability and encouraging growth, even though Italian PM Silvio Berlusconi didn’t propose any new measures to accomplish these goals in a letter he wrote to some members of the summit today.
- The European Banking Authority estimates that only €106 billion ($147 billion) in funding will be needed to recapitalize European banks and help them meet capital requirements of 9%. Turns out it didn’t actually conduct new stress tests accounting for adverse scenarios this time around. European Council President Herman van Rompuy told reporters that banks must reach this 9% ratio with only the “highest quality capital.” We’re hoping he means Tier 1 capital and will not allow banks to use riskier convertible bonds to meet this number.
- We aren’t likely to see a final roadmap on EU treaty changes until March 2012.
- A statement from the summit can be found here.
Clearly there’s still a lot more progress to be made towards truly solving the crisis. None of these steps alone — or even altogether — will do that, not to mention that the numbers we’re seeing here have not all been written in stone. Indeed, until we see EU authorities start to execute some of these proposals, it will be difficult to bank on their success.
That said, the fact that EU leaders actually made (at least preliminarily) plans on a lot of the issues they said they would — particularly after all the negative news today and earlier this week — will reassure markets that these leaders are indeed capable of accomplishing something when pressed.
Looking forward, we will be looking to see EU leaders make good on these proposals, without diluting them to ineffectiveness. In particular, treaty changes — probably the most controversial of any measures we’ve heard discussed thus far — will be key to actually mending the broken bones of the euro area.