Peter Tchir

All Hands on Deck or Abandon Ship for the EU

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Europe is in a make or break week.
Peter Tchir

Peter Tchir

It’s Time For Europe to Stop Screwing Around

Enough of summits, 30 page MOU’s, convoluted documents needing approval, “aid” in stages with so many strings attached that the next round is always in doubt. It’s time to act and get money out there and use the firewall.

We have the Fed tomorrow, which while important, is dwarfed in importance but what we see out of Europe this week. Europe is in a make or break week. I continue to believe they will do enough to justify continued strength in Spain, Italy, and the banks, but the U.S. markets look stretched, even with Europe acting.

What Europe Can and Can’t Do, or Will or Won’t Do

ECB bond purchases in the secondary market are unlikely. The market will likely react negatively if that is the case, but, so what? The German’s in particular have been against ECB buying, but the reality is that it has not been an effective tool. It has failed to transfer money to the country that needs it. It has caused big problems of subordination in Greece. With so many Spanish and even Italian bonds tucked away in non mark to market accounts, this move wouldn’t even really help banks. If we get this, the market will be happy, and it is okay, but by itself is not that important. The market has put too much emphasis on ECB buying in the secondary market, but it just isn’t that important.

EFSF bond purchases are likely. This has to happen. The EFSF needs to start buying bonds since it doesn’t violate and treaties and can be effective. I would prefer primary market participation. Ideally, I would prefer EFSF to offer 2 year and 5 year money at cheap rates like a “revolving credit agreement”, but that is a stretch of their mandate. I think primary is most important as over time the secondary market will respond and no one is using the secondary market to price anything anyways. The secondary market price just isn’t that important, but it is likely that EFSF will add a secondary market element as well. The EFSF should be pari passu with other bond holders, which is good. The concern with the EFSF is that it is running out of resources. The fact that the EFSF has limited capacity is an issue and is one reason I would prefer to use them in the primary market rather than the secondary. On the other hand, getting leverage to buy bonds isn’t that hard. Get an LCH account and you can leverage 7 year bonds more than 10 times. You can get 20 times leverage on 2 year Spanish bonds. Set up repo lines with some banks for the same effect. So EFSF will need to use leverage, but it doesn’t require a banking license or anything complex. KISS (keep it simple stupid) applies here. For all the talk about 1st loss tranches, or bank licenses, if EFSF wants to leverage up bond purchases, there are easy and effective ways to do it.

The more the plan depends on ESM, the more concerned I will be. The ESM should be able to do far more in the secondary markets than EFSF, but the ESM has to be created. I don’t like relying on any entity in Europe that hasn’t yet been created. The ESM should take over various responsibilities that would go to EFSF on day 1, and can greatly expand the secondary market purchases, especially if it gets a banking license, but this is far from certain. The creation of ESM and its use will be icing on the cake. If it is the primary source of the EU’s new plan, then I would sell for now as there is no guarantee it comes on line in time.

The ECB and LTRO and rates will be key. The EFSF did take bank default risk significantly down. Too much attention was paid to the “carry” trade and sovereign debt and not enough to how much it helped the banks. Another round of LTRO would continue to help banks. The LTRO should be 5 years as that would open up far more potential collateral and make it far easier for banks to use corporate loans as collateral. Anything that encourages the banks to use LTRO for corporate loans, even more than for sovereign debt should be viewed positively. It means if and when corporations see opportunities that require investment, the money will be there. A big LTRO is within the ECB’s mandate and can be the “shock and awe” number. People can argue over how effective it will be (I think it is) but this is the easiest part of the program for the ECB to come out and attempt to overwhelm the market with its size and duration. While rate cuts are ineffective in the markets since nothing is pricing off of the ECB’s overnight rates, it is useful for the banks as LTRO costs would go down. As LTRO becomes a key component of bank funding, the rate cuts do slowly but surely add some extra net interest income for banks. Without a big LTRO announcement, look out below, since this is the easiest thing for the ECB to do on its own.

Other Steps

Those other steps are all necessary to be announced this week. Without that the market will end the week in a steep decline. Some other key decisions could be made that would help. The timing isn’t as critical, but the sooner the better.

ECB accepting some form of PSI on its SMP holdings. There is talk that the ECB is finally willing to accept “cost” rather than par from Greece. That is a savings for Greece, and has no cost to the ECB. I have never understood why the ECB demanded a big profit and not just cost. No mention whether the ECB will disgorge previous profits (and they have lots when you add up the interest income and repayments at par). I also think that it would be in everyone’s interest for the ECB to accept PSI maturities and coupons on their bonds. Again, the cost to the ECB is minimal since they aren’t a financial institution in a normal sense, and the saving to Greece would be significant as it would lower their current burden dramatically. It would also send a positive signal as the ECB wouldn’t be viewed as being so senior to every other holder. I think something along these lines will happen and is encouraging, though the more they do the better. The ultimate best case would be for the ECB to also extend maturities, reduce coupons, and only demand cost, from other countries whose bonds the ECB purchased. That wouldn’t have as much direct benefit to Spain and Italy, but the signaling impact would be immense. Again, this seems well within the ECB’s mandate.

Bank recapitalization needs to start YESTERDAY. The bank recapitalization needs to have started yesterday. There has to be real urgency on this. Maybe no announcement this week, but the first wave of Spanish recap money has to be put to use, and the damn Greek bank situation needs to be resolved. Floundering banks do NOT help anyone. This needs to be a priority as getting capital into the banking sector reduces flight risk and reduces the need to deleverage and could even let some better banks being an asset accumulation phase. If the EU doesn’t do a lot of steps already mentioned, I think the recap won’t happen because the situation will have jumped to dire. If they make it through this week, the recap needs to be done, and should be extended to other countries. There is no reason not to offer Italy, Ireland, and Portugal similar programs. That would be big for those countries and again send a strong message to the market. They may have to allocate some of the €100 billion targeted for Spain until ESM is established because EFSF doesn’t have the firepower. Yes, I realize that is a bit contradictory as I don’t want to rely on ESM for anything, but adding bank recap programs like Spain’s to other countries will take time anyways. If EFSF had enough money, that would be better, but they don’t have enough to activate this idea.

EIB Project Bonds and stimulus need to be launched. Everyone seems in agreement on these, so it is time to launch some projects. Shovel ready or not, the countries need to see some shot at growth. Getting some projects started with EIB involvement and funding seems the best way. The EU seems in agreement on it, and it is within the scope of normal EIB activities, so just do it. Projects need to be announced and started. It can get some job creation going and may be the spark that ignites more private development (especially if other programs are implemented at the national level).

Banking Union and Pan-European deposit insurance. Blah, blah, blah, Santa Claus, blah, blah, blah. This will all be talk. It might happen, it might even happen in a reasonably short time frame, but on its own does nothing and could easily take years.

Eurobonds. LMAO. ROFL. This may eventually occur, but will take years and years to establish enough similarities between the countries for everyone to get comfortable with the concept – if they ever do. Eurobonds may make for some nice headlines but aren’t realistic in the next 2-3 years. We may have to listen to some babble about how some of the earlier programs are “Eurobond like” or “Eurobond light” but it doesn’t matter. Don’t get fooled by Eurobonds and the more they spin something like that, the faster you hit the sell button while nodding yes and appeasing whoever is spinning that tale.

The Fed

I am struggling with how to play the Fed. I don’t think they will act aggressively ahead of the EU. Right now the ball is primarily in the EU’s court. So we may get some disappointment tomorrow, but I think it will be short lived and a buying opportunity (since I continue to see evidence that Europe is getting ready to launch a full scale assault).

Copyright © 2012 · Peter Tchir

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