The Pan-European Sovereign Debt Crisis: If I Were to Short Any Country, What Country Would That Be?

This is a trick question, for the fates of many European countries
are now inextricably tied by what appears to be a poorly conceived
methodology of handling diverse political and economic entities under a
single currency without a truly authoritarian governing body.
Basically, it's the old American saying, "Too many Chiefs and not
enough Indians". If one member faces a harder landing, chances are that
several others will follow. When I first started this series, a few
pundits accused me of being sensationalist. I assume their weren't
studying the numbers. It's funny how a few days can bring so many to
your side of the table. Now it is becoming much clearer that this is
more of a pan-European issue than a pan-Hellenic one.
The printer
of the world's reserve currency had a problem selling debt. How well do
you think the EMU members will be able to hawk their record trillions
of (now apparently obvious to all) relatively stressed debt? Well, Europe's Economic Recovery Almost
Stalls as Germany Unexpectedly Stagnates as the IMF
Joins EU, ECB in Pledging Support for Greece. This is an
extreme blow to the credibility of the Euro. Just a year ago, (silly)
pundits were speculating that the Euro would replace the dollar as the
world's reserve currency, and now the IMF is coming to a EMU members
aid just has it has third world and emerging countries.

This is part 3 of my Pan-European Sovereign Debt
Crisis Series. See The Coming Pan-European Soverign Debt
Crisis and What Country is Next in the Coming
Pan-European Sovereign Debt Crisis? for the first two parts.

Much of the analysis that I have seen fails to put enough weight
on the bad loan/NPA issue in each country's respective banking system,
which essentially is the cause of most of the countries' particular
malaise to begin with. I have thrown together a crude, rudimentary
chart to put this into perspective...

When
comparing these sovereigns using metrics that encompass more than the
usual suspects, you get a clearer picture. The bank bailouts were
expensive, arguably too expensive. It may have been better to let them
fail in the market and nationalize them. Notice how the nations with the
highest NPAs are doing the worst. In addition, one should remain
cognizant that the "extend and pretend" game has allowed hundreds of
billions of "phantom" NPAs to roam free in each of these countries' GDPs
unrecorded. I believe there may be some surprises left in quite a few
of the German banks. We will probably see if I'm right over the next
few quarters. See German Recovery Stalls Unexpectedly in
Fourth Quarter:German gross domestic product showed no growth in the
final quarter of last year, official data showed on Friday, leaving
Europe's largest economy on a weak footing going into 2010.

All
one really has to to is follow the banking losses. They are deeply
concealed in the Spanish banks, but are now coming home to roost (From Bloomberg: BBVA Fourth-Quarter
Profit Plunges 94% to $44 Million on Asset Writedowns). As was
illustrated by Speigel online below:

DER
SPIEGEL

National deficits have increased in many countries
belonging to the European common currency.

 Even
Speigel states: European Union Sees Threats to the Euro - Late
last year, it became fashionable to predict the dollar's demise. This
year, however, shaky state finances within the European common currency
zone have many worried about the future of the euro. Even the EU
thinks the monetary union could be in danger.

Notice how
all of the big deficits also have big bank NPA chunks as a percent of
their GDP? I warned of this just over a year ago, focusing on Spain and
their busting housing boom. See The Spanish Inquisition is About to
Begin... and the original forensic report and macro
analyis of Spain's housing bust from January of 2009, Reggie Middleton on the New Global
Macro - the Forensic Analysis of a Spanish Bank Wednesday,
28 January 2009 (paying subscribers may download the BBVA forensic
analysis, whose subject matter is now quite timely). In this post I made
clear that BBVA had considerable problems, Spain was heading down and
to quote from the actual post, "Those of you who
attended the BoomBustBlog Boat rides should have heard me express my
opinions that I believed the Pound, Euro and oil would all head sharply
southward."

Below are excerpts from
an excellent article on Spain from the blog "A Fistful of Euros":

 A New Spectre Is Haunting Europe, A
Spanish One

The
impact of the stimulus package can also be seen in the seasonally
adjusted unemployment numbers supplied to Eurostat by the Spanish
Statistics Office (INE). Unemployment (which
hit 19.3% in September - see chart below) has been rising continuously
since mid 2007, but the sharpest increases were registered during the
fourth quarter of 2008 and the first quarter of 2009.

It is very hard to see any real difference in the trend rate of
increase between the second and third quarters of 2009, and we should
expect this trend job attrition rate to continue until it once more
accelerates under the impact of either the government being unable to
continue funding the stimulus, or the banking sector having a financial
crisis (possibly induced by someone being forced into trying to sell
some of the housing units they are accumulating only to discover that
there are no buyers, since the market is effectively dead)...

That is to say, credit is once more starting to flow freely
round the French economy, while here in Spain banks continue to
accumulate reserves, lending generously to the government, while money
for struggling small companies and for young people looking to buy
homes is hard to find. What is more, if we look at the chart below
(which was prepared by Dominique Barbet and Martine Borde for PNB
Paribas) we will see that the stock of unsold new homes – which was in
any event never very high in France, maybe 100,000 in the spring – is
down by 20% as sales steadily pick up again, while here in Spain we
continue to play a guessing game to decide just how many (more than a
million surely) such properties there are here, and the number is
growing, not declining, since real new sales to private individuals (as
opposed to newly completed properties contracted two years or so ago,
or exchanges between developers and banks) are almost non existent at
this point. Everyone knows prices will fall further, and are waiting
for them to go down...

Then on Friday we had the key piece of information, which confirmed
what many of us already suspected, since Markit PMI data for October
retail sales made plain the presence of very divergent trends across
the Eurozone, with ever more robust growth in France contrasting with
falling sales in Germany and Italy. As Jack Kennedy, economist at
survey organisers Markit Economics said “While the sense of growing
optimism should be treated with some caution – it appears the increase
in sales was also supported by widespread discounting and the
continuation of the government’s car scrappage scheme – the
outperformance of France relative to Germany and Italy offers further
evidence that it is France that is leading the Eurozone recovery.”..

And here, with this very outperformance comes the problem, since
the ECB policy rate will be set to target average eurozone inflation,
which will certainly be lower than inflation in France, and possibly
significantly lower. Which means the ECB policy rate will be below the
one which the French economy will, in reality, need...

Between
2000 and 2008 the structural dynamics of the Eurosystem were different
from now. Spain was the “exceptional student”, with above-average
growth, and inflation which was consistently over the Eurozone average,
and for long periods above the ECB policy rate. This had the
consequence, of course, that French inflation was nearly always below
the average. Now things have changed. We are coming out of recession
with a eurozone divided into three groups. French growth is becoming
robust, while Germany and Italy are dependent on exports and just
keeping their head above water. Spain, on the other hand, fails to
recover and continues to contract. This is what makes the current
situation critical, since starting in 2010 France will have an
inflation rate over the EU average, and in all probability over the
ECB interest rate. Which means that if something isn’t done, and soon,
to force the situation in Spain, and produce a recovery, France will
have negative interest real rates during a sharp economic rebound,
with all the risks that that implies...

Only last Wednesday
Norway became the first western European country to raise interest
rates since the start of the financial crisis after its central bank
reported finding “signs of renewed growth” in the global economy.
Central bankers from across the global, from Washington, to Sydney, to
Delhi and to Oslo are all now busily telling us they are going to take
increasing account of future accelerations in asset prices in an
attempt to avoid repeating policy mistakes that are presumed to have
inflated two speculative bubbles in a decade – and left the entire
Spanish economy in a lamentable state. If France had its own monetary
policy I have no doubt La Banque de France would be itching to follow
the Norges Bank and raise rates, but there is one small problem, La
Banque de France has no capacity to decide on monetary policy in this
way, and herein lies the heart of what is now Europe and the ECB’s
greatest dilemma.

While denied
by the EMU members, it appears to be without a shadow of a doubt that
fractures are showing in the monetary union. The Euro was not well
concieved. It gets worse. The stresses to the Euro will also come from
well outside of the European Union. Many of the Euro countries have
significant exposure to central and eastern European countries who are
significantly more fragile than the one's mentioned above. This exposure
will easily daisy chain through Europe if it were to ignite. Well, the
CEE countries primary trading partners are in the Eurozone, and as the
Eurozone slows down, the chances of CEE issues increases. That will be
the subject of my next Pan-European Sovereign Debt Crisis post and I
will have several specific banks on a detailed watchlist for paying
subscribers to download, which should help you ahead of the curve.

As
I stated in parts one and two of this series, although Greece is in
bad shape, it is a drop in the bucket in comparison to the problems
abound in the other countries.

• Paying
  subscribers can download a tear sheet on all Spanish banks investigated
  here:  Spanish
  Banking Macro Discussion Note 2010-02-09 02:48:06 519.40 Kb).
• Paying
  subscribers can also download the 11 page tear sheet featuring 7
  Italian banks worth noting, including one with a 100% ratio (meaning
  the bank has more non-performing assets than it has equity =
  insolvency!) Italian bank here:  Italian Banking Macro-Fundamental Discussion Not 2010-02-09 17:00:40 792.07 Kb.

In the news:

We have some sell side guys stealing ideas from
my blog :-)

Greek Government Bailout May Damage
Corporate Credit Quality Feb. ...

... Credit-default swaps insuring against losses on company bonds in Greece, Portugal ... underlying securities or the cash equivalent should a company fail to adhere ...  - 2010-02-11

The
inevitable "vig" to be paid on pushing out these sovereign bonds:

 Portugal Pays Investors Premium on
10-Year Bond Sale (Update2) Feb ...

... cash equivalent
should a company or country fail to adhere to ... The spread on

Portugal’s new bonds should narrow ... to Harvinder Sian, a senior bond
strategist in ... 
- 2010-02-10 

Euro in ‘Lose-Lose’ Deal on Greek
Bailout, Jen Says (Update1) ...

... unions in Greece and other PIIGS countries now know they are too big to fail. ... extend a financial lifeline to Greece at a summit tomorrow sent bond yields to ...  - 2010-02-10

With all of the
needs for sovereign debt issuance, the private sector will most
assuredely get crowded out. This is probably worse than it sounds,
since most banks are still coddling significant hidden losses and NPAs
(even though many are reporting profits and paying bonuses), hence will
not be lending anytime soon. There will be no recovery without
available credit, and if there was ample credit supply available (which
there really is not) the sovereign nations will be soaking it up
anyway.

From part two of the Pan-European Sovereign Debt Crisis: 

Let's examine exactly how much debt we are talking
about and when...

The weaker
Eurozone countries will start flooding the market with sovereign debt
rollovers starting THIS MONTH. It remains to be seen whether Germany
will backstop Greece, but if they do how can they avoid backstopping
Spain, Portugal and Italy. The Spanish and Italian backstops will be
particularly tricky since there are bank NPAs hidden in their whose
extent has been purposely kept a big mystery. Reference the NPA as a
percetn of GDP chart above. If Germany doesn't backstop these countries
then it's left up to the IMF and their goes the credibility of the
Euro. If Germany does backstop the countries, then their goes those
Bund rates! An interesting conundrum, indeed.

The near term debt
issuance is simply the tip of the iceberg here. According to Merrill
Lynch, we have trillions of nigh unwanted sovereign debt to deal with
(Click to enlarge, by way of Zero Hedge):

 

Gulf Borrowers Face More Costs on Debt
Talk, Deutsche Bank Says ...

... Dubai World, which is in talks to reschedule $22 billion of debt, failed to present ... is in the process of raising $750 million in an Islamic bond sale and may ...  - 2010-02-10 Asia to Pay Higher Yields at Government Debt Auctions (Update1) ... ... Contagion’ Asia’s 10 largest local bond markets declined ... Vietnam failed to sell 1 trillion dong ($54 ... 80 billion rupees ($1.7 billion) of bonds maturing in ...  - 2010-02-09 Hungary Rate Room Limited by Greek Contagion Risk, Banfi Says Feb. ... ... The country failed to qualify for the switchover because of a ballooning budget deficit ... s woes are part of a fiscal crisis that has roiled bond markets across ...  - 2010-02-09

Asia-Pacific Bond Risk Surges on
Sovereign Woes (Update1) Feb. 5 ...

... on growing concern that governments will fail to close ... swap indexes are benchmarks for protecting bonds against default ... securities if a borrower fails to meet ...  - 2010-02-05

Treasuries Gain on Deficits in Europe,
Losses in US Payrolls Feb. ...

... risk.” Treasuries climbed yesterday, pushing 30-year bond yields down ... The economic numbers failed to alleviate ... tying $81 billion of notes and bonds next week ...  - 2010-02-05

Debt Sales in Europe Fall as Investor
‘Bond-Picking’ Prevails ...

... 20 million euros in
damages for failing to accept ... Junk Sales Halt Company bond sales
in Europe have ... demand to own European investment-grade bonds was
unchanged ... 
- 2010-02-05

Spanish Borrowing Costs Jump at
Three-Year Note Sale (Update2) Feb ...

... The bonds of some
of the weakest economies in the euro region tumbled in the past
two
months on concern governments will fail to meet their debt
commitments. ... 
- 2010-02-04

Comments

[Anonymous]

R.M...very nice article...

Do you have similiar charts for good ole' USA???

[Reggie Middleton]

I'm going around the world with the research as I tighten up my short positions. I'm not sure things won't pop before I get to the US, though.

[Jim in MN]

Great stuff Reggie!  Nice to see you covering more macro turf.

News item: ECB Chief Economist says no money for weakened sovereigns

http://news.yahoo.com/s/afp/20100212/bs_afp/ecbgreecefinanceeconomy

Fan request: I have felt for some time now that one of the main untold stories in the crisis was the possible impact of further writedowns/haircuts on the life and health insurance industries.  Maybe this is part of the Armageddon Story told by Paulson and Co. to Congress that fateful day...and why our 'mega-Japanese' policy in the US may have been inevitable.  Problem is, no one is telling us the whole story.

What if insurance company invested premiums, along with pension funds, got seriously whacked by bond haircuts?  Could the health insurance companies even function?  Would the health care system collapse in the US?  Would Joe and Jane Sixpack finally revolt when their life insurance 'nest eggs' got scrambled?  Maybe that was the redline for the NY-DC elite.  No Mas.  No Haircuts. 

The implication of that is...well, everything else falls into place.  No haircuts means no major structural changes in the financial sector, because both bankruptcies (private-side) and nationalizations (public-side) would entail reconcilation of assets and market values.  So, freeze frame.  Gov't subsidies for MBS and other toxic waste?  Check. 

Reggie, what the heck is going on in the life and health insurance industries?  How vulnerable are they?  Is the mega-Japan policy in fact prudent and necessary?  Because I think we are stuck with it, because of the insurance/pension vulnerability, and the implications are far-reaching indeed.

Happy Presidents Day Weekend!

--Jim in MN

[THE DORK OF CORK]

Will there be a revival of the French Gaullist economic model for Europe ?

I think so - all that crap in the Lisbon treaty about "free markets" will have to be thrown on the dung heap of History.

[Jim in MN]

Well, we could just stop measuring inflation at the national level in Europe, but that wouldn't help the core problem; central banks need to stop using interest rate policy as a weapon of mass economic destruction.  And their hubris and belief systems are quite immovable. 

I think they will crash the airplane.  When human systems collide with natural systems, the natural systems tend to win.

[Anonymous]

Most of the Western World will be in a depression soon.

[Reggie Middleton]

Greek Recession Deepens, Putting Debt Plan at Risk

Greece's economy contracted more sharply than expected, by 0.8 percent in the fourth quarter, and official data on Friday showed downward revisions for the previous three quarters too, spelling a deepening recession.

Aris Messinis | AFP | Getty Images
The fourth quarter contraction was far deeper than the 0.5 percent forecast in a Reuters survey and followed a revised fall of 0.5 percent in the previous quarter. The NSS statistics agency originally put the third quarter fall at 0.4 percent.

The economy shrank 2.6 percent on a year-on-year basis following a revised fall of 2.5 percent in the last quarter of 2009, which had first been put at 1.7 percent.

Economists said the data suggested Greece's economy shrank by around 2 percent over last year as a whole, spelling problems for a government plan to cut its spiralling deficit and exit a debt crisis.

"The Greek governement's (growth) forecast is far too optimistic," said Ben May of Capital Economics. "This is going to be another factor making the fiscal adjustment Greece is trying to achieve very difficult.

"The chances are if they do achieve that it's going to lead to a pretty nasty recession," he added.

[Reggie Middleton]

Spanish unions are already pushing back against the "austerity" plans. Greece won't be the only country with issues: 
http://finance.yahoo.com/news/...?x=0&.v=2 
MADRID (AP) -- Spanish unions called Friday for demonstrations against a plan to raise the retirement age, the first hint of labor unrest since the government unveiled austerity measures to trim a ballooning deficit and restore credibility on markets rattled by the Greek debt crisis. 

Nationwide rallies have been convened over a two-week period, starting February 23 in about 10 cities including Madrid, Barcelona and Valencia, General Workers Union leader Candido Mendez said at a news conference. 

Besides the proposal to gradually up the retirement age from 65 to 67, unions are angry with a government plan to change pension formulas. In most cases that would mean a smaller pension in a country where the average one is about euro800 ($1,100) a month. 

Late last month the government said it would cut spending by nearly $50 billion ($70 billion) over four years to rein in a deficit that has swelled to an outsized 11.4 percent of gross domestic product as the country struggles with recession and 19 percent unemployment. 

The government's goal is to trim the deficit to the EU limit of 3 percent of GDP in 2013. 

It also announced the plan to raise the retirement age to protect a social security pension fund which is separate from the budget and currently in surplus but faces troubles ahead due to a steadily graying population and longer life expectancies. 

Ignacio Fernandez Toxo, another labor leader, said Friday the government is wrong to associate the two pots of money. 

"Our social security system is perhaps the most solvent institution in the country," he said, insisting the government is triggering alarm unnecessarily.

"This is reckless at the very least," Fernandez Toxo said.