Europe Is Fighting the Wrong Battles Again

Tyler Durden's picture

Via Peter Tchir of TF Market Advisors,

Europe continues to fight the wrong battle, and continues to spread contagion risk.

It is clear that Greece has had a solvency issue now for over 2 years.  The ECB and Troika chose to treat it as a liquidity problem.  Maybe, they could have argued that in early 2010, but by the summer of 2011 it was obvious to any credit observer that the problem was solvency, yet they continued to treat it as one of liquidity.  That is scary because if they fail to see the problem correctly now, they will fail miserably.  Not only is the problem clearly solvency, but now forced currency conversion has been added to the mix. Any “solution” from the EU must now address that risk, and it is not the same as solvency.  Programs that can protect against solvency may do nothing for the redenomination risk.

Not only did Europe fail to address the problems, but in spite of convincing themselves that all these programs prevented contagion risk, they actually ensured contagion risk.  That contagion risk, that they forced on themselves is now coming back to haunt them, and must be carefully addressed in any policy “solutions”.

Two Years of Bad Policy Have Created a Situation Like No Other

There is a lot of talk about what a Greek exit would or wouldn’t look like.  People are comparing it to other defaults and currency devaluations.  They are wrong.  Greece is now unique in that almost all of the debt is owed to institutions that normally step in after devaluation.  Greece is also unique in that  it is leaving a currency union that is already fragile, and being the first to leave will open the floodgate of speculation as to what other countries will leave.

Greece is running a primary deficit, but that doesn’t make its interest payments any less important.  Greece has €150 billion in loans, roughly half of which seem to be at 4% and half seem to be tied to PSI, so I conservatively assumed 2% on those.  About €4.5 billion of interest is being paid to the Troika annually on these loans.  The ECB (and EIB and other central banks) hold approximately €50 billion of bonds at about 5% average coupon for another €2.5 billion of interest.  True “private sector” holders of Greek debt only receive about €1.5 billion.  Most goes to pay the €66 billion of 2% coupon PSI debt and the rest is for the €4 billion of holdout English law bonds.  I did ignore the €14 billion of t-bills in this analysis.

It is very obvious though, that for Greece to get any help on its current interest expense it has to cut back on the Troika and ECB in particular.  Over 80% of its annual interest expense now goes to pay government and quasi governmental entities.

It’s not just the interest payments that are heavily skewed towards the Troika, it is also the debt redemptions that Greece is facing.  A staggering 98% of all debt redemption in the next 6 years goes to pay off the Troika and ECB, with the ECB’s remaining bond portfolio representing 35% of the total, and almost all of the payments in the next 3 years.

Never has there been a situation where a country is in such deep trouble that it needs to default and virtually all of the debt is already held by entities which normally step in AFTER a default and currency devaluation.

Damned if You do, Damned if You Don’t

If Greece defaults or restructures or reverts back to the Drachma without forcing the Troika and ECB to take a hit, then Greece is doomed to another round of defaults, likely within the year.

Speculation is that a return to the drachma would result in a 25% to 50% currency devaluation.  Just forcing the private sector to convert their debt to the new currency does almost nothing for Greece.  The interest burden of attempting to pay Euro denominated debt with devalued drachma’s would be impossible.  The redemptions would become unbearable.  Greece cannot revert to a drachma without immediately affecting the Troika’s holdings, or defaulting, likely within a year.

This is where it is so different than any other situation we have seen in the past.  There is no private sector to take the hit.  The private sector already got wiped out with PSI.  Germany and the ECB should have made concessions then, but chose not to.  Now they are in a situation, where less than 3 months after a massive private sector hit, the horrible plan is already falling apart, and Greece needs immediate relief, or needs to leave the Euro.

So far Germany in particular has kept to the “austerity” and “original plan” line.  Neither the ECB nor the IMF have done much for Greece, but at least don’t seem to be as belligerent or as antagonistic as Germany.  Rather than arguing why Germany, the ECB, and IMF should rework the plan, I will look at the logical consequences of failure to do so.  I think the potential risk of forcing a “Grexit” at this stage will become too obvious and be too large for the EU to risk it until better policies are put in place.

Direct Impacts of Greek “Drachmatization”

If Greece returns to the drachma there is a real risk that trade will break down.  How will companies be treated?  What happens to contracts that Greek companies made?  Will they be honored in original form or also be subject to being redenominated?  Can Greek companies afford the contracts after introduction of the drachma?  This is just basic stuff, but in a world that depends on global trade, it is hard to tell what the consequences of a trade breakdown with Greece would be.   We saw from the Japanese earthquake how sensitive and widespread problems from seemingly isolated supply line problems can develop.

That is all based on the hope that the world doesn’t become fixated on a chaotic breakdown of Greek society.  The worst case is shortages of fuel and food where prices skyrocket in the immediate aftermath of the redenomination.  Industry grinds to a halt from a lack of raw materials.  This should be the easiest element of a devaluation to deal with, but it will require planning.

I’m assuming that depositors will be forced to accept drachmas in their bank accounts rather than keeping Euros.  If they are allowed to keep Euros, then the situation would be better, except for the fact that the already insolvent banks would become more insolvent if forced to pay out depositors in Euros while have most of their assets turned into drachma.

These problems are unlikely to get out of control, and should be “merely” disruptive but would benefit from planning and preparation, none of which has really occurred yet.

Bank runs in Italy, Spain, and Portugal

This is the most likely result, no matter what happens to the ECB, IMF, and EFSF’s positions.

If you have a deposit in a bank in a country at risk of redenomination, then you would have to seriously consider taking money out to avoid that risk.  This isn’t default risk.  This is different.  You aren’t concerned that your bank is going to default you are concerned that €1,000 will turn into 1,000 lire or pesetas of unknown value.  Pan-European deposit insurance will NOT stop that flight of depositor money, unless it also ensures against forced conversion.  That is a big risk to insure against, and may not be even remotely in the ECB’s mandate.  So this is another difference from any other situation.  If Argentina devalues, there is always risk that Brazil would devalue as well.  That contagion risk played out in Asia in the late 1990’s.  That risk is amplified here, because Greece will be a template for the others.  In the back of every depositors mind, will be the fear that their country does it too.

I am scared that the ECB thinks they can address that risk with liquidity measures because they cannot.  I am scared that the ECB thinks they can address that with solvency measures because they cannot.  Real fear of forced currency conversion and devaluation is a new fear and new problem.  You may not be concerned that BBVA is going to default, but you may be afraid that your account will be turned into something worth a lot less.

The only way to stop this is to insure against it (difficult) or to force Greek banks to pay depositors in Euros.  But it is unclear how the Greek banks could afford to pay people out in Euros.  The banks are already insolvent and the amount of additional money they would need to pay depositors in Euros would just push the problem elsewhere into the system.

I don’t see an easy way to stop a run on the banks in any of the weak countries if Greek depositors are forced into Drachma, and I don’t see any way for the Greek banks to pay depositors in full in Euros.

Anticipating what forced currency devaluation would really do is a new aspect to the crisis.  It isn’t a liquidity or a solvency problem, it is its own problem.  Politicians and central banks have to focus on this issue.   I remain afraid, that like at so many other stages in this crisis, they will fail to understand the real problem, so their “preparations” will fail to stop this run and the crisis will escalate.

ECB Losses and Contagion

What will the ECB do with their losses?  This seems to be a case of being stubborn and foolish.  The ECB is not a mark to market entity.  It funds incredibly cheaply and can print money.  I remain convinced that it would cost the ECB much to convert their existing Greek bonds to PSI bonds at cost.  With the debt maturity schedule that Greece faces, this would be a big benefit and would take a lot of pressure off the governments.  Not the pressure to implement reforms, but the pressure that is killing the economy.

If Greece leaves, what is the ECB really going to do?  Do they really expect Greece will pay them back at par in Euros with their new weak currency?  That is stupid.  Will the ECB print money to make up for the losses?  That is one possibility, but given how stubborn Germany has been about austerity and how they hate printing money even more, I expect that the ECB would not print money to cover the losses.

If the ECB is going to take a loss and won’t print money, then they would have to go to their members and ask for more money.  That seems highly unlikely, especially if Spain and Italy are busy trying to prevent a run on bank deposits.  So, sadly, the plan seems to be to sell the bonds to the EFSF at either cost or par and let the EFSF take the loss.

Feeding more losses to the EFSF starts to fan the flames of contagion.  The EFSF will have losses on its own loans, but now for the first time, obvious to everyone, the EFSF will be just a loss transfer mechanism.  It will pay good money for garbage and then ask the EFSF members to pay for it.  Because of the guarantee program they may not have to ask Germany and France for money right away, but the pretense that the EFSF guarantees don’t count against a nation’s debt burden will be shattered.

Attention will quickly focus on how much new money Spain and Italy are on the hook for.  They are both contributors, and Spain will be dealing with regions that are running out of money, and both will be dealing with full fledged banking crisis of their own.

The scam that guarantees don’t count will be exposed.  Spain and Italy may even need EFSF money by now.  Investors will be thinking about the €160 billion or so of Spanish, Italian, and Portuguese debt sitting on the ECB’s balance sheet and wondering what is going to be done with that?  Who is going to take the loss on that pile of bad debt?

Everywhere you turn, you will see exposure that was never accounted for and is getting worse.  Some Bundesbank official will blabber on about not printing money and the market will become dizzy with fear.  The ECB’s bond portfolio turns into losses for the EU.  The EFSF turns into losses for the EU.  Spain and Italy will need money from the EU for their own problems.  The EU is just Germany and France.  They don’t have the money. Pandemonium ensues.

Maybe it won’t be that bad.  The ECB will launch LTRO3, but given the half life of LTRO2, that may do nothing to quell the fears.  Actually, depositors and bond buyers in banks that used a lot of LTRO money will become scared of solvency.  The LTRO helps banks last longer, but any bank that defaults will have incredibly low recoveries for unsecured lenders.  The ECB will have all of the collateral, which will be declining in value requiring ever more to be posted to the ECB and less there for general creditors.

Just because the LTRO worked the first 2 times, doesn’t mean it will work a 3rd time, especially since its flaws have been exposed.

Simply put, the ECB should negotiate a better deal with Greece now, rather than risk this potential turn of events, and pretending that EFSF doesn’t actually create contagion is naïve.

Crumbling IMF Firewalls

The ECB won’t be the only entity to lose.  The IMF will too.  The IMF is more senior, but will they really be able to enforce any of their rights?  This is also where the problem is completely circular.  Greece will need IMF money to function.  The IMF’s primary function is to ensure a country on the edge can get the funds they need.  So the IMF will be the biggest existing creditor, but also the most likely future creditor.  What a mess.

A self-made mess since the IMF traditionally forced defaults before lending.  Remember back in 2010, the IMF changed its policy for Europe and didn’t really force them to do anything to private lenders before stepping up?  They had those policies in place for a reason, precisely to try and avoid this sort of situation.

Then there is Lagarde’s precious firewall.  Do you think she told any country they might have losses on old loans within 2 months of agreeing to this new and bigger firewall?  I think a lot of people pledged their support because it seemed costless and were assured that the IMF never loses money and would likely never need this money.

With Greece, the IMF will lose money in the initial devaluation, or when Greece defaults because they played hardball.  With countries witnessing the losses, and seeing the risk that any “firewall” contributions to Spain and Italy go down the tube as well, the reluctance to live up to pledges will grow.

The IMF could try to impose very strict terms on Spain and Italy for “firewall” money, but then it is highly unlikely it will really be of much help, and will just once again shift around who bears the ultimate cost.

The IMF, another entity without anything resembling a real world P&L might just be tempted to cut the interest payments and extend the maturities on its existing loans to Greece and others.  If not, look for the fabled firewall to be just that – a fable.

They See the Light or Dark Bottomless Pit

I keep playing with scenarios and find it hard to find out where a Greek exit doesn’t result in a steep sharp decline in the market.  We could go through more ideas of ECB intervention, but in the end most will have flaws.  Dealing with currency conversion risk is huge.  Dealing with the contagion risk that has been created by the EFSF is huge.

I believe that as they start to plan, they will eventually listen to some of the “doomers” and decide that they should attempt some policies to retain Greece for now.  To fix the situations in Spain and Italy so that a return to the drachma isn’t likely to spark fears that Spain and Italy will also redenominate.

Can Greece leave and the damage be contained?  Sure, it’s possible, but seems highly unlikely.  Can Europe do enough to keep Greece in for another 3 to 6 months and make plans that make an exit controllable or possible avoid an exit altogether?  That is possible, and seems a better solution.  Will Europe force Greece out thinking they have a plan that fails miserably and sparks the miserable series of consequences I’ve outlined?  Sadly, yes.

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endicott glacier's picture

Status quo is the easiest solution everyone seemed to seem to agree to, so they will maintain it as long it does work and then they can blame whatever causes it to not work, bad financial engineering at its best

Colombian Gringo's picture

The only real liquidity in Europe is the urine running down the pant legs of the Barosso and Van Rompuy, and the rest of the eurocrat criminal cabal. They may be actually forced to work someday.

philipat's picture

I can't wait for the Nigel Farage speech in Brussels after that becomes clear!! "I told you so" is such a childish position. However........

Oh regional Indian's picture

While it all looks rather terrible (I can imagine swaet running out of every pore of those "private" hands holding Greek Debt), at least so far, I think the fear and loathign on display at high levels is pure theater. They are all game players.

If the regular, intelligent folk on a blog can figure so much out, I'm sure they have that and more horse-power + a real history of where all this sprang from, of which most of us have no clue.

IF we are seeing the classic 5% of the ice-berg, it's cleary less than 5% of the story if you throw in obfuscation.

When IT comes, it'll come like like a bat out of hell, from left field and will be a surprise only to the masses.

Very interestingly, here in India, the kleptocracy that has run this country for our brit masters for 60 years, allowed a free hand... are now being culled. Jailed, threatened with exposure, mocked, lot's of dirty sex-tape type blackmail... like we are being readied for something different. 

All in all it smells really bad and it's definitely NOT what is being presented for our collective consumption. We all knwo that Greece will be fine if they exited the clutches of their EURO debt masters.



The Monkey's picture

Europe is in big trouble. Evidence is mounting for a Chinese hard landing. India and emerging markets are slowing. Housing bubbles that have not yet popped, or are in the early process of doing so, are scattered across the globe. US home owner equity is at a record low while the household savings rate is hovering around 3%.

As Alan Greenspan, Warren Buffet and Goldman Sachs recently asserted, it's a great time to buy stocks. Dick Bove probably gave the best advice to buy the banks "with both hands".

It is amazing to me how the market did not see this coming, but then, it never does.

boogerbently's picture

They were supposed to be "planning for the painless Greek exit" for the last 2 years.

If it were possible, they would have already done it.

Tsukato's picture

Online I found a list of "bad words" which red flag emails, texts, etc. by the authorities. I thought to myself " most people are too afraid to ever rise up against the man, but perhaps there is some passive-aggressive action that most people could be bothered to do, and could keep the g-men busy/overloaded". This list of words should be spread to everyone, and attached at the end of every message we all write online, during chat, emails, etc. Please take this list, and pass it along to everyone you know. Thanks and vaya con Dios. Here is where to find the list:

koperniuk666's picture

just put half dozen of the 'bad words'  in below the signature line of all your emails and get everyone else to do it.

then ALL emails will trigger.

Hey that will fuck 'em

attack, terrorist, H1N, emergency, fuck Obama, school shoot out. DHS wankers

ootofthehoos's picture

The creeps posted the list as three jpegs so you can;t copy and paste the words.

gatorengineer's picture

Well lets be stupid on a Saturday night with this what if......  What if Greece were to become the 51st state, Portugal 52, Spain 53...... Etc......  Benny covers them all with the magic press.  Barry becomes at the end of his second term the first president of the one world government.....  This is where they want to take it so lets get going.... I doubt Greece is much more of a welfare state than say Puerto Rico.....  No one ever saw DC as the capital of the one worlders, but why the hell not......

To quote what was said in an earlier post tonight


Go big or go home.........................


Manthong's picture

So who gets the next Bernanke $50 Billion, Greece..

or California?

TBT or not TBT's picture

Governor Moonbeam will get us high speed passenger rail, lots of high paid government jobs, welfare a plently, and 100% green everything everywhere.   Finance Shmynance!

boogerbently's picture

...or JPM, GM, NASDAQ, FannieMae.....

boogerbently's picture

...or JPM, GM, NASDAQ, FannieMae.....

l1b3rty's picture

But it is oh-so tough to fathom where we would be without our fiat masters there to paper over the wounds with damp band aids

philipat's picture

I'm sick and tired of Greece and Europe. I wish something would just happen and let the chips fall where they may so that the rest of us can move on. If a bunch of German and French Banks go under, it couldn't happen to a nicer bunch of Guys IMHO!!

Vampyroteuthis infernalis's picture

It is like waiting for a teakettle to boil. This teakettle is industrial size though!

grid-b-gone's picture

As the article points out, the last three years and two major bailouts were wasted pretending Greece has a liquidity issue when solvency was the core problem.

Now that market forces have asserted themselves despite various central bank and political tamperings, talk of "growth" is the new substitute for facing any hard choices.

If Greece can grow its way out of insolvency, then the 46 million food stamp recipients in the U.S. can grow their way out of the need for that benefit. While we're at it, let's grow ourselves out of the looming Social Security shortfall, the underfunded pensions problem, the student loan disaster, and the probable $100 trillion derivatives market collapse.

In case it's not yet understood, "growth" = printing and rising bank runs in these circumstances have been a historical fixture since... um... banks were created.

The Monkey's picture

Sadly, those students who were suckered into the latest credit ponzi are quickly going to find out they are graduating into an economy with very few jobs. It doesn't take an MBA to manage a Taco Bell.

jeff montanye's picture

not to say that it isn't a very hard job to do properly and profitably (and getting harder).  it's just that an mba probably doesn't help much.  (disclosure: mba, wharton, '72)

GtownSLV's picture

If Greece leaves the Euro why would the ECB expect to be paid back at all, or any other creditor for that matter. 

philipat's picture

The UK and Switzerland are not members of the Eurozone but still conduct business with Eurozone members in Euros. If you had leant and were due Euros you might see it differently.

Terrorist's picture

If you lent Euros to Greeks you might be an idiot.

philipat's picture

:P Agree with that! But the Banks who made those idiotic loans continue to get bailed out by the Taxpayer, albeit without the consent of the taxpayer.

Also, if you are a Greek with Euros still in any Greek Bank you are an even bigger idiot?

Harbanger's picture

When they account the outstanding debt you will need a lot of Drachma's for 1 Euro.

JackT's picture

What a freaking mess. Really not much else can be said about it.

SwingForce's picture

Yeah yeah yeah, same bullshit different day

Cabreado's picture

There is no reason to believe or hope that the mindset that has paved the path will behave more appropriately once faced with the fallout, when the game reaches its breaking point.

Those masking as leaders (everywhere) are surprised, they are in turmoil, they are as rats with the lights turned on, with nowhere to hide.

Stop looking for appropriate behavior from the Self-Absorbed.

The path of the Self-Absorbed-as-leader leads to Hell, eventually.

The Greeks need Trust in their leadership, first, and at all costs.

As do we all...

Terrorist's picture

Kudos toTchir for sharing this. There will be repudiation. This is just the beginning.

bank guy in Brussels's picture

Yes, Peter Tchir is absolutely primo in his commentary.

He's one of the best on ZeroHedge, often superbly on-target like with this article above.

shovelhead's picture

I'd like to try snorting some of that Euro pixie dust that has been floating around. That shit must be some hallucinating mofo gear.

What, exactly, did they expect would happen when you loan to bankrupt banks and bankrupt countries? That they will become magically solvent again?

Seriously... Did they find an abandoned short bus somewhere and put all the inhabitants in charge of the central banks?

Europe better send out for some trashcan punch because they're soon going to party like it's 1789.

 America will join in the festivities too.

gatorengineer's picture

they thought for some reason they were buying years not months, and more over the neglected the electorate....One more seat for Pasok in the last election and we would likely be looking at 1500 S&P right now....  The effect is kinda like LTRO first one bought a fair bit of time, second one not so much....

max2205's picture

I contend there will be massive loan forgiveness followed by more printing after Grexit.

Problem solved....bullish

JeffB's picture

If they did the printing a little earlier, per my understanding of Mr. Tchir's article, they could potentially avoid the Grexit and the associated big problems that would bring. If they're going to do it, why not when they'd get the most bang for the Euro?


Non Passaran's picture

Unlikely, IMHO.
Creditor countries like Germany woild have to spend trillions. It's cheaper for them to exit eurozone.
But I wouldn't mind to see the EUR sink to parity with the US dollar.

boogerbently's picture


"Paper" forgiveness for "paper" losses.

Bailing out insolvent banks is like paying FB losers for their bad investment.

CuriousPasserby's picture

What if they all just went back to their old currencies from before this stupid idea was tried? At the original exchange rate. It wasn't a big deal to switch to Euros, would it be a big deal to switch back if everyone did it?

JeffB's picture

The problem is the massive debt overhang.

Things aren't as they were before.

Switching the currencies back wouldn't magically revert them all back to former debt levels.


oogs66's picture

It was. Italy in particular scared bond investors per euro

slewie the pi-rat's picture

high in the sky apple pie charts

philipat's picture

The ECB prefers pi charts because that goes on forever. Probably printing.

pissing_excellence's picture

The end of 2001 is coming to mind, too much too soon, and alwayts got a juicy monday covered in puppet shows.   How much money is enough to be a worm?


Take care zh

sangell's picture

Enjoy reading Mr. Tchir's thoughts. Six months is a long can kick though when Greece is meeting NONE of the conditions set for it right now. Committing more billions in Troika funding when default is inevitable makes no sense.

AnAnonymous's picture

Solvency/insolvency is quite hard to appreciate with US citizen economics going on.

Non tradable goods, dismissal of the physical world etc...

US citizens are indeed aware of that and act accordingly, knowing that insolvency/solvency trip is just a trick that have been used to fleece nations around.

At one point, in a finite environment, with US citizen economics going around,sooner than later, one has to face the point when one has consumed more than it is left to consume.

This is the point when repaying a debt has to be questioned.

Repaying a debt means replacing the consumption brought from the future back in the future.

What when US citizen miscalculations are?

What when you've seen the future much bigger than what it will be and brought in the present much consumption based on this conception?

US citizen economics has led to default on the physical debt for decades by now.

With their various plans bugging out (the grand fiasco of the space conquest expansion scheme, the sham of renewable energy sources), US citizens have to face the issue of considering if it is worth trying to repay a debt that can not be physically repaid.

It is no surprise that US citizens are trying preserve the big actors in the overconsumption drama, pushing over the train the lesser actors.

It is funny because actually one can see the extortion/farming scheme logics at work here.

US citizens have tortured in the barrel for centuries now nations that got monetary insolvent but physically solvent while right now, US citizen nations can barely be insolvent monetary wise but the world is running out of resources to sustain US citizen societies.

It is always about transfering wealth. US citizen economics is all about transfer of wealth. And painting physically solvent nations as insolvent is a good way to get their wealth transfered to US citizen societies.

SHRAGS's picture

"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."

-- Ludwig Von Mises

falak pema's picture

the contagion risk has been imbedded in the system from day 1 of TArp and 2008 meltdown. We all know that on ZH as this site was created as a reaction against that global scam. The core problem is the private banking debt resulting from banking funny money hanky panky, played over twenty years in non regulated irrational exuberance and crony capitalism,  that has over multiplied since 2008 days even more and spilled over into the sovereign debt BUBBLE. Don't blame the hole in the Titanic, blame the captain and the way he ran into that iceberg. Now everybody moans about INEVITABLE consequences not about root causes. Delusion play of first magnitude. 

The home of this ponzi is in WS/DC. The rest is a side show. It has one major expression of its cancerous nature : the shadow banking OTC/HFT conundrum and Oligopoly sleight of hand derivatives mountain. Netting that out for whatever reason, in the current case due to the Greek crisis, the current tiny pebble in the shoe, will create banksta bubble implosion. Print to infinity IS the big lie, and the central bank cabal of FED wants to play it on as long as they can as they NEVER intend to pay their creditors. That's the bottom line, so dilution and de facto money devaluation of RESERVE currency is their ONLY card; ad nauseum.