Something quite notable has shifted in recent weeks in Europe, and it originates at the European paymaster - Germany. While in the past it was of utmost importance to define any Greek default as voluntary (if one even dared whisper about it), and that the money allocated to keep the Eurozone whole would be virtually limitless, this is no longer the case. In fact, reading between the headlines in the past week, it becomes increasingly obvious that Greece will very soon become a new Lehman, i.e., a case study where the leaders are overly confident they can predict the outcomes of letting a critical entity default, and manage the consequences. Alas, this only proves they have learned nothing from the Lehman case, and the aftermath is still not only unpredictable but uncontrollable. But that's a bridge that Europe will cross very shortly. And what is truly frightening is that this crossing may happen even before the next LTRO hits the banks' balance sheets, thus not affording Euro banks with sufficient capital to withstand the capital outflow and funds the unexpected. In the meantime, here is UBS summarizing the palpable change in European outlook over Greece, and over the entire "Firewall" protocol.
The German government seems uneasy about the firewall discussion. Some German media recently carried stories that a 'super rescue umbrella' would be agreed at the next summit on 1 March, amounting to €1.5 trillion, a number arrived at by adding up the €500bn of the ESM, the €440bn of the EFSF (though only about €250bn remain available) and the $500bn that managing director Lagarde has been seeking in additional financing for the IMF. There is a sense that trying to impress the market with a large number may once again backfire as analysts would quickly shoot down in any such attempt, for example by arguing that the IMF money would not actually be earmarked for the Eurozone, or more seriously maybe, that countries such as Spain and quite possibly France may come to be seen as unable to contribute ever more rescue funds. Instead, it is felt that the preferable option may be to point out that the ESM will be a much better designed and effective instrument than the EFSF, and that €500bn is enough for the problems at hand.
One gets the sense that the German government is not a priori unwilling to commit more financing to crisis management, but not now and only if it becomes clear that really the existing funds are insufficient. Also, there is a view that the government may at times have listened too much to advice from market sides, which then led to initial positions that subsequently needed to be revised. For example, bank recapitalisation was mentioned as something that ultimately seems to have done more harm than good and is now widely criticised for accelerating deleveraging. Also, the insistence that any Greek restructuring had to be 'voluntary' initially stemmed from fear of upsetting markets, but has now come to be criticised as having serious adverse implications such as undermining the sovereign CDS market. As a result, the German government may now be more inclined to stay firm on the firewall discussion and insist that €500bn for the ESM is sufficient for now.
While this step was inevitable from the beginning, what also was inevitable was the fact that leaders would be forced to exude confidence over what happens next. The truth is that they have no idea. Because if Paulson was proven 100% wrong in under 5 days following the Lehman default, when the money markets broke and the Fed has to literally force a bailout of the global financial system, what can one say about two bit second tier politicians from Europe, who have never even seen a DCF model?