It's time to forget about Europe's headlines for 15 minutes and refresh what is really going on in Europe, and why European leaders are scrambling day to day to come up with a solution to what is ultimately an intractable problem. Technically, the problem, as explained below, is manifested in three distinct symptoms, which exist in a self-referencing feedback loop that amplifies good input signals when times are good (and incremental debt is ample) and vice versa, or become a toxic spiral where one problem is amplified in the other two, when the system is caught in a deflationary spiral, until the entire system is threatened by collapse. The three "problems" are summarized best in a chart by Morgan Stanley's Huw Van Steenis (see below) in what we have dubbed the "Triangle of Terror" - these are i) Bank Solvency, ii) Sovereign Stress, and iii) Bank Funding Stress. At the end of September, Europe found itself in a perfect storm, in which concerns about all three hit peak levels. Since then, fears have subsided somewhat, following ECB intervention and rumors of bank recaps, not to mention an attempt to control sovereign "solvency" via a naked CDS ban, yet the festering question of overall Sovereign Stress remains. And what is worse, in a replica of a game of financial "communicating vessels", any time there is an improvement in one or two, it is the third that gets beaten down. This explains why while banks have seen a boost in confidence expressed by rising stock prices, now that Europe is addressing Bank Solvency and Bank Funding Stress via actions of the ECB and the EFSF (the fact that the EFSF is even needed, when the Fed could address both issues at the same time, shows how woefully incapable the ECB is to deal alone with Europe's problems), sovereign spreads have exploded, and OAT-Bund spreads hit all time wides overnight.
All that said, the core problem at the very heart of European instability, is nothing more than, you guessed it, excess debt, €1.7 trillion worth of it to be precise: this is how much debt has to be rolled over the next 3 years, and also explains the magical €2 trillion number needed for the EFSF as only something that big can i) backstop the debt roll and ii) insure the needed bank recap, which in reality needs more like €400 billion but that is the topic of a different post. And without the abovementioned support pillars of bank solvency, funding and sovereign stress being address and fixed, in a credible manner and at the same time, this debt will not be able to roll, and effectively lead to systemic European insolvency. And that, in a nutshell, is what the issues facing Europe are. Everything else is headlines, smoke and mirrors.
First, presenting the "Triangle of Terror." As Van Steenis opines, "Intensity of Policy Response to Address the 3 Interconnected Issues – Stress in Sovereign Funding, Bank Funding, and Bank Solvency – Has Stepped Up, But Much Still to Be Done"
Here is how Europe's has address the Bank Recap problem for the time being, and which banks will see major dilution as a result of incremental capital infusion:
In addition, the ECB has done all it could to address the Bank Funding issues: "To Address the Stress in Bank Funding, ECB Has Undertaken 6 Initiatives in Recent Months. We Think More Needs to Be Done to Support Term Funding." However, as we report every day, this has so far failed - liquidity conditions in Europe are once again as bad as they were in mid September and deteriorating rapidly.
Yet the most disturbing chart is the following, showing how much debt Europe has to roll in the next 3 year: "Policy Makers and Investors Have Consistently Underestimated the Bank Funding Roll as a Transmission Mechanism of Sovereign Fears Into the Banks and Real Economy – €1.7 Trillion of Term Debt to Roll"
As a reminder, this is debt that has to be roll. This does not include the trillions in incremental debt that has to be issued at both the corporate and the sovereign level to preserve "growth", because as every Fed president knows, one can only have growth in the modern ponzi, Keynesian system, when one has incremental debt. In other words, forget growth for the sake of this analysis. Europe has its hands more than full with simply preserving its current status quo in the face of an ongoing deleveraging tsunami. Which is why any indication that it will fail in addressing all three of the core issues at the same time in a way that the market deems credible (we can't underling this enough), namely Europe bank solvency, and funding, and sovereign stress, will result in another major risk off move, now that the market is convinced that all three can be resolved simply with words, hope and a telegraphed desire to fix problems. They can't.
This explains why so much rests on Europe, and why as we explained previously when we actually did the math, Europe will, whether it is at Summit 1, 2, 3 or 123, disappoint massively as what is going on is nothing more or less than a simple regression to the mean. And, as hard as they try, Central Banks while being very powerful entities, can not overturn the simplest rules of nature.