Markets soared in Asia, Europe, the US, everywhere. Let the good times roll. The euro jumped to the highest level in a couple of weeks. Yields on Spanish bonds plunged to the lowest level since, well, Monday. A miracle had happened. German Chancellor Angel Merkel had blinked. Um, a little bit
All eyes were on her at the EU summit in Brussels, the one summit that would once and for all save the Eurozone, THE summit, where she’d be forced to submit to the majority of the Eurozone, and indeed to the majority of the world, and where she’d be forced to come to her senses and give in to the demands set out before the summit.
There was the Grand Plan, issued by European Council President Herman Van Rompuy. It included all the goodies: an unelected European Treasury with power over national budgets and how much countries could borrow; Eurobonds; a banking union that would guarantee deposits; and the ESM that would bail out the banks directly.
There was French President François Hollande’s plan, first issued during his campaign, then reiterated many times since. It included Eurobonds and the ability by the European Central Bank to directly buy sovereign bonds of debt sinner countries. He’d formed a triumvirate with Italian Prime Minister Mario Monti and Spanish Prime Minister Mariano Rajoy to corner Merkel.
Rajoy had been begging for help but didn’t want Spain to take the bitter medicine that the bailout Troika would prescribe if he asked for a full-fledged bailout. Hence his emphasis on bailing out the banks directly, and let Spain run its dismal affairs as it saw fit. Monti had warned last week that the Eurozone would break apart if summit attendees didn’t sign off on his list of items that were “absolutely necessary” to save the Eurozone.
So, here are the summit results on these items:
– Eurobonds? Nein.
– A banking union with tools to prop up banks and with a common deposit insurance fund. Nein.
– Allowing the ECB to buy sovereign bonds directly? Aber nein!
They did agree on a common banking regulator (even Merkel had wanted that). Of course, they already have one, the European Banking Authority (EBA), established in late 2010. It conducted “stress tests” on 91 major European banks. Results came out in July 2011. And in October, the 12th safest bank, the Franco-Belgian megabank Dexia, collapsed.
So now, they want a different regulator. The ECB should play a role, the agreement said, but…. The Federal Association of German Banks and the Federal Association of Public Banks both expressed their opposition to the ECB becoming a regulator. Since the UK declared it wouldn’t have any part of it, German banks were worried that they’d experience pressures from the regulator that UK banks would not experience. And they were worried about the conflict of interest between the ECB’s role in funding states and in supervising the banks that were also funding the states.
And Merkel did blink. Or at least she redrew the line in the sand: she agreed to the tweaking the European Stability Mechanism (ESM), the permanent bailout fund. The ESM doesn’t exist yet and hasn’t been ratified by a whole slew of countries, and it’s getting scrutinized by the German Constitutional Court, but assuming it will see the light of the day, it would be changed in several ways, including:
– It can bail out banks directly, rather than lending to the government which then recapitalizes the banks. This way, on paper, this new debt to bail out the banks would not raise the indebtedness of the country. One of the core demands by Spain.
– It can buy sovereign bonds of countries that stick to their commitments to cut budgets and implement structural reforms; thus, no further austerity measures if they ask for aid. Spain and Italy might fall into that category.
However, funding banks directly won’t be possible until after the Eurozone banking regulator has been established. The Commission will present a proposal in the near future. If member states pass it by the end of the year, direct aid to banks would be possible at the earliest in 2013.
So, the ESM will be able to bail out Spain and Italy, and their banks, and all the other countries, to which Slovenia may be added by end of July—and do all this with the €700 billion it may in theory have some day. In theory because the €700 billion includes the contributions of Spain and Italy, the very countries that the fund would have to bail out.
Merkel’s switcheroo on the ESM caused a lot of consternation in Germany. “A new breach in the dam,” it was called. Others complained that “the ink isn’t dry and they already announce the next changes,” and that it was one more step towards a “transfer union.” As before, it will pass. The line in the sand has been moved. And the wait for Merkel’s big blink on Eurobonds continues.
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– Germany cannot escape Europe, Germany cannot escape the Euro-zone's fate, regardless of what Merkel does or doesn't do. Spain, Greece … France AND Germany are all dependent upon external financing (as well as for 'lender(s) of last resort').
– Merkel's lines are irrelevant. The problem is the cost of fuel and the inability of 'using' (wasting it) to meet this cost. Nothing is changed, Greece is destroyed by debts and fuel costs, so is Spain and the rest. Watch and see the chain of policy adjustments… the long slide into the drain. Next comes China and Japan. The US will not escape.
– The problem isn't in Brussels or Madrid, it is at the end of people's driveways. What is taking place in Europe is 'conservation by other means'.
– How long will this quick fix last? How about a week? Spain and the rest are still bankrupt.
– A factor is that international finance has embargoed European debt. The outcome is a large amount of European fuel consumption becomes exportable to the US without any attached cost! Somebody in the US right now is burning some Athenian dude's gasoline!.
– Fuel prices exploded 9% today. Any increase in new credit (demand) pushes the price. Part of this was a short-squeeze across all the cash markets but the underlying fundamental is still limitless fuel demand against constrained supply. Anyone with a TV is a potential car-buyer.
"It can bail out banks directly, rather than lending to the government which then recapitalizes the banks. This way, on paper, this new debt to bail out the banks would not raise the indebtedness of the country. One of the core demands by Spain."
Yes but it will raise the indebtedness of the country which needs to top-up the Piggy Bank so that it is not empty…
So effectively the deficit reduction plans of Northern Europe get bombed and the Northern European taxpayers get hammered for being fiscally responsible in exchange for allowing the irresponsible to maintain their unsustainable states!
Hi Wolf,
According to their statement, "the ESM could, following a regular decision, have the possibility to recapitalize banks directly."
As you can't recapitalize a bank with more debt (ie loans), this means an equity purchase if the ESM is really going to do this "directly." Obviously, an equity purchase would put ESM contributions behind all others in a recovery, including unsecured bondholders. Do you think the Germans realize this yet? Do you think Merkel realizes it?
Hi Blankfiend!
Indeed, the devil is in the details. And they haven't worked out the details. It seems to have been a last-minute compromise. Maybe their new banking regulator, once it comes into existence, will come up with new rules that will consider special ESM loans a form of equity capital.
It's officially labeled equity, Germans will be upset … it'll be another step towards a transfer union.
Hey Wolf.
My compliments on your excellent, provocative, and tireless work on this blog. I have obviously lost steam over at Fibs And Waves, but try to post strategically now where I think it may have some impact…
I actually did start a post on Friday, which I abandoned. I was going to title it "Augenblick," to represent the apparent blink of an eye timing of Merkel's about face. However, I am no longer so sure, as you and your contributors point out, that she really conceded nearly as much as the market may think…
Anyway, from a post I just made on Gavyn Davies' blog on the FT:
"If these are secured LOANS, then they are NOT capital injections. You simply cannot recapitalize a bank with secured loans. CAPITAL is essentially a loss buffer that consists of common equity, reserves, and certain debt instruments issued by the bank. These debt instruments, according to Basel III, must meet the requirement that they are "neither secured nor covered by a guarantee of the issuer or related entity or other arrangement that legally or economically enhances the seniority of the claim vis-à-vis depositors and general bank creditors." Additionally, CAPITAL MUST BE "Subordinated to depositors, general creditors and subordinated debt of the bank." (See http://www.bis.org/publ/bcbs189.pdf, starting on page 12).
How a de facto senior ESM loan to Spain gets taken off of Spain's balance sheet and becomes junior bank debt that would meet Basel III capital requirements is beyond me. For Merkel to say that "finance ministers would have to work out whether the state or the banks would be legally responsible for repayment of the loans thereafter" is either a) disingenuous, or b) ignorant. While it could be the banks that would be responsible for repayment through some circus stunt of financial engineering, the funds in question would be subordinate to ALL other general creditors and subordinated bank debt."
To me, such a release of funds by the Bundestag on a absolutely unsecured basis would indeed:
1. Be a transfer.
2. Not seem to meet the smell test for the Karlsruhe court.
Blank – The interesting thing is that none of these mechanisms even exist, neither the new ESM (even the old one hasn't been ratified yet), nor the new regulator that is a precondition for the bank recap via the new ESM. At this point, it's all just loose talk. And it seems some of it is already unraveling.