Euro Bailouts - The Good, The Bad
& The Ugly
Axel Merk, Portfolio Manager, Merk
October 27, 2011
October 27, 2011
The markets appear euphoric about the ability for European policy makers to
deliver on new promises. Low market expectations were met. We, too, have a
positive takeaway, but only because of one detail of the grand plan;
actually, let’s call it a “grand sketch,” as many details are still unknown.
Just as the U.S. bailout fund “TARP” was used to bolster U.S. banks as
opposed to buying toxic securities in the market, the most effective tool to
bolster confidence in the Eurozone is to ensure
banks are able to stomach losses on their sovereign debt holdings. The
movement to focus on banks in earnest started earlier this month. On October
5, 2011, German chancellor Merkel embraced in earnest the notion that bank
capital must be bolstered; we turned significantly more positive on the euro
that day. Her change of heart came after the market had provided ample
“encouragement,” in the form of widespread selling of bank shares and debt;
the process had been enabled by European stress tests that disclosed sovereign
debt holdings in detail.
This is real money that banks will need to raise. The financial system, as a
result, will be substantially more robust. Relevant for the euphoria is that
there is a focus on bank capitalization. Regulators have started to embrace
market value assessments, another huge positive.
Just like many, we would like even higher capital targets. One has to be
realistic, though, that bank capital alone will not unfreeze interbank
lending markets. Banks with a tier one ratio of 9% must still finance 91
percent of their balance sheet. We must move away from myopic bank regulation
coercing banks to favor domestic sovereign debt to a pan-European approach
where corporate debt (the interbank lending is lending amongst financial
institutions, which are corporations) is valued on its merits rather than
Greece. A debt write-off before a country has been able to achieve a primary
surplus (budget deficit before interest payments) is counter-productive, as
it takes away a powerful incentive to invest and engage in further reform.
Having said that, this is mostly bad for Greece; financial institutions have
now been warned that they must have adequate buffers going forward. We
avoided a 60% write-off, and may end up with two 50% write-offs. Consider,
though, that 18 months ago pundits called for an implosion of the financial
system should Greece default. Then, the euro was trading around 1.20 versus
the dollar. Now Greece clearly defaults (even if it is possible to avoid the
triggering of credit default swaps), but the euro is trading at over 1.40.
The European Financial Stability Facility (EFSF) that’s touted to protect one
trillion euros is a scheme where even policy makers
don’t yet know what exactly it is going to look like. It is not a “bazooka,”
as it cannot refinance itself at the European Central Bank (ECB). Indeed,
gearing it up appears to be done through the back door, by making it an
insurance scheme. Even so, it only has a fraction of the capital paid-in of what
its commitments are going to be. As such, it’s a smokescreen, albeit a very
powerful one. In a leveraged world, appearances count for a lot. However, it
would be far healthier for policy makers to finally realize that
de-leveraging is the answer, not to put up ever-greater commitments that
–particularly in the case of Greece – may well be called upon.
The good news is that the markets will be vigilant. When the current euphoria
is over, the bond market will have little mercy with those ducking from their
responsibilities. And that’s a good thing that should continue to prove wrong
those that have called for the demise of the euro. Long live the euro!
Starting November under new leadership at the ECB. Talking about leadership:
Has anyone noticed that the Federal Reserve might be paving the way for QE3?
President and Chief Investment Officer, Merk
Merk Investments, Manager of the Merk Funds