The Self Preservation Society

AKA the ECB...

There’s been a lot of handbags between the ECB and EU leaders this week, after some leading EU politicians admitted that there could be some form of debt restructuring of Greek debt. Both Olli Rehn, EU Economics Commissioner, and Jean-Claude Juncker , Prime Minister of Luxembourg, suggested that there could be an extension of loans given to Greece (although its not clear whether this would just involve the official loans or private sector loans as well).

Needless to say, this did not sit well with the ECB, particularly ECB board member Jurgen Stark. After suggesting that any form of restructuring would be a catastrophe, Stark also accused “vested interests in the US and the UK” of undermining the economic adjustment programme in Greece. He also issued what seemed somewhat like a veiled threat, saying that the ECB may not accept Greek bonds as collateral for ECB lending to banks after a restructuring – a move which would probably push Greek banks into bankruptcy.

At first glance it is surprising just how removed the ECB is from the views of the rest of Europe (as we've argued for some time, restructuring is probably inevitable - an increaing number of people are coming around to this view). But ultimately, the ECB's posturing simply comes down to self interest. The ECB is holding masses of Greek bonds (we’d reckon around €60bn in nominal value) in addition to €140bn in state related collateral it has accepted from Greek banks. This €200bn exposure to Greece then presents the potential for large losses for the ECB under a Greek restructuring.

You may ask: why does the ECB care? It’s backed by eurozone governments, and therefore taxpayers, so they will ultimately foot the bill.

True – and another unfortunate potential hidden cost for eurozone taxpayers – but going cap in hand to eurozone governments to ask to be recapitalised after these losses would be incredibly humiliating for the ECB. It would also give eurozone leaders huge leverage over the ECB on future economic decisions and policy. The only other choice for the ECB is even worse though - printing money to cover its losses. This would mean abandoning its raison d’être (price stability) instead going down a path that could lead to pretty scary levels of inflation.

Arguing anything other than staying the course would therefore probably have dire consequences for the ECB, highlighting the impossible situation it’s managed to get itself into.

Up, up and away…

That’s been the story with Greece’s debt and deficit figures for some time, particularly since it’s become almost customary for the figures to receive at least one upward revision on their original estimates. However, Eurostat’s latest figures suggest the problem (of missing targets) looks to be spreading to other peripheral eurozone countries (not that the spotlight isn’t still firmly on Greece).

Eurostat yesterday released its debt and deficit data for 2010 and it included some interesting revisions – upwards as always. Starting with Greece, we see that the government missed its deficit target by 1.1% of GDP (all % are of GDP from now on), coming in at 10.5% instead of the 9.4% which the Greek government proudly predicted in January. To be fair, this still means the deficit fell by around 5% last year, but the figures show that less than 2% of the decrease came from increased revenue. Things continue to look bad for Greece, as we, amongst others, struggle to see where the government will find the money it needs. The programme of spending cuts is already pushing austerity to its limit and the government just doesn’t seem to be able to increase revenue (tax evasion is still massive but the ongoing recession, which is worsened by the austerity, just makes tackling it all the more difficult).

Meanwhile, Portugal also saw its deficit revised upward for the second time in a matter of months. It now stands at 9.1%, way above the government’s estimate of 7.3%. The government still put the difference down to changes in accounting rules enforced by the EU, although it is strange that it seems to affect Portugal so much more than anyone else…in any case Portugal now needs to cut the deficit by close to 5% to meet its target for 2011. Its debt burden was also increased, putting it at 93% in 2010.

Ireland fortunately didn't see its deficit or debt estimate revised, although with the deficit coming in at a whopping 32.4% this isn't much of a consolation (most of the deficit is down to the bank bailouts, but even excluding them the deficit was around 12% - the highest in the eurozone).

All in all the figures weren’t exactly expected to be encouraging but the continuing string of upward revisions and missed targets doesn’t exactly inspire confidence.

Is the ECB becoming a bad bank?

Its common knowledge that the ECB has been providing massive amounts of liquidity to eurozone governments both directly (through the purchase of government bonds) and indirectly (by taking on large amount of government debt as collateral for lending to banks). The extent of this – and therefore also the implications – are less clear, mostly thanks to the ECB’s reluctance to publish any data on its holdings of collateral or government debt.

FT Alphaville highlights a note from JP Morgan, which suggests that the indirect exposure of the ECB to the Greek state is massive - and then we mean massive. JPM estimates that Greek banks have posted almost €140bn in state related collateral with the ECB (€85bn of state guaranteed bank paper, €45bn of Greek government bonds owned by Greek banks and €8bn of zero-coupon bonds which the Greek government had lent to Greek banks in 2008). Combining this with the direct holdings of government debt (thought to be around €60bn, as we noted in our paper on Greece) you get total exposure of the ECB to the Greek state of around €200bn.

That is a phenomenal amount.

Though these amounts are slightly speculative at the moment, there are some interesting and possibly disturbing implications here, particularly for those of us who believe that Greece will need to restructure its debt at some point soon (not that we’re alone, this group includes nearly all investors and apparently the IMF). This exposure to the Greek state is in the direct firing line if a restructuring occurs. First, there are likely to be large write downs on the direct holdings of Greek government bonds (at least 35% to have any significant impact on the debt burden) and secondly, the state backed paper could become close to worthless. Potential losses are still hard to quantify but would easily be upwards of €40bn.

Comparing this loss to the capital and reserves which the ECB holds, around €79bn, shows the potentially difficult situation which the ECB could find itself in following a Greek restructuring. Essentially the ECB would either have to ask eurozone governments for an injection of capital or or try to print their way back to an acceptable level of capital and reserves.

Therefore, following a Greek restructuring the ECB may have may face a difficult choice: completely ignore its primary mission (i.e. price stability) and print money or go hand in cap to governments - like the bad banks in the financial crisis - and ask for cash (almost like a bail-out).

Two questions: how in the world did the ECB allow itself to get so deep into this mess? And do German politicans/economists/opinion formers understand how incredibly exposed the ECB - once dubbed the world's strongest central bank - actually is?

Emerald Isle stress tests get a gold star (for now)

Yesterday afternoon Ireland announced the results of its recent round of banking stress tests. They showed that the banks need €24bn to recapitalise; that is undoubtedly a huge number for an economy the size of Ireland’s. So why are investors not running for the hills?

Well, from our perspective at least, the Irish stress tests seem to do something that none of the ones that have gone before have – make a genuine attempt to fully estimate the potential losses which banks could face.

This is a good start and the stress tests should be commended, but more important is how the banks and the government respond to the results. Unfortunately, that has been less commendable.

The government was expected to announce a series of measures to raise the necessary capital and set the banks on a sustainable course. However, there was only talk of ‘some’ capital being raised by investors and private lenders, with the main chunk expected to still come from the €35bn allotted to the banks by the original Irish bailout. There was also no mention of bondholders taking losses or of the widely reported new ECB medium term liquidity mechanism. So what we have is some more clarity of the state of Irish banks - which is good - but we're still missing a solid, revised plan to to address the mess.

The response of the banks was also slightly worrisome. Both AIB and Irish L&P suggested that their losses will not be as high as estimated due to the nature of the Irish mortgage market and real estate sector. This is essentially a reference to forbearance – when a lender allows a borrower extra time to repay a mortgage rather than foreclosing on the property. This allows the lenders to delay the realisation of losses, while giving the impression that the extra time given is designed to give a break to struggling taxpayers. Whatever the motivation, this is only a short term policy and, unless the Irish economy has a miraculous turnaround, most borrowers will be unable to repay these loans despite an extension in maturity.

Lastly there is the issue of the deleveraging – the sale of assets to bring the deposit-to-loan ratio back to a sustainable level – or as some people are terming it, the ‘fire sale’. Irish banks will need to shed €72bn of assets by 2013, which is a massive amount to dump into fragile financial markets. The losses on these assets will, in many cases, be substantial although the stress tests claimed to have accounted for this. Whether or not they were fully able to accurately predict the market value of some of these assets, especially since they will be sold over time, remains to be seen.

So a gold star for the stress tests (relatively at least) but they’re only a start. How the government and banks respond will deter whether Irish banks can recover quickly or whether markets will lose faith in them completely - meaning that an Irish restructering and/or another bail-out could be around the corner.

Socrates needs to get philosophical

Looks like Portugal could be asking for a bailout by the end of the week.

Pedro Passos Coelho, Leader of the main opposition party, said on Saturday:

“We need external aid. The Prime Minister does not want to admit that, but the whole country has already understood it.”

He also said he will continue to oppose the new austerity measures, which are due to be voted on by the Parliament tomorrow or Wednesday.

Portuguese Prime Minister, Jose Socrates, announced that:

“Should the Parliament vote against, then the government would no longer have the means to act.”

With massive public protests against austerity in Portugal over the weekend, there seems less and less political incentive for the opposition to cave in and support the new measures. The only thing that everyone seems to agree on is that if the new austerity measures are voted down, Portugal will be forced to ask for a bailout.

However, given Socrates stance the government may fall if he fails to garner the support he needs.

That does not bode well given the EU summit at the end of the week. Socrates needs to get his thinking cap on…as going into summit negotiations without a government cannot be a good strategy.

German Parliament flexes its muscles

As we've highlighted before, a bust-up in Germany over the fate of the eurozone's bail-out schemes could be imminent, both on the EFSF and its permanent successor.

As if Merkel didn't have enough on her hands, the Bundestag yesterday approved a motion that explicitly demands that the German government bans the EFSF from buying government bonds from troubled eurozone countries. In effect, the Bundestag is asking Merkel to backtrack on last weekend's agreement between eurozone leaders which would have given the EFSF the mandate to buy bonds directly. That's a pretty big set-back for the Chancellor.

The motion isn't binding for the government, but still hugely problematic since the Bundestag needs to approve any deal to increase the scope and size of the EFSF.

The vote illustrates the growing gaps between Angela Merkel and parliamentarians belonging to all three coalition parties (CDU, CSU and the FDP). If this happend in the UK it would be labelled an outright "rebellion" against the government.

According to Märkische Allgemeine, the Bundestag gave its consent to a permanent eurozone bail-out fund, a European Stability Mechanism (ESM), which would take over from the EFSF in 2013. However, it attached a number of strings, including:

- strengthened stability and growth pact
- guarantees for the independence of the ECB
- safeguards that the ESM would only be activated in emergency cases
- a mechanism which would involve private creditors in the rescue fund (unclear how this would work)
- a restructuring procedure which would include private creditors
- a guarantee that the eurozone would not turn into a transfer union.

If you think about it, those are not small thing to ask for in the current climate. This one could be interesting.