What We Know About the Pan European Bailout Thus Far

Monday, 10 May 2010 15:26

What We Know About the Pan European Bailout Thus Far

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In continuing my rant of earlier this morning, let's take a look at what we know thus far about the Great Pan-European Bailout. Before we go on, I would like to make clear how dangerous this bailout game is for those in the confines of the EMU. Suppose.... Just suppose, as with the Greek Bailout(s) announced just weeks ago, the markets call the bailers' bluff? Exactly what ammunition will be left to move forward? The ECB/EU had better hope that this rally will hold up (and recent history shows that it will probably have an ever decreasing half-life), for if it doesn't the member countries are in a world of hurt.

Unlike many pundits, I am more than willing to offer solutions in lieu of just bitching about problems. So, what is the solution? Everyone needs to come clean in regards to the true state of their economic affairs, as well as the realistic prospects of earning their way out of their respective problems using realistic numbers. In this fashion, I would never be able to pen a piece called Lies, Damn Lies, and Sovereign Truths: Why the Euro is Destined to Collapse! Once we have an honest, realistic starting point, then we move forward with very, very stringent contingencies on loan dollars and specific demands on selling off state assets using realistic valuations as estimates. As it stands now, the loans are given to counties that are knowingly attempting to mislead, and have a history of chicanery in their attempts to join the EMU. This can easily smell like a farce and the risk of failure is very high. Yes, the promise of massive liquidity will drive a big rally in risky assets, but if these risky asset prices diverge from their fundamentals, the snap back will be destructive. It is my opinion that offering money without a structural solution is a non-solution of throwing good money after bad. Remember, monetization is now on the table and in a big way. This means that the REAL value of the Euro is still looking downward...

A quick rundown of the bailout

EU policy makers have come out with a massive rescue plan worth EUR 750 billion to combat with the unprecedented crisis that threatens not only the stability but the very survival of the monetary union. The new EU stabilization mechanism which will be backed by funds of up to €750 billion, of which two thirds will be provided by euro-zone members (€500 billion) and one third by the IMF (€ 250 billion), is by far the strongest effort by EU and the ECB to avert a regional debt crisis.

Of the euro-zone’s €500 billion share, €60 billion is readily available and the remaining €440 billion is to be sourced through an SPV and is subject to the same approval process as the joint loan to Greece (thus it is contingent upon approval and not necessarily a done deal).
The loans would be extended according to the same pricing formula as the loans to Greece (i.e., variable-rate loans will be based on 3-month Euribor. Fixed-rate loans will be based upon the rates corresponding to Euribor swap rates for the relevant maturities. A charge of 300 basis points will be applied. A further 100 basis points are charged for amounts outstanding for more than 3 years. In conformity with IMF charges, a one-off service fee of maximum 50 basis points will be charged to cover operational costs.)

This mechanism is further supported by the ECB’s Securities Markets Program under which the ECB plans to intervene directly in the ‘euro area public and private debt securities markets’. The scope of the intervention is yet to be decided. In order to sterilize the impact of the above interventions, specific operations will be conducted to re-absorb the liquidity injected through the Securities Markets Program. The European Central Bank also announced the reactivation of short-term loans against government and private debt. Moreover, the ECB also will reactivate, in coordination with other central banks, the temporary liquidity swap lines with the Federal Reserve, and resume US dollar liquidity-providing operations.

Though, it looks likely to succeed in calming markets in the short term, its probability for long-term success depends on the mechanism’s implementation as questions on financing and activation of the facility still remain unanswered. EU members’ willingness to contribute to the rescue package over the next several years also remains uncertain since Germany, which is expected to be a major contributor is already facing public anger on providing support for the Greece bailout package, see Merkel Suffers Significant Voter Setback After Greece Bailout.

Additionally, there are concerns on how much debt will the ECB buy, since ECB policymakers have been extremely reluctant to take this step in the past, believing it would compromise their conservative monetary principles.

Moreover, the new mechanism is only a safety net which will only buy three years for the troubled PIIGS countries, and would not solve countries' fundamental problems. Thus, the real success of the plan will depend on how well the troubled countries are able to repair their finances and reform their uncompetitive economies. This was the primary problem before the announcement of the bailout, and this is the same primary problem after the announcement of the bailout.

Market reaction – The reaction to the news in the markets is summarized below

CDS market – The announcement of the concerted effort to salvage the drowning PIIGS had a tremendously positive reaction in the CDS market. The sovereign CDS spread of Greece shrunk sharply to 561 from the previous close of 1000. CDS spread for other troubled PIIGS countries also contracted sharply. For Spain, the CDS spread came down to 144 from previous close of 228 while Portugal CDS spread came down to 426 from 236. Italy’s spread came down to 151 from 228 and Ireland’s CDS spread fell to 207 from the previous close of 255.

Equity markets – The STOXX Europe 600 surged 5.8% (and as high as 9.6%). Broad market indices in Greece and Spain sprung 9.4% and 12.0%. The market indices in France and Germany jumped 4.3% and 8.1%, respectively.

Bond market – The Greek 10 yr bench mark government bond yield slipped to 7.46% from Friday’s close of 12.5%. The difference between the Greek 10 yr benchmark yield and German 10 yr benchmark yield contracted to 4.5% against the Friday’s gap of 9.6%.

Government Bond yields in other PIIGs also fell sharply. Portugal 10 yr benchmark yield dipped to 5.0% against the Friday’s close of 6.3% while the Spain 10 yr benchmark yield was down to 3.95% against the Friday’s close of 4.4%.

Forex market – Euro surged 2.0% against the previous close of 1.28 dollars per euro. The EU’s announcement of complete sterilization of the quantitative easing (QE) will lend some support to the Euro. However, questions still remain over the amount of liquidity support and QE that EU will undertake and the ability to sterilize the entire intervention