The European Summit and its aftermath

What’s at stake: European policymakers eventually came to an agreement at 4am on Thursday after 11 hours of talk. The package consists of three related parts: (i) reducing Greece’s debt to a sustainable level by a voluntary agreement with private creditors to accept the loss of half the value of the bonds; (ii) recapitalizing Europe’s banks to the tune of €106 billion; and (iii) creating a larger firewall to prevent the spread of panic with a leverage of the EFSF. There has therefore been an agreement on all the sticking points but it could be weeks before the details that underpin the entire package are finally ironed out. Many hope that a significant amount of details will to be filled by next week for the November G20 meeting in Cannes.

Gavyn Davies writes that it is notable that the summit has not really raised any new money, apart from an increase in the private sector’s write-down of Greek debt by some €80bn. The deal was intended to provide adequate medium term financing for sovereigns and banks, which have been facing urgent liquidity problems. But all of the remaining “new” money, including €106bn to recapitalise the banks and over €800bn to be added to the firepower of the EFSF through leverage, has yet to be raised from the private sector, from sovereign lenders outside the eurozone, and conceivably from the ECB. There is no guarantee that this can be done. The eventual out-turn of this summit will depend on whether this missing €1,000bn can actually be raised.

The Greek debt write-down

Peter Spiegel reports that officials said that at its most basic the Greek haircuts will work like this: someone owning a €100 bond will trade it for a bond with a face value of €50. But the real value of the new bonds will be highly dependent on their annual interest rates – or so-called “coupons”– and how long it takes for the €50 to be paid back – known as maturities. By adjusting coupons and maturities and taking into account other “sweeteners” already agreed by European officials – such as the €30bn ($42bn) in collateral they will provide to back the new bonds – the pain on bondholders could be lessened considerably.

Felix Salmon argues – in his chart of the day – that what’s worrying is the sequencing: it seems that everything else is contingent on Greece getting its write-down first.

Eurointelligence writes that the banks will not be able to deliver a voluntary participation of €100bn. Many banks would be better off if the haircut were involuntary, given their offsetting positions through credit default swaps. The whole idea for a CDS is to ensure the creditors against an involuntary default. By agreeing a voluntary deal, the insurance will not kick in. We are therefore not yet convinced that the IIF can deliver on such a large number. There is a significant likelihood that this agreement will end up as an official credit event. The participation in the July agreement was very different. This deal was considered good for the banks. They had an interest in participating for as long as they were assured that this would not trigger further requests for participation, which is what just happened.

Gavyn Davies concludes that that the Greek headache has not been definitively solved, and probably will not be until there is a significant write-down of official debt. The effect of the 50% haircut is to reduce the Greek debt ratio from 152 per cent of GDP in 2020 to 120 per cent, assuming that all of the Greek fiscal restructuring can be implemented in the meantime (which seems highly improbable). But these debt figures are higher than expected, and may well prove unsustainable once again.

FT Alphaville writes that official sources will also provide €30bn of credit enhancement to bondholders in the debt swap. We don’t know what this really boils down to, and probably won’t for some weeks. It might be that EFSF collateral attached to the restructured Greek debt is offered, purely because that’s how the first swap proposal worked (and, it appears, banks really wanted it again this time round). Of course there were proposals yesterday to give bondholders cash upfront. We strongly desire to know about other possible features that we just don’t know about so far, such as the legal status of the new bonds (would they be governed under English law?).

Leveraging the EFSF: the official first-loss insurance scheme and the new SPV

Perry Mehrling has useful video on the INET blog that makes use of balance sheet relationships to appreciate how the EFSF is supposed to support the market for peripheral debt, in much the same way that the national banking systems of the affected countries were themselves doing, until their own credit came into question.

Guido Tabellini argues that the first-loss insurance remedy – like the innovations of the past – will fail to restore market confidence. The EFSF was created as a remedy to the structural flaw of the Eurozone – the separation of monetary and fiscal policy. After realizing that its size was insufficient, its capacity was enlarged. A new idea came out of the European summit, namely to extend its scope, concentrating the resources of the EFSF in order to partially guarantee newly issued debt of countries at risk. This would allow both Italy and Spain to issue debt, which would be partially guaranteed until the end of 2013. But the resources of the EFSF will be exhausted in a few years, while confidence cannot have an expiration date. Knowing that there could be a confidence crisis in a couple of years, why should one trust the solution today?

Daniel Gros argues that any state of the world where Italy restructures by 20% is a situation akin to Fukushima. In short, this sort of ‘first-loss’ insurance is not very likely to make much of an impression to clearheaded bond-buyers when it comes to Italian or Spanish bonds. The official reasoning behind this approach of offering a ‘first-loss’ insurance was quite simple. Perhaps it was too simple. Since the debt burden of Italy (as well as that of Spain) appears manageable, investors should expect only a modest loss in case of default. If the expected loss in case of default were only 20%, a ‘first-loss’ guarantee should actually make the bonds riskless (implying a large fall in interest rates for Italy and Spain). However, this reasoning overlooks the hard facts. Sovereign default is a very rare event, but when it does occur, it’s big – like a tsunami flooding a nuclear reactor.

The bank recapitalization and Term Funding guarantees

The IIEA blog reports that the Summit reached a broad consensus on the EBA’s proposal to create a “temporary buffer” of 9% Core Tier One capital ratio to be achieved by 30 June 2012. The European Council agreed that banks would have to seek funding from private sources first, but capitalization will be provided from national governments and the EFSF in order to avoid “excessive deleveraging”. The technical details on defining the temporary buffer (e.g. whether to include controversial CoCo bonds) will be left to the Eurogroup/Ecofin meeting in November, but will not be ready in time for the G20 Summit in Cannes on 3-4 November. The EBA tentatively estimates that €106.447bn additional funding will be needed to achieve the target capital buffers: €30bn for Greece; €26bn for Spain; €14.7bn for Italy; €8.8bn for France; €7.8bn for Portugal; €5.2bn for Germany; €4.1bn for Belgium; €3.6bn for Cyprus; €2.9bn for Austria; €1.4bn for Sweden; €1.3bn for Norway; €297m for Slovenia; and €47m for Denmark.

Ryan Avent writes that the plan calls for it, but it’s likely to proceed too slowly. If the banks are unable to raise sufficient money on their own, then governments will need to get involved. Governments are sure to prove reluctant while markets seem chipper, and so it's likely that recapitalization will proceed too slowly until markets begin attacking one point or another, at which point either the sovereign or the EFSF will be called upon to fill holes and save the day.

The EBA in a Q&A describes in some details the funding guarantees which will have to be coordinated at the EU level. Contrary to 2008/2009 guarantee schemes which worked on a purely national basis, the European approach should be pan European and shouldn’t be free. Banks will have to pay a premium in return for this guarantee to their national authorities to compensate for the risk taken by tax payers.

The governance of the EMU

European Voice reports that Olli Rehn, the European commissioner for economic and monetary affairs, is to get expanded powers to oversee the eurozone's economy and the euro. Barroso said that Rehn to will be appointed vice-president within the Commission in charge of the euro and will be given a wider remit to more effectively monitor national fiscal policies.

Expectations for the G20 Cannes Summit

Barack Obama argues that our citizens will be watching for the same sense of common purpose that allowed us to rescue the global economy two years ago from a financial crisis when leaders of the largest economies meet next week in France.

Domenico Lombardi– of Brookings – writes that the G-20 Cannes Summit will provide an opportunity for a collegial assessment of the European response by non-European leaders and for escalating pressure on euro area leaders. Non-euro area G-20 leaders will be able to leverage on the terms of their support for fur- ther IMF engagement in the European crisis, including a follow-up aid program for Greece, and a much-needed expansion of the IMF’s financial capacity to underpin its financial safety nets. More specifically, emerging economies—which are expected to contribute to a revamped IMF war chest through bilateral lines of credit—will want to see a sustainable strategy in place before committing their own resources.

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