Raul Larios

Has the run on Europe begun?

Eurozone map in 2009 Category:Maps of the Eurozone

Since my last article on September 28 regarding the crisis in Europe, I have been following with much interest the progress (or lack thereof) by the European authorities.  In my September post, you read about George Soros’ belief that the euro was in trouble; that unless really drastic measures were taken immediately, it was just a matter of time before the euro collapsed.

Well, time is running out.  A couple of days ago, Henry Blodget posted an article entitled “The Run on Europe begins…” where he claims that a bank-style run on Europe has already begun.  He cites as an example the fact that American money-market funds have withdrawn over half of their deposits (more than $250 billion) from European banks.  He also cites other huge institutional withdrawals by Japanese and European pension funds.

According to the New York Times November 22, 2011 edition, European banks were screaming for emergency funds from the European Central Bank (ECB), as much as 247 billion Euros, “the most since early 2009 in a clear sign that [European] financial institutions are having trouble obtaining credit at reasonable rates on the open market.”

Needless to say, the European authorities are aware of the problem.  They have been woking on the European Financial Stability Facility (EFSF) for quite awhile. (If you are not familiar with the EFSF, think of it as their TARP bailout fund). The problem with the EFSF is that it is already committed to bailing out Portugal, Ireland and Greece.  If those bailouts are triggered, the EFSF would only have about 300 billion Euros available to bail out Italy, which is not enough to cover even 6 months of borrowing by the Italians. Nothing for Spain!

This is why the ECB is floating a new idea to address the enormity of the problem. The Euro Bond. This would be a financially engineered instrument by which the 17 euro-zone members of the monetary union would refinance their current national bonds through joint, euro-zone guaranteed bonds.  The idea is to quickly replace some or all of the current and future national debt with Euro-zone bonds that carry only partial guarantees from member governments.  Partially (versus fully) guaranteed euro bonds could be brought to market rapidly, without having to make changes to the European Union (EU) Treaty.  Full guarantees from the monetary union members would require Treaty re-negotiation, which means 17 different affirmative referendum votes (one per EU member).  That could take years to implement.

The idea of refinancing current national debt with euro bonds has so many holes, it looks like Swiss cheese.  The number one hole is the fact that Germany is totally opposed to the idea of getting stuck with the bill for the spendthrift ways of their neighbors.  You see, converting national government debt into euro bonds could weaken budget discipline even further because a significant portion of the weaker members’ debt will be magically lifted off their balance sheets, AND it will be guaranteed by the stronger members.  There will be no stopping weak members from more deficits that they can finance with more euro bonds.  To prevent such a scenario, the Germans will want tighter budget restrictions on all members.  This would require Treaty changes, putting us back to square one.

Another, more serious hole is “re-denomination risk”.  In other words, what would happen to the buyer of a euro bond if the financial engineering does not work and the EU breaks up?  Does the debt stay in euros or is it denominated in some new currency.  What will be the value of this new currency, relative to the U.S. dollar?  Which leads to an interesting institutional-type question: can said buyer even hedge a position in a currency that doesn’t exist?

Jens Nordvig, a Managing Director and senior currencies analyst for Nomura Holdings, asked these kind of questions in a recent 12-page report where he ponders the possible ramifications of a breakup, including queries about the applicable legal jurisdiction.  If you are owed money in Euros via a straight sovereign bond you bought, say, from the Greek government and they default, what is your workout scenario?  Well, it depends.  If the loan was issued under local Greek law, your bond will most likely be converted from Euros into a new Greek currency (formerly known as the drachma).  The value of this new currency relative to the euro or the dollar is unknown.  Also unknown is if this new currency will depreciate, by how much and how quickly.

If the sovereign bond in question was issued under English or New York law, then the defaulted debt might remain in Euros.  I say “might” because it depends on whether the euro breaks up altogether.  In which case, a different set of laws would apply (the “Lex Monatae Principle”), or maybe even a new European Currency Unit (ECU-2).

Now multiply by 17 the re-denomination risk inherent in the plain-vanilla sovereign bond example above.  The resulting multiplication product would be the workout scenario of a defaulted euro bond that is partially guaranteed by 17 different legal jurisdictions.

This is Europe’s solution?!

Obviously the euro bond is very complicated, very risky financial engineering.  Almost as risky as slicing and splicing thousands of sub-prime mortgages into dozens of tranches, securitizing them into a collateralized mortgage obligation with a AAA rating, and selling it to an unsuspecting investor…

Speaking of, I leave you with these electrifying words from Henry Blodget’s article: “Recall how quickly Bear Stearns and Lehman Brothers went from angry denials and “exploring options” to bust.  Recall how quickly, [just] a month ago, MF Global went from confident to flailing to broke.”  You can read Mr. Blodget’s entire article here: (http://www.businessinsider.com/the-run-on-europe-begins-as-global-investors-head-for-the-hills-2011-11).

Don’t get caught with your pants down, again.  Learn from the Lehman experience, and adjust accordingly.

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November 29, 2011 - Posted by | New York

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