The Wheels Are Coming Off The Wagon Again

Spain, Greece and The Union of Hopers

By Pater Tenebrarum

The evolving situation and growing uncertainty over Greece's future and the recent fourth attempt to right the floundering ship of Spain's banking industry predictably has markets on edge.

As to Spain's banking plan, it is already ridiculed for the way too low cost estimates mentioned by finance minister Louis de Guindos, who opined that   less than €15 billion in public funds will be required and that 'no effect on the public debt is to be expected'. In some other universe perhaps, but not in this one.

Guindos also expressed the opinion on Monday that the political impasse in Greece represents the greatest problem at present, implying that the sudden spike in Spain's bond yields and CDS spreads observed on Monday was due to the contagion effect from Greece. He reportedly 'shrugged off' suggestions that his government's banking reform plan didn't go far enough, but we all know better of course. Spain's banking system is facing the 'moving target problem' – the goal posts regarding required loan loss reserves are constantly shifting as the real estate bubble's collapse progresses. De Guindos in any case has now given Spain's most pressing problem a new name, and it is 'Greece'.

Note here that the construction sector, similar to other countries that went through housing bubbles, used to provide countless jobs in Spain. It is not easy for people trained in construction jobs to switch into completely new occupations. The problem is exacerbated if people begin to be 'bound' to their  homes due to being underwater on their mortgages. This problem is even more pronounced in Spain than in the US, due to the fact that mortgage debt in Spain is full recourse. Moreover, Spain's labor legislation is reportedly among the most rigid in Europe and that is really saying something. It is therefore not easy to gauge for the newly jobless in which sectors of the economy demand for labor is likely to pick up – as right now, with the exception of the relatively small export sector, Spain's companies are struggling and scared to exercise demand for labor in case the economy fails to improve. This would be less of a problem if it were as easy to fire people as it is to hire them. Naturally, as is the case elsewhere in Europe, Spain has a large pool of institutionalized unemployment mainly due to minimum wage rates.

It is clear that in an unhampered market economy, the real incomes of workers will rise to reflect increasing economic productivity which in turn is the result of  capital accumulation. As Mises reminded us frequently, the  gains workers have allegedly achieved through so-called pro-labor legislation are a consequence of rising labor productivity, not of legislation. If not for a progressing economy, there would be no income gains that could be allocated by legislative fiat.

Sadly, the attempt to ensure a 'living wage' condemns all those whose skills the market values below the levels assigned by minimum wage rates to permanent unemployment (not surprisingly, there are vast 'shadow economies' all over Europe, which is the only way to ensure the livelihood of many of  those who would otherwise be forced to simply subsist on handouts).

It should be obvious that only very comprehensive structural reforms can possibly get the cart out of the mud, and even if those are implemented,  it will take some time for things to turn around.

Unfortunately the European welfare state mentality remains deeply rooted in many countries – everybody seems to think they can rely on someone else's money. Or let us rather state: people erroneously seem to think that the State possesses a horn of plenty that only needs to be activated by sheer force of political will. Hence the recent electoral successes of the political left, although it could well be argued that this is simply due to the negative social mood being poison for the election chances of incumbents regardless of their political   affiliation. There is in any case little difference between the mainstream parties, all of which are wedded to statism. As the example of SYRIZA's success in Greece's election shows, the non-mainstream radicals are even more statist in their outlook. This is certainly telling with regards to the 'choice' citizens allegedly have, whereby it is certainly doubtful whether the majority even wants a true choice.

Anyway, regardless of Mr. de Guindos' creative reclassification of Spain's main problem, it is clear that the Greek post-election to-and-fro has alarmed the eurocrats in Brussels and elsewhere. Recall that the Greek problem was considered buried for a good while after the PSI deal and the signing of the second bailout agreement. Significantly, the leaders of Greece's 'old guard' mainstream parties had to commit themselves in writing to the EU's plan. Antonis Samaras was holding out, as he correctly perceived that his election chances were dimming with every step he took in support of the troika's (EU/IMF/ECB) austerity program.

In the end the eurocracy resorted to blackmail: euro-group chief JC Juncker, various Brussels-based officials like Herman van Rompuy, Manuel Barroso and Olli Rehn all reiterated the German position articulated by Mrs. Merkel and Mr. Schäuble: unless Samaras was prepared to sign on the dotted line, preferably in his own blood, there would be no more money. In February Samaras relented at literally almost the last minute.

No-one in Brussels thought of asking for the signature of Alexis Tsipras (which they wouldn't have gotten anyway). It is probably not much of an exaggeration to say that by bullying Samaras into signing, the eurocrats handed Tsipras and other radicals in Greece the election on a silver platter.

At the same time, they thought that by forcing Samaras to sign, they had all the political eventualities in Greece covered. Oops!

As we have pointed out previously, the rhetoric emanating from Brussels and Berlin has not really changed much – but there is evidently growing unease over the evolving situation in Greece. Surely many in Brussels are asking themselves whether it is really true that Greece can be cut off from aid and pushed out of the euro area without major economic upheaval following in the wake of the event. Indeed, this is difficult to gauge with any certainty, but JP Morgan has just published a research report stating that a Greek exit from the euro area would result in about €400 billion in 'immediate losses', and likely even more through contagion effects. And as everybody is well aware of these days, JP Morgan knows a thing or two about sudden big losses.

Thus there was a toned down version of the harsh austerity rhetoric on display on Monday, an odd mixture of threats and pleading:

“Leading European Union finance officials on Monday promised to stand by Greece as a member of the eurozone provided it sticks to its bailout terms and stays the course of its painful austerity program to prevent even worse economic hardship.

Greeks fed up with the painful austerity measures had voted for parties that had promised an end to the harsh austerity measures that had been agreed as part of the country's bailout. Many euro finance ministers attending a meeting in Brussels warned, however, that Athens must stick to the terms of the rescue package if it wants to remain in the 17-nation euro  currency. In return, no one was seeking to squeeze Greece out of the shared currency, said Luxembourg Prime Minister Jean-Claude Juncker, the chairman of the Eurogroup.

"Nobody was mentioning an exit of Greece from the euro area. I am strongly against," Juncker said after the meeting of the group.

The ministers were unwilling however to offer Greece significantly better bailout terms, stressing that whether it leaves the common currency or not, it would take years of belt-tightening to ease its debt.

"An exit will solve nothing," said Belgian Finance Minister Steven Vanackere. His Austrian counterpart, Maria Fekter, noted that Greece was nevertheless moving closer to such an exit as the main political parties in Athens struggled for a ninth day to create a coalition government. They will gather for more talks on Tuesday and if they fail, new elections will be called.

But in the face of pressure from markets, Juncker put up a united front.

"We are 17 member states being co-owners of our common currency. I don't envisage, not even for one second, Greece leaving the euro area. This is nonsense. This is proproganda," Juncker said.

The main political parties that agreed to Greece's international bailout do not have the majority to create a new government and smaller parties are reluctant to join them, noting that Greeks have clearly voted against the bailout's austerity terms. "The situation is serious," Fekter said.

The Commission, the EU's executive body, said it was best for Greece to stay with the pack and bear the hardships with conditional aid close at hand. EU Commission spokeswoman Pia Ahrenkilde Hansen said Greece should remain in the euro. "We believe that this is the best solution for Greece, the Greek people and Europe as a whole."

The gentle tone contrasted with tough talk from her boss, Commission President Jose Manuel Barroso, who told Italian television over the weekend that "if a member of a club does not respect the rules it is better that it leaves the club, and this is true for any organization, or institution, or any project." Though the Commission noted Barroso was not referring specifically to Greece, his comments were among the closest a leading EU official had come to envisaging the country's exit from the 17-nation financial project.

Propaganda! We wonder if Mr. Schäuble has taken note he's now considered a  fount of propaganda. Alexis Tsipras can not fail to be encouraged by this change in tone however – and this means he will gladly go for a new election which SYRIZA is expected to win.

Mene, Mene, Tekel…

Like King Belshazzar of Babylon, the eurocrats are apparently seeing the writing on the wall following recent elections in Greece and elsewhere. The market reaction promises that the era of 'emergency summits' is close to coming back with a vengeance, just as everybody thought summit inflation was  finally quelled for a little while.

The stunning electoral successes of SYRIZA and 'Golden Dawn' in Greece and of Marine Le Pen's Front National (which wants to do away with the euro altogether) and Jean-Luc Melenchon's  Left Party in France represent a real threat to the eurocratic establishment. In Greece's case the point has been reached where the radicals must either be co-opted or be made to slink back into obscurity. It is too late for the latter and the former is an uncertain prospect indeed.

Evidently the establishment doesn't quite know how to deal with someone like Tsipras. He doesn't seem to want anything and instead of meekly submitting to threats like Samaras has done (who surely curses himself every day for having given in), he has a habit of issuing threats himself. This is a completely new experience for the nomenclatura in Brussels. Maybe Tsipras has read the JP Morgan report on contagion. A few pertinent quotes from the report follow below:

“Greek banks have run out of ECB eligible collateral already and can only access Bank of Greece’s ELA, but even with ELA, the collateral, typically loans, is not unlimited. They have already borrowed €60bn via ELA which, assuming 50% haircut corresponds to around €120bn of loan collateral. Outstanding loans are €250bn, so Greek banks have a maximum of €130bn of remaining loan collateral which allows for a maximum of €65bn of additional borrowing from Bank of Greece’s ELA. This corresponds to around 40% of Greek bank deposits which stood at €170bn as of the end of March. The true maximum amount that Greek banks can borrow via ELA is likely though to be significantly smaller because not all loans are accepted as collateral via ELA. The alternative is for Greek banks to be allowed to issue more government guaranteed paper but the ECB can, with a 2/3rd majority, block a steep and unsustainable increase in Bank of Greece’s ELA. This would effectively cut Bank of Greece off from TARGET2 and force it to eventually issue its own money.

Unfortunately, we need to wait until the end of June for the ECB’s monthly MFI balance sheet data to get an accurate picture of the impact of Greek elections on deposits. Anecdotal evidence from the Greek press and elsewhere suggests that deposit outflows re-accelerated post elections. […]

The main direct losses correspond to the €240bn of Greek debt in official hands (EU/IMF), to €130bn of Eurosystem’s exposure to Greece via TARGET2 and a potential loss of around €25bn for European banks. This is the cross-border claims (i.e. not matched by local liabilities) that European banks (mostly French) have on Greece’s public and non-bank private sector. These immediate losses add up to €400bn.

This is a big amount but less assume that, as several people suggested this week, that these immediate/direct losses are manageable. What are the indirect consequences of a Greek exit for the rest?

The wildcard is obviously contagion to Spain or Italy? Could a Greek exit create a capital and deposit flight from Spain and Italy which becomes difficult to contain? It is admittedly true that European policymakers have tried over the past year to convince markets that Greece is a special case and its problems are rather unique. We see little evidence that their efforts have paid off.

The steady selling of Spanish and Italian government bonds by non-domestic investors over the past nine months (€200bn for Italy and €80bn for Spain) suggests that markets see Greece more as a precedent for other peripherals rather than a special case.

And it is not only the €800bn of Italian and Spanish government bonds still held by non-domestic investors that are likely at risk. It is also the €500bn of Italian and Spanish bank and corporate bonds and the €300bn of quoted Italian and Spanish shares held by nonresidents. And the numbers balloon if one starts looking beyond portfolio/quoted assets. Of course, the €1.4tr of Italian and €1.6tr of Spanish bank domestic deposits is the elephant in the room which a Greek exit and the introduction of capital controls by Greece has the potential to destabilize.”

In light of the above, the bravado displayed by German politicians over the weekend may have been a tad premature, although they seem strongly committed not to 'pay for Greece's vacations from reality'. Needless to say, the   immediate effects of a euro exit on Greece itself would not exactly be a joyride either, so both sides have something to threaten the other with.

Still, it is clear that everybody (with the possible exception of Tsipras) is 'hoping' now, and praying that a further deterioration of the situation can be avoided. In Spain's case, things are beginning to look very dicey indeed, as you will see from the charts below.

Credit Markets Update

Below is our customary update of credit market charts, including the usual suspects: CDS on various sovereign debtors and banks, bond yields, euro basis swaps and a few other charts. Charts and price scales are color coded (readers should keep the different price scales in mind when assessing 4-in-1 charts). Where necessary we have provided a legend for the color coding below the charts.  Prices are as of Monday's close.

CDS on Spain's sovereign debt have reached a new all time high, while its government bond yields have jumped sharply higher and are now closing in on the level widely considered as 'unbearable'.

Most CDS spreads and yields elsewhere in the euro area and much of the CEE region have followed suit. Strangely enough, CDS on Greece have barely budged, but are trading at a highly distressed level of nearly 6,000 basis points anyway. Greek long term bond yields have however continued to increase by leaps and bounds. Meanwhile there has been a big break lower in euro basis swaps and our proprietary index of CDS on European banks is once again at a new high for the move.