Germany Steps Up Demands For A European Sovereign Debt Default Mechanism With Investors Bailing-In And Defaulting Countries Out Of The Currency Union

November 9, 2010: EuroIntelligence reports German Coalition Backs Two Step Insolvency Plans: Angela Merkel’s coalition backs proposals for a two-step crisis mechanism to make bondholders pay for any future euro-area crisis, Leo Dautzenberg, the parliamentary finance spokesman for her party said according to Bloomberg. Finance minister Wolfgang Schäuble is working up the proposals in time for the Ecofin meeting on Nov. 15-16 meeting in Brussels.  Schäuble wants contracts for euro-region bonds “to spell out in the future exactly what will happen to the demands of the investor in a crisis situation,” Der Spiegel cited him as saying. The International Monetary Fund should manage the process of applying the crisis mechanism,  he said

And EuroIntelligence continues reporting that credit default swaps surge to record levels: Credit-default swaps on Ireland and its banks surged to record high levels on concern the cost of bailing out the nation’s financial system is unsustainable, Bloomberg reports. The Markit iTraxx SovX Western Europe Index of swaps on 15 nations rose 3.75 basis points from a record closing level to 174.75. Contracts on Ireland soared 28 basis points from a record closing level to 606; Contracts on Portugal jumped 9 basis points to 454, Spain climbed 9.5 to 259.5 and Italy increased 4 to 195. Greece declined 3 basis points to 195.

Also EuroIntelligence adds that the Irish government considers new taxes to meet budget plan: The Irish government is now considering a property tax and flat-rate water charges to meet its €6bn Budget plan, the Irish Independent has learned. This development came after EU commissioner Olli Rehn urged Irish political parties last night to put their differences aside and support the fiscal consolidation effort. Pressure on the Irish government is rising to back down over plans to cut the state pension and the package of social welfare cuts in the Budget had not been signed off at this stage. There are concerns that the weakened Fianna Fail-led government may fail to secure parliamentary backing for next month’s crucial austerity budget, the FT writes.

November 5, 2010: Reuters reports US Policy ‘Clueless’, German Finance Minister Says. Europe needs to strengthen economic governance and agree on a permanent crisis resolution mechanism, all the more so given current U.S. economic weakness, German Finance Minister Wolfgang Schaeuble said on Friday. France and Germany should maintain their leadership role in Europe, Schaeuble said, especially in order to harmonise its economic policy and bolster stability given current economic uncertainties.

These are being worsened by reckless policy in part from the the United States, Schaeuble said, sharpening his criticism of the Federal Reserve’s program to buy an additional $600 billion worth of U.S. government bonds. Pumping more money into the economy will not solve the country’s problems, he said, adding that the world needed U.S. leadership that was currently lacking. “With all due respect, U.S. policy is clueless,” Schaeuble said. “(The problem) is not a shortage of liquidity. Late on Thursday, Schaeuble said Germany would take up this point critically with the United States both bilaterally and at next week’s G20 summit of industrialised and emerging nations.

November 3, 2010:  I write: Germany Tries To Impose Its Domestic Economic Concept Of Ordnungspolitik (Governance) On The Eurozone, An Effort Likely To Fail, Wolfgang Munchau Says

November 2, 2010: Financial Times reports that European Central Bank President Jean-Claude Trichet warned that a future rescue mechanism for indebted countries, designed to shift responsibility to investors from taxpayers, could inadvertently push up their borrowing costs, citing European Union officials.

November 1, 2010: I write: European Shares Fall Lower On News That Van Rompuy Is Tasked To Develop A European Nation Sovereign Debt Default Mechanism: The EU Leaders’ European Economic Governance Summit of October 2010 concluded with an announcement assigning Herman Van Rompuy to design a sovereign debt default mechanism. This immediately turned the European stocks lower. Bond Vigilantes called interest rates higher on US Treasuries, turning their value lower. A higher US Dollar, rising volatility and other factors signaling a coming downturn in US stocks.

The European Shares fell on news that Herman Van Rompuy has been tasked with preparing the legalities and procedures for a nation’s sovereign debt default. European Financials, EUFN, fell 1.5%. Europe Small Cap Dividends, DGS, fell  1.6%.  Spain, EWP, fell 2.7%. Italy, EWI, fell 1.8%, Austria, EWO, 1.2%. European stock, VGK, fell 0.6%.

The sovereign debt default mechanism is a 180 degree turn from the sentiment expressed in May 2010 as reported by Bloomberg reporters James G. Neuger and Gregory Viscusi in EU Backs Stiffer Deficit Sanctions, Rules Out Default Mechanism and as I reported that EU Finance Ministers Announce European Economic Governance And Call For A Monetary Union With Seigniorage Authority To Issue Eurobonds.  

EuroIntelligence comments EU Leaders Trigger Another Bond Market Crisis: “We believe that the EU leaders remain complacent about the future of the eurozone, as they push their narrow national interests. We have been warning readers of a gulf between the German position on future crisis resolution in the eurozone and that of other EU member states, and that the fundamental conflicts of the first half of this year remain unresolved.

The summit only agreed some minimum parameters for Herman van Rompuy’s next task force, but the difference of the positions on the crisis resolution mechanism remain extreme.

Germany wants a bail-in mechanism to replace the EFSF, as a result of which European bond spreads have risen again.

Investors understand that the German proposal will dramatically increase the probability of future sovereign default in the eurozone. The EFSF is not a solution to a crisis resolution, it is merely a temporary arrangement.” Yesterday, Irish 10 year-spreads move towards 5%, and Greeks spreads towards 9%, as investors igested the implications of last week’s summit. Reuters quotes Lorenzo Bini Smaghi as saying that it was easy to talk about an orderly crisis resolution mechanism, but much more difficult to implement it – a criticism of the German approach. “In advanced economies the restructuring of the public debt would have to involve a much larger number of financial assets and liabilities, including those of the domestic banking system, vis-a-vis residents and non residents … It can be easily seen that there can hardly be anything ‘orderly’ in such a process.”

This whole chain of events shows clearly that EU leaders continue to underestimate the complexities of a monetary union. The structure is simply not capable of handling default, while simultaneously ruling out bailout and exit.

The resistance to the German plans in the European Council remains severe, and we simply cannot see Greece, Ireland, Spain, or Portugal agreeing to a crisis resolution mechanism, whose main effect would be to drive up their bond rates. It would be like turkeys voting for Christmas. Expect this to run well into next year. In fact, we would not be surprised if this debate were to continue right until the expiry of the EFSF in 2013.

Daniel Gros writes in EuroIntelligence article Liquidate Or Liquefy?: ”The obvious way out should be controlled rescheduling and/or restructuring in order to avoid turning parts of the euro periphery into ‘zombie countries’.

Brent Radcliffe in Yahoo, Ivestopia writes: “Defaulting on sovereign debt can be more complicated than defaults on corporate debt because domestic assets cannot be seized to pay back funds. Rather, the terms of the debt will renegotiated, often leaving the lender in an unfavorable situation, if not an entire loss. The impact of the default can thus be significantly more far-reaching, both in terms of its impact on international markets and of its effect on the country’s population. A government in default can easily become a government in chaos, which can be disastrous for other types of investment in the issuing country.”

On February 25, 2010, the Euro, FXE, stood at 111.35 and six trading days on March 5, 2010 later it plunged to 109.75.  It was at this time that Drago Tzvetkov of the Atlantic Council wrote on the Threat of Sovereign Debt Default relating:  The Atlantic Council’s Global Business and Economics Program hosted a conference call with Professor Leszek Balcerowicz on the Euro debt crisis.  Balcerowicz, a former Finance Minister of Poland, shared his views on the measures needed to ensure Eurozone unity and assessed the current difficulties facing European nations as they attempt to rein in public spending and decrease their deficits.

The financial crisis has entered a new phase.  What began as a series of mortgage defaults soon became a crisis of bank insolvency.  The dire state of Greece’s budget and debt points to a more chilling aspect of the crisis: insolvency of sovereign nations.  EU leaders have yet to outline a concrete plan.  With fourth quarter GDP numbers in the Euro-zone looking dismal, unemployment high, and economic growth low, selling a “bail-out” plan will be politically unpopular. Dr. Leszek Balcerowicz analyzed three options for Greece and Europe to mitigate damage to Europe’s economy, and the Euro itself:

  1. Fiscal adjustment to prevent default: Greece needs to make “radical and deep” adjustments, including fiscal changes to cut excessive spending.  This should be coupled with aid from the IMF, which should provide conditional crisis lending.
  2. A bail-out by EU governments: While acknowledging that this is not a long-term solution and that it is “not politically feasible” given German public opinion, Balcerowicz put the bailout option on the table.  The negative risk of the resulting public resentment would sow further distrust of the Euro project.
  3. The departure of Greece from the Eurozone: Monetary independence would allow Greek authorities to depreciate the currency but ignore the fundamental causes of its budget distress, and add skyrocketing Euro-based debt to Greece’s woes. With no constitutional or legal mechanisms for leaving the Eurozone, the Greek public would not be willing to enter “politically unchartered waters.”

Recommending fiscal discipline as the only viable option, the former Polish Finance Minister and architect of the “shock therapy” that led the Polish economy communism to the global marketplace said, “Shocks from time to time are great educators.  I don’t know of any country which would have suffered because of excessive fiscal discipline.”  He emphasized that Greece should face the consequence of its actions and be expected to implement the necessary reforms.

The bond vigilantes were active today, in front of the US Federal Reserves QE 2 announcement, calling the Interest Rate on the 30 Year US Government bond, $TYX, higher to 4.017%; its charts suggests that a breakout out through triangular consolidation is at hand. And the Interest Rate on the 10 Year US Government bond, $TNX, rose to 2.659%. the Interest Rate On The 2 Year US Government Note, $UST2Y, traded unchanged at 0.34%.

Higher interest rates means The End of Credit has commenced.

And on November 8, 2010, Morgan Kelley writes in the Irish Times,  We can only rely on the kindness of strangers.

During September, the Irish Republic quietly ceased to exist as an autonomous fiscal entity, and became a ward of the European Central Bank.

It is a testament to the cool and resolute handling of the crisis over the last six months by the Government and Central Bank that markets now put Irish sovereign debt in the same risk group as Ukraine and Pakistan, two notches above the junk level of Argentina, Greece and Venezuela.

September marked Ireland’s point of no return in the banking crisis. During that month, €55 billion of bank bonds (held mainly by UK, German, and French banks) matured and were repaid, mostly by borrowing from the European Central Bank.

Until September, Ireland had the legal option of terminating the bank guarantee on the grounds that three of the guaranteed banks had withheld material information about their solvency, in direct breach of the 1971 Central Bank Act. The way would then have been open to pass legislation along the lines of the UK’s Bank Resolution Regime, to turn the roughly €75 billion of outstanding bank debt into shares in those banks, and so end the banking crisis at a stroke.

With the €55 billion repaid, the possibility of resolving the bank crisis by sharing costs with the bondholders is now water under the bridge. Instead of the unpleasant showdown with the European Central Bank that a bank resolution would have entailed, everyone is a winner. Or everyone who matters, at least.

The German and French banks whose solvency is the overriding concern of the ECB get their money back. Senior Irish policymakers get to roll over and have their tummies tickled by their European overlords and be told what good sports they have been. And best of all, apart from some token departures of executives too old and rich to care less, the senior management of the banks that caused this crisis continue to enjoy their richly earned rewards. The only difficulty is that the Government’s open-ended commitment to cover the bank losses far exceeds the fiscal capacity of the Irish State.

The Government has admitted that Anglo is going to cost the taxpayer €29 to €34 billion. It has also invested €16 billion in the other banks, but expects to get some or all of that investment back eventually.

So, the taxpayer cost of the bailout is about €30 billion for Anglo and some fraction of €16 billion for the rest. Unfortunately, these numbers are not consistent with each other, and it only takes a second to see why.

Between them, AIB and Bank of Ireland had the same exposure to developers as Anglo and, to the extent that they were scrambling to catch up with Anglo, probably lent to even worse turkeys than it did. AIB and Bank of Ireland did start with more capital to absorb losses than Anglo, but also face substantial mortgage losses, which it does not. It follows that AIB and Bank of Ireland together will cost the taxpayer at least as much as Anglo.

Once we accept, as the Government does, that Anglo will cost the taxpayer about €30 billion, we must accept that AIB and Bank of Ireland will cost at least €30 billion extra.

In my article of last May, when I published my optimistic estimate of a €50 billion bailout bill, I posted a spreadsheet on the website, giving my realistic estimates of taxpayer losses. My realistic estimate for Anglo was €34 billion, the same as the Government’s current estimate.

When you apply the same assumptions about lending losses to the other banks, you end up with a likely taxpayer bill of €16 billion for Bank of Ireland (deducting the €3 billion they have since received from investors) and €26 billion for AIB: nearly as bad as Anglo.

Indeed, the true scandal in Irish banking is not what happened at Anglo and Nationwide (which, as specialised development lenders, would have suffered horrific losses even had they not been run by crooks or morons) but the breakdown of governance at AIB that allowed it to pursue the same suicidal path.

Once again we are having to sit through the same dreary and mendacious charade with AIB that we endured with Anglo: “AIB only needs €3.5 billion, sorry we meant to say €6.5 billion, sorry . . .” and so on until it is fully nationalised next year, and the true extent of its folly revealed.

This €70 billion bill for the banks dwarfs the €15 billion in spending cuts now agonised over, and reduces the necessary cuts in Government spending to an exercise in futility. What is the point of rearranging the spending deckchairs, when the iceberg of bank losses is going to sink us anyway?

What is driving our bond yields to record levels is not the Government deficit, but the bank bailout. Without the banks, our national debt could be stabilised in four years at a level not much worse than where France, with its triple A rating in the bond markets, is now.

As a taxpayer, what does a bailout bill of €70 billion mean? It means that every cent of income tax that you pay for the next two to three years will go to repay Anglo’s losses, every cent for the following two years will go on AIB, and every cent for the next year and a half on the others. In other words, the Irish State is insolvent: its liabilities far exceed any realistic means of repaying them.

For a country or company, insolvency is the equivalent of death for a person, and is usually swiftly followed by the legal process of bankruptcy, the equivalent of a funeral.

Two things have delayed Ireland’s funeral. First, in anticipation of being booted out of bond markets, the Government built up a large pile of cash a few months ago, so that it can keep going until the New Year before it runs out of money. Although insolvent, Ireland is still liquid, for now.

Secondly, not wanting another Greek-style mess, the ECB has intervened to fund the Irish banks. Not only have Irish banks had to repay their maturing bonds, but they have been haemorrhaging funds in the inter-bank market, and the ECB has quietly stepped in with emergency funding to keep them going until it can make up its mind what to do.

Since September, a permanent team of ECB “observers” has taken up residence in the Department of Finance. Although of many nationalities, they are known there, dismayingly but inevitably, as “The Germans”.

So, thanks to the discreet intervention of the ECB, the first stage of the crisis has closed with a whimper rather than a bang. Developer loans sank the banks which, thanks to the bank guarantee, sank the Irish State, leaving it as a ward of the ECB.

The next act of the crisis will rehearse the same themes of bad loans and foreign debt, only this time as tragedy rather than farce. This time the bad loans will be mortgages, and the foreign creditor who cannot be repaid is the ECB. In consequence, the second act promises to be a good deal more traumatic than the first.

Where the first round of the banking crisis centred on a few dozen large developers, the next round will involve hundreds of thousands of families with mortgages. Between negotiated repayment reductions and defaults, at least 100,000 mortgages (one in eight) are already under water, and things have barely started.

Banks have been relying on two dams to block the torrent of defaults – house prices and social stigma – but both have started to crumble alarmingly.

People are going to extraordinary lengths – not paying other bills and borrowing heavily from their parents – to meet mortgage repayments, both out of fear of losing their homes and to avoid the stigma of admitting that they are broke. In a society like ours, where a person’s moral worth is judged – by themselves as much as by others – by the car they drive and the house they own, the idea of admitting that you cannot afford your mortgage is unspeakably shameful.

That will change. The perception growing among borrowers is that while they played by the rules, the banks certainly did not, cynically persuading them into mortgages that they had no hope of affording. Facing a choice between obligations to the banks and to their families – mortgage or food – growing numbers are choosing the latter.

In the last year, America has seen a rising number of “strategic defaults”. People choose to stop repaying their mortgages, realising they can live rent-free in their house for several years before eviction, and then rent a better house for less than the interest on their current mortgage. The prospect of being sued by banks is not credible – the State of Florida allows banks full recourse to the assets of delinquent borrowers just like here, but it has the highest default rate in the US – because there is no point pursuing someone who has no assets.

If one family defaults on its mortgage, they are pariahs: if 200,000 default they are a powerful political constituency. There is no shame in admitting that you too were mauled by the Celtic Tiger after being conned into taking out an unaffordable mortgage, when everyone around you is admitting the same.

The gathering mortgage crisis puts Ireland on the cusp of a social conflict on the scale of the Land War, but with one crucial difference. Whereas the Land War faced tenant farmers against a relative handful of mostly foreign landlords, the looming Mortgage War will pit recent house buyers against the majority of families who feel they worked hard and made sacrifices to pay off their mortgages, or else decided not to buy during the bubble, and who think those with mortgages should be made to pay them off. Any relief to struggling mortgage-holders will come not out of bank profits – there is no longer any such thing – but from the pockets of other taxpayers.

The other crumbling dam against mass mortgage default is house prices. House prices are driven by the size of mortgages that banks give out. That is why, even though Irish banks face long-run funding costs of at least 8 per cent (if they could find anyone to lend to them), they are still giving out mortgages at 5 per cent, to maintain an artificial floor on house prices. Without this trickle of new mortgages, prices would collapse and mass defaults ensue.

However, once Irish banks pass under direct ECB control next year, they will be forced to stop lending in order to shrink their balance sheets back to a level that can be funded from customer deposits. With no new mortgage lending, the housing market will be driven by cash transactions, and prices will collapse accordingly.

While the current priority of Irish banks is to conceal their mortgage losses, which requires them to go easy on borrowers, their new priority will be to get the ECB’s money back by whatever means necessary. The resulting wave of foreclosures will cause prices to collapse further.

Along with mass mortgage defaults, sorting out our bill with the ECB will define the second stage of the banking crisis. For now it is easier for the ECB to drip feed funding to the Irish State and banks rather than admit publicly that we are bankrupt, and trigger a crisis that could engulf other euro-zone states. Our economy is tiny, and it is easiest, for now, to kick the can up the road and see how things work out.

By next year Ireland will have run out of cash, and the terms of a formal bailout will have to be agreed. Our bill will be totted up and presented to us, along with terms for repayment. On these terms hangs our future as a nation. We can only hope that, in return for being such good sports about the whole bondholder business and repaying European banks whose idea of a sound investment was lending billions to Gleeson, Fitzpatrick and Fingleton, the Government can negotiate a low rate of interest.

With a sufficiently low interest rate on what we owe to Europe, a combination of economic growth and inflation will eventually erode away the debt, just as it did in the 1980s: we get to survive.

How low is sufficiently low? Economists have a simple rule to calculate this. If the interest rate on a country’s debt is lower than the sum of its growth rate and inflation rate, the ratio of debt to national income will shrink through time. After a massive credit bubble and with a shaky international economy, our growth prospects for the next decade are poor, and prices are likely to be static or falling. An interest rate beyond 2 per cent is likely to sink us.

This means that if we are forced to repay the ECB at the 5 per cent interest rate imposed on Greece, our debt will rise faster than our means of servicing it, and we will inevitably face a State bankruptcy that will destroy what few shreds of our international reputation still remain.

Why would the ECB impose such a punitive interest rate on us? The answer is that we are too small to matter: the ECB’s real concerns lie with Spain and Italy. Making an example of Ireland is an easy way to show that bailouts are not a soft option, and so frighten them into keeping their deficits under control.

Given the risk of national bankruptcy it entailed, what led the Government into this abject and unconditional surrender to the bank bondholders? I have been told that the Government’s reasoning runs as follows: “Europe will bail us out, just like they bailed out the Greeks. And does anyone expect the Greeks to repay?”

The fallacy of this reasoning is obvious. Despite a decade of Anglo-Fáil rule, with its mantra that there are no such things as duties, only entitlements, few Irish institutions have collapsed to the third-world levels of their Greek counterparts, least of all our tax system.

And unlike the Greeks, we lacked the tact and common sense to keep our grubby dealing to ourselves. Europeans had to endure a decade of Irish politicians strutting around and telling them how they needed to emulate our crony capitalism if they wanted to be as rich as we are. As far as other Europeans are concerned, the Irish Government is aiming to add injury to insult by getting their taxpayers to help the “Richest Nation in Europe” continue to enjoy its lavish lifestyle.

My stating the simple fact that the Government has driven Ireland over the brink of insolvency should not be taken as a tacit endorsement of the Opposition. The stark lesson of the last 30 years is that, while Fianna Fáil’s record of economic management has been decidedly mixed, that of the various Fine Gael coalitions has been uniformly dismal.

As ordinary people start to realise that this thing is not only happening, it is happening to them, we can see anxiety giving way to the first upwellings of an inchoate rage and despair that will transform Irish politics along the lines of the Tea Party in America. Within five years, both Civil War parties are likely to have been brushed aside by a hard right, anti-Europe, anti-Traveller party that, inconceivable as it now seems, will leave us nostalgic for the, usually, harmless buffoonery of Biffo, Inda, and their chums.

You have read enough articles by economists by now to know that it is customary at this stage for me to propose, in 30 words or fewer, a simple policy that will solve all our problems. Unfortunately, this is where I have to hold up my hands and confess that I have no solutions, simple or otherwise.

Ireland faced a painful choice between imposing a resolution on banks that were too big to save or becoming insolvent, and, for whatever reason, chose the latter. Sovereign nations get to make policy choices, and we are no longer a sovereign nation in any meaningful sense of that term.

From here on, for better or worse, we can only rely on the kindness of strangers.

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