24/1/2012: Europe's Latest Non-Leadership on ESM/EFSF

Another heated non-debate is sweeping Europe. In the latest round of bizarre, outright Kafkaesque rhetorical contortions, European leaders are now engaged in a heated discussion on the 'enlargement' of ESM. Alas, the whole thing is clearly heading for the same outcome as Europe's previous rounds of 'solutions'. Here's why.

Recently, as reported in German press (here) Angela Merkel started to yield on the idea that the 'permanent' ESM fund should be increased from €500 billion to closer to €1 trillion by, among other things, allowing for concurrent running of existent €250 billion EFSF facility and the setting up of the new ESM.

Sadly, this 'solution' is really a complete red herring, despite all the hopes the EU is pinning onto it. In fact, it so much of a fake, the markets are simply likely to laugh their way through it.

The EFSF is designed to run out of time in the end of 2013. ESM is designed to start the earliest in mid-2012. Which means that even in theory, combined ESM/EFSF can last not much longer than 12 months. In practice, however, even this is not going to happen.

Firstly, EFSF is becoming increasingly funded through short term debt issuance and this means that as we hit 2013, the rate of EFSF paper maturing is going to accelerate. To roll this into longer-dated paper will require more than just re-writing the statutes of the EFSF. It will require EFSF raising funding at the same time as ESM is raising funding. The likelihood of this being a successful market funding strategy is zero.

Secondly, ESM capital basis of (meagre) €80 billion is not going to be fully invested on the initiation of the fund. Which means ESM even in theory is not going to come out on day 1 and borrow full €500 billion capacity. In practice, it can't be expected to raise even 1/4 of that in the first year of operations.

Which means that even running concurrently, EFSF+ESM duo will not constitute a fund with anything close to €750 billion capacity. And this means that European leadership is clearly in line for winning the Global Non-Leadership Prize again this year. IMF, insisting on the concurrent running of EFSF/ESM as well, is going to be a runner up.

27/11/2011: Even with IMF's €600bn - Italy is too big to bail

There are some interesting reports in the media over the weekend, speculating that the IMF is preparing a super package for Italy, rumored to reach €600 billion. Here's a link from zerohedge that outlines the details of these rumors (here). There are several reasons to be skeptical as the feasibility of such a package and the potential effectiveness of it.

Here are these reasons.

Firstly, the IMF is a rules-based organization that normally can lend only 4-5 times (400-500%) of the country quota. Italy's country quota is SDR7.8823 billion or €10.7bn which can allow IMF to lend under normal arrangements up to €53.5 billion (at a severe stretch, I must add as the fund prefers not to lend to the full leverage of 500%).

In addition, IMF has announced two new programmes last week (discussed here). The Flexible Credit Line programme - whereby IMF does not specify lending leverage to be achieved, applies only to "members with very strong track records... based on pre-set qualification criteria to deal with all types of balance of payments problems." So IMF would have to qualify Italy as a country with "strong track record" and its solvency problems as "balance of payments problem". This, of couse, is possible, though not probable, as Italy's "strong track record" is hardly that "strong". In addition, the new lending will have to take place outside the normal arrangements mentioned above, as the deployment of such arrangements would not be consistent with "strong track record" even in theory. So to raise €600 billion, IMF will have to leverage Italy's SDR allocation 6,000%.

Let's put this number into perspective. Lehman Bros TCE leverage ratio was 4,400% at the time of collapse and its average TCE leverage ratio prior to collapse was 3,100%.

At any rate, IMF is most likely to assign Italy a precautionary borrower status under Precautionary Credit Line (see link above) which allows for 24 months leveraging up to 1,000%. This, of course means Italy will be able to raise just €107 billion through IMF loans or about 1/3rd of its roll-over requirements (not to mention new borrowings demand) through 2012.

Secondly, suppose IMF does indeed lend Italy €600 billion - enough to barely cover the country refinancing needs for 2012-2013. Then, two things happen:

1. 1/3rd of Italy's total Gross Government Debt becomes overnight senior to the rest of its debt - as IMF always assumes seniority in lending. This will push existent Italian bonds yields to 15% or 18% or more. We do not know, of course, exactly where the debt will be traded, but what we do know with almost certainty is that there is not a snowball's chance in hell Italy will be able to refinance maturing debt after 2013 on its own. So IMF lending Italy today commits IMF to lend to Italy in 2014 and on.
2. €600 billion is unlikely to cover all Italian needs for 2012-2013, especially if Italian banks are to take a hit on other sovereign bonds. let me run through the EBA banks stress tests model under the following assumptions: Greece haircut 80%, Italy haircut 10%, Portugal haircut 25%, Spain haircut 10% (notice - all very benign) and CT1 ratio of 9%. Italian banks shortfall on capital is €34 billion. Now, recall that Italy also has insurance companies (e.g. A.Gen) and pensions funds - which will see some fall-outs from the haircuts as well. Say €10 billion. Italian bonds downgrade due to IMF lending (see item 1 above) is likely to cost banks and other financial sector companies another  €11 billion and €4 billion. So we are into total bill of ca €60 billion right there. Italian deficits in 2012-2014 are expected to gross €76 billion per IMF latests forecasts. As shown in the chart above, debt maturity, plus new deficits financing will consume some €453.4 billion in 2012-2014 and €630.5 billion in 2012-2016. 

So the total funding that Italy might require is in the neighborhood of €510-690 billion, depending on which period we assume the package will cover (2012 through either 2014 or 2016 respectively).

And this assumes no deterioration in GDP growth (tax revenues) or deficit spending etc. It also assumes that market funding costs IMF built into its deficit forecasts (4% 10-year average pre-November 2010) remain under the IMF lending deal. In fact, of course, that is open to speculation if IMF can lend Italy €600 billion at anything below 5.3-5.8%.

So overall, folks, I am skeptical as to the IMF's ability to conjure €600 billion for Italy. And furthermore, I am skeptical as to Italy's ability to manage cover for its deficits, banks and roll-over needs under such a package. This doesn't even begin to address my concerns as to Spain waiting in the shadows.

Now, lastly, you might suggest that the IMF loans can come in conjunction with EFSF loans. Alas, the EFSF has some serious troubles itself - the following two posts from the zerohedge amply illustrate: here and here.

You see, Italy is too big to bail. Even if it is also too big to fail.

31/10/2011: Bailout-3: The Gremlins Rising premiers

What a day this Monday was, folks. What a day. Just 4 days ago I predicted that the latest 'Bailout-3: The Gremlins Rising' package by the EU won't last past January-February 2012. And the markets once again cabooshed my perfectly laid out arguments squashing my prediction.

As of today we had:

• Italian bonds auctioned last week at 6.06% yield for 10 year paper, the most since 1999. The yield was up from 5.86% at the auction a month ago which marked the previous record high. For Italy, given its growth potential and debt overhang, yields North of 5.25-5.3% would be a long-term disaster. Yields close to 6.1% are a disaster! But things were worse than that last Friday: the Italian Treasury failed to fullfil its borrowing target of €8.5bn to be sold. Instead, the IT sold only €7.9bn worth of new paper. Boom - one big PIIGSy gets it in the 'off-limits' region!
• Also on Friday, Fitch issued a note saying that 'voluntary' haircuts of 50% on Greek debt will constitute... eh... a default / credit event (see report here). Which kinda puts a boot into the softer side of the 'Bailout-3' deal. Boom - Greece gets it in the gut!
• Today, Belgians went to the bond markets and got rude awakening: Belgium placed €2.155bn worth of bonds along 3 maturities: 2014, 2017 and 2021. The country wanted to raise €1.7-2.7bn (with upper side being more desirable), so there was a shortfall on allocation. 10 year bond yields for September 2021 maturity are at 4.372% against 3.751% for those issued in September 2011. Belgium is yet to raise full €39bn planned for 2011 as it has so far covered €37.517bn in issuances to-date. it will be a tough slog for the country with revised deficit of 5.3% of GDP in 2012 (assuming no new austerity measures) and debt/GDP ratio of 94.3% expected in 2012. Boom - a non-PIGSy gets a kick too.
• Also today, Germany marched to the markets with €1.933 billion in new 12-month bubills at a weighted average yield of 0.346% and the highest accepted yield of 0.354%. On September 26th, Germany sold same paper at an average yield of 0.2418%. Today, Germans failed to allocate €67mln of bills despite an increase of 40% in yields in just 5 weeks. Big Boom - the largest Euro area economy gets smacked!
• And for the last one - per reports (HT to @zerohedge : see post here): Europe, hoped to issue €5 billion in 15 year EFSF bonds. Lacking orders, it cut issuance volume by 40% to €3bn and the maturity by 33% to 10 years. As @zerohedge put it: "But so we have this straight, Europe plans to fund a total of €1 trillion in EFSF passthrough securities.... yet it can't raise €5 billion?" Massive Boom, folks - mushroom cloud-like.

So here we have it, a nice start for the first week post-'Bailout-3: The Gremlins Rising'...