In a note to clients this morning Credit Suisse downplayed the severity of the crisis in Europe and explained why they believe it is contained.  Specifically they said:

“We continue to believe that this is not a systemic crisis for 3 reasons:

(1) The total cost of a worst-case write-off in the Ireland, Greece and Portugal is €170bn, on our calculations (this is based on the cost of severe emerging market banking crises in the past, which has been 30% of GDP, compared to write-offs amounting to 8% of GDP in the European periphery so far). Against this, the amount of money available is around €670bn (€250bn EFSF post haircuts, €60bn from EU, €250bn from the IMF, €110bn from Greece).”

So, clearly these smaller nations are merely the appetizer.  They are too small to threaten the EFSF’s ability to “work”.  But the math is not friendly once we move onto Spain and Italy.

“(2) Core Europe cannot afford to turn its back on peripheral Europe. The direct cost of doing so would be at least $500bn, because the ECB now owns €63bn of peripheral European bonds directly and nearly €320bn indirectly via repos, with two thirds of the cost of any ECB recapitalization falling to core Europe. Furthermore, core Europe has nearly $900bn of banking assets in peripheral Europe. The indirect costs of a failure of the monetary union would be even greater, namely the loss of a single market, with the newly established Deutsche Mark likely to appreciate by 20%, hitting German exports, the probable erection of trade barriers etc.”

As I’ve long maintained, there is simply too much political will invested in the Euro’s success for it to be allowed to unravel completely.  They are fully invested in the Euro’s continued existence even though it is now proven to be a failing project. CS says the 800 pound gorilla (Spain) is sustainable for now:

(3) The situation in Spain is sustainable for now. This is critical because there is nearly €460bn of core European bank assets in Spain and Spain accounts for 11.5% of European GDP (70% larger than Portugal, Ireland and Greece together). The reasons the situation in Spain looks sustainable is that: on current bond yields, interest payments are 3.7% of GDP (if all of debt is funded at the long end), compared to 6.7%, 7.4% and 16.7% in Portugal, Ireland and Greece – and, critically, they are below the long-term nominal GDP growth rate. Spain looks sustainable until bond yields rise to 6.5% from 4.7% currently.

Even if we assume that ultimately the government has to take on a third of Spain’s excess private sector leverage (on our calculation the resultant deleveraging needs to be 60%-90% of GDP-looking at the private sector deleveraging that has occurred after previous emerging market banking crisis), Spain’s government debt to GDP ratio would end up at 85%, from 64% currently. This would still leave funding at sustainable levels (interest payments as a proportion of GDP would still be 4%, even if all the funding was done at the long end).

Furthermore, we note that:
– Spain has had no fiscal slippage for the current year and is set to hit the deficit target of 9.3% of GDP;
– Spain is unlikely to hold general elections until 2012, making the political situation more stable than in, say, Ireland;

– Borrowing from the ECB by the Spanish financial sector has fallen by nearly 60% since June.

There’s a huge “if” in all of this.  If an analyst had written this commentary regarding Ireland in 2009 they likely would have come to the same conclusion – as long as yields remain at reasonable levels the country should have no problem funding itself.  Of course, that all changes when the bond vigilantes show up at your doorstep, and yes, there most certainly are bond vigilantes in Europe.

(Irish 10 year bond yield)

Portugal is certainly next in line for aid here.  As Danske Bank recently stated the probability of aid requirement in Portugal is “very high”:

“If Ireland seeks help (Scenario B) we expect Portugal to follow, either immediately or following a short period of market tension. The answer to everyone’s question – “who is next” – is without doubt “Portugal”. Therefore, everyone may find themselves running for the door (once again) if Portugal tries to avoid this fate. In that case it will eventually have to follow. Portugal has already faced two rehearsals so they are likely to have learnt their lesson and try to end the pain sooner rather than later. The biggest risk is that the debt crisis will spread to Spain and Italy.”

Credit Suisse agrees with this analysis:

“Portugal is in a better position than Greece and Ireland – but we still think the situation is unsustainable. First, Portugal has a current account deficit of 9% of GDP (this shows its huge loss of competitiveness and its need for even more acute deflation and de-regulation than elsewhere in peripheral Europe). Second, on current bond yields, interest payments would be nearly 7% of GDP, 2.5% above long-term trend growth. This means, it would require cyclically adjusted fiscal tightening of around 5% of GDP to stabilise government debt to GDP. Private sector credit to GDP is 171% (the best fit line suggests that it should be close to 110%). The reason why Portugal is in better shape than Ireland and Greece is that: a) the cyclically adjusted budget deficit is 3% of GDP. Without any cyclical adjustment, the budget deficit is 7.5% of GDP in Portugal versus 9.4% of GDP in Greece and 12% of GDP in Ireland (excluding the cost of bank recapitalizations for this year); b) the economy has actually managed to grow over the past three quarters; and c) private sector excess leverage is less extreme than in Ireland. We would advise clients not to bottom fish in Portugal.”

Bond yields in Portugal are already surging and credit markets  are not only honing in on Portugal, but already looking past Portugal at Spain.

(Portuguese 10 year bond yield)

(11/22/10 CDS Wideners)

JP Morgan noted the other day that some tensions are already reappearing in the Spanish banking system:

“The most recent issues and debt exchanges came with a heavy premium relative to secondary market levels, suggesting that it is becoming harder and more costly for Spanish banks to refinance their debt. In Caja Madrid’s debt exchange this week, covered bonds were priced at 250bp above mid swaps. CajaMar’s covered bond issued at the beginning of the month was priced at 290bp over mid swaps. These levels are close to the wides of the summer…”

So, in essence, we have all eyes on Spain.  If Spain is forced to tap the EFSF markets will start getting very panicky.  Back in May I described why the EFSF would likely fail.  The EFSF was never really intended to handle Spain in the first place.  It was in essence, a gamble that the very existence of such a fund would ease tensions across the region and buy some time, but Europe is running out of time.  This remains a currency crisis in which a solvency crisis is merely a symptom.  At the end of the day single currency systems simply don’t work in the best interests of all involved.  It is the primary reason why the gold standard failed and it is the reason why pegged currencies create distortions and disequilibrium in markets (just look at the bickering between the USA and China).

Sadly, I think the Europeans are so heavily invested in the Euro that they have no choice but to kick the can and see that it continues to exist in some form of its current self.  That likely means many more years of depression in many countries and ultimately some real reform that at least partially fixes the structural flaws in the EMU.  Full unity, a United States of Europe is simply not realistic in my opinion.  That likely means the core will be forced to fund the periphery until one of two things happen:

  • The periphery nations revolt and realize that they are suffering at the hands of foreign bankers and an inherently flawed currency system.  OR;
  • The core realizes that they are going to be forced to fund the periphery deficits for years to come.

In the end, this all leads to one road – defaults (or restructurings of some kind) and/or defections.  The Euro is a flawed single currency system.  Even if we get extremely lucky and survive this crisis without any serious repercussions the likelihood of future problems are 100%.  This is simply what single currency systems do.  They put particular trade deficit nations at risk of severe financial constraints.  The inability to properly deal with these problems has always led to major reform, abandonment, default, revolt or war.  Let’s hope we can avoid the last one.


Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • GreenAB

    well written and there´s a lot of truth in there.

    but in my opinion it´s not just europe that wants to see the euro prevail but the whole world.

    the reason is pretty simple. everybody is playing the beggar thy neighbor game, nobody wants to lose exports.

    let the euro fail (with PIIGS reverting to devalued original currencies) and pretty much over night Germany but also China and the US would be faced a whole new army of cheap competitors. re-armed with their own printing presses PIIGS would induce a currency war the traditional export powerhouses won´t win.

    thats why i think it´s still cheaper for the US and China to maintain a status quo.

    Spain will be the line in the sand. and should the markets get them into trouble i would expect not only european but globally coordinated help.
    over the last months the chinese numerous times made it clear that they stand to support Spain. so i think that they will continue to participate in spanish bond auctions and we won´t see yields get out of hand.

    the fed on the other hand doesn´t want to see the dollar appreciate. should things in Spain get out of hand i wouldn´t be surprised to buy Spanish debt.

    Portugal will get it´s bailout soon.

    thats my short term view for the next 12 months.

    the question is – how long are the PIIGS willing to take the pain, especially if their economies continue to shrink?

    when the first member leaves the Euro imo it´s pretty much over and we´ll see the euro break apart followed by trade and currency wars.

  • boatman

    sadly, in this case the war will be started by the spoiled poplulace towards any imposition of reality.

  • Nils

    The Irish are emigrating again…

  • boatman

    i see the germans letting spain go, much less the rest of the world.

    its going to be hard enough to extend unemployment benefits extended here…..forget spain

  • Nils

    It’s the european way. Unemployment benefits for life.

  • Mikie

    The math for continual EURO bailouts just doesn’t work once you move beyond Portugal.
    Lets face it, Germany is just 25% of the EUROzone economy. The PiiGs are 40%.
    In the middle you gave France (not as strong as Germany by any stretch of the imagination) and small rich countries like Luxembourg.
    The scale starts to tip over once you get too deep into the PiiGs and Germany would risk bankrupting itself trying to bail them all out

    I think its obvious at this stage that all these liquidity facilities just buy time and each one seems to buy less time. The EFSF rally lasted a few months, Ireland bailout rally lasted about 2 hours.

    The market is not buying it anymore. It knows the end game is massive restructuring s with crippling austerity

    There is alot of political will in the Eurozone…but once we get to the point of massive fiscal transfers from Germany/France to others and its becomes obvious it will never be repaid, their own citizens will stand up and just say NO. The political will evaporates quickly at that point.

  • boatman

    and to most over there, pulling them out of thin air shouldn’t be a problem.

    how anyone cannot see this as the end game of the real estate bubble(world currency crisis) is beyond me.

    my head tells me the US gets thru this, my gut tells me it won’t be pretty for the DOW or the dollar(eventually-and compared to certain tangible things)

  • Scoremore

    history tells me that socialism doesnt work. It breaks my heart to see this happening,the crisis that EURO people have been experience…i agree that this is not a systematic…thanks for sharing this.

  • roger erickson

    “nobody wants to lose exports”

    This is really puzzling me. Why on earth the fixation on exporting? We have a trade lobby & a banking lobby, but where’s the “aggregate demand” lobby (AGL)? I’d even call the AGL the Net Capability Growth lobby – or NCG party. If that’s the only interim way to promote common sense, maybe we need one!

    Why is it so freaking hard to manage the net PRODUCT[of education, production & utilization] in-house?

    The answer always boils down to the cost of thinking, and trading the cost of transportation for the familiar comfort of specializing in some rote activity. I realize it’s always attractive to nab something seemingly already available, but savvy groups, like our DoD, are more than well aware of the power of resilient vs momentarily cheap sourcing. JIT logistics for non-critical resources fits sound cost-control statistics, but JIT delivery of absolutely critical resources is more risky. One classic example is that most animals sequester calories as fat & carbs, but dont’ sequester & store, say, oxygen to the same extent. It all depends on context details.

    To me, fixation on exports seems VERY risky, and a 3rd world strategy flowing from superficial thinking. (Which we seem to have in spades right now, which Geithner & Summers bear witless to. [sic])

    In historic terms, symbiosis is indeed always an option, but ONLY as the result of a RIGOROUS selection process. It’s usually better to receive than to give, but even then NOT at the loss of resiliency as the core basis of managing both known risks & uncertainty. In the end, anything we’re willing to import can’t be mission critical. So why would WE ever want to export?

  • roger erickson

    The math is that this is a currency supply task throughout Europe. Since they lack a unified Treasury to coordinate fiscal spending, i.e., currency creation, the ECB could just step in and create & distribute adequate currency yearly per some derived formula. [Until they either form a central treasury, or go back to sovereign currencies.]

    The only downside would be letting the Euro Fx float. Why would they care? Any devaluation of the Euro would increase German exports and lower the cost of PIIG vacations – which should satisfy the Germans.

    Europe’s whole approach to this as an operational issue seems surprisingly juvenile. These are the same people that can build CERN, mind you. They’re displaying a very selective pattern of applying basic logic.

  • Oroboros

    Exports is the “easy fix” meme of the day. Much like “we need to get the banks lending again” was a year ago.

    I agree with GreenAB. No one, including the USA, wants the Euro to fail at this point. Especially when we’re trying to lower our currency to raise exports. [insert circular logic emoticon here]

  • TPC

    Spanish bond yields hitting highs. The market appears to be looking at Spain already as if Portugal is a foregone conclusion.

  • Mountaineer

    Some of it can be attributed to this…

    Now, call me crazy, but if my nation was in the midst of a full blown crisis I would be sure to cross the t’s and dot the i’s on my public reports before my debt auctions. Maybe that’s just me. Regardless of whether the auction officially “failed” or not, the yields they went off at are alarming. 2.11% on a 6 month? Bunds are at .65%.

  • roger erickson

    “when the first member leaves the Euro imo it´s pretty much over and we´ll see the euro break apart followed”

    this may be confusing some readers; the EEU existed for a long time before the EMU; collapse of the EMU won’t immediately end the EEU

    besides, there are still many options; the member countries could also:

    1) circumvent the screwy official austerity by moving bigger proportions of the grey economy

    2) alleviate the screwy official currency shortage by proliferating multiple purely local currencies to denominate local transactions

    3) despite all odds, they COULD come to their senses & do something logical, like let the ECB do currency distributions, or even form a EEU Treasury (I know, I know … PIIGS could fly too :) )

  • roger erickson

    if you read the comments at your link, there’s real confusion between the English/Spanish versions of the same press releases;
    gotta read the fine print, in all relevant languages!

  • InvestorX


    This is from you on Greece from your links:

    “This is just one very simple example of the types of inherent restrictions a single currency system imposes on a nation, but it’s particulary pertinent as we see this exact event unfolding in Greece – where the single currency system is destroying the country and handcuffing the government from properly defending their economy and thus providing for their citizens. Instead, they are risking default (a risk which does not exist within a sovereign issuing floating exchange system) and forcing their citizens into recession all so the surplus nation of Germany can enjoy price stability and continued high exports.”

    I would argue here the specific case of Greece. Here you focus on the negative effect of the single currency after a crisis has started. But this is not fair at all, as you forget that the single currency also enabled and led to the crisis – Greeks took a lot of debt from the West and squandered it / gifted it to state workers (e.g. train drivers receiving top salaries – not much different from the stories one hears about the US). And this whole process lasted for 10+ years, where Greeks enjoyed undeserved good life and did not think of the future / thought that they can steal from the West forever. Well, now you complain that after 10+ years they have to endure some recession. Believe me what they deserve is 10 years of recession unless they reorganize their criminal ways and start producing something they can sell abroad. The Michael Lewis report shows it – it is their civic society that has disintegrated and is so corrupted that no economic policy makes any sense. I a gree that a FX devaluation would make them competitive more quickly, but they can still default and reintroduce the Drachma, so I do not see where is the problem. (The real problem is that Western banks do not want to recognize the losses).

  • DDT

    Before WWII, Europe was the unquestioned world power. Afterwards, the destruction or their economies, the collapse of their colonial empires, and the threat of the USSR, made the EU very appealing. Details in its construction were overlooked.

    Today is vastly different. The dream of colonial empires is long gone, as is the USSR. The continent has been rebuilt and life is good. However, the imposition of the EU constitution despite being voted down is a GIANT red flag. Somehow they’ve created government that is not a democracy. The EU parliament is NOT elected. What were they thinking?!?

    Europe’s history is replete with megalomaniacs trying to forcibly “unify” it under a dictatorship. Think Napoleon here. They have tried this many times but it has never worked. Churchill called for a United States of Europe, which made sense right after WWII, but can never really work. And the reason is simple: the cultures are just too different.

    Personally, I enjoy all the different cultures of Europe and would hate to see them further homogenized.. There are good things about the EU: standardized industrial codes, standardized certification of medical personnel, safety and environmental regulations, ease of travel. But these hardly justify the elimination of democracy!

    The EMU is even worse, it cripples the weaker economies threatening to make them vassal states to Germany (A prospect far too reminiscent of WWII). The only way the PIIGS can operate in the EMU is to borrow at unsustainable levels. Once the debt gets too large, they must default in one way or another. This default falls on the stronger states. Even if Germany and France end up owning Greece, Ireland and Portugal by seizing collateral after they default, the system still will not work.

    As an idealistic effort it was spectacular, but these countries are different enough that they need the escape valve of floating their own currencies. Perhaps Europe will have a little less influence without the Euro, but I that’s a price worth paying to avoid systemic imbalances.

  • TK7936

    The Euro cant fail because its an organic system. The PIIGS States can leave but so can the richer states together. PIIGS is only 25 % of the Economy, so if Euro “fails” your left with a 75 % Currency that sheded its sick branches. Such a process would cause a GDP decline between 2-4 % for 1 year and that would be the worst case scenario. Yaaawn.

  • 3421138532110

    LOL – It’s the 75% that hold the debt! Who cares about GDP.

  • Joe

    The euro is in for a lot of pain in the coming weeks and months. In my view, there are two scenarios:

    a) ECB withhold the euros necessary to save the pigs, risking default and withdrawal from the EU. (euro collapses)

    b) ECB pumps enough currency to stave off default, the euro survives, but at ’02 levels against the dollar.

    Political will is way too strong to choose “a.”

  • billw

    War will not be an outcome in Europe IMHO. War in these situations comes from socialists taking over and promising people way more than they can deliver. It is possible, but I think that Europeans have already had enough of the empty promises of socialism. China on the other hand is an entirely different matter. It has been a known fact that for at least the last 40 years they consider war with the US to be inevitable. They seek to grow in power and we stand in their way. Just like we knew years before WWII that the Japanese planned on eventually attacking us; we have known for years that the Chinese military plans the same. It is not an if but a when, and the when is hopefully years away.

  • roger erickson

    I stand corrected:
    E.U. President Herman Van Rompuy warns: “If we don’t survive with the eurozone, we will not survive with the European Union.”

    ps: the comments at this link show the fervor & diversity of public opinion pro & con for the Deutschland view of Euro finances

    there’s a LOT of misinformation; never a good sign when tempers get heated over the wrong teapot

  • Andrew P

    I wouldn’t be so pessimistic about the prospects for “full unity”. The EU’s Founding Fathers designed the Euro to be a stepping stone to full unity, and they designed it with inherent flaws that could bring about a sudden crisis. The prospect of a hanging always concentrates the mind, and if a massive bank run starts in core Eurozone countries, all bets and assumptions based on prior political history and public sentiment go out the window. My prediction is that if such a crisis happened, there would be an emergency conclave of Europe’s masters, and full Federalization of the EU would take place immediately. Yes, there might be a few stragglers that leave the union at the same time, but they are likely to be the isles that aren’t geographically connected to the mainland, or the more distant perhiperal countries. And yes, a union that was consumnated under such a crisis would have inherent political flaws that would ultimately lead to its demise, but that fate would be many decades away. Bad political systems can stay alive for a very long time.

  • TPC


    I love your optimism. I just really have a hard time believing that Germans will buy into the notion that their tax dollars are going to help fund Greek lifestyles. There is a societal gap here based on thousands of years of history. This isn’t CA vs Texas. I hope you’re right. But I don’t think it will be easy.

  • Hal (GT)

    Great post and insight. I still get the feeling that there is a lot of unrest to follow and a number of bigger dominoes to fall. Until some real hard choices are made to face up to the bad decisions instead of kicking the can down the road, things are only going to intensify beyond control.

  • Nils

    There still are people alive who fought against each other in World War 2. The Germans might even take it, but the French will probably riot again.