THE 5 MOST LIKELY EMU SCENARIOS
Analysts at RBS recently released the 5 potential scenarios they see unfolding in Europe. Their highest probability event involves a Greek default, recapitalization, increased ECB bond buying and no defections. I think they basically have this one dead right. The EMU can’t avoid some form of restructuring in Greece. What they can avoid is a massive banking melt-down and contagion. But their response will have to be massive on the recapitalization side. What they won’t allow is a Greek default and defection which spirals into mass contagion and a worst case scenario.
European banks have $121B in Greek exposure so a Greek default/restructuring isn’t exactly a disaster if it’s accompanied by a substantial recapitalization. The risks rise exponentially if they should allow a Greek default to spread fears into other regions or through the rest of the banking system. The European banks have total exposure of ~$700B to PIG’s (Portugal, Ireland and Greece) debt. Italy alone amounts to ~$750B in European banking system exposure and Spain at ~$580B. So you can see that the game changes entirely if contagion occurs. Greece HAS to be contained and the potential for Portuguese default has to be prepared for. For this reason, any recapitalization has to get out ahead of this issue and it has to be substantial. We’re talking about some sort of bailout amounting to the trillions. A bazooka for the banks.
The disaster in this inevitable bailout is that, just like in the USA, it will not resolve the crisis although it will take the worst case scenario off the table. This entire crisis is due to an inherent flaw in the currency union itself and the only true resolution is the creation of an autonomous EMU with a central Treasury. Either that or a break-up. I think we can rule that scenario out. In the end, Europe will bailout their banks, impose austerity on the periphery and the end result will be slow growth and more of the same that we saw in the USA in 2009. The big difference is that Europe isn’t going to supplement their TARP with a ARRA. So, this bank bailout is even worse than the ineffective one in the USA. Main Street gets nothing and Wall Street gets everything. If the taxpayers in Europe catch on to this there is a very serious risk that the Greek riots of last year begin to look rather benign….This is a risk that cannot be overlooked. The taxpayers in Europe have every reason to be very very angry if Europe bails out their banks and imposes austerity on the periphery without resolving the flawed currency crisis…..
The 5 scenarios (via RBS):
“Scenario 1 (35%): Greece defaults by December, Portugal and Ireland suffer renewed contagion, Spain, Italy and France suffer from contagion. EFSF is upscaledto Eur1tr. ECB buys more bonds including covered bonds to support banking system. EFSF injects capital into banks and lends to ailing sovereigns. Crisis drags on with bouts of volatility but no country exits.
Scenario 2 (20%): Greece gets through its PSI and does not default despite missing targets as Europe gathers together once again to show solidarity. Portugal and Ireland get additional funding, Italy regains market confidence through austerity measures while avoiding a recession. Euro area muddles through in a low growth scenario.
Scenario 3 (5%): Shock and awe policy response. Banking sector is TARPed, periphery is haircut by 50%, ECB goes full QE to mitigate negative impact.
Scenario 4 (30%): Greece defaults by December, Portugal and Ireland suffer renewed contagion, Spain, Italy and France suffer from contagion. EFSF is not upscaled as AAAs are under threat. ECB goes on a buying strike leading to major political crisis and heightened risks of dismantlement of the Union.
Scenario 5 (10%): Greece defaults by December, Portugal and Ireland suffer renewed contagion, Spain, Italy and France suffer from contagion. EFSF is not upscaled as AAAs are under threat. ECB goes on a buying strike leading to major political crisis and heightened risks of dismantlement of the Union. European Commission saves the day by introducing a common bond that meets legal and political constraints.”
Source: RBS
95% of the options given involve varying levels of stress but no near term defaults other than Greece. Only 5% Scenario 3 involves a big haircut for the periphery. Is this really such a small likelihood?
Even if the Greek default is handled with exceptional skill from this point, and the markets are soothed (really?), why won’t the citizens of the periphery immediately demand similar reductions to their debts?
John Mauldin talks about his recent Ireland trip here…
http://www.johnmauldin.com/frontlinethoughts/
“When you press politicians and establishment types (and I did) who are against unilaterally disavowing the debt, a strange thing happens. I kept asking, “But the voters seem to want to forego the debt. And the math suggests that Ireland can’t pay back these foreign bankers without great sacrifices.” At first, they would point out that Ireland is doing what needs to be done: cutting spending and payrolls. We are not Greece, they say; there is a need for “respectability.” But when pressed, they would come around to admitting that, “Yes, Ireland will get a haircut.” Everyone I met expected it to happen. The difference was the path to the haircut. But while the politics matter, the destination is the same.
Some favor doing it outright. Others truly believe they will be offered a haircut when Greece and Portugal get theirs. They fully expect it.”
“In a meeting with an establishment-insider economist (off the record), who was at the table when the first deal was done, he said there was an implicit understanding with the IMF (and ECB) that whatever was offered to Greece, et al. would be available to Ireland. So Ireland went along with the bailout to keep from imploding the euro and averting a crisis that would have been biblical in proportions.”
How do they contain a Greek default?
I don’t know Cullen, this might seem a bit simplistic but to me it just seems that they don’t know what they are doing. They agreed to agree at the end of the month (another small kick in the can) without giving any hint on credible plans for the Eurozone because they cannot agree on anything. One of my greatest concerns is also the lack of LEADERSHIP, because times like these require it! and a lot of it! Throughout this entire crisis, there has been no common voice of Europe, only endless debates and rejections of plans from one side or the other. They refuse to see the problem as an inherent flaw of the currency system, even refuse the idea of euro bonds (even though they would work only under fiscal union, the fact that they took it off the table so quickly says a lot). To me it looks like they will be pushed to the brink, only then they will panic and actually come up with clear and fast decisions. Europe is still in denial, just look at French news papers, it’s like we’re still economically booming.
http://www.telegraph.co.uk/finance/comment/jeremy-warner/8818937/Banque-de-France-turns-a-blind-eye-to-European-financial-crisis.html
Martin Wolf again…
http://www.ft.com/intl/cms/s/0/f84a5d76-f368-11e0-b98c-00144feab49a.html#axzz1aUexFnPA
Non of the scenario’s here look quite right to me. Firstly I don’t think Greece will default or exit the euro, but will have its debt restructured. The hinderance to restructuring is French banks and they will be placated with capital from the EFSF. Portugal and Ireland will follow, but the haircut on peripheral debt will be around 50% and not be enough to stop the decline in the peripheral. The EFSF will not be enlarged, but the ECB will start buying covered bonds and take further liquidity actions to support the european banks. For a short while things will rally until it becomes obvious that europe is not turning around and Italian and Spanish debt is drifting more expensive. Markets will assume that banks need even more capital for potential Italian and Spanish debt restructuring and the EFSF will be forced to comply. Politicians will realise there is no more money in the EFSF as the market shuns EFSF bonds and the ECB needs recapitalising. Then either the european commision saves the day by introducing some sort of eurobonds or the euro area breaks up.
Politicians will think they have introduced shock and awe through support to the banking system, but will realise too late that it has not done enough to support the peripheral area. The cost of that delayed realisation will be ratings downgrades for core europe or non AAA rated eurobonds. Most likely the turning point will be mass demonstrations in Paris and Berlin. So for me it is scenario one which eventually morphs into either scenario 4 or scenario 5.
I agree. I also don’t view a debt restructure as a default. Default would be that Greece runs out of funds to make interest payments. A restructuring prior to that event is the haircut that everyone wants someone else to take.
How many billions in junior bonds are in the balance sheet of US an British banks? Why the price of junior bonds (and even senior for many banks) are 20% or less below the nominal price and still going down? And why the RBS bonds are the worst performing bonds despite the fact that the bank is owned by the government…
Please be serious.
I don’t believe bank recapitalizations are enough to take off the worse case scenario. Sure enough, current market thinking is that recapitalization will do. But if Greece gets a restructuring, I bet that Portugal and Ireland will get one as well, at least as generous as the the Greek one. They can recapitalize their banks when Greece goes under, when Ireland and Portugal come asking for a restructuring as well I think some more countries that were just fine before will experience debt stress. Belgium and France comes to mind. And then you have a new ball game with higher stakes sometime down the road. Match that with a potential Chinese hard landing. 2012 isn’t looking pretty.
How about the EFSF? The whole reason why the PIIGS have been willing to tolerate austerity is because they were led to believe that Europe would come to their rescue through the EFSF. What do you think the reaction will be like if Germany and France tells them that the EFSF money will instead be used to save German and French banks and that the PIIGS can go take a hike?
So zero percent chance they actually fixing the underlying monetary problem and only 10% chance of implementing a solution that will at least make the Euro more workable from a monetary perspective.
That must mean 100% chance that nobody important knows what they’re doing.
I’m with Brick on that one. He accurately describes what i view as a very credible scenario.
I do not see how we can avoid death spiral/negative feedback effects without either: ECB acting as last resort lender OR central treasury and fiscal unity (or nuking off the earth rating agency and credit officers)
Now, the potential surprise is: Merkel and Sarko mentioned they were to modify the european treaty…anyone has a clue of what they are intending ?
Greek national debt is somewhere around 333b EUR, Ireland is at 108b EUR, Portugal at 148b EUR. All in all 588b EUR. 60% of that would be 352.8b EUR. That looks certainly doable. It’s the one year national budget of Germany… It would at least ease the load of interest payments so the countries can ease off the austerity. Ireland will probably be fine on it’s own, Portugal and Greece will need some strengthening of the private sector. I might even move to Portugal if they lower taxes enough (currently contemplating Poland though).
Its not so much the size of the sovergin debt but if it is internal – In Ireland most of the sov debt is external so therefore credit deposits are subtracted to service the interest of the external debt.
If no credit bubble can be engineered to service this external debt then only starvation and or emigration is a option.
A similar thing happened in Ireland back in the 19th century – you had many absentee landlords who lived abroad – they collected rent via agents and spent it in London – the money supply diminished…………..
The Irish problem could have been solved easily back in 2008 – the credit deposits could have become goverment paper – sov debt problem over.
Now after 3 years of this subtraction our deposits cannot finance our debt
Viewed from France, I have to agree with Frenchy’s comments above.
This we for instance almost no tv news or newspaper were focusing Sarkozy-Merkel meeting, alle yes were focused on the shallow socialist party primary contest to pick their candidate for the 2012 presidential elections. You don’t feel at all a sense of urgency and that’s what worries me most.
Add to that almost daily interviews in frnehc eco press from main banks ceo’s saying “no, no, no we d’on’t need new capital at all” when the balance sheet size of BNP alone is almost 2.5 times french GDP and you wonder on which planet these guys live.
Lack of quality leadership is our main issue over here.
News outlets were reporting a recap plan of $50-100 Euro …. ha ha ha.
It’s a bit disturbing that China is recaping at the same time … mmm … the spidey senses are tingling …
The way I see it, ESM is coming to town early. There could even be a regime of conditionalities mixed with increasing fiscal union of some sort. I expect an EFSF bazooka in the mix and significant bank recap. I also expect the ECB to play a more supportive role in the draghi era. It boils down to this, the structure of arrangements already put in place, the treaty amendments decided upon (that have been drafted to avoid referendum) suggest to me that the one europe mission will be pursued. The key is whether they can create the sort of support for the south that’s needed. The answer to that is almost certainly no. So, the measures will be aimed at one europe, but the political risks are extremely high.
I keep reading the term “bailout banks”. Well,that covers a multitude of sins that also dilutes shareholders and bondholders so frankly let’s wait and see exactly what that term ends up covering.I really have serious doubts that it will be a “bailout” in the sense alluded to.
This quote came from an article in the Telegraph:
http://www.telegraph.co.uk/finance/financialcrisis/8819195/German-push-for-Greek-default-risks-EMU-wide-snowball.html
“Although Greece’s 10-year bonds are trading at a 60pc discount on the open market, European banks do not have to write down losses so long as there is no formal default and the debt is held in their long-term loan book. The danger arises if banks are forced to “crystallize” the damage before raising their capital buffers.”
He (Mr Schäuble) ruled out any attempt to leverage the EFSF beyond €440bn by letting it act as a bank: “That would be to monetise European state debt. That is not acceptable.”
The apparent German veto on any expansion of the EFSF leaves it unclear how Europe’s debt crisis can be contained if the region tips into a double-dip recession, which would play havoc with debt dynamics. City analysts say the fund needs €2 trillion to restore confidence.
Interesting that European Banks haven’t taken their marks yet on the debt.
Here is another European source and viewpoint. Note it was recorded on September 30th. It is long but I think it contains some interesting insights in to Euro-think. I don’t see these problems as academic exercises but more a people problem and it is going to remain a people problem.
http://www.goldmoney.com/video/zulauf-turk-interview.html
I just went over to Zero Hedge..third time I’ve looked around this site….
In reading the posings and comments I felt like at any second I would be directed to some Eastern European porn sites or allowed access to buy credit card info.
Can anyone tell me how best to use Zero Hedge? Seriously..putting my sarcasim aside. If you find this site useful where do you go and who do you read?
Theres some real lack of understanding of the Monetary System on that site. I would point it out but felt like I’d get my ass kicked by some of the commentators. Rough crowd
Zerohedge is pretty much useless. They believe in hyperinflation, gold at 5000+, a conspiracy everywhere to form a one world government, and that we’re going to DOW 4000 or something. From time to time they have useful posts, but they are the exception rather than the rule, and most of them are research from hedge funds and the like.
I used to go there when they posted a lot of hedge fund letters and research reports, but unless I’m bored, don’t.
VII, ZeroHedge is a good blog in a sense that they compile a lot of info from a bunch of different sources that not everyone knows, commented with someone that constantly brings out his hatred for “money printing”. Just read the headlines, if you find something interesting, then read through the lines.
@VII ZH needs to be read with a grain of salt, as they have a doomsday outlook, and tend to color their commentary in that vein. having said that, they offer quick reporting of events and commentary (and in the EU, commentary seems to be taking the place of events) that you might not catch elsewhere.
@cullen, i find it interesting that scenario 4 is given a 30% chance. if you read the germans at face value, none of the things that are a predicate for the other more optimistic scenarios are likely to happen. put another way, combining #1 and #4, and blending their results, RBS assigns a 2/3rds likelihood that something pretty ominous is going to happen
actually, if you add #5 to the mix, that’s a 75% likelihood that something ominous is about to happen…although i don’t see a eurobond meeting legal constraints absent a whole new treaty round. good luck with that.
my basic point is that given the non-linear behavior of financial panics, my take-away if that RBS assigns a 75% chance that we enter into a period where events become increasingly unpredictable and fear will exacerbate. IMHO
Ambrose Evans-Pritchard seems to think a fiscal union is a non-starter.
NEIN, NEIN, NEIN, and the death of EU Fiscal Union
Cullen, what makes you believe so steadfastly that a fiscal union will be accomplished?
In most member states it will require a referendum. I certainly won’t vote for my power to the EU.
Wow I should not re-edit 10 times and then hit “post”. I wanted to write: I certainly won’t vote for my sovereign powers to go to the EU.
I just dont think they have another choice. It wont happen overnight, but it will happen imo.
Cullen,
For “it” to happen, leadership is required. Concerted, EU-centric leadership that is free of sovereign interests and bankers’ influence.
I find it difficult to believe that sort of EU leadership exists today. And the crisis will unfold and flare up much faster than such leadership can evolve.
Still trying to work out who you mean by ‘they’… This mysterious ‘they’ crops up in many of your posts about the Eurozone – as in, eg. ‘they won’t allow a break up’.
The crux of the entire problem, plainly, is that there is no homogenous ‘they’. If you’re referring only to the leaders of the core nations, do you imagine they have the power to prevent peripheral nations from recognizing their own self-interest when the going gets really tough?
As the coming recession bites and austerity drags some countries into virtual depression, pro-European peripheral governments will become more and more vulnerable to nationalistic and reactionary forces (Slovakia’s mini-rebellion today is surely just a first taste of this).
I can see some of the core countries making heroic efforts to save the euro as a smaller union with much tighter fiscal integration. But a U.S.E. with Greek, Portuguese, Italian and Spanish governments all signing away their spending powers to Brussels? With the blessing of their electorates in legally-required referendums? The idea is pure fantasy.
<>
There are lots of choices and lots of prices but some prices are unpayable.
I am not sure of your nationality but to suggest that it will somehow happen because it is in some way reasonable is to misunderstand the entire Euro project. The whole thing has been conducted by the politicians of all the member states without the consent of the sovereign peoples of their respective nations. Grudging compliance has been extracted from the various electorates under false pretences and with scare stories of what will happen if the voters reject the latest surrender of responsibility to the centre; “We can’t go it alone, think of all the trade we’d lose if the eurozone was closed to us” etc etc. blah, blah. These are lies that Goebbels would have been proud of and the fact is that the sh17 hitting the fan right now means that these lies are now being shown for what they are. The majority of the electorate in the majority of euro countries are utterly opposed to the EU, since it is fundamentally undemocratic and demonstrably not in their interests. Fiscal union is expressly prohibited under the Treaties, and despite the fact that respect for these treaties by the europols is non-existent, it is still true that no form of fiscal union would be possible without the explicit consent of the electorates. For any politico to argue in favour in the face of increasingly resolute opposition across the various eurozone countries (did I read that 75% of Germans are against further integration with the EU ?), would be a career ending, not to mention civil war inducing proposition. It won’t happen. The euro will break up. (imo obviously)
“If the taxpayers in Europe catch on to this there is a very serious risk that the Greek riots of last year begin to look rather benign….This is a risk that cannot be overlooked. The taxpayers in Europe have every reason to be very very angry if Europe bails out their banks and imposes austerity on the periphery without resolving the flawed currency crisis…”
Yeah, well — how big are the chances that “the taxpayer” in Europe will ever catch on to this. 99% of people don’t even understand the BASICS of monetary and banking operation.
Most people don’t even remotely understand what’s wrong with the Euro.
Unless there is some concerted effort by the mass media to correctly inform the public — which, in turn, would require *them* to first understand the problem and then be willing to go public about it — any riots that might (will?) occur will not be directed at anything specific, or directed at symptoms at most.
Currently I see absolutely no political platform for a long-term fix of the EMU.
“EFSF is upscaled to Eur 1tr. ECB buys more bonds including covered bonds to support banking system. EFSF injects capital into banks and lends to ailing sovereigns. Crisis drags on with bouts of volatility but no country exits.”
Scenario 1 is the winner. The ECB will keep buying time by buying enough sovereign debt to avoid outright default as the Germans and the North become slowly acclimated to the fact that the ECB’s use of keystroke money to bail out European banks and avoid an uncontrolled default in the periphery is not inflationary; rather, it is simply anti-deflationary.
The asset marks used by European banks for periphery debt held to maturity are a fantasy compared to mark to market; mark to market tells the true story of how much money in the form of peripheral sovereign debt has already been destroyed. No one in power in Europe wants a true default because no one wants to trigger credit default swaps, which are going to be many multiples of the face amount of defaulted debt on a notional basis.
Cascading counterparty failures are the black box risk central banks fear the most; no one knows how important Greek debt really is, and the world’s bankers aren’t telling, because the black box is their TBTF insurance policy. After the failure of a second rater like Lehman nearly ended the world, no central bank wants to take a look into that black box again. As the WSJ noted today, the bankers all say that their European risk is “manageable” or “well hedged” or “neglible on a net basis”, as the CBs wring their hands and sweat.
One facto is missing… the discontent in germany, no matter what the others do, if germany decides pull out end of the game….
Yes, an orderly Greek default would be better. Except . . . that has been the reason given for delay these many, many months, that has always proved to be the excuse for inaction. Be very sure, this time is no different.
Greece is gangrene; the longer its amputation is delayed, the further the rot will spread. The least bad solution is to chop it off, brutally, NOW.
And ideally, chop more than a few politicians and bureaucrats too.
Don’t forget that at some point the Fed (and by default the American taxpayer) will likely become the lender of last resort – as I understand it they are already pumping money into the EU system.
We’re screwed. Banks 1, Humans 0
The house of cards has less support than appears. Hope for the best, but prepare for the worst. With little credit available, we will see deflation and this will, at first, help businesses and then devour them. Beware!
I think this is saying that if Greece stays, it will be a partial default (50%?). If Greece leaves then it will be total default. Why does that make such a hugh difference? The the EU tax payers will foot the bill either way and I can’t see the differene is so great. And why does Greece leaving the EU damage the EU so much. Greece’s economy is so small.
Yes, the importance Greece is far overplayed. The problem is, there is no mechanism to leave the Euro. We are talking about 340b EUR here and probably some fallout from the CDS market. Of course, if the EU countries keep lending money to them they just make the problem bigger and bigger, especially since the Greek economy contracts at alarming speeds due to austerity (which means that debt:gdp ratios rise even if they didn’t borrow a cent more).
Calling it a loan is just an attempt to conceal the fact that the transfer union is already a reality (and has been for some time really).
These scenarios seem to imply that Greece’s problem is a one-time balance sheet issue and that all they need is one big haircut on their debt. Greece has a structural problem that as long as they are in the EURO, they will dig their hole and require bailouts in perpetuity.
Also, how much austerity will the other PIIGS tolerate when Greece get yet another pass.
There is at least a sixth scenario were Germany stops paying for the party (probably after Italy starts to crack) and returns to the DM and the EU dissolves. It may not be likely, but the odds are not zero. Just because it is unthinkable to the establishment (just like a Lehman failure), does not mean it could not happen.
WWII ended over 60 years ago and Germany’s guilt has it’s limits.
I’d like to think you’re right about Germany, but over half a century they’ve invested so much political capital in the success of the Euro that only utter catastrophe would force them to abandon it.
I think it’s far more likely they’ll take on the role of doomed ship’s captain. It’s holed beow the waterline, the rats are deserting, but the band plays on.
I don’t like the idea of bailouts at all. What would happen if Italy or Spain collapsed? If for example Italy went down, who would provide a couple of trillion to bail it out?