Monday, July 11, 2011

Invisible Elephant Now Visible; EU Ready to Tell Trichet to "Stuff It"; Help for Italy?

by Mike Shedlock

ECB president Jean-Claude Trichet has been battling Germany, the bond markets, and EU officials over his "No Greek default, not even a soft one" stance. That battle is about ready to come to an inglorious end for Trichet.

The Financial Times reports EU stance shifts on Greece default
European leaders are for the first time prepared to accept that Athens should default on some of its bonds as part of a new bail-out plan for Greece that would put the country’s overall debt levels on a sustainable footing.

The new strategy, to be discussed at a Brussels meeting of eurozone finance ministers on Monday, could also include new concessions by Greece’s European lenders to reduce Athens’ debt, such as further lowering interest rates on bail-out loans and a broad-based bond buyback programme. It also marks the possible abandonment of a French-backed plan for banks to roll-over their Greek debt.

“The basic goal is to reduce the debt burden of Greece both through actions of the private sector and the public sector,” said one senior European official involved in negotiations.

Officials cautioned the new tack was still in the early stages, and final details were not expected until late summer. But if the strategy were agreed, it would mark a significant shift in the 18-month struggle to contain the eurozone debt crisis.

Until now, European leaders have been reluctant to back any plan categorised as a default for fear it could lead to a flight by investors from all bonds issued by peripheral eurozone countries – including Italy and Spain, the eurozone’s third and fourth largest economies.

A German-led group of creditor countries has for weeks been attempting to get “voluntary” help from private bondholders to delay repayment of Greek bonds, a move they hoped would lower Greece’s overall debt while avoiding a default.

But in recent days, debt rating agencies warned any attempt to get bondholders to participate would represent a selective default. Rather than abandon bondholder buy-ins, however, several European leaders have decided to return to a German-backed plan to push current Greek debt holders to swap their holdings for new, longer-maturing bonds.

The move essentially scraps a French proposal unveiled last month, which many analysts believed would only add to Greek debt levels by offering expensive incentives for banks that hold Greek debt to roll over their maturing bonds.

Officials said the Institute of International Finance, the group representing large banks holding Greek debt, has gradually moved away from the French plan and begun to embrace elements of the German plan.
At long last Trichet is about to find out he is not bigger than the bond market.

Help for Italy?

Bloomberg reports Euro Falls to Two-Week Low as Leaders to Meet Amid Contagion Concerns
The euro dropped against most major peers after Die Welt reported that the European Central Bank is seeking to expand a fund to include help for Italy, following a coordinated rescue for Greece by the European Union and International Monetary Fund.

“Italy is a very large economy, and if indeed we do see contagion spread toward Italy, then the ECB, EU and IMF will need to come up with a totally different plan to deal with it,” said Khoon Goh, head of market economics and strategy at ANZ National Bank Ltd. in Wellington. “Ongoing sovereign concerns are proving to be a real drag on the euro.”

The yield on Italy’s 10-year bond rose to a nine-year high of 5.27 percent on July 8, driving the premium over German bunds to a euro-era record of 244 basis points.

The bailout fund may have to be doubled to 1.5 trillion euros ($2.13 trillion) to cover a crisis in Italy, the ECB said, according to the German newspaper Die Welt. The Financial Times cited unidentified senior officials as saying European leaders are prepared to accept that Greece should default on some of its bonds.
Invisible Elephant Now Visible ...

In regards to the escalating sovereign debt crisis in Europe, most eyes have been focused on Greece, Ireland, Spain, and Portugal, the so-called PIGS.

Dr. Evil, a former government bond trader for a very prominent bank pinged me regarding my post PIGS Exposure Table, Explaining the Panic by Numbers. Her message was to pay more attention to the second "I" in PIIGS, namely Italy, the "invisible elephant".
Dr. Evil writes ...

Hello Mish

I just saw your table on the PIGS and I see the biggest one of all missing, ITALY. I traded Euro Government bonds for 11 years and know this market inside out. Spain is a big one should it go but Italy has a cool 2 Trillion EUR in debt and has much worse debt statistics than Spain.

Italy's debt-to-GDP ratio is 118% (2009). Greece got in trouble at 116%. Italy's deficit is smaller and has a high savings ratio. However, nobody focuses on that as Spain is in the limelight with a debt-to-GDP ratio under 60%. Should austerity measures result in a nominal GDP contraction in Italy, its debt stats will worsen very rapidly.

Italy is the elephant in the room not Spain.

Dr. Evil
Let's take a closer look at sovereign bonds spreads in Europe, comparing German 10-year government bonds to Italian 10-year government bonds.

German 10-Year Government Bonds

Italian 10-Year Government Bonds

Since mid-October, German 10-Year Government bond yields are up .64%. In the same timeframe, Italian 10-Year Government bond yields are up 1.04%.

The flight-to-safety divergence increased starting around December 16, 2010. Since then, German bonds yields are off .16% while Italian bond yields rose .14%.

Government Bond Spreads as of January 7, 2011

On January 7, 2011 the German-Italian spread government bond spread is 1.88% and rising. Table is courtesy of the Financial Times.

Web of Debt

Here is an interesting chart courtesy of the New York Times regarding Europe's Web of Debt that helps explain the picture.

click on chart for sharper image

The graphic is from May, 2010 so it's a bit dated. However, it does explain the interrelationships quite nicely.

Note that Italy owes France a whopping $511 billion, 20% of the French GDP. Moreover, nearly 1/3 of Portugal's debt is held by Spain. Meanwhile Spain owes huge amounts to Germany, France, and the UK.

Do you think all of that will be repaid? I don't.

Critical Court Ruling Coming Up

In Feb 2011 the German court gives its verdict on the constitutionality of the bail-out. Fifty academics and politicians sued the government over it. February is crunch time. For more details please see EU Commission Plans Haircuts on Bank Debt; Greek Yields Hit New Record; China Buys Spanish Debt; German Courts to Decide Bailout Constitutionality.

If the German courts uphold the constitutionality of these various bailouts, the crisis is merely pushed a bit further down the road.

New Irish Government Likely To Demand Haircuts

In March a new Irish government will take over and it is highly likely that government questions the hundreds of billions Ireland owes German, French, and UK banks.

I believe Ireland should tell the ECB and IMF to go to hell and default. For my rationale, please see To Ireland With Love. Here is the "Trojan Horse" image I used with the article.

Italian Snowball and Off-Balance Sheet Derivatives

In a subsequent email, Dr. Evil elaborated on Italy's off-balance sheet debt.

Hello Mish,

If Italy were to go into a nominal GDP recession on account of its austerity programs, its debt-to-GDP ratio would likely be 130% by 2012. It's difficult to see how the market would ignore that.

Also check out Italy's debt compared to Germany. Here is the official EU Gross Government Debt Figures by country. Note that as of 2009, Italy's Debt is 1.763 Trillion EUR, about the same as Germany. Obviously the German economy is far bigger.

Moreover, I assure you that Italy has a lot of off-balance sheet debt. Some European countries took some very creative measures to reduce interest payments on debt. Italy was one of those countries.

I have seen Italy do HUGE (10+ billion USD) derivative transactions. Those transactions were all off-balance sheet but the cash flows behind the transactions were very real.

Italy was the number 1 customer for big investment banks in London for years. You won't find anything about that in the press.

In 2011, Italy will need to rollover a pile of debt. It will be interesting to see how that goes. I believe that if the 10-year yield hits 6%, an irreversible snowball effect similar to what Greece and Ireland went through is likely.

That's when gold hits $2000

Dr. Evil
2011 Italian Debt Issuance

Inquiring minds are reading Italian Public Securities By Maturity to see how much debt Italy will need to rollover in 2011.

A quick look at page 3 totals approximately 281 billion in euro debt rollovers. Assume a 5% budget deficit on a GDP of roughly 1.5 trillion euros and you end up with 281 + 75 billion or roughly 356 billion euro total debt issuance.

Will the market accommodate that issuance at a good interest rate? If not, the "Invisible Elephant In The Room" will quickly make its presence known in a rather rude manner

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