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from MacroScope:

Today in the euro zone – a blizzard of bailout numbers

Brace yourself for a blizzard of numbers.

EU finance ministers gathered in Copenhagen are poised to decide precisely how much firepower their new rescue fund – to be launched mid-year – will have. A draft communiqué suggests that as of mid-2013, presuming no new bailouts have been required in the interim, the combined lending ceiling of the future ESM and existing EFSF bailout funds will be set at 700 billion euros (500 billion pledged to the ESM plus the roughly 200 billion already committed to Greek, Irish and Portuguese rescue programmes).

Up to mid-2013, if 700 billion proves to be insufficient -- i.e. someone else needs bailing out -- euro zone leaders will be able to bolster it with the 240 billion euros as yet unused in the EFSF, according to the draft, although German Finance Minister Wolfgang Schaeuble said last night that 800 billion should be the absolute limit.

Sorry, there’s more. Because the ESM will not have its full 500 billion euros capacity on day one – it will build up over time – the real available figure for the next year is more like 640 billion euros. Confused? You should be.

Nonetheless, this is probably sellable by Angela Merkel to German MPs and her public as not being a real increase at all (which is not that far from the truth) while also  probably being enough for Christine Lagarde to seek greater crisis-fighting funds for the IMF from its non-European members, most of whom have said they would provide nothing until the euro zone shows some serious intent of its own. The IMF spring meeting looms next month.

The big question is, is it enough to keep markets calm? The possibility of drawing on the extra 240 billion over the next year might do the trick but it’s not yet guaranteed that that will be agreed. If the ministers only offer up a 500 billion fund plus the money already committed to bailouts (which really is not new money at all), there could well be a wobble. The other big setpiece of the day is the Spanish budget, which Rajoy insists will be tough. Markets are watching closely. Spain reported a budget shortfall of 8.5 percent of GDP in 2011 and faces a target of 3 percent next year. It can ill-afford any slippage; its bond yields have already started rising since Prime Minister Mariano Rajoy rejected the first 2012 target agreed with the European Commission and secured a softer goal. 

Rajoy has promised a tough budget which economists predict will push Spain into a pretty deep recession this year. The government believes 35 billion euros of cuts will allow it to meet its deficit targets but given an economic downturn will cut government revenues, some analysts estimate nearly double that amount will be needed. The outside pressure for reform is unrelenting. Schaeuble said a youth unemployment rate nearing 50 percent was little surprise considering the state of Spanish labour laws.

from MacroScope:

Today in the euro zone – the elusive firewall

Conflicting pressures for the euro zone bond market today – a strong signal from Germany that it is willing to increase the firewall built around the currency bloc but ongoing concerns that Spain is being dragged into the mire.

Litmus tests are provided by an auction of a mixture of Italian debt worth up to four billion euros and the sale of short-term Spanish t-bills. While Spanish yields on the secondary market have come under pressure there has been no sign yet that primary sales will have any difficulty, given the more than 1 trillion euros of three-year ECB money sloshing round the financial system.

Italian Prime Minister Mario Monti and Spain's Mariano Rajoy are both in South Korea for a nuclear summit and could well break cover.

Rajoy insisted on Monday he would press on with a tough budget on Friday despite only a pyrrhic victory in weekend elections in Andalusia but markets are on red alert since he ripped up a Brussels-agreed deficit target last month. Italy is getting more benefit of the doubt but for that to persist, Monti will have to push through labour reforms in the teeth of union opposition.

That makes it all the more vital that euro zone finance ministers, meeting in Copenhagen later this week, agree on a method of bolstering the crisis firewall by combining some of the resources left in the temporary EFSF bailout fund with the ESM, a 500-billion-euro facility that comes into force from July.

Looking at German Chancellor Angela Merkel’s statement on Monday, it seemed she was lining up behind the option of combining the 192 billion euros of EFSF money already committed to bailouts of Greece, Ireland and Portugal with the 500 billion ESM. That would likely underwhelm markets since the 192 billion has either already been spent or is committed, so doesn’t count as new money.

However, German sources say Berlin is likely to allow the remaining 240-odd billion of EFSF money to be used until mid-2013, thereby creating a 740 billion euros fund which is likely to be enough for the IMF to seek crisis-fighting resources of its own. If both those elements come into place, there is optimism that defences will be sufficient to protect Spain and Italy although the prospect of the fund shrinking back to a 500 billion total in just over a year’s time leaves some room for doubt.

from Breakingviews:

Europe needs to ease on firewall obsession

By Neil Unmack

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

How big should Europe’s firewall be? Some analysts reckon the euro zone needs as much as two trillion euros, enough to bail out Italy, Spain, and some others if need be. By comparison, the size of the planned 500 billion euros of the European Stabilisation Mechanism (ESM), the euro zone’s permanent bailout mechanism, looks paltry. Unless it includes the unused funds of the European Financial Stability Facility (EFSF), the temporary structure put in place in the wake of the Greek fiasco.

The current thinking is to lift the 500 billion euro cap in order to create a firewall big enough to convince the International Monetary Fund to cough up funds too. The most ambitious plan, devised by the European Commission, is to fold the EFSF’s unused guarantees into the ESM, which would boost the total size of the facility to 940 billion euros.

But increasing the firewall too much may not be desirable, or necessary. Once the money is there, there is a danger markets will push governments to use it. Countries with high borrowing costs may also become addicted to cheap bailouts. A fund big enough to bail out Italy and Spain could be created, but such large bailouts would be destabilising; governments in northern Europe will be highly reluctant to sign up, and their own credit would be impaired. Then there’s the risk that after Italy, France might one day follow.

Bailouts are necessary sometimes. Greece needs such deep social reconstruction that it will be on life support for years. Portugal may find itself in the same camp if its efforts to reform don’t pan out, and it may need to tap the bailout fund again. Ireland could need some extra money too. But it doesn’t look like other euro zone countries need the full treatment. Take Italy; last year its bond yields topped seven percent, prompting commentators to argue that a bailout was inevitable. But it wasn’t; a few months of high yields was enough to topple Silvio Berlusconi. Keeping countries exposed to market forces may be a better way of enforcing change than bailing them out.

Leaving markets to act unchecked could be dangerous. The Italian crisis last year was contained because the European Central Bank kept bond markets from spiralling out of control by buying government debt. It then protected Europe’s banks by making long-term funds available. Clearly, that requires the ECB to put member states’ capital at risk, just like the ESM will do. But the ECB route is better: market forces are still brought to bear, the ECB lends against collateral, and buys bonds at a discount, even turning a profit. When the crisis eases, it can quickly withdraw, as was done with Italy. Save for their psychological effect, the bailout funds don’t need to be increased at all.

from MacroScope:

Today in the euro zone

Investors who bought Greek default insurance discover how much they will be paid today. Memories of the chaos that flowed from CDS payouts after the collapse of Lehmans mean there is a degree of nervousness but the signs are this will be nothing like as serious.

A  payout of around $2.5 billion to holders of the insurance contracts on Greek bonds will not cause the calamity once feared by euro zone politicians and the ECB as it represents a drop in the ocean of losses investors have already taken on money lent to Greece. That doesn’t mean, however,  that a few banks have not been foolish enough to write vast amounts of contracts on Greek debt which will now fall due.

There is a complex auction process to go through where bonds are bought and sold in order to determine a final price, or 'recovery rate'. That will also give a more accurate guide to the market outlook for Greece since the new bonds issued as part of the bond swap are barely being traded so far. That view ain’t likely to be pretty.

The European Financial Stability Facility -- the euro zone's rescue fund -- is busy raising money for the Greek bailout to meet its 109 billion euro contribution. It has asked BNP Paribas, Commerzbank and DZ Bank to arrange a conference call with investors on Monday to discuss a potential new bond issue with a 20-30 year maturity, according to banking sources. This will be the first time it has attempted to sell bonds of this length of maturity. EFSF chief Regling will field questions from potential buyers.

Not much for markets to get their teeth into yet. German Bunds have edged up while European stock futures opened flat. The Greek central bank issues a monetary policy report today in which it is likely to keep up the pressure for the government to pursue its economic reform pledges with alacrity. The Bundesbank issues its monthly report at 1100.

Big focus this week will be on Italian premier Mario Monti’s efforts to drive through labour reforms in concert with trade unions. The largest union says a deal is “impossible” by an end-of-week deadline despite signs of watering down of  measures by the government already. A lot hangs on this. A number of key factors have moved the euro zone debt crisis on from critical to chronic, top of the list was the ECB's creation of a trillion euros of three-year money but not far behind came the elevation of Monti and the hope invested in him that he can turn the Italian economy around. If the euro zone's fourth largest economy fell over, the currency bloc really would be on the skids.

from Breakingviews:

Governments are now world’s financial engineers

By Antony Currie and Agnes T. Crane The authors are Reuters Breakingviews columnists. The opinions expressed are their own.

The last financial crisis was supposed to have killed off financial engineering. It certainly seems to have for the most part turned excess leverage and overly complex borrowing structures into a pariah. But Western authorities have embraced them with gusto.

Recent responses to the mess in Europe provide the latest examples. The European Financial Stability Facility, or EFSF, plans to employ a design that mimics credit derivatives, something European leaders have publicly skewered the private sector for using, to help the fund get a bigger bang for its buck. But with the future of the euro zone up in the air, engineering can’t make up for investor skepticism. The fund may raise just 700 billion euros, barely a third of the most optimistic earlier estimates.

Greece’s bailout, meanwhile, offers a sleight of hand to make investment bankers proud. The current package secures a manageable interest rate for the country, but only by forcing it to invest a chunk in safer bonds than its own.

In fact, many policy responses since the bust have been built with tools used during the heady bull-market days. In 2007, U.S. Treasury Secretary Hank Paulson wanted to relieve banks of problems caused by structured investment vehicles by creating a Super-SIV to mop them up. It never got off the ground.

Later efforts to help banks offload dodgy assets or fund new deals - PPIP and TALF, for example - required elaborate architecture and large doses of debt. They ended up being much smaller than initially touted.

The U.S. government has even adopted the worst of private-market practices in subprime mortgages. Not only does the Federal Housing Administration require minimal down payments, it has piled on leverage. Its capital reserves are just 0.24 percent, a staggering 417-to-one ratio that makes Bear Stearns and Lehman Brothers look ultra-conservative.

from Hugo Dixon:

Don’t leave Plan B too late

It is fashionable for pundits outside Germany to lambast its government, the Bundesbank and the European Central Bank for being inflexible or stupid or both. Can't they see that all that's needed is for the ECB to fire its bazooka by printing unlimited money, and the euro crisis would be over?

After spending a couple of days in Frankfurt and Berlin last week, my impression is that these three institutions are neither stupid nor totally inflexible. That said, Germany is still determined to try its current plan for solving the euro crisis, though it has little chance of working. And by the time the trio get round to implementing a Plan B, the euro zone could be in deep recession or even have exploded.

The current plan has three elements. First, the governments of troubled countries such as Italy and Spain need to implement structural reforms and austerity. Second, the zone's fire extinguisher, the European Financial Stability Facility, needs to be got in good working order in case the fires in Rome and Madrid become uncontrollable. Finally, governments need to agree a treaty committing them to long-term budgetary discipline.

A month ago, this plan might just have worked. But investor confidence has now deteriorated so sharply that even promising new prime ministers in Italy and Spain haven't been able to stop their bond yields rising. Meanwhile, Belgium has become the latest country to get dragged close to the danger zone, with the yields on its 10-year bonds approaching 6 percent. Even Germany suffered a failed bond auction last week. The fire extinguisher also looks faulty: plans to leverage up the EFSF so that it is big enough to bail out Rome and Madrid have run into trouble.

Even the proposed treaty, which Germany's Angela Merkel has been trumpeting with much ballyhoo, is unlikely to do much to restore confidence. While investors will like the idea that governments won't rack up excessive debts in the future, they might not be so happy about the austerity needed to get every country's debts below the promised level of 60 percent of GDP.

What's more, there's no guarantee that the current treaty can be changed given that it needs unanimous approval not just by the 17 euro zone countries but also by the 10 other members of the European Union, such as the UK. In some cases, there may also be referendums, whose results tend to be unpredictable. This explains why Germany and France are now casting around for alternative ways of getting the same result -- say by having new treaties signed by a smaller group of countries.

from Bethany McLean:

The euro zone’s self-inflicted killer

By Bethany McLean The opinions expressed are her own.

There were a lot of things that were supposed to save Europe from potential financial Armageddon. Chief among them is the EFSF, or European Financial Stability Facility.

In the spring of 2010, European finance ministers announced the facility’s formation with great fanfare. In its inaugural report, Standard & Poor's described the EFSF as the “cornerstone of the EU’s strategy to restore financial stability to the euro zone  sovereign debt market.”  The facility itself said in an October 2011 date presentation that its mission is to “safeguard financial stability in Europe.”

That of course hasn’t happened. And the evidence suggests that the EFSF may have only exacerbated the problems.

In theory, the facility is supposed to provide a way for a country that the market perceives as weak to still borrow money on good terms. The initial idea was that instead of the financially troubled country itself trying to sell its debt to live another day, the EFSF would be the one to raise the money and lend it to the country in question. The logic was simple: country X might be shaky, but the EFSF deserved a triple-A rating.

For all of its would-be financial firepower, the EFSF isn’t much to see—it’s just an office in Luxembourg with a German-born economist CEO named Klaus Regling, who oversees a staff of about 20. Its power—and that rating—is derived from the assumption that any debt it issues is guaranteed by the members of the euro zone. Initially, each member pledged unconditionally to repay up to 120% of its share of any debt the EFSF issued. (A country’s share is determined by the amount of capital it has in the European Central Bank.)

On paper, it all sounded great. The reality is that the EFSF wasn’t meant to be an active institution; it was supposed to be a fire extinguisher behind glass: never to be used. “The EFSF has been designed to bolster investor confidence and thus contain financing costs for euro zone member states,” wrote Standard & Poors in its initial report granting the triple A rating. “ If its establishment achieves this aim, we would not expect EFSF to issue a bond itself.”  Moody’s, for its part, wrote that the EFSF “reflects the political commitment of the euro zone member states to the preservation of the euro and the European Monetary Union.” That show of commitment alone was supposed to be enough to reassure the market.

from The Great Debate UK:

Put the euro zone out of its misery

By Laurence Copeland. The author is a professor of finance at Cardiff University Business School. The opinions expressed are his own.

Let me make a wild guess – just a hunch, a vague feeling, the kind you get when you hear a football club chairman say “the manager has my full support”. My forecast is that the IMF monitors currently poring over the Italian government’s books will uncover a black hole somewhere, probably one big enough to swallow the euro zone, and the discovery will leave them as shocked as Captain Renault when he found there was gambling going on at Rick’s Bar in Casablanca.

My gut feeling is based on a deeply rooted suspicion of Italian statistics dating back to the early 1970’s, when I got my first job in academic life, as a research assistant in the University of Manchester. In that more tranquil era, it seemed possible to uncover a number of stable relationships between macroeconomic variables for all the other countries in the industrial world, but somehow never for Italy, which was always the outlier. Suspicion of the data is reinforced by the well-established claim that as much as 25 percent of Italy’s production is in the economia sommersa, the underground economy, exempt from taxation, unmonitored and unregulated (in fact, the Italian authorities have sometimes seemed to take a pride in its size, notably in 1987, when by a sleight of the statistician’s hand, Italy’s GDP was deemed to have overtaken that of Britain, thanks to an overnight reassessment of the scale of the country’s black market).

Even if Italy’s predicament is no worse than it appears from official statistics, the outlook is grim. It is hard to imagine a Berlusconi-led government successfully enforcing a serious austerity regime, but neither is it likely that an opposition dominated by ex-Communists could succeed where he failed. Moreover, as with Greece, those who are enthusiastic for a non-partisan administration made up of technocrats forget that mustering support in parliament is not enough. Restoring Italy to fiscal health will need a government able and willing to enforce spending cuts, raise taxes (or at least collect them more vigorously) and deregulate labour markets in the face of bitter and potentially violent opposition from trade unions, the professions and probably much of the public. It is not obvious to me that a government of supposedly neutral technocrats is better placed to achieve all this.

With a total debt of nearly two trillion euros, even a relatively modest haircut for Italy would be ruinously expensive to the European Financial Stability Facility (EFSF), and a Greek-style coiffure of 50 percent or more would use up all the additional funding promised (but not yet delivered). Moreover, there would be devastating consequences for the creditworthiness of the core countries -- France in particular, but even Germany, and of course for all the major European banks.

For months now, commentators have been urging the EU authorities finally to get ahead of the curve, something they have repeatedly failed to do in the case of Greece. They began by refusing to admit the need for a bailout, then denied the inevitability of a partial default, then were forced to recognise the need for a 20 percent haircut, and have now been reduced to begging Greece to accept a 50 percent writedown, an offer which will still leave the country facing a crippling debt-to-GDP ratio for a decade or more and which may be rejected anyway -- in which case we will end up with a disorderly default after all.

The same sort of slow-motion trainwreck with Italian debt will sink Europe’s (and possibly the world’s) banking system – yet the authorities in Brussels and Frankfurt seem set on that course. To those who ask whether we face another Lehman Brothers, the answer is yes – and probably worse than in 2008.

from James Saft:

Euro plan drives into ditch

James Saft is a Reuters columnist. The opinions expressed are his own.

The early returns on the euro rescue are as straightforward as the plan was vague: it probably isn't going to work.Two numbers tell the tale: the 177 basis points over German debt the supposedly AAA-rated euro rescue fund was forced to pay to borrow on Monday; and 6.67 percent, the 14-year record amount Italy had to pony up to borrow for 10 years.

Neither of those numbers fit in well with the plan announced last week to recapitalize banks, bail out Greece, erect a firewall around the larger weak economies and produce credible plans for fiscal and economic reform.

Put simply, these numbers are telling us that the market and debt investors do not believe the plan will work in its current form. And little wonder, it is now just days later and Greece's government has fallen, Italy's Berlusconi is under siege and the much hoped-for support from outsiders like China has failed to materialize.

When the European Financial Stability Facility (EFSF) tried to sell 3 billion euros of 10-year debt Monday it only just managed to scrape up the cash and was forced to pay much more than it has in past. In some ways this is no surprise; the rescue plan was vague about crucial details of how the EFSF would be structured and employ leverage.

Hopes that China and other emerging powerhouses would step up and support the plan have so far gone exactly nowhere.

Not only did Chinese President Hu Jintao leave France after the G20 summit without committing, the head of the country's sovereign wealth fund went as far as to attack European ''sloth.''

from James Saft:

Europe’s three simple problems

James Saft is a Reuters columnist. The opinions expressed are his own.

The plan to rescue the euro zone faces only three hurdles; democracy, reality, and supply and demand.If they can overcome those, it is going to work perfectly, and, amazingly, they just might.

Democracy reared its rather large head when the Greek government decided suddenly that it wanted a sign-off from its voters and moved to put the plan to a plebiscite.

While it is hard to argue with the idea of a people getting a chance to vote directly on a plan that will mean tough times for the better part of the next decade, the move jeopardizes not only the confidence on which the entire rescue relies but also the next infusion of much-needed cash Greece is slated to get in November.

If the Greeks vote against the plan it means a full-fledged, badly controlled sovereign default, with all that implies for euro zone banks. Is that something the Greeks will vote for, even if it means ejection from the euro zone? Just the specter of the vote makes it far harder for euro zone officials to put the rest of their plan into effect, a number of whose planks are already looking shaky.

Democracy, or whatever alternative term you would prefer to use, is also doing the rescue no favors in Italy, where Prime Minister Silvio Berlusconi is under pressure to step aside for a government of national unity. There is also precious little faith that Italy will produce credible fiscal and structural reforms. All of this is reflected most starkly in the reality of the bond market. Italian 10-year bond yields now stand at about 6.16 percent, a level that is unsustainable, considerably higher than before the grand plan was announced, and a threat in and of itself to the rest of the plan's moving pieces.

Remember, Italy is not only the third-largest economy in the euro zone, and probably too big to bail out, but the third-largest government bond market in the world. A plan that can't bring Italian borrowing costs back down is one which will fail.