Felix Salmon

The market has had a full day now to digest the results of the ECB’s debt auction, and Floyd Norris, for one, is wildly enthusiastic about them. The ECB’s strategy, he writes, “may be enough to stem the European crisis for at least a few years, and go a long way to recapitalizing banks in the process”.

Norris’s bullishness is based on what you might call the Sarkozy trade — the idea that a huge amount of the ECB’s new lending will end up being invested in Eurozone government debt. He calls it “an obvious, virtually risk-free, option” for the banks who borrowed ECB funds:

It would be nice if some of it were lent to the private sector to spur growth and investment. But the logic of putting it in two- or three-year government notes is obvious.

Well, it’s not that obvious. Here’s the math: if you take all the new ECB money which entered the market yesterday and subtract out all the maturing ECB debt which needed to be rolled over, you end up with some €210 billion in new funds — a number which is startlingly close to the €230 billion of European bank debt which is coming due just in the first quarter of 2012.

And for the time being, the ECB is the only entity in the world willing to lend European banks €230 billion. Which means that the prudent course of action, for Europe’s banks, is to use this ECB money to pay down their own debts. Doing so would address a big funding risk, and would also help derisk their balance sheets in the eyes of the world and of Basel.

The big question, then, is how long the ECB is going to be doing this kind of thing. If this operation is a signal to the market that the ECB will be the lender of last resort to European banks for at least the next couple of years, then the banks don’t need to worry so much about their own financing needs and can lock up the funds in two- or three-year government bonds as Norris and Sarkozy anticipate. On the other hand, if this is more like Federal Reserve quantitative easing — something designed to be temporary rather than quasi-permanent — then banks will be looking to help themselves before they help others.

Gavyn Davies, for one, is clear on this point: “we should call a spade a spade,” he writes. “This is quantitative easing on a significant scale.” And he has the chart to prove it:

I suspect that the ECB is not going to be happy seeing this line rise indefinitely. The Federal Reserve’s balance sheet is bloated enough, after two rounds of QE, and it now stands at $2.85 trillion. The ECB is just getting started on this round — the next disbursal of 3-year debt comes in February — and already its balance sheet is well over $3 trillion and rising.

Greg Ip has been talking to the ECB, and has come back from a trip to Europe with a blog post saying that its lending is “eternal and infinite”. Which carries its own risks:

The longer Europe muddles through, the more banks’ demands on the ECB will grow. Even if the ECB can, legally, become the sole source of funding for peripheral euro-zone banks, is that sustainable politically? At some point won’t the leaders realise that lacking all private-sector confidence, their banks can no longer finance a growing economy? At that point, they will conclude the euro is not sustainable and prepare to exit, and the ECB’s limits will have been reached.

So there’s clearly a limit somewhere. If I were running a European bank, I’d fill up on ECB lending now, when it’s plentiful, because you never know for sure when that limit might be reached. That’s what happened yesterday. But I’d definitely think twice before turning around and lending it all back out again to Italy or Spain. Yes, that trade is a profitable one. But the one thing that European banks need more than anything else right now is liquidity. Profits come second.

“By this time next week,” says Simone Foxman, “the euro crisis could be over”; she obviously doesn’t think much of Fitch’s analysis, which concludes that “a ‘comprehensive solution’ to the eurozone crisis is technically and politically beyond reach”.

I’m with Fitch on this one. But it’s worth looking at the bull case for the eurozone, as spelled out by the likes of Foxman and Tyler Cowen. At heart, it’s pretty simple:

1. The way to solve the euro crisis, at least for the next couple of years, is for the ECB to act as a lender of last resort.
2. The ECB is, quietly, doing just that — specifically by lending money for as long as three years against a much wider range of collateral than it accepted in the past.
3. Even though that money is going to banks rather than sovereigns, the banks will borrow as much as they can, at interest rates of about 1%, and invest the proceeds in Spanish and Italian debt yielding more like 6%, in a massive carry trade.
4. Which means that the ECB is, effectively, printing hundreds of billions of euros and lending it to distressed European sovereigns after all.

This, at least, is how Nicolas Sarkozy has been spinning things:

“Italian banks will be able to borrow [from the ECB] at 1 per cent, while the Italian state is borrowing at 6-7 per cent. It doesn’t take a finance specialist to see that the Italian state will be able to ask Italian banks to finance part of the government debt at a much lower rate.”

But look at the headline of the article that quote appears in: “EU banks slash sovereign holdings”. Here’s a taster:

Europe’s banks have slashed their holdings of sovereign debt issued by the peripheral nations of the eurozone, selling €65bn of it in just nine months…

BNP Paribas cut its holdings by the most, shedding nearly €7bn of the sovereign debt of Greece, Italy, Ireland, Portugal and Spain and leaving it with €28.7bn as at end-September. Deutsche Bank’s €6bn reduction was by far the biggest in percentage terms (66 per cent) and left the bank with just €3.2bn of GIIPS exposure.

My feeling is that, at the margin, banks are going to continue to reduce their holdings of PIIGS debt, rather than decide to follow in the footsteps of MF Global. But don’t take my word for it:

Senior bankers say they will cut further, despite pressure to use newly available, longer-term ECB loans to buy government debt as part of an officially-sanctioned carry trade.

“When investors are constantly asking what you have on your books and the board is asking you to reduce your exposure, it doesn’t really matter about the economics of the trade,” said the treasurer of one of Europe’s biggest banks. “Am I going to buy Italian bonds? No.”

That view echoes comments from UniCredit chief executive Federico Ghizzoni, who this week told reporters at a banking conference that using ECB money to buy government debt “wouldn’t be logical”. The bank had traditionally been one of the biggest buyers of Italian government bonds, with almost €50bn on its books.

Cowen says that “public choice mechanisms will operate so that desperate governments commandeer their banks to make this move, whether the banks ideally would wish to or not” — and normally I’d be inclined to agree with him. Sovereign borrowing always crowds out other forms of bank lending, when a national government decides it really needs the money.

But in this case, it’s not going to happen. Why? For one thing, the main tool that governments can use has already been deployed: if banks load up on sovereign debt, it carries a lower risk weighting under Basel rules and therefore makes their risk-adjusted capital ratios look more attractive. But that’s been the case for decades now, and it can’t be beefed up at all. Meanwhile, bank regulators and investors are looking at a lot of other ratios too, like total leverage. And as we saw with MF Global, they’re hyper-aware of European sovereign exposures these days. Any bank wanting to be considered healthy will stay well away from Spanish and Italian debt.

On top of that, the financing needs of Spain and Italy are much bigger than their respective national banks can fill — especially in the context of those banks trying to deleverage, and seeing their deposit bases move steadily to safer European countries. While national governments are reasonably good at twisting the arms of their own domestic banks and forcing those banks to lend to their sovereigns, they’re much less good at twisting the arms of foreign banks and getting them to do the same thing. Is there any way at all for the Italian government to persuade French banks to lend to it? No.

And more generally, the national debt of big European sovereigns like Italy and Spain is so enormous that it has to be held broadly, in bonded form, by individuals and institutions. Banks alone won’t suffice. Greece is small enough that most of its debt can be held by banks. Italy, not so much.

There’s an argument that it doesn’t really matter whether the banks buy Italian and Spanish debt or not: the main thing that matters is that the ECB is printing money, which is entering the system via the banking system, and which will ultimately find its way into sovereign coffers one way or another, especially since there’s precious little demand for commercial bank loans these days. But I don’t buy it: there’s a virtually infinite number of potential investment opportunities around the world, and there’s no good reason to believe that the ECB’s cash is going to wind up funding Italy’s deficit rather than, say, getting invested in Facebook stock.

If Europe’s banks use ECB cash to deleverage and buy back their own high-yielding debt securities, the investors getting that money are not going to automatically buy sovereign bonds with the proceeds. Especially since those investors don’t care at all about Basel risk weightings.

So much as I’d love Sarko’s dream to come true, I don’t think it’s going to happen. The eurozone’s sovereign crisis is here to stay.

There’s a lot of chatter right now about the euro, which is now worth less than $1.30. That’s a reasonably big fall: it was as high as 1.3385 on Monday. But it’s worth keeping things in perspective. Here’s a five-year chart of EURUSD, or the value of one euro in dollars:

The main thing to notice here is the volatility: we’re basically back to exactly where we were five years ago, but we’ve had a very bumpy ride along the way. Going forwards, it seems sensible to expect that there will be more of the same: currencies going up and down in a fundamentally unpredictable manner.

The second thing to notice is how tiny a move from 1.33 to 1.29 really is, in the grand scheme of things. Is EURUSD volatile right now? Yes — but it’s been this volatile for years. There’s really nothing new or different or important going on.

The third thing worth noticing is that news reports nearly always talk in terms of currencies weakening rather than strengthening. If EURUSD goes down, then that’s always a reaction to the latest eurocrisis, whatever it might be. On the other hand, if EURUSD goes up, that’s never taken as a sign of strength in Europe: instead, we get bombarded by stories about the weak dollar, normally accompanied by doom-laden prognostications about the US economy.

For all that it’s a tempting narrative, however, currency moves should not be taken as some kind of market referendum on the health of a given economy. In the Wall Street Journal, Richard Barley has ventured that “the euro may now have become the main indicator of the depth of the currency bloc’s crisis” — but in truth there’s no good reason that should be the case. And it’s an unprovable assertion, too: the minute that the euro rises as the crisis gets worse, Barley can simply declare that something else has replaced it as the indicator to look at.

Let’s say that the eurozone is going to fracture, with weaker countries like Greece leaving the currency and returning to the drachma. Would that be good or bad for the value of the euro? It’s hard to tell. The rump eurozone would be stronger, and currencies can do pretty well during a crisis, depending on how the central bank reacts. After all, in the short term, currency flows are largely a function of interest rates, which are set by central banks: money goes to where it can earn the most interest.

And in the longer term, no one really has a clue what might happen. Four years ago, Bloomberg caused a global stir when it reported that supermodel Gisele Bundchen was insisting on being paid in euros, on the grounds that the dollar was simply a bad bet. The value of the euro back then? $1.45. And of course Bundchen looked smart, for a while — until the euro fell off a cliff a few months later.

Right now, there are similar stories doing the rounds about Metallica, who are reportedly bearish on the euro. They, too, are likely to look smart until they look stupid.

The main thing to remember here is that the European Union is still an economic powerhouse, with 27 countries pumping out trillions of dollars’ worth of domestic product every year. All those goods and services are worth real money, no matter what happens to the political union. And the European Central Bank is incredibly reluctant to print money, which means that the chances of the euro being eroded by inflation are even lower than the chances of the same thing happening to the dollar.

For the foreseeable future, then, we can expect the euro to rise and fall in its now-standard pattern of unpredictable volatility. If a period of the euro falling happens to coincide with a period of especial crisis in the eurozone, then we can also expect a spate of stories extracting spurious causation from a random correlation. And similarly, if a period of the euro rising happens to coincide with bad economic data in the US, then we’ll all be told that the dollar is weakening on a deteriorating growth outlook.

What does this mean for the 99.9% of us who don’t play the currency markets? If you’re an international traveler, then visiting Europe just got a bit cheaper. If you’re not, then you can probably ignore currency rates altogether. And if you’re concerned that the crisis in Europe is going to tip the world into another global recession, then if I were you I’d look at European interbank lending rates and sovereign debt yields to get an indication of how bad things are. The euro/dollar exchange rate is just too noisy to be able to tell you much of anything.

Am I feeling a bit sheepish about my extreme pessimism of last night, in the wake of a healthy stock-market reaction in both Europe and the US? Not really. Markets did rise, but the movement was within what you might consider standard noise for stock indices these days: roughly 2% in Europe, a little lower in the US. A resounding vote of confidence in the EU this was not: instead, it looks more like the bad deal done in Europe was already priced in, and the markets just continued, today, on their normal volatile and noisy path. In fact, it’s not at all clear that the EU treaty was responsible for any of today’s market move at all.

In the video I shot yesterday with TBI’s Simone Foxman, Simone talks about how Europe’s bailout mechanism is a fragile thing. For one thing, she admits that “the ECB has to get involved in one way or another”, and that we’re not seeing that right now; later on, she wonders whether the markets would even place all that much faith in a German guarantee of PIIGS debts if Germany has been downgraded. “It’s going to be really tricky to not lose a lot of investor confidence” if and when the eurozone breaks up, she says, and when Germany is called upon to provide guarantees, “by then, markets may not trust them enough. If that fear keeps rolling, it snowballs down the mountain and all of sudden becomes an avalanche”.

This is one of those situations where the conventions of reporting market moves on a daily basis are decidedly unhelpful if you want to get a feel for what’s going on in Europe. The fact is that Europe still has a lot of very strong companies, which are worth real money going forwards; in many ways, owning those companies is a much smarter thing to do than simply putting your euros on deposit in a European bank. So looking at the share prices of European companies is really not a great way of working out what the market thinks of the prospects for the future of the eurozone. And looking at the value of the euro doesn’t help much either. Instead, you want to look at more obscure indicators, like the amount that Italian and Spanish banks need to pay if they want to borrow money on the interbank market.

More simply still, just look at the amount of new capital that Banco Santander — one of the strongest banks in Spain, if not Europe as a whole — is now being asked to raise. (More than €15 billion, if you must know.) Here’s Santander’s share price, over the past couple of years. The thing to notice is the inexorable downward slide, not any small uptick today. Does anybody really think we’ve now seen the all-time lows for this indicator? If not, then let’s stop treating intraday market noise as some kind of referendum on the latest Euro treaty.

I thought disasters were all meant to happen over the weekend? Somehow, in Brussels, EU leaders have contrived to pull defeat out of the jaws of victory on Thursday night, leaving Friday for finger-pointing and recriminations and wondering whether anybody who signed on to this deal has any chance at all of even getting re-elected, let alone being remembered as one of the leaders who saved the euro.

Remember how Wolfgang Münchau said that the Euro zone had to get it right at this summit or it would collapse? Well, the Euro zone has most emphatically not got it right. Take any of the list of prescriptions of the minimum necessary right now — from Münchau, from Larry Summers, from Mohamed El-Erian — and the one thing that jumps out at you, especially in light of the most recent news, is that if you look at anybody’s list, there’s an enormous number of items which has zero chance of actually happening.

Here’s how the FT put it on Wednesday:

It borders on hysterical to say there are but hours to save the euro, but there is a risk that if the crisis is not now tamed the price of a rescue might start to spiral out of politicians’ grasp. The stakes are therefore very high at Friday’s summit. The world cannot afford another half-baked solution.

And yet, inevitably, another half-baked solution is exactly what we got. Which means, I fear, that it is now, officially, too late to save the Eurozone: the collapse of the entire edifice is now not a matter of if but rather of when.

For one thing, fracture is being built into today’s deal: rather than find something acceptable to all 27 members of the European Union, the deal being done is getting negotiated only between the 17 members of the Euro zone. Where does that leave EU members like Britain which don’t use the euro? Out in the cold, with no leverage. If the UK doesn’t want to help save the euro — and, by all accounts, it doesn’t — then that in and of itself makes the task much more difficult.

But that’s just the beginning of the failures we’re seeing from European leaders right now. It seems that German chancellor Angela Merkel is insisting on a fully-fledged treaty change — something there simply isn’t time for, and which the electorates of nearly all European countries would dismiss out of hand. Europe, whatever its other faults, is still a democracy, and it’s clear that any deal is going to be hugely unpopular among most of Europe’s population. There’s simply no chance that a new treaty will get the unanimous ratification it needs, and in the mean time the EU’s crisis-management tools are just not up to dealing with the magnitude of the current crisis.

The fundamental problem is that there isn’t enough money to go around. The current bailout fund, the European Financial Stability Facility, is barely big enough to cope with Greece; it doesn’t have a chance of being able to bail out a big economy like Italy or Spain. So it needs to beef up: it needs to be able to borrow money from the one entity which is actually capable of printing money, the European Central Bank.

But the ECB’s president, Mario Draghi, has made it clear that’s not going to happen. Draghi is nominally Italian but in reality one of the stateless European technocratic elite: a former vice chairman and managing director of Goldman Sachs, he’s perfectly comfortable delivering Italy the bad news that he’s not going to lend her the money she needs. He’s very reluctant to lend it directly, he won’t lend it to the EFSF, and he won’t lend it to the IMF. Draghi has his instructions, and he’s sticking to them — even if doing so means the end of the euro zone as we know it.

And there’s more bad news, too. All of Europe’s hopes right now are being placed in something called the European Stability Mechanism — a permanent successor to the temporary EFSF. Since it’s permanent, the ESM is going to have to be constructed with the ability to put out fires of any conceivable size. And as such, it’s going to have to be able to borrow enormous amounts of money, and lend them on to countries which have found themselves in trouble.

But that would make the ESM, essentially, a bank. And the European leaders seem determined, today, to prevent the ESM from operating as a bank at all. Which means it will never get the firepower it needs to be taken seriously.

Oh, and did I mention that the ESM seems set to be capped at a mere €500 billion euros? That’s a lot of money, of course, but compare it to Italy’s total debt of roughly €2 trillion. And that isn’t even counting Spain, or Portugal, or Ireland, or whatever money Greece might yet still need.

Don’t think that Europe’s banks might be able to step in and lend their governments the money they need, either. The European Banking Authority, with exquisite timing, informed the world on Thursday that the continent’s banks need to raise €115 billion in new capital, including more than €15 billion for Spain’s Banco Santander alone. Where are they going to find that kind of scratch? Certainly not from their beleaguered governments. And there aren’t many private investors clamoring to invest in this particular train-wreck, either.

It all adds up to one of the most disastrous summits imaginable. A continent which has risen to multiple occasions over the past 66 years has, in 2011, decided to implode in a spectacle of pathetic ignominy. Its individual countries will survive, of course, albeit in unnecessarily straitened circumstances. But the dream of European unity is dissolving in real time, as the eyes of the world look on in disbelief.

Europe’s leaders have set a course which leads directly to a gruesome global recession, before we’ve even recovered from the last one. Europe can’t afford that; America can’t afford that; the world can’t afford that. But the hopes of arriving anywhere else have never been dimmer.

TBI’s Simone Foxman has got her wonk on and is getting into the weeds of Eurozone bail-in policies — a crucial subject about which there isn’t nearly enough public coverage. Simone says that I’m wrong, and that the EU is in no way intending to guarantee the debts of the PIIGS. And I very much hope that she’s right about that.

Part of the problem here is that we’re all just working from whispered and unsourced news reports: it’s not like there’s any clear public language about what Merkozy is proposing. And even if there were, it would of course be subject to change over the course of the current negotiations.

Foxman points me to a form of words in an official Eurogroup statement from November 28:

Rules will be adapted to provide for a case by case participation of private sector creditors, fully consistent with IMF policies. In all cases, in order to protect taxpayers’ money, and to send a clear signal to private creditors that their claims are subordinated to those of the official sector, an ESM loan will enjoy preferred creditor status, junior only to the IMF loan.

And today there’s a letter from Merkozy which is even more opaque:

As far as the private-sector involvement is concerned, the ESM treaty should be revised to make clear that Greece required a unique and exceptional solution. We recall that all other Euro area Member States reaffirm their inflexible determination to honour fully their own individual sovereign signature. A recital in the preamble should clarify that the euro area will apply the IMF practice. As agreed, common terms of reference on CACs shall be introduced in national legislations.

The good news here is that it looks like there won’t, after all, be anything like an explicit Eurozone backstop of all members’ sovereign debts: the only thing which is abundantly clear about both of these formulations is that they’re explicit about absolutely nothing.

For one thing, the idea that anybody could turn to “IMF policies” for guidance on these matters is laughable: there are no IMF policies on the subject, beyond a general rule that the IMF itself won’t lend to a country which is in default to its private creditors. (And even the IMF seems happy to break that rule when it needs to.) As for “IMF practice”, that basically means a case-by-case “we’ll cross that bridge when we come to it” approach. Which is reasonably sensible.

So I suspect that the “IMF policies” language is going to stay in there, precisely because no one really has a clue what it means. I doubt, however, that we’ll keep the bizarre notion that that the ESM will both have preferred creditor status and be junior to the IMF. The whole point of preferred creditors is that they never take losses, while the whole point of being junior is that you might take losses. I’m pretty sure that the IMF would be very unhappy indeed with the precedent-setting idea that a preferred creditor could accept a haircut, even if that preferred creditor was not the IMF itself.

And meanwhile, the “inflexible determination to honour fully” sovereign debts is being devolved down to the individual member-state level, where it has always been, rather than being run up to the EU level.

So where does this leave private-sector bondholders? They could still get bailed in if the ESM takes a haircut — but the ESM is clearly determined not to take a haircut, as is evidenced by its attempt to give itself preferred creditor status. But if a Eurozone country gets into fiscal trouble and is forced to hand over a certain amount of fiscal sovereignty to the EU, will the EU then force that country to restructure its bonds? My feeling here is that the answer is no.

If the ESM goes according to plan, then basically what happens is that the EU as a whole steps in when a country can’t get its fiscal act in order, and takes over to provide adult supervision and to force hard decisions to get made. One of those decisions will be to honour fully all sovereign debts. Ex hypothesi, the country in question can’t roll over those debts — which means that the ESM will have to step in to fund all budget deficits. And so even as private-sector debts are coming due and being rolled off, the ESM will be providing new-money funding.

All of which looks very much like an EU guarantee of sovereign debt.

But at the same time, the chances of the ESM going entirely according to plan have to be reasonably slim. And there’s enough wriggle room in the language as currently envisioned that if things start going really pear-shaped in Italy or Spain, private-sector bondholders could still see themselves forced to accept some kind of haircut.

It would just take the failure of the ESM for that to happen.

So is the ESM an EU guarantee of all Eurozone sovereign debt? To a first approximation, if it works, then I think it probably is. But it’s not a blanket, iron-clad guarantee. And that, at least, is good news.

The European Central Bank has been notoriously reluctant to print money during this crisis. But what if it had to?

Aaron Tornell and Frank Westermann have a wonky post up at VoxEU about the flows between various national central banks within the Eurozone, which includes this key chart:

Assets of the Bundesbank

The line to concentrate on, here, is the solid one in blue. It shows a key part of the Bundesbank’s assets — its loans to other institutions — falling perilously low to zero, even as its loans to other European central banks — the maroon dotted line — continue to rise inexorably. (These loans from one national central bank to another are known as the TARGET system.)

Up until now, the Bundesbank has managed to fund the latter by means of selling off the former: when it’s asked to lend money to PIIGS central banks, it just sells off some other loans and advances the cash to the Irish or Portuguese central bank instead.

But it can’t do that any more, because the Bundesbank is down to its last €21 billion in private loans. And when that hits zero, the only things left to sell are the Bundesbank’s gold and reserves. Which, it’s pretty safe to say, the Bundesbank is not going to sell.

There’s good news and bad news here. The bad news first:

Before long, the Bundesbank’s stock of domestic assets is going to hit zero, and it is highly unlikely that it will agree to sell its gold or borrow more in private capital markets. At that point, the Bundesbank will not be able to lend more funds to the Eurozone TARGET mechanism… If a critical mass of agents were to engage in capital flight away from fiscally weak countries, the TARGET system would be overwhelmed. In principle, a speculative attack could occur within a day, and the ECB would have to assume all of the marketable securities from countries that suffer the speculative attack. Since the ECB has a relatively small capital base, it would not be able to purchase a large amount of assets from countries that suffer the attack.

This is a bank run, basically, with the banks suffering the run being the central banks of euro-periphery nations. Bank runs are always about liquidity, and so long as there’s a firehose of liquidity somewhere able to give anybody who wants it all the cash they want, bank runs are non-issues. But the point here is that the network of European central banks is running out of cash, and that the Bundesbank — which has been the main provider of liquidity to date — has now pretty much run out of it.

Here’s how Izabella Kaminska reads this:

If the ECB doesn’t act to discourage the borrowing (or for that matter fails to somehow top up the Bundesbank’s assets), it could become a victim of a speculative attack not dissimilar to that experienced by the Bank of England during the ERM crisis of 1992.

There are, after all, many similarities in both situations. Most notable is the fact that both central banks seem to have under-estimated the amount of quality assets (or foreign exchange in the case of the BoE) they needed to hold to defend their monetary policy effectively.

I, on the other hand, am (uncharacteristically) a little more optimistic here. Faced with the imminent collapse of a national central bank, it seems to me that the ECB would have no choice but to print as much money as was necessary to meet that country’s demand for liquidity. The problem in 1992 was that the pound was overvalued, and that the market was demanding Deutschmarks, which the Bank of England couldn’t print. In this case, the market would be demanding euros, which the ECB can print.

Basically, there’s a constant flow of money out of the European periphery and towards the center. Up until now, that flow has been matched by an equal and opposite flow of central bank lending from the Bundesbank to the PIIGS central banks. And when the Bundesbank runs out of money to lend those central banks? The ECB will have no choice but to step in and print all the money necessary to stop those banks from going bust. And that, I think, is how we’re going to see the ECB finally take on the lender-of-last-resort role it has been so reluctant to adopt until now.

Update: Karl Whelan takes issue with Tornell and Westermann’s assumptions.

The FT is reporting today that the new fiscal rules for the EU “include a commitment not to force private sector bondholders to take losses on any future eurozone bail-outs”. If this principle really does get enshrined into some new treaty, it will be one of the most fiscally insane derelictions of statesmanship the world has seen — but it certainly helps explain the short-term rally that we saw today in Italian government debt.

Right now, the commitment is still vague:

Ms Merkel agreed that private sector bondholders would not be asked to bear some of the losses in any future sovereign debt restructuring, as she had insisted this year in the case of Greece’s second bail-out. However, future eurozone bonds will still include collective action clauses providing for potential voluntary rescheduling of private debt.

Ms Merkel said it was imperative to show that Europe was a “safe place to invest”.

You can safely ignore the bit about collective action clauses. They’re part of the sovereign-debt architecture now, and taking them out would be far more trouble than it was worth: they have to stay in, no matter what. The important thing is that they won’t be used — because if no one’s going to ask bondholders to bear any losses, then they won’t have any proposals to agree to.

The impetus for this completely insane policy seems to have come from the ECB, which genuinely seems to believe that bailing in private-sector banks, in the Greece restructuring, was the “terrible mistake” which caused the current euro crisis. Talk about confusing cause and effect: it was Greece’s fiscal disaster which caused the restructuring and the necessary bail-in.

To understand just how stupid this is, all you need to do is go back and read Michael Lewis’s Ireland article. The fateful decision in Ireland was to take the insolvent banks and give them a blanket bailout, with the banks’ creditors all getting 100 cents on the euro. That only served to put a positively evil debt burden onto the Irish people, forcing a massive austerity program and causing untold billions of euros in foregone growth, while bailing out lenders who deserved no such thing.

Are we really going to repeat — on a much larger scale — the very same mistake that Ireland made? Does no one in Europe realize that this is the single worst thing they can do?

Markets reflect underlying realities, and up until now, the realities have been clear. Europe’s periphery is sinking under the weight of too much debt, and the result will be inevitable pain for private-sector creditors. The best case scenario is that those countries bite the bullet and restructure their debt now, since to delay is to make any restructuring much more painful and expensive than it needs to be.

The worst case scenario is that the EU kicks the can down the road with one new bailout facility after another, until it eventually gives up throwing good money after bad and imposes the restructuring which was inevitable all along. In that case, as one hedge fund manager was explaining to me last week, private sector creditors get devastated: because the EU and the ECB and the IMF won’t take any losses on their loans, all of the haircut, pretty much, will have to be borne by a private sector which accounts for only a fraction of the debt. So the private sector could end up with very, very little indeed.

Now, however, Angela Merkel has come up with another plan. The details aren’t clear, but it seems to involve the EU guaranteeing the debts of its member states. Why this is acceptable while eurobonds aren’t acceptable is a mystery: a mulit-trillion-euro contingent liability is hardly preferable to a couple of hundred billion euros of real liabilities. But there’s eurologic for you.

The immediate result of this plan is that everybody will rush into the highest-yielding bonds in Europe, which is exactly what seems to have happened today. The other effect of the plan, however, is that every country in Europe is now effectively guaranteeing everybody else’s debt. Which is more than sufficient to explain why S&P is minded to downgrade every country in Europe, up to and including Germany.

In order for markets to work, lenders need to suffer when they make bad lending decisions. If the Europeans didn’t learn from Ireland, couldn’t they at least learn from the Fed’s much-criticized decision to pay off all AIG creditors at 100 cents on the dollar? Blanket guarantees at par are pretty much always a really bad idea — and this one, if it comes to pass, will be the biggest one yet. It won’t end well.

Mohamed El-Erian is calling for massive recapitalization of the banking system:

The global financial system is being refined “day in and day out,” El-Erian said, and as a result the balance between public and private is shifting and regulation is altering. “This is not being done according to some master plan,” but in reaction to a series of crisis management interventions.

None of these piecemeal policy moves restored confidence in the markets, he said. What is needed is a coordinated and simultaneous set of policy actions globally in four areas: restoration of credit markets, elimination of deteriorating assets from balance sheets, injecting capital quickly into the banking system, and regulatory forbearance.

Oh, wait, that was El-Erian back in October 2008. But he’s saying something very similar now:

In addition to specifying higher prudential capital ratios, governments must now bully banks to act immediately. Where private funding is not forthcoming, which should now be the presumption for a growing number of banks, recapitalization must be imposed, in return for fundamental changes in the way financial institutions operate and burdens are shared.

The main difference, here, is the move from “regulatory forbearance” the first time around, to governments forcing “fundamental changes in the way financial institutions operate” today. But either way, this is basically, the bank-nationalization debate all over again.

In the U.S., we didn’t nationalize in 2009. We ended up taking only modest stakes in banks, and getting through the crisis through the massive application of liquidity by the Fed. If the central bank, as lender of last resort, ensures that banks will always be funded, then you don’t need nationalization. It’s a bailout by monetary rather than fiscal means, and it’s a lot friendlier to bank shareholders than nationalization is.

But the problem in Europe is that the ECB is displaying neither the willingness nor the ability to act as a lender of last resort — and in that situation, the only policy action left is for governments to step in and try to backstop the banking system directly. This is a very dangerous road to travel down: it’s basically what Ireland did when it guaranteed the liabilities of the entire Irish banking system, thereby consigning itself to a national fiscal nightmare for the foreseeable future.

So color me unconvinced that the solution to a liquidity crisis is an injection of capital. At best it’s insufficient; at worst it’s unnecessary, and only serves to exacerbate the painful process of deleveraging in a pretty drastic manner. After all, liquidity problems can hit anybody, no matter how solvent they are — just ask the German government. The Bund auction failed in large part because the European liquidity-go-round is utterly broken right now, and it’s hard to see how things would improve if Europe’s sovereigns, including Germany, started getting into the banking business.

The idea behind sovereign recapitalizations is our old friend Anstaltslast — the idea that if a bank is owned by the state, then there’s an implicit government guarantee on its liabilities. If Europe’s sovereigns started taking substantial equity stakes in their own banks, then there would be fewer worries over bank solvency: it’s almost impossible for a bank to go bust if the sovereign really doesn’t want it to. But in the context of serious worries over sovereign solvency, this tack doesn’t make a lot of sense. Once you’ve nationalized, there’s no real end to the degree to which you might end up being on the hook for the banks you now own: you can’t credibly claim that the banks you own are now so well capitalized that they’ll never need any more money. And in this case, of course, the worries over European bank solvency are worries over European sovereign solvency. You can’t tie these two rocks together, through nationalization, and expect them to float.

El-Erian is very good at explaining the problem which needs solving:

Europe must still stabilize its sovereign debt situation. But this is now far from sufficient. Policymakers must also move quickly to contain banking sector frailties, and do so using a more coherent approach to the trio of capital, asset quality and liquidity.

It seems to me, though, that sequencing matters here. Liquidity is — always — more important than capital/solvency. Give an insolvent bank enough liquidity, and it can live indefinitely. Remove liquidity from a bank, and it dies immediately, no matter how solvent it might be or how high its capital ratios are. And as for asset quality, we’re pretty much talking a zero-sum game here: when the banks’ dubious assets are the sovereign’s liabilities, the real solution is inflation, not nationalization.

And as for banks’ non-sovereign assets, good luck with selling those. The shadow banking sector knows exactly what happens to asset prices when sellers put €5 trillion of those assets on the market at once, and there’s literally no one out there who would dream of buying such things at or near par.

In every crisis there’s a point of no return — if you don’t do XYZ in time, it’s too late, and the crisis is certain to get out of anybody’s control. I’m increasingly convinced we’ve already passed that point of no return in Europe. The banks won’t lend to each other, the Germans won’t do Eurobonds, and the ECB won’t act as a lender of last resort. The confidence fairy has left the continent, and she isn’t about to return. Which means, as we used to say in 2008, that things are going to get worse before they get worse.

I had a long lunch meeting on Friday with a hedge-fund manager with an astonishing ability to navigate the Bloomberg Blackberry app. And there was one chart in particular which he clearly pulled up on a regular basis: the spread on senior unsecured bank debt in Europe. As Lisa Pollack points out, it’s tempting but dangerous to look at the iTraxx Senior Financials index in this context, because it’s an easy index to follow but it also includes non-bank names like Aviva, Axa, and Munich Re. So here’s the 3-month Euribor/Eonia spread, instead, which also has the advantage of going back to 2007. It’s not the best indicator when it comes to measuring banks’ cost of funds, but it’s fantastic if what you’re looking for is a guide to how stressed the Euroland funding market is.

This chart comes from a 40-page note on European bank liquidity published by Daniel Davies and Jag Yogarajah of Exane BNP Paribas; I can highly recommend you try to get yourself a copy of it somehow. And in fact the situation is worse than this chart makes things look, since in the months immediately following Lehman’s bankruptcy, the three-month interbank funding market effectively did not exist, and the numbers being charted here are, in the note’s words, “arguably somewhat hypothetical“. Take out the nonexistent market following Lehman’s collapse, and spreads in Europe are right at their all-time highs.

We all know why this is, of course. European banks have lots of European sovereign debt. European sovereign debt is falling in value. Therefore European banks are insolvent. Therefore, they have greatly increased credit risk. Therefore, spreads are rising.

Except, this isn’t really true. Greek banks are insolvent, it’s true, if you mark their sovereign debt exposure to market. But to a first approximation, no other banks are. Mark French banks’ holdings of Italian sovereign debt down by say 10%, and they’re still fine; their capital drops, of course, as it would with any write-down, but certainly to nowhere near zero.

What is true is that Europe is in the middle of a textbook liquidity crisis. Banks are not lending to each other — and the ECB isn’t stepping in to solve the problem. This is a serious structural issue with the way that the European monetary system was constructed: the ECB is tasked only with guarding inflation, and not with ensuring the health of the banking system. Individual national central banks are meant to do that. But they can’t print money — only the ECB can. So when there’s a liquidity crisis, no one’s able to step in and solve it.

Here’s another chart from the report:

The light-blue line is the share prices of US banks. They fell steadily through all of 2008 and the beginning of 2009, with TARP barely making a difference. Who caught that falling knife and stabilized US bank share prices? Not Treasury, but the Fed, with its quantitative easing. As soon as that started (see the dark blue line), US financial institutions suddenly looked as though they’d be fine.

For this reason, the Exane analysts are convinced that talk of European bank recapitalizations is silly — essentially, it’s treating the wrong disease:

There is no reasonable amount of capital that can cure a liquidity shortage. The reason why people are refusing to lend to the banks is not primarily because they fear an underlying solvency problem (although some people do), but because they fear an obvious and immediate liquidity problem. It is rational not to lend to an institution that you believe to be illiquid.

The real problem here is simply that banks are hoarding their cash and not lending to each other. Look at the way that bank debt issuance has fallen off a cliff — even the issuance of covered bonds, which to a first approximation don’t have any credit risk.

And the way the banking sector works, banks have to be constantly lending to each other: in nearly every country in Europe, the amount of bank debt coming due every day is higher than the total amount of bank capital in the system. The overnight interbank market is the bloodstream of the European financial system, and the flow of blood is coming to a halt. Or, as the Exane report puts it, “if we think of wholesale funding as commodity input, it is much more like the supply of limestone to a kiln than the supply of flour to a bakery – not only can the banking sector not produce loans without new financing, it cannot shut down for a short period of time either, it needs constant supply.”

And here’s how a recent BIS report put it:

Quantitatively, private liquidity dominates official liquidity… private global liquidity is highly cyclical because it is driven by divergences in growth rates, monetary policies and, above all, risk appetite.

Private liquidity can give rise to international spillovers… This international component of liquidity can be a potential source of instability, because of its own dynamics or because it amplifies cyclical movements in domestic financial conditions and intensifies domestic imbalances.

The liquidity situation at European banks is similar to that at the sovereign level, too, as James Macdonald explains very cogently. Italy’s debt, it turns out, is not particularly high, by historical standards.

Instead, the problem is that Italy is being forced to roll over its debts on a regular basis.

Before World War I, countries considered truly creditworthy borrowed on terms that are unrecognizable nowadays. The vast majority of their debts were in the form of perpetual annuities…

In 1900, for example, France had a public debt amounting to 105% of GDP; but over 96% of it was in the form of perpetual annuities, and less than 4% in the form of short-term Treasury bills. Therefore the country’s annual funding requirement was only 4% of GDP. The credit of a country with such a debt structure was virtually impregnable short of a world war.

Since those halcyon days, however, western governments have raised their debts on a far shorter-term basis… France, with a public debt of (only) 86% of GDP, now has an annual funding requirement equivalent to over 20% of GDP. It is in good company. Belgium Italy, Spain, and Portugal also have to finance 20-25% of GDP each year. The USA has a funding requirement of nearly 30% of GDP, thanks to the folly of the Treasury Department’s decision to stop selling the 30-year T-bond in 2001 in a misguided attempt to shorten the average duration of the debt.

The result is that the sovereign borrowers that the markets have been accustomed to think of as “risk-free” have become a little similar to banks… At any time, a ripple of suspicion about their long-term ability to repay their debts (not unreasonable given the relentless build-up of their off-balance sheet liabilities since the war) could set off a chain reaction which ends up with a self-defeating rush for the exits.

This is what is happening to Italy.

You can see the dilemma facing the ECB here. It’s facing a dual liquidity crisis: not only within the European banking system, but also at European sovereigns. And it doesn’t really have a mandate to address either one.

But it’s liquidity crises which are the most violent, and which can kill a financial system — indeed, an entire economy — more or less overnight. Someone in Europe needs to come up with a plan for how to address the current crisis — now. Because if it gets any worse, it could well be too late.

It’s important not to read too much into today’s mid-afternoon stock-market wobble. But in the wake of the news that Germany and France have been talking for months about creating a “core” euro zone with real fiscal union, markets sure as hell didn’t go up. And one anonymous diplomat gave a succinct explanation of why:

This will unravel everything our forebears have painstakingly built up and repudiate all that they stood for in the past sixty years,” one EU diplomat told Reuters. “This is not about a two-speed Europe, we already have that. This will redraw the map geopolitically and give rise to new tensions. It could truly be the end of Europe as we know it.”

I’ll go out on a limb here and guess that the diplomat in question isn’t German. But whoever it is, they have a point. There is no way that the European periphery will go quietly, resigned to their second-tier fate and their third-tier currencies. And without their consent, this idea is going to get very messy, very quickly. Even if it never happens, simply debating it could suffice to cause enough intra-European mistrust and vitriol that the markets simply cease lending to all but the very safest borrowers. And the ECB can’t lend to everybody.

Meanwhile, Silvio Berlusconi has turned himself into a lame duck, and is being as obstructionist as possible with respect to allowing his successor to do his job. In fact, it seems at the moment as though new elections won’t take place before February — which is far too long as far as impatient markets are concerned.

If you haven’t read it yet, you should really check out Mark Carney’s speech from last night in London, on the subject of global liquidity — something he describes as “the Keyser Söze of international finance”.

If you die, the proximate cause of death is always the fact that blood has stopped flowing to the brain. Similarly, if you’re in a crisis, the proximate cause of the crisis is liquidity, or rather the lack of it. You can be insolvent for as long as you like, so long as the money keeps flowing; it’s only when the money stops that things come to a head.

And we’ve reached the point, in Europe, at which the money has stopped flowing. Barclays has already declared that Italy is “beyond the point of no return”, and Greece hasn’t been able to fund its deficits either domestically or in the international markets for ages now. This is what happens in crises: the money stops, and then governments and central banks are faced with a choice. Do they step in, lending freely where private actors fear to tread? That’s the right thing to do if what you’re facing is merely a liquidity problem. But if it’s fundamentally a solvency problem, then layering on extra debt just makes matters worse.

And in Europe, of course, the governments are as likely to be part of the problem as they are to be part of the solution — if there is a solution, which is looking increasingly improbable.

All of which is to say that there are going to be many more days like this. Europe is becoming increasingly unpredictable: the crisis has claimed the scalps of two prime ministers in the past week, and they surely won’t be the last.

Martin Wolf says that the eurozone is unlikely to survive. Paul Krugman is saying the same thing. I’ve been saying it too. But one thing’s for sure: a euro breakup is emphatically not priced in to markets. So fasten your seatbelts: it could come sooner than you think.

Sometimes the conventions of dead-tree newspapers are much more effective at getting a story across than the same article on a website. Landon Thomas’s 1,100-word piece on George Papandreou is a case in point: you can work through the whole thing, or you can glance at it in the paper, where a pair of sub-heads do the job rather effectively. “Prime Minister Lacked Forcefulness” says one; the other tells us that “a leader proved unable to connect with constituents.”

Meanwhile, a similar prime ministerial ousting seems to be taking place in Italy, where the highly forceful Silvio Berlusconi — a man who connects viscerally with his constituents — looks as though he might get pushed aside in the national interest much as Papandreou was.

What we’re seeing here is the crucial role that national leadership has to play in sovereign debt crises. There have been questions over Italy for a while, but conventional wisdom has generally had it as being either the third or the fourth of the PIGS dominoes to fall. Instead, it now looks as though it’s falling so fast it could even, conceivably, overtake Greece.

The amorphous blob known as the “international community” — as represented by the likes of the ECB, the IMF, and even the US Treasury — is playing a dangerously technocratic game in Italy, largely oblivious to the enormous tail risks involved. The general idea seems to be that Berlusconi is a massive liability, but that underneath it all, the fiscal program he’s being forced to agree to is a good one. Kick him out, install a more professional technocrat, and all should be fine.

But just look at Greece, and the fate of Papandreou — the very model of a modern professional technocrat. When the populace is revolting and the government is imposing tough choices on its citizens, you need someone in charge who can do more than navigate committees and corridors in Brussels and Washington. In fact, that kind of thing is best delegated to finance ministers and central bank governors. The leader of the country has a much more important job — which is to lead the country.

I’m thinking here of Brazil, which managed to come out of its own debt crisis, in 2001, thanks to some very smart and able technocrats at the finance ministry and central bank. But — and this is crucial — it was also led by a popular and charismatic leader, who managed to persuade the country that he was acting in its best interests. There are many people who deserve credit for the fact that Brazil avoided default in 2001-2, but Lula — an uneducated union leader without a technocratic bone in his body — has to be at the top of the list.

At the same time, and crucially, Lula had the full support of the international community in everything he was doing. At no point was any entity as powerful as the ECB or the German government using sticks, threatening to force him into default if he didn’t do what they wanted. Everybody understood that their interests were aligned, and that it would be best for all concerned if they tried as hard as possible to work with rather than against each other.

And this is why the current Europe crisis is looking so bad. Interests aren’t aligned at all: everybody wants to push the costs of the crisis onto someone else. And in the past couple of weeks, things have gotten significantly worse: the northerners have started quite explicitly threatening the southerners with a lack of cooperation and the consequent inevitable default if they don’t pick up their game.

This is a strategy which is almost certain to end badly. It can work in the short term — but only in the very short term. Because if the markets think there’s a serious risk that the Eurozone powers might let Italy fall, then they will simply walk away. And suddenly the entire burden of financing Italy’s budget deficit for the foreseeable future will fall on the ECB, Germany, and the rest. Which is a situation which is simply unsustainable.

Or, to put it another way: Europe has a leadership problem raised to the 17th power. One weak or bad leader — Papandreou, or Berlusconi — can suffice to hole the euro project below the waterline. But parachute in the best of all possible leaders into Greece and Italy, and you still have a problem. There’s Germany, and France, and the ECB, and even the likes of David Cameron and Tim Geithner meddling where they’re not really welcome. And the only way that this crisis can work itself out effectively is if they all agree on the same solution.

But the essence of leadership is, well, leading. It’s not simply agreeing to do the same thing that the other 16 guys want to do. In Brazil, Lula set the course, and the international community — as well as his own technocrats — implemented it and made sure it worked. There was no doubt who was in charge. In Europe, no one has a clue who’s in charge, and 17 different people all want to set the course. Which means, I fear, that it’s doomed.

This is beginning to feel like 2008, complete with all the rumor and chaos and volatility we saw back then. MF Global is a bit like those Bear Stearns hedge funds which went bust — an isolated datapoint in one respect, but ominous in many others. And right now the best case scenario is that Greece ends up being Bear Stearns, rescued by an international community petrified of what might happen in the event of a chaotic collapse.

But Greece being Greece, of course, a chaotic collapse has to be pretty much an inevitability at some point.

Of the many ways in which the euro project was fundamentally misguided, this might be the proximate cause of its demise: it was never robust to the messy world of political reality. And in the real world, people — including heads of state — make stupid decisions all the time.

So it’s a bit silly, frankly, second-guessing George Papandreou’s fateful decision to call a referendum on the latest Greece bailout. It might not have been the most statesmanlike thing to do, but the fact is that, judged by the standard of most Greek prime ministers, Papandreou’s pretty much the best that Europe could reasonably hope for. (Just think: Greece could be run right now by someone more like Silvio Berlusconi. Or, for that matter, Jon Corzine.)

In Greek tragedy, humans don’t rise above events to triumph; rather, they are crushed by forces greater than themselves. (It’s one reason why The Wire was such an innovative piece of television: it reached back past that great humanist, Shakespeare, to his Greek antecedents.) The architects of the eurozone displayed classic hubris: they saw the increasing economic ties between the various countries and locked themselves in to a momentum trade where such ties could only ever strengthen and never weaken.

And in the event it took much less time than even the skeptics had anticipated before that hubris resulted in the inexorable nemesis.

There is a decent chance that the G20 summit will somehow muddle through in Cannes. There’s even a possibility that Greece will manage to extract itself from its current political mess, implement the reforms that Merkel and Sarkozy are insisting on, and live to collapse some other day.

But at this point I see no sign of the pan-European unity at the head-of-state level which is needed to preserve the eurozone project over the medium term. Commeth the hour, commeth the backbiting and finger-pointing and recriminating. Greece is going to default and leave the euro; the only question is when. And when it does, the EU will find that its protections against contagion are about as effective as that $1.6 billion tsunami breakwater in Kamaishi.

Greece can fall and the eurozone can still survive. But Italy — which is just as politically dysfunctional as Greece — can’t. Which is why those Olympian forces will ultimately spell the end not only of Greece’s membership in the euro, but also of European monetary union more generally.

Bloomberg View’s Mark Buchanan has been taking a long, hard look at a 2009 paper by Italian physicist Stefano Battiston, Joe Stiglitz, and others; he explains what it says quite clearly and accurately on his personal blog. Basically, the paper quantifies the concept of “too interconnected to fail”: when you have a financial system with lots of banks, all of which have exposure to each other, then the system itself becomes much more fragile.

Here’s the chart:

What you’re looking at here is a blue-dotted “baseline”, where the probability of failure falls steadily as the number of counterparties goes up, and a sold-red reality, where a few counterparties help, but a lot of counterparties only serve to reinforce trends, exacerbate downward credit spirals, and generally increase systemic fragility.

So far so uncontroversial. But equally, there’s absolutely nothing in this paper to justify Buchanan’s Bloomberg headline: “Credit-Default Swap Risk Bomb Is Wired to Explode”.

There’s a germ of an interesting point in Buchanan’s column. Because the CDS market is unregulated, no one knows the degree to which it makes this syndrome worse, and exacerbates the interconnectedness of the financial system as a whole. So there’s a strong case to be made for moving the CDS market onto exchanges, where it can be watched far more closely.

But the paper Buchanan’s talking about never mentions the CDS market at all. And although Buchanan talks a lot about credit default swaps in his column and in his headline, the fact is that all of his points apply to just about any kind of interconnectedness. The paper concentrates on credit — the interbank market, basically. Buchanan extends that to credit default swaps. But most interbank derivatives exposure is not CDS related, and most of Buchanan’s points about CDS also apply, mutatis mutandis, to derivatives exposure more generally.

And this is far from convincing:

What reduces risk for individual institutions in small quantities spells trouble for the larger banking system when pushed too far. This is especially worrying when you consider that the number of CDS contracts outstanding on European sovereign debt has doubled in only the past three years, even after the AIG catastrophe. We don’t know if similar dangers lurk in the network of CDS contracts that links European banks with one another, as well as with banks in the U.S. and elsewhere.

Firstly, the amount of CDS written on European sovereign debt is tiny. Yes, it has increased over the past few years, as the Euro crisis has gotten steadily worse. These are called credit default swaps, after all: you only care about them insofar as you care about creditworthiness, and up until a few years ago European sovereign creditworthiness was not really an issue on the radar. But the European sovereign CDS market is still very much a backwater as far as the CDS market as a whole is concerned. (You can see one reason why when you look at Greece, where it looks very much as though in the first instance there’s going to be a sovereign default without a credit event.)

And secondly, we do know, pretty accurately, how much CDS protection has been written on European banks. We know this for the same reason that we know how much CDS there is outstanding on Greece: the DTCC does a very good job of keeping track of such things.

One of the interesting lessons of Lehman’s bankruptcy was that its CDS settled without a hitch, despite a lot of apocalyptic forecasts on the subject. That doesn’t mean the CDS market is fully robust, of course: it’s just one datapoint. But in the wonky world of counterparty hedging, the kind of effects that Buchanan is talking about are the first and biggest worry facing any desk. They’re not some kind of forgotten detail; they’re the whole reason why counterparty hedgers are in such demand in the first place.

It’s fair to say that CDS are more problematic than other derivatives in terms of interconnectedness issues, because of the “jump risk” involved and the fact that moves in CDS prices can themselves cause worries about a bank being close to failure. But it’s not fair to say that there’s a “risk bomb wired to explode” here. Banks don’t, in point of fact, hedge their European sovereign credit risk in the CDS market — if they did, the European sovereign CDS market would be much bigger than it is. And sovereign-debt crises are always banking crises, regardless of whether CDS even exist or not.

So while it’s fair to say that a sovereign crisis in Europe could threaten the entire banking system, it’s not fair to blame that fact on CDS. It would be true even if CDS had never been invented.

All the talk about sovereign CDS of late — pegged off the fact that the Greek restructuring might not trigger an event of default — is I think missing three big points. First, why ISDA’s rules make sense. Second, why Greece’s CDS spreads are still extremely wide. And third, what sovereign CDS are used for.

But before we get to any of that, it’s important to understand the big picture. Greece has a lot of private-sector debt; most of it is held by banks. There is a small amount of sovereign CDS outstanding, which references that Greek debt. To give you an idea of the orders of magnitude here, we’re talking about roughly €200 billion in Greek bonds, and less than €4 billion in net CDS exposure. Even if all of the net CDS exposure was held by bank creditors, it wouldn’t remotely offset the write-down they’re going to have to take on their bonds.

In reality, the banks have de minimis net CDS exposure. They might trade the CDS, and have either a long or a short position on their trading books at any given time, but they’re not using the CDS to hedge their bonds.

Those bonds are freely tradeable: if at any time a bank wants to reduce its exposure to Greece, all it has to do is sell some of its bonds. Doing so would almost certainly involve taking a loss, of course, since the bonds are trading at about 40 cents on the dollar. Which is why the banks are even thinking about accepting an offer at 50 cents.

And in fact, an offer at 50 cents is exactly what Greece is going to give them. Although it’s not really 50 cents in cash; it’s 50 cents in partially-collateralized new Greek debt, which your guess is as good as mine where it will trade if and when any exchange is finished.

The banks may or may not have much of a choice when it comes to accepting Greece’s offer. Some of them are having their arms twisted extremely hard by their respective governments, and feel that they have to do what they’re told. Others are more prone to asserting their independence. Again, it’s going to be a while until it’s clear what the final outcome of any exchange offer will be. But one thing I can guarantee you: there won’t be 100% take-up. In fact, there almost certainly won’t even be 90% take-up. All we know for sure is that if and when this exchange offer comes along, some bonds will be tendered into it, and others won’t be.

Now the way a credit default swap or an insurance contract works is that it’s contingent on some bad event happening out there. If that bad event happens, then you get paid out. The person who owns the CDS or the insurance contract is a passive player in this game — they can’t unilaterally determine whether there’s a payout. So the event of default cannot be a decision to tender a bond into a bond exchange — because that decision is taken not by the debtor but rather by the creditor. Debtors can offer to buy back their debt any time they like, at any price they like. That’s not a credit event, it’s a market.

Now if the offer to buy back the debt is coercive, then things change. But again, the question is who is doing the coercing. Is it the debtor? Is Greece promising to do unspeakable things, under Greek law, to any holders of outstanding bonds who don’t tender into the exchange? Is it threatening to default on those bonds? Is it going to take actions which make the bonds untradeable? If so, then we’re looking at a credit event, since bondholders would be damaged greatly either way.

On the other hand, if it’s France and Germany and other European governments who are being coercive, things change, because the coercion is creditor-specific. It’s in the fundamental nature of bonds that they’re fungible: if we both own the same Greek bond, then anything which is true of my bond must be true of your bond. (I believe this is related to Leibniz’s law of the indiscernibility of identicals, but let’s not go there right now.) France and Germany might be able to twist the arm of BNP Paribas or Deutsche Bank. But if I’m sitting at home in New York with a few Greek bonds in my brokerage account, I’m not going to care very much what Sarkozy or Merkel say. No matter how much they scream and shout, that screaming and shouting can’t constitute a credit event on my bonds.

So let’s wait until Greece does something coercive which seriously damages its outstanding bonds. At that point, we can declare a credit event, and move on.

And that’s going to happen: all you need to do to understand that is to look at where Greek CDS are trading. The tender offer itself might not be a credit event — although it might, if Greece starts larding it up with exit consents and the like. But at some point, there’s going to be a credit event on those reference obligations, if only because no European politician is going to stand for free riders holding on to their old Greek bonds and happily cashing coupon checks at 100 cents on the dollar. Once Greece has swapped out most of its old bonds for new ones, don’t for a minute expect that the holders of the old debt will be free and clear.

And if you want to take the Greek government to Greek court for the money they owe you under Greek law — well, good luck with that. Basically, post-exchange, the cost of default for Greece is tiny. So there’s no reason for Greece not to do it.

Sovereign CDS aren’t dead, then — they just take a little longer to pay out than some people in a hurry might like.

And that’s fine, for the kind of people who actually use sovereign CDS for anything beyond purely speculative reasons. These instruments aren’t used by banks to directly hedge their Greek bond exposure. Instead, they’re used by institutions who are financially exposed to the country of Greece, and who want to hedge their country risk. If you do a lot of business in Greece, or if you have a lot of receivables from there, or if you partner with Greek companies whose failure would hurt your business — then there aren’t many ways of hedging that exposure, but Greek CDS is one of the best of a bad bunch.

Greek CDS is useful even for hedging indirect exposure — a small holding of Greek CDS, for instance, can partially help offset a larger and vaguer exposure to the eurozone as a whole.

And the market in Greek CDS has been pretty efficient when it comes to this role. As Greece has got ever riskier, the price of buying credit protection on Greece has risen, and people owning that protection have made money. That’s the way it’s meant to work.

The only reason that Greek CDS spreads didn’t spike when the latest euro bailout was announced is that they were essentially already pricing it in. If and when Greek CDS spreads come down even as Greece’s creditors are forced to take a 50% haircut, I’ll concede that the sovereign CDS market is broken. But for the time being, it seems to be working OK.