MacroScope

So much for the lasting power of the ECB’s 1 trillion euros in cheap bank loans. Spain is again looking like a basket-case, more because of market dynamics rather than any particular policy misteps.

Many observers have praised Spain for its willingness to implement reforms. And yet the markets have another idea. The cost of insuring debt issued by Spanish banks against default has risen sharply over the past month, as a tough budget this week did little to soothe concerns over the country’s deteriorating fiscal situation.

Default insurance for Santander is up 52 percent since March 1 to 393 basis points and the equivalent for BBVA jumped 54 percent over the same period. Both Spanish banks underperformed the Markit iTraxx senior financials index – which measures Europe’s financial institutions’ insurance, or credit default swap prices. It rose by 20 percent over the same period.

Markit analyst Gavan Nolan said a lot of the move was caused by the European Central Bank’s low-interest, three-year loan programmes, or LTROs, that have pumped money into the banking system.

They’ve actually tightened the relationship between the banks and the sovereign. So the banks have been buying sovereign debt and that has made their fortunes even more intertwined than they have previously.

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.

Wall Street-made financial instruments purportedly created to protect investors against default actually hasten corporate bankruptcies, according to a new study. And it’s not Occupy protesters bashing these credit default swaps (CDS) –  the report comes from none other than the New York Society of Security Analysts. Its findings are as follows:

We present evidence that the probability of credit rating downgrade and the probability of bankruptcy both increase after the inception of CDS trading. […]

Lenders who insure themselves by buying CDS protection help push borrowers into bankruptcy, even though restructuring may be a better choice for the firm from the conventional (without CDS protection) lenders’ perspective.

I don’t want to be the idiot who asked “is it all over?” … but is it all over?

Almost certainly not, is the answer. Greece is shored up for now but Portugal will probably need to follow it in seeking a second bailout and Spain, heading back into recession, will have to make deep, deep cuts over the next two years to meet EU deficit targets. Greek and French elections could easily upset the apple cart, the former producing a fractured government with less will to tread the austerity path, the latter a new president who wants to renegotiate the bloc’s new fiscal rules (though neither are guaranteed).

In Italy, a lot of faith continues to be placed in Monti but the proof of his ability to deliver the structural reforms needed to regalvanise the economy has yet to be seen. On that front, the Italian government is talking with trade unions during the week on radical reform of labour market rules, with the aim of clinching a deal next week.

For all the ifs and buts about the latest euro rescue agreement, one of its most profound market legacies may be to sound the death knell for sovereign credit default swaps -- at least those covering richer developed economies. In short, the agreement reached in Brussels last night outlined a haircut on Greek government bonds of some 50 percent as a way to keep the country's debt mountain sustainable over time. But anyone who had bought default insurance on the debt in the form of CDS would not get compensated as long as the "restructuring" was voluntary, or so says a top lawyer for the International Swaps and Derivatives Association -- the arbiter of CDS contracts.

ISDA general counsel  David Geen said there would be no change in the ruling to account for the size of the haircut:

As far we can see it's still a voluntary arrangement and therefore we are in the same position as we were with the 21 percent when that was agreed (in July)

So much for Germany being insulated from the euro zone’s troubled periphery. German credit default swaps are already beginning to price in the country’s worst nightmare: that it will have to pay a hefty bill for a deepening euro zone debt crisis.

The cost of insuring 5-year German debt against default rose more than 50 percent over the past month to a record high of 118 basis points.  French CDS rose  around 11 percent over the same period to 189 basis points, according to Markit data. The rise indicates investors are beginning to associate greater risk to holding German debt, even as the triple-A rated bond continues to benefit from safe-haven flows. German Bund futures saw their biggest quarterly rise between July and September since the launch of the euro.

The problem is Germany, the largest sovereign contributor to bailout funds already agreed for Greece, Portugal and Ireland, is expected to pay a high price for any solution to the debt crisis or, given its banks’ high exposure to peripheral debt, for any failure to resolve it.

It’s been a rough week for the euro zone and Italy is feeling the pain.

Despite regular purchases of Italian bonds by the European Central Bank since August — a policy aimed at keeping funding costs affordable — yields on benchmark 10-year Italian government bonds rose as high as 5.6 percent this week. Before the ECB started intervening in the secondary market, yields surged above 6 percent. Beyond 7 percent, funding costs are perceived to be unsustainable.

This raises questions over the effectiveness of ECB policy – doubts heightened  by the shock news that the central bank’s chief economist Juergen Stark would leave the institution early because of disagreements over the bank’s bond-buying policy.

The news highlights the rift inside the central bank over the handling of the worsening debt crisis. It drew a dramatic close  to a week of uncertainty: a debt swap meant to help Greece avoid default hung in balance;  a row over collateral for Greek bailout loans remained unresolved; and national parliaments had yet to ratify increased powers for the euro zone’s rescue fund.

After a round of tax cuts, fiscal expansion and other bailout plans in the United States to rescue the economy, investors are betting that the chances of a U.S. government debt default are almost equal to the probability of a default by hamburger chain McDonald's.

The cost of insuring U.S. government debt against default for five years is $48,562 a year for $10 million of U.S. Treasuries or 47.562 basis points, according to Credit Default Swaps (CDS) prices.

This compares with around $54,750 a year for McDonald's or $41,000 for telecom company AT&T.