About 10 minutes into the 2003 comedy "Team America," spy chief Spottswoode brings his star recruit for a ride in a flying limousine.
"A limousine that can fly," says the recruit. "Now I’ve seen everything."
"Really?" asks Spottswoode. "Have you seen a man eat his own head?"
"No," the recruit answers. "But I’ve seen the European Financial Stability Facility."
He doesn’t actually say that, but he would have if he had seen the EFSF, which is the largest of the emergency lending facilities that the European Union set up last year to provide a safety net for faltering EU economies — primarily Portugal, Italy, Ireland, Greece and Spain, or the "PIIGS" if you prefer. It’s backed by 16 of the 17 Eurozone countries, and because it’s backed by sovereign debt, it’s another troubled Triple-A entity. In 2013 it will be replaced by the European Stability Mechanism, which also takes over the tasks of another emergency lending facility, the European Financial Stabilization Mechanism (EFSM).
But here’s where it gets weird: More than two-thirds of the financial backing comes from four countries: Germany (27%), France (20%), Italy (18%) and Spain (12%). Italy and Spain, the third and fourth largest economies in the Eurozone, also are among the five most financially troubled, yet are responsible for nearly 40% of the guarantees. As we go to press, France also is taking heat, and the other PIIGS are contributing to the bailout fund — calling into question the validity of more than 60% of the bailout fund. All European governments pumped billions into their ailing banks during the liquidity crisis, leaving public-sector bonds exposed to the credit risk of banks that are required to hold those same public-sector bonds as collateral.
On Aug. 2, the same day the U.S. government averted default, markets shifted their attention to Europe in general and the health of Greece, Italy and Spain in particular. The result: Risk premiums on Italian and Spanish bonds surged to record highs, and bank shares plummeted, bringing the euro down against the dollar and other currencies.
Within a week, the European Central Bank (ECB) had gone on a multi-billion-euro buying spree of Italian and Spanish bonds — a practice previously reserved only for Greece, Portugal and Irleand. That drove down the risk premiums on the debt of those two countries, but signaled increased volatility in the weeks ahead.
The market’s "discovery" of such heavy debt and the self-swallowing nature of the EFSM resulted in the kind of sudden shift to long-known but ignored information that has defined the relationship between the dollar and euro since the credit crisis hit in earnest — even as both currencies have slid sustainably against the Swiss franc (see "The dollar-euro-franc triangle," below). It is likely to underlie trading in all markets for the foreseeable future.
"There are so many wildcards in this market now and also so many well-recognized problems that the market only seems to focus on one thing at a time, and traders will do best by just figuring out that week’s focus," says Jessica Hoversen, a foreign exchange and fixed income analyst at MF Global in New York. "It’s an odd market, and one that seems incapable of multitasking."
It’s also the kind of market that keeps David Hiscock up at night. As deputy head of regulatory policy and market practice for the International Capital Market Association (ICMA), he’s one of the people tasked with keeping an eye out for new systemic risks, and he believes current capital requirements have created one of head-swallowing proportions.
More specifically, he’s concerned about capital-requirement rules that focus on liquidity buffers, which are the liquid assets that banks have to keep on hand for disasters. Generally speaking, those buffers are supposed to be comprised of sovereign debt because sovereign debt is something that is both safe and easy to sell in a pinch.
"This works well if one bank is having a problem, and the problem is related to the bank," he says. "But what if the banking system itself is having a problem, and the banks’ sovereign has assumed risk on their behalf, which drives down the value of the sovereign debt, which forces the banks to take losses on the paper of the sovereign debt that they are forced to hold…?"
Beyond the PIIGS
Ten years ago, the Organization of Economic Cooperation and Development issued a glowing report on the future of the Greek economy — with an embedded cautionary tale. Published in May 2001, "Regulatory Reform in Greece" lauded the government’s efforts to reduce red tape and predicted a roughly 10% boost in GDP if the country could abandon its protectionist ways, attract foreign investment and fix its bloated bureaucracy.
As we all know by now, the country not only failed to achieve those objectives, but even failed to achieve many of the objectives it was credited with having achieved in the first place. About the only thing it seems to have done well is cook the books that got it into the Eurozone.
It wouldn’t be so bad if Greece and the PIIGS were the only problem, but France, Europe’s second-largest economy, is carrying massive public-sector debt (84% of GDP, compared to just 64% for the United States). Any default on a loan from the EFSF will increase the amount of debt carried by the countries that back it, and traders have been treating French bonds as equivalent to those of the EFSF, while continuing to cut Germany slack. From early July to early August, for example, the spread between the German bund and the EFSF’s 3.375% July 2021 bond widened from less than 60 basis points to more than 90, and equivalent French bonds followed — from less than 40 to almost 80.
"This is the kind of nightmare that has everyone on edge," says Holger Schindler, who manages currency risk for Hanseatisches Logistik in Hamburg. "French bonds should not be tracking EFSF, but they are — because people are scared."
Germany’s burden
The latest Greek bailout under the EFSF came in July, and is built upon a promise to include the private sector, mostly in the form of a 21% "voluntary" haircut on Greek bonds. Philipp Rösler is the man charged with selling that deal to the German private sector, and his is a name that traders likely will hear more and more often in the months ahead. He serves both as Germany’s vice chancellor and its federal minister of economics and technology as well as head of the relatively free-market-oriented Free Democratic Party. He has promised to keep public-sector involvement to a minimum. Early on, he was one of the people touting a €37 billion ($53 billion) private-sector contribution based on an apparently groundless assumption that 90% of the banks being pressured to participate would go along. When pressed for a number in early August, however, he refused to give one.
"The fact is that no one really knows how much the private sector will pitch in or how much this will all cost," Hoversen says. "This thing will keep markets guessing for a long time."
New bond contracts?
Futures traders have a variety of stocks, bonds and currencies they can trade, with one of the more interesting possibilities also being one of the newest: Namely, Italian government bonds on Eurex. The exchange launched futures on the long-term Euro Buoni del Tesoro Poliennali (Euro BTP) in September 2009, and added futures on the short-term instrument in May of this year. Both trade on the same platform as Eurex’s well-established German bonds (Bund, Bobl and Buxl), making it easy to spread German debt against Italian debt.
Euronext also is exploring the creation of continental interest rate products to compliment its Euribor and Gilt contracts, but hasn’t put anything into production yet.
"The idea of one single cohesive European yield curve obviously doesn’t hold together anymore, and what we have now is more like the market for American state and municipal bonds, where California trades in a way that is completely different from states with fiscal rectitude and so on," says exchange consultant Patrick Young. "Here in Europe, we’ll likely see more bond products in futuresland, but it won’t be 20 or even 10 new products; instead, it probably will be something like one high-quality benchmark, one medium benchmark and one absolutely lousy quality benchmark."
Indicators
With fear being the driving force in this market, Hoversen advises keeping an eye on anything that ratchets up stress in Europe. Credit default swap spreads have been one of the most widely followed such indicators, but she also advises looking at ECB tenders and the issuance of commercial paper.
"This isn’t a liquidity crisis, it’s more of a solvency crisis, but fear of insolvency could be expressed in tight interbank funding," she says. "So, look at three-month ECB tenders and seven-day tenders. If those start getting substantial subscription, it would suggest that banks aren’t lending to each other."
She also advises following the issuance of foreign financial commercial paper, which is short-term paper issued by foreign financial firms in the United States. Non-U.S. banks use such paper for short-term funding, and the freezing of that market requires banks to go elsewhere to fund obligations.
The United Kingdom has chosen austerity over stimulus, and that doesn’t bode well for the pound, at least not in the short-term.
"Data is weakening in Europe, but the core data is still better than in the UK," says Hoversen. "The scope for interest rate hikes is also higher in Europe, given the ECB’s mandate for price stability."
Eventually, she says, the UK’s austerity will pay off — but when is anyone’s guess.
Regulatory reform deferred
Adding to — and flowing from — the uncertainty are delays in long-planned regulatory reforms.
"Senior officials are distracted by the credit crisis, and these are the same officials who would be driving forward decisions on regulatory reform," says ICMA’s Hiscock, who points out that many of the same issues plaguing Dodd-Frank in the United States have given pause to the Markets in Financial Instruments Directive (MiFID) and the European Market Infrastructure Regulation (EMIR), both of which were supposed to be finalized in the summer but now are on hold.
Broadly speaking, MiFID relates to markets while EMIR is the implementing mechanism for the G-20 agreement to move OTC derivatives onto clearinghouses. Both are part of larger reforms that also include an updated Market Abuse Directive and a new Capital Requirements Directive (CRD) designed to reflect new Basel II requirements. These separate initiatives do what Dodd-Frank does, and the fragmented approach has led to several instances of duplicate and even contradictory legislation.
EMIR, for example, has exempted certain hedgers from the central clearing requirement, but the current iteration of the CRD imposes capital requirements that essentially negate that exemption.
Furthermore, says Hiscock, regulators and practitioners alike are coming to fear the unintended consequences of a surge in demand for whatever is defined as adequate capital.
"The total amounts of collateral that may have to be mobilized is a large sum of money, and there’s going to be a scarcity of high-quality collateral," he says. "More work needs to be done to ensure that an adequate supply of adequate assets is available."
Regulators even are rethinking the wisdom of pushing too much business onto clearinghouses.
"There is a lot of debate now on the potential for CCPs to act as risk concentrators," he says. "We all know the old argument about how we’d be creating efficiency in netting by allowing some optimization of offsets in contracts across the market, but in reality that won’t be captured because different regulators want CCPs to be in their own territories."
EMIR currently does not contain a provision for guaranteeing CCPs, but several lawmakers have suggested extending them access to central bank liquidity.
"We may be solving one problem and replacing it with another one," Hiscock says. "Can you imagine a few years down the road being told that CCPs are too important to fail?"
