Coda: European Kool-Aid

February 28, 2017 11:52 AM

It might seem a bit redundant to revisit European partisan Kool-Aid consumption after our posts of the past two weeks. Yet, there is another development outside of the previously explored persistent weakness of the Greek economy and seemingly intractable nature of its debt dilemma: the process and proposed solution to rescue Italian banks. And the weakest is the poster child for the problems not only to date, yet also how the proposed "solution" might backfire. That is, of course, regarding Banca Monte dei Paschi di Sienna SpA (MPS.)

The contingencies now plaguing the rescue of the world’s oldest (founded 1472) and Italy’s third largest bank are nothing less than dizzying. Along with July’s extended hard deadline for the next phase of the ongoing Greek bailout, this threatens to drag the European Union (EU) and Euro-zone back ‘through the looking glass’ once again.

Not a lot of press at present

It is reasonable to ask why these combined stressors are not commanding more attention in the financial press at present. A good question, for which our friends in Europe have an obvious answer: the upcoming elections (in order of appearance) in the Netherlands, France and Germany. While the latter will likely see German economic success provide Angela Merkel a solid victory, the other two are much sooner and at the margins more likely to deliver populist victories.

The Netherlands is early, with the vote on March 15 being led by Far-right anti-EU leader Geert Wilders’ Party for Freedom (PVV) leading in the polls. The only saving grace for the centrist political parties is that the Netherlands relies on coalition governments, and most political parties have sworn not to work PVV. This is one distraction from any technical developments in Greece and Italy. Yet any delay may be negative for the EU, Euro-zone and International Monetary Fund (IMF) Greek bailout funding agreement.  

Considered far more important is the two round French Presidential election on April 23rd and May 7th. Here as well the extreme populist National Front leader Marine Le Pen is polling much better than had been expected as late as mid-2016. Also an anti-EU and anti-euro crusader, she ultimately has a much lower chance than Mr. Wilders of winning in the final runoff. Yet after Brexit and Trump, this is a primary focus that can capture all of the attention versus the technical aspects of the Greek and Italian financial rescue efforts.

Through the Looking Glass

In Lewis Carroll’s 1871 novel “Through the Looking Glass” the Mad Hatter explains to Alice why he and the March Hare are always having tea. Even though the Hatter escaped decapitation after he offended the Queen of Hearts, ‘time’ (referred to as "he" in the novel) halts himself in respect to the Hatter. That keeps the Hatter and the March Hare stuck at 6:00 p.m. forever: Tea Time.

When Alice arrives at the tea party, the Hatter is characterized by switching places on the table at any given time, making short, personal remarks, asking unanswerable riddles and reciting nonsensical poetry. This is much like the ever-shifting positions of the Euro-zone creditor nations. For more on that see the graph of the historic shifts in the EU’s Greek GDP projections in last Thursday’s EU & IMF: More European Kool-Aid post. It seems their modus operandi is ‘anything to avoid further Greek debt forgiveness.’ 

All of this eventually drives Alice (the IMF) who is insisting on more realism away from the table. Meanwhile the March Hare (a reference to irrational seasonal behavior) is Greece itself. After all, what else but a bout of madness could have led to the Tsipras government throwing in with the creditor nations against the IMF? What the Greek government misjudged was the flexibility of the creditors’ demands (they were not.)

The creditors were offering only unrealistic reform demands and unachievable Greek GDP growth projections against the more realistic IMF request for effective debt forgiveness that is obviously in the Greek’s interest. Yet having made its political bed with the creditors, Greece can only maintain credibility by (insanely) agreeing it might be able to achieve the growth targets (with more on that as well in last Thursday’s post.) 

Euro-zone Banking Problem (Again?)

Well, obviously in this case it is ‘still’ rather than truly ‘again’. We are referring to Italy and its still weak banks. As noted above, the poster child for that is Banca Monte dei Paschi di Sienna SpA (MPS). The contingencies now plaguing its rescue are dizzying.

In December the Single Supervisory Mechanism (SSM, ECB’s supervisory wing) controversially rejected MPS’s plea for more time to deliver on a €5.0B plan to raise fresh capital, and increased the amount of capital the lender needed to raise to €8.8B. According to an article in Last Thursday’s Financial Times (FT), “The (SSM) believes it is waiting for Brussels to agree a plan to restructure MPS and approve state aid. Yet Brussels, in turn, thinks it is waiting for the supervisors to agree a capital plan with MPS before it can finalise restructuring terms.

“One person involved in the process called the situation ‘surreal’.” 

The ‘Bail-In’ canard

Surreal indeed. And even that procedural dysfunction does not begin to review another key issue which lies at the heart of the received wisdom. That is the entire process (in use for the past five years) of the previously very selectively applied “creditor (including depositors) ‘bail-in’.” That is where a bank which is in trouble must receive some funding from a percentage of funds in depositors’ savings accounts along with losses of bond holders to qualify for state aid.

Those funds would be confiscated (even if some interest in depreciated securities might be provided) in the case of MPS to cover previous and projected losses by the bank prior to any taxpayer funds being utilized.

All we can say to that is, “Are you kidding?!” Yet this is now part of the assumptions on the next steps for any MPS rescue. From that same FT article…

“A document on the Bank of Italy’s website sets out the reasoning behind the new €8.8bn figure — including detailed information on how much the Italian state could contribute to the capital raising and how much must come from retail depositors under the terms of the EU’s bail-in rules.”

That is immediately preceded by, “‘The biggest test [facing the SSM] is clearly Italy,’ said Nicolas Véron, a senior fellow at Bruegel, a think-tank in Brussels. ‘A corner was turned with the refusal to extend the MPS plan, but things have been very slow since then . . . If we don’t see something soon, there will be a big question mark.’”

Track Record Not Encouraging

You’ll pardon us if we feel the inability to more rapidly advance a plan to confiscate a portion of the retail depositors’ funds is NOT the big question mark here. The real question should be what happens to the depositor base of an already ailing institution if the retail depositors suddenly feel their funds are not safe. This is definitively through the looking glass from the longstanding opposite situation: security provided by depositor guarantees that had always encouraged holding money in retail savings accounts.

Yet it seems the European powers-that-be have all convinced themselves that bail-ins can work, and are a net benefit due to the taxpayer protection they provide. We need to allow there have been a limited number of bail-ins of smaller banks in Spain and Portugal where the retail depositors were more upset in the latter due to the extent of the rescue that hit their accounts versus major international operators.

And already in Italy, four small banks bailed-in subordinate debt holders and unsecured depositors. The latter accused the banks of not clearly articulating the risks in the bail-in securities they received. Needless to say there has never been a bail-in that has been well-received by previously better protected bond holders and, of course, the plain old retail depositors.

The key point here is that this has never before been attempted at an institution of both the size and likelihood of a weak capital structure remaining as MPS. According to Bail-In Tracker, in the original smaller Danish Institute Amagerbanken bail-in back in 2011, “The bail-in threat caused a discernible rise in funding costs for smaller Danish banks and induced a creditor flight from the country’s banking sector.”

So what happens if an institution the size of MPS spooks depositors and bond holders by skimming off even a slight percentage of their holdings? Our snide, sarcastic view could be a rare specific equities sector recommendation: BUY European mattress makers. On a more realistic note, what if the ‘bail-in’ assumptions are as upside-down as we suspect they might be? Might this end up being the sort of ‘rescue’ exercise that is actually the equivalent of tossing the drowning entity an anchor?

The Law of Small Numbers

One of the most telling and earliest "judgment under uncertainty" aspects Michael Lewis highlights in his recent “The Undoing Project” after the biographical backgrounds of brilliant psychologists Daniel Kahneman and Amos Tversky research is the risk of inferring major conclusions from very limited data sets. In fact, the ‘Law of Small Numbers’ is a bit of a misnomer, as what it really says is, “Don’t trust small data sets to say anything reliable about the more general condition in any given area.” There is a good reason ‘big data’ has become, well…big.

And on current form the European bank regulation and state supervised rescue organizations seem to be counting on no really negative broader result coming from what have been very limited bail-ins. That would support their idea this can be applied to a Monte dei Paschi di Sienna…Italy’s third largest bank.

This reminds of us of how a bit of blending of subprime mortgages into a select number of Mortgage Backed Securities (MBS) in the U.S. led to tragedy in the intermediate term after it seemed alright in limited instances. Expanding the approval of subprime mortgages and giving MBS AAA debt ratings was based on faulty ‘small numbers’ assumptions.

Small Numbers Kool-Aid

The American Kool-Aid that supported massive expansion of such a specious ‘small numbers’ success was the idea that U.S. housing prices had always, and would always only move higher. Part of the current European Kool-Aid (in addition to Greek GDP projections) behind the ‘received wisdom’ on the current, only temporarily stalled, MPS rescue plans is that very limited previous bail-in examples are indicative of the future.

However, if as in the Danish example the bond buyers and especially retail depositors forced to contribute to the bank’s rescue flee such a much more important institution, what then? We are not trying to say there will definitively be a crisis sooner than not. Yet there is latitude for higher risk in what has become well-entrenched ‘received wisdom’ suffering from that reliance on the previously very limited tests ("small numbers.") What happens to the depositor base or external funding costs? It seem we are going to find out sooner than not.

Is the IMF Gaming the EU?

On another aspect of European Kool-Aid consumption and potential future EU problems explored in previous posts, we return to the Greek Debt Dilemma. And it is a only a ‘dilemma’ at present instead of a ‘crisis’ due to there being a bit more time for study and discussion prior the final ‘crunch point’ in July. Yet the problems persist in spite of the EU and IMF blowing off a self-imposed deadline to reach agreement last week Monday.

This classic case of "kick the can" seemed a bit odd in the wake of such a continued (for almost two years now) and recently more definitive IMF case for further significant debt forgiveness for Greece. That was the reason for our near-term assessment that the anti-Greek debt forgiveness European minority on the IMF board had won out over the pro-debt forgiveness non-European majority. Or has it?


As a major international NGO (non-governmental organization) the IMF has a long history and much expertise in diplomatically finessing the crosscurrents of divergent opinions and plans. Achieving an agreement into last Monday’s self-imposed EU-IMF deadline for the next round of Greek Bailout funding would have been impressive. Yet as it was indeed self-imposed, it is neither a tragedy nor a crisis that no agreement was reached.

There is still quite a bit of time to go prior to the real deadline (July’s scheduled Greek debt repayment.) So, in agreeing to consider and study further whether the creditor nations’ very upbeat projections are possibly achievable, the IMF can allow them the luxury of more time to quaff the ‘Kool-Aid’ that assists them in believing they can avoid providing Greece more significant debt forgiveness.

Yet as a diplomatic organization, the IMF might also be figuring that in can indeed do just that… play for a bit more time, and evidence. With so much sound and fury from the creditors (including a column in the February 9th FT by ISM Managing Director Klaus Regling on how the IMF analysis was ‘short-sighted’) regarding why they were not inclined to provide Greece more relief, it was probably not ‘politic’ for the IMF to dig in its heels at this time.

Still Weak

And after the unexpectedly weak Greek Q4 GDP surprise (down 0.4% after a 0.9% Q3 rise), why not just wait for a bit more data? By April the agreed further ‘study’ by the IMF team in Greece will have a good idea of whether it remains weak into Q1. If not, it may need to go along with the EU’s higher growth assumptions (a whopping 2.7% for 2017), and join in despite its reservations.

However, if Greece exhibits further weakness or even a lack of growth in Q1 2017, then the IMF will be within its rights to tell the EU creditors their projection of 2.7% Greek growth in 2017 is just not reasonable. It will be a case of giving the other side enough rope to hang itself, and possibly having a stronger case later for more Greek debt relief rather than fighting a theoretical battle now.

Constructively diplomatic. And it will be very interesting to see what the creditors say in April if the data does not support their current position. Yet it would be wrong to think in the current political environment they will actually shift their position toward any real Greek debt relief. The Hatter will likely just pop up somewhere else at the table with some new unanswerable riddle or nonsensical poetry to justify its position.

Market Implications

Given the distended nature of these evolving EU and Euro-zone problems, it is unreasonable to anticipate any of it reaching crisis proportions in the near term. However, coming out of March into April (or possibly just a bit sooner if the EU authorities proceed with the proposed MPS bail-in in March) there is a chance that the next Euro-zone crisis will become a bigger influence than at any time since its 2010 travails.

This would create the potential for a larger equities correction than we have seen in a while, and also obviously pressure the euro currency once again. It would also be a boon to the government bond markets, especially the German Bund.

Yet we doubt that even such negative developments in Europe have the potential to derail the overall economic growth and bullish equities trends elsewhere, especially the U.S. For a better idea of why that is the case, just refer to the early February Organization for Economic Cooperation and Development’s latest set of Composite Leading Indicators (in our mildly marked-up version.

Thanks for your interest.

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About the Author

Alan Rohrbach is Lead Analyst and President of Rohr International, Inc.  He is an international equity index, interest rate and foreign exchange trend advisor. His forte is ‘macro-technical’ analysis of how fundamental influences blend with technical aspects to drive trend psychology. Clients include international banks, hedge funds, other portfolio managers and individual traders.