Fixing old toxic debt with new improved debt
There are an almost endless number of politicians, presidents and business leaders calling for a “quick solution” to the eurozone crisis, one that will “solve” the debt crisis “once and for all”. The problem however, is that each time a solution is announced it still amounts to the same thing, i.e. adding more debt to a debt crisis.
Take this weekend’s announcement that Spanish banks will receive around €100 billion ($126 billion) for example. It may have a new acronym in the form of the FROB, or Fund for Orderly Bank Restructuring, but it still amounts to using new debt to payoff old debt.
As an interesting aside, the €100 billion that will be directed at Spanish banks is almost the exact amount of capital that European banks were required to raise by this time under the emergency “three-pronged” deal agreed in Brussels last October. According to the BBC, the €106 billion which was agreed in response to the Greek crisis, was designed to help shield the banks “against losses resulting from any government defaults and protect larger economies – like Italy and Spain – from the market turmoil.”
Where will the money come from?
This latest bailout – though Spain’s Prime Minister, Mariano Rajoy, has been careful not to call it a bailout, instead he’s calling it a “victory” that will restore the “credibility of the euro” – amounts to 10% of GDP, not a small sum by any standards.
According to Luis de Guindos, Spain’s economy minister, and the man behind the nation’s bank bailout, the sole source of the bailout funding will be the European Stability Mechanism (ESM) and/ or the European Financial Stability Facility (EFSF). The ESM, which is designed to be the permanent rescue fund, is due to come into force on 1 July 2012, while the EFSF will continue in its current capacity until July 2013 after which it is due to be wound down.
The problem with the ESM is that it still has to be ratified by the German parliament, who as recently as 30 May stated that it’s firmly against using the ESM to directly recapitalise eurozone banks.
German Chancellor, Angela Merkel, has said that she is determined to ratify the ESM (and fiscal pact) before the parliament’s summer break which begins on 6 July. The situation does however leave a serious question mark over the use of the ESM in this latest bailout and rather puts the focus on the EFSF.
In October 2011 the European Council announced that the member states had agreed to increase the effective capacity of the EFSF from €440 billion to €1 trillion. However, according to some, the EFSF only contains around about €200 billion in available resources, of which €92.5 billion has been committed to the fund by Spain itself. Assuming then that the Spanish contribution will no longer materialise, and I think it’s a pretty safe assumption, the fund will have just enough cash available to “rescue” the Spanish banks, but will then be empty.
Who’s next in line?
Of course now that Spain has become the recipient of a bailout the markets will turn their attention to the next worse eurozone debtor, i.e. Italy, and if we add Italy to the list there simply aren’t the funds available in either the ESM or the EFSF to mount a rescue.
A chart produced by Ray Dalio’s Bridgewater sheds light on the colossal funding gap that would exist if, or when, Italy runs into difficulties.
Source: Bridgewater Associates
The bottom line
The bottom line is this. European banks are insolvent because they own the bad debt of insolvent European countries, and these nations are insolvent because they owe too much money. Therefore rather than helping the banking system, going further into debt in order to bail them out, actually makes the banks more insolvent.
So the policy of socialising losses continues, as does the shift away from capitalism towards corporatism, or crony capitalism. As a result investors can expect more market intervention, more bailouts, and ultimately more debasement of paper currencies.
In this environment of extreme uncertainty and heightened systemic risk a defensive stance is definitely warranted. In the short term cash is king, but no portfolio should overlook the security and safety provided by physical gold.