The Titanic Is Listing

Even though the recent news from Greece promised the markets a certain degree of relief Papandreous's government remains in charge and has once again committed itself to implementing further austerity measures in order to keep the bail-out funds flowing – something is still very wrong in euro-land.

It appears that the damage from the Greek iceberg has done irreparable harm to the hull of the Euro Titanic.

The interconnectedness between various players in the financial system the Greek debt crisis has once again laid bare is now beginning to play havoc with the funding mechanisms of the euro area's banks – just as the economy appears to be slumping.



According to Bloomberg:


European Central Bank President Jean-Claude Trichet said risk signals for financial stability in the euro area are flashing red as the debt crisis threatens to infect banks.

On a personal basis I would say yes, it is red, Trichet said late yesterday in Frankfurt after a meeting of the European Systemic Risk Board, referring to the groups planned dashboard to monitor risks. The message of the board is that the link between debt problems and banks is the most serious threat to financial stability in the European Union.

Trichet, who chairs the ESRB, made the remarks as European leaders meet in Brussels to discuss how to stave off a Greek default, while preparing a second bailout. The EU is trying to avoid a repeat of the financial crisis that followed the 2008 collapse of Lehman Brothers Holdings Inc. (LEHMQ) and resulted in European governments setting aside more than $5 trillion [? – we're not sure where that number comes from, ed.] to support banks.

(our emphasis)

It is certainly possible that Trichet is overly alarmist on purpose, in order to drum up support for the ECB's demands as to how to handle private sector involvement in the Greek rescue operation. Reports on the degree to which the euro area's banks are prepared for an eventual Greek default vary quite a bit. A number of analysts have recently opined that the banks have had enough time to minimize the extent to which the fall-out of a default would threaten them. However, we would caution here that in a fractionally reserved system, the commercial banks are teetering on the edge of insolvency all the time anyway. Moreover, we would argue that the ECB knows better than anyone else what a rickety affair the euro area's banking system currently represents, as it gets to hold large amounts of toxic collateral that the banks are pawning off to it in short term repos (note that since the beginning of the crisis, the maturities for such repos have been lengthened markedly by the ECB).

As it were, we now have both anecdotal and market-based signs that the euro area banking system's funding of dollar liabilities is beginning to hit snags. We have previously remarked on the astonishing extent to which US based money market funds, in their desperate hunt for yield, have extended short term financing to the euro area's banking system (see 'Greece Continues to Pose a Major Risk' for details). Should these money market funds get into problems over this one can probably thank Ben Bernanke, whose zero interest rate policy has made it very difficult for money market funds to earn a return they deem acceptable.

However, now that it has become fairly common knowledge that US MM funds have such vast European exposure, they have reacted by cutting back on it. First the WSJ reported about the 'growing concerns' this has engendered:

As Greece slips closer to default, some U.S. regulators and lawmakers are concerned about money-market mutual funds' exposure to European banks.

While the biggest U.S. money funds have minimal direct holdings of Greek government debt, they hold roughly $1 trillion of debt issued by big European banks such as BNP Paribas SA, Barclays PLC and Deutsche Bank AG, according to industry analysts. And those banks hold piles of Greek and other European government bonds, exposing them to large potential losses if the European sovereign-debt crisis takes a turn for the worse.


Some Securities and Exchange Commission officials are worried about the situation, while the Federal Reserve is monitoring it closely, said people familiar with the matter. The House Committee on Financial Services will hold a hearing Friday with industry leaders to discuss the financial stability of mutual funds.

(our emphasis)

$ 1 trillion in exposure to euro area banks? Whoa. No wonder the Fed is 'monitoring the situation closely' (like that is going to help – just remember all the 'monitoring' it did in 2008).

As Reuters notes here, US money market funds are now getting cold feet, which clearly has implications for the European banks:

Some U.S. money market mutual funds are being forced to cut their exposure to euro zone banks due to growing public anxiety about a possible Greek debt default.

Worries over the issue prompted Federal Reserve Chairman Ben Bernanke and Federal Deposit Insurance Corp. Chairman Sheila Bair to emphasize the need for more regulation of the funds. As the Greek debt crisis intensified in recent days, money funds have been identified as a channel through which the euro zone crisis could spread to U.S. markets if Greece or another struggling euro zone sovereign were to default.

"They do have very substantial exposure to European banks and the so-called core countries — Germany, France, etc.," Bernanke said at a press conference following the Fed's latest policy meeting on Wednesday. "So to the extent that there is indirect impact on the core European banks that does pose some concern to money market mutual funds and is a reason why the Federal Reserve and other regulators are continuing to look at ways to strengthen money market mutual funds."

There are already signs of money funds reducing exposure to euro zone countries, said Alex Roever, head of short-term rates strategy at JPMorgan Securities in New York.

"There's probably some paper that's maturing, that's being allowed to mature without being redeployed, and some paper that's maturing that's getting redeployed at shorter maturities than they otherwise would have," he said. "By shortening the tenors of the investors, it puts the money funds in a position where if something does happen their exposure isn't very long."

Roever said the length of loans to European banks was dropping from three months down to one month or to overnight loans.

"The investors know these credits and they've known them well for a long time," Roever added. "When I look at where the money is today, it's concentrated in very highly rated, well-capitalized institutions." 

(our emphasis)

How 'highly rated' and 'well capitalized' these institutions are and 'how long they have known them' of course won't matter one whit if the crisis goes haywire. Recall that as of late 2007 and early 2008, both the Federal Reserve and treasury secretary Paulson assured investors that the 'US banking system has never been stronger than it is now'. For example, on March 18 2008, Paulson said:

We've got strong financial institutions . . . Our markets are the envy of the world. They're resilient, they're…innovative, they're flexible. I think we move very quickly to address situations in this country, and, as I said, our financial institutions are strong."

Those 'strong financial institutions' were all de facto insolvent about seven months later and would not have survived without the biggest taxpayer financed bailout in all of history. So every time someone tells us about how 'well capitalized' banks are that are loaded to the gills with toxic securities and loans, we should take such assertions with a big spoonful of salt.

In any case, it appears now that euro area banks will once again have to scramble for funding of their dollar liabilities if a $1 trillion sized source of funding is beginning to dry up, that is no doubt a meaningful event.

Economy Flounders, Bond Yields Keep Surging

While these troubles for the euro area's banks begin to come to the fore, we have also learned that the euro-zone economy hitherto in the main held aloft by Germany's strong economic performance has begun to flounder significantly. As it were, Germany remains the one positive holdout, but we would note that the German business confidence index has recently tumbled sharply, so this may not be true for much longer. It should be especially worrisome though that growth is decelerating sharply in France (as to why we are saying this, see further below).

As reported by Finfacts:

Eurozone growth in June is weakest since October 2009. Led by a sharp manufacturing slowdown, the Markit Flash Eurozone PMI (Purchasing Managers' Index) Composite Output Index, based on around 85% of usual monthly replies, fell from 55.8 in May to a 20-month low of 53.6 in June.

Output growth has slowed sharply since peaking in February, taking the average composite Output Index reading for the second quarter as a whole down to 55.7, which is lower than the average of 57.6 seen in the first quarter but still well above the average of 54.9 observed in the final quarter of last year.

However, the loss of momentum during the second quarter has been marked, especially in manufacturing, where output growth slowed to the weakest since September 2009. A more modest easing in activity growth was seen in services, to the slowest since December. In contrast to the trend since the recession, the rate of manufacturing expansion has fallen increasingly below that of services since April.

New business rose at the weakest rate since November 2009, led by the first (albeit small) decline in manufacturing new orders since July 2009. New export orders for manufactured goods rose only modestly, posting the smallest increase since September 2009. Inflows of new business into the service sector meanwhile slowed for the second successive month, showing the weakest rise for seven months.

Other forward-looking indicators also turned down. The index measuring expectations of service sector activity in the coming year saw the joint-largest monthly fall since October 2008, taking confidence to the lowest since July 2009. Meanwhile, the ratio of manufacturing new orders to inventories, which acts as a guide to near-term output developments, fell to the lowest since April 2009.

The rate of expansion held up well in Germany, down sharply on the strong pace seen in the first quarter but up slightly compared with May. However, the composite figure disguised a further steep slowdown in manufacturing, which was offset by faster services expansion. In contrast, growth slowed in both sectors in France, taking the overall rate of expansion down to an eight-month low.

Elsewhere in the Eurozone, outside of France and Germany, output fell for the first time since November 2009. The rate of decline was the fastest since September 2009.


Euro area business activity, as measured by PMI and Eurostat's manufacturing output data – click for higher resolution.

The output gap between the euro area's core and its periphery also keeps growing as can be seen below:


Output growth of the euro area's 'core' vs the periphery a wide gap remains – click for higher resolution.


This sudden deterioration in economic activity is certainly worrisome in light of the continuing debt troubles besetting the peripheral euro area sovereigns. The question is: how is this debt ever going to be serviced? With euro area economies either slowing sharply or plunging back into outright contraction, debt service will remain extremely difficult.

The reason why we noted above that the slowdown in France is especially noteworthy is that France's public debt is well on its way to expand into territory where it will likely become a focal point for the already nervous financial markets. France's national public audit office has just sounded the alarm. As reported by Reuters:

France's debt is approaching a danger zone, making it all the more important for Paris to stick to its deficit reduction targets, the national public audit office said on Wednesday. The government, which has made keeping France's coveted AAA credit rating a top priority, nudged up its debt forecasts on Tuesday, estimating that the public debt would peak in 2012 at 86.9 percent of gross domestic product.

"The deficits remain much too high to keep the public debt from taking off, and in comparison with many other European countries," the audit office's head Didier Migaud told a commission of lawmakers at the lower house of parliament.

"We are approaching the danger zone where the debt to GDP ratio becomes increasingly closely watched," he added.

This appears to us to be the first sign that the debt troubles of the periphery are beginning to infect the 'core' of the euro area a development that is not entirely unexpected, but one of great moment nonetheless. We will keep a close eye on France. Note in this context that CDS on French government debt have recently been quite firm.

As all these bad news hit the wires, the government bond yields of Ireland and Portugal kept surging to fresh all time highs. Spain's ten year yield, which we have previously pointed to as the most important bond yield in the entire euro area at present, appears to have absolved a successful retest of its recent breakout and is once again surging as well.

It is quite remarkable that in spite of the fact that Greece's ultimately inevitable default seems once again to have been successfully delayed, these bond markets are not even pausing with their ongoing collapse. ECB president Trichet's assessment that this constitutes a 'red alert' situation seems well founded.

Will there really be another ECB rate hike in July? We're beginning to strongly doubt it. More likely the ECB will feel compelled to once again become 'creative' in its liquidity provisions to the euro area banks. In other words, renewed monetary pumping should be in train shortly. The recent stalling out of money supply growth in the euro area will probably turn out to have been 'transitory' in hindsight.

We mentioned in ou r report on the FOMC decision  that the BoE has been discussing an extension of its 'quantitative easing' (i.e., money printing) program. As it were, the commercial banks in the UK are apparently still shrinking their loan books, in short their activities are exerting a deflationary pull on money supply growth in the UK. In spite of government intervention aimed at increasing bank lending, the opposite keeps happening. The culprit is credit demand, which remains extremely weak. UK Economic activity appears to be weakening rather noticeably as well. This may explain why the BoE seems eager to resume, or rather extend, its monetary pumping activities. As the WSJ reports:

Bank lending to U.K. businesses fell again in May and by more than in the previous month, despite an agreement, known as Project Merlin, between the government and major lenders to boost access to credit.

The British Bankers Association on Thursday said bank lending to businesses fell by 」2.5 billion ($4.02 billion) in May, a larger decline than the 」3 00 million drop recorded in April. Separately, U.K. retail sales fell to their lowest level for a year in June, the Confederation of British Industry said Thursday, in the latest sign that weak consumer spending is likely to hold back the economy in the coming months.

The CBI said its monthly distributive trades survey fell to a balance of minus 2 of in June from plus 18 in Maythe weakest reading since June 2010, when the balance was minus 5. The balance is the difference between the percentage of retailers reporting higher sales than a year ago compared with those reporting a decline.

"After a year of growth, high street sales volumes fizzled out in June," said Judith McKenna, chair of the CBI distributive trades panel. "Consumers are really feeling the pinch as disposable incomes continue to be squeezed by rising prices and weak earnings growth."

Bank lending to small businesses was below the Project Merlin target in the first quarter. Under the deal, the five leading banks have agreed to lend 」190 billion to U.K. firms this year, a 6% increase on loans extended a year earlier. In return, the government has pledged not to impose any new taxes or levies on the banks. The BBA said the fall in lending reflected weak demand from cautious businesses.

In short, although the UK is outside of the euro area, its economy and banking system are apparently just as affected by what happens in euro-land. The UK economy has been in 'stagflation' for over a year now. While the economy is very weak, prices have continued to rise sharply. The BoE's administered short term interest rate currently amounts to a negligible 50 basis points, even while CPI clocks in at 4.5%. It is astonishing that the BoE is considering even more outright money printing under these circumstances. This is like taking a leaf from the playbook of Rudolf von Havenstein.

Meanwhile, although the euro has held up fairly well against the US dollar, its decline vs. the Swiss Franc has continued with great verve:

Euro-CHF weekly. These currencies used to hardly move against each other prior to the 2008 crisis. Ever since, the euro has been in a severe bear market against the CHF. This is bad news for all the CHF mortgage holders in Europe that tried to make hay from the interest rate differential. The blow-up of this particular carry trade continues and weighs heavily on the economic situation of many a borrower.

We also want to point readers to a very interesting article by Philipp Bagus, entitled 'The EMU as a Self-Destroying System'. Mr Bagus argues that at the core of the euro area's problems we find a variation of the 'tragedy of the commons'. It is the fact that in a fiat money system property rights are ill-defined and ill-defended that has ultimately given rise to the euro area's problems. As Mr. Bagus writes, inter alia:

During the 20th century, governments absorbed and monopolized the production of money. Private gold money with clearly defined property rights was replaced by public fiat money. This money monopoly itself implies a violation of property rights. Central banks alone could produce base money, i.e., notes or reserves at the central bank. Property rights are also infringed upon because fiat money is legal tender. Everyone has to accept it for debt payments and the government accepts only the legal-tender fiat money for tax payments.[4]

By giving fiat money a privileged position and by monopolizing its production, property rights in money are not defended and the costs of money production are partially forced upon other actors. If no one had to accept public paper money and everyone could produce it, no external costs would evolve. People could simply decide not to accept fiat money or produce it themselves.

The benefits of the production of money fall to its producer, i.e., central banks and their controllers (governments). External costs in the form of rising prices and, in most cases, a lower quality of money are imposed on all users of fiat money. Not only do additional monetary units tend to bid up prices, but the quality of money tends to fall as well. The average quality of assets backing the currency is normally reduced by fiat-money production.


In our modern banking system,[7] where property rights are not clearly defined and defended,[8] any bank can produce fiduciary media, i.e., unbacked demand deposits, by expanding credits. At the level of base money, when a single central bank can produce money, there is no tragedy of the commons. Yet, at the level of the banking system, a tragedy of the commons occurs precisely because any bank can produce fiduciary media.

In banking, traditional legal principles of deposit contracts are not respected.[9] It is not clear if bank customers actually lend money to banks or if they make genuine deposits. Genuine deposits require the full availability of the money to the depositor. In fact, full availability may be the reason why most people hold demand deposits. Yet banks have been granted the legal privilege to use the money deposited to them. As such, property rights in the deposited money are unclear.

Banks that make use of their legal privilege and the unclear definition of private-property rights in deposits can make very large profits. They can create deposits out of nothing and grant loans to earn interest. The temptation to expand credit is almost irresistible. Moreover, banks will try to expand credit and issue fiduciary media as much and as fast as they can. This credit expansion entails the typical feature found in the tragedy of the commons external costs. In this case, everyone in society is harmed by the price changes induced by the issue of fiduciary media.


We hope these excerpts have piqued our readers' interest and strongly recommend reading the article in its entirety.

The Charts

Below we present our usual collection of charts on CDS spreads, euro basis swaps and selected bond yields. The most noteworthy developments are the continuing slow-motion fall of euro basis swaps deeper into negative territory, which serves as indirect confirmation that the funding of dollar liabilities is becoming more difficult for euro area banks, and the sharp rise in the bond yields of the peripheral sovereigns ex-Greece. The sell-off in these bonds has in fact accelerated markedly in the case of Ireland and Portugal. As an aside to this, Ireland is once again threatening to impose haircuts on senior bondholders of Allied Irish Bank a stance we wholeheartedly agree with, but which could further fan the crisis in the short term. Naturally Ireland is eager to use the currently tense market situation to get the EU/IMF bailout combo to lower the cost of its loans. The putative haircut to bondholders of Irish banks is likely part of its negotiating tactic. Perhaps though Ireland really wants to put an end to the hare-brained 'no bondholder left behind' scheme that has driven it into sovereign quasi-default. Better late than never.

1. CDS (prices in basis points, color coded):

5 year CDS spreads on Portugal, Italy, Greece and Spain all are once again surging. Note that Italy is in a 'catch-up' move here. Portugal at a new all time high, and CDS on Spain and Italy at a new high for the move. Greece lands close to its all time high with CDS on its debt surging to 2278 basis points. This continues to imply a default probability close to 90% – click for higher resolution.

5 year CDS spreads on Ireland, France, Belgium and Japan. Following the 'PIGS' spreads higher. Ireland almost back at the recent all time high, and there has recently been a notable deterioration in CDS on Japan's sovereign debt. One should certainly keep an eye on this, given Japan's extremely dire public debt situation – click for higher resolution.

5 year CDS spreads on Hungary, Romania, Bulgaria and Austria all rising once again, although they remain far below the highs attained in January – click for higher resolution.


2. Other Charts

One year euro basis swap: going in the wrong direction – click for higher resolution.

5 year euro basis swap flat on the day, but the trend deeper into negative territory remains intact – click for higher resolution.

Ireland's 10 year government bond yield reaches a new high and sits now at a harrowing 11.79% – click for higher resolution.


The rise in Portugal's 10 year government bond yield has been even steeper lately. It is close to catching up with commensurate Irish yields and clocks in at 11.42% currently. Note that both countries sport steeply inverted yield curves, similar to Greece. E.g. Portugal's 2 year note yield is well above 14% at present – click for higher resolution.

Spain's 10 year government bond yield this looks like a successful retest of the recent breakout. This is the yield that is bound to give ECB president Trichet and his fellow eurocrats many a sleepless night – click for higher resolution.


Greece's 2 year note yield remains just below 30% and actually looks ripe for a correction here. Alas, one can not be sure of that. If the situation deteriorates further, which is possible given the ongoing debate over private sector creditor involvement in the rescue, this yield could streak even higher – click for higher resolution.


Lastly, several bank analysts have recently wondered whether 'economists have become too pessimistic', as can be seen in this article at the 'Big Picture' blog. We note that Societe Generale is not the only bank making this observation. This is certainly possible, but it is just as possible that they are not pessimistic enough. Normally the bulk of mainstream economists has a tendency to be over-optimistic and the same goes for Wall Street analysts who retain 'buy ratings on the vast majority of stocks. These ratings have barely been altered thus far, in spite of the deterioration in economic data.

Charts by: Bloomberg,



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One Response to “Euro Area – A Deepening Crisis”

  • Floyd:

    The Fed manipulating interest rates to subsidized the whole banking system at the expense of prudent savers is an intended consequence.
    Needless to say that the practice of a state mandated agency practice such an involuntary wealth transfer is outrageous, immoral, moral hazard, etc. [I’m yet to find the right description for this awful injustice].
    The only difference between myself and my dad, is that I have a job and he depends on fix income or chipping of the principal.

    It is probably an unintended consequence that US MM funds plunged into the complex and obviously hi-risk European debt interdependency network.

    It would have been funny if it wasn’t real.

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