Sovereign debt bubble thread

[Sheilbh]

I thought this was a really interesting bit of work from a research student and his prof in Italy:

Contagion in Europe: Evidence from the sovereign debt crisis
Paolo Manasse   Luca Zavalloni
25 June 2012

If Greece defaults, what about Spain, what about the rest of the Eurozone, and what about the rest of Europe? "Contagion" has become a buzzword in international economics. This column asks whether markets are responding irrationally to the nightmare scenario or finally waking up to reality.

"Contagion" is today's buzzword (de Haan and Mink 2012, Manasse and Trigilia 2011).

• The troika's bailout of the Greek government and the heavy haircut imposed on private bond holders have failed to reassure markets about Greece's permanence in the Eurozone.
• The relief brought about by the recent election results waned in a matter of hours.
• Similarly, the decision by the EU to pour about €100 billion into Spanish banks has not proved sufficient to convince investors that the umbilical cord between the State's and the banks' balance sheets have been severed.
• In the meantime, confidence on peripheral sovereign bonds and banks has been crumbling, as interest rates and CDS spreads rose in the past weeks.

While proposals for a banking union, Eurobonds (Manasse 2010) and fiscal union still belong to the realm of dreams (or nightmares, depending on who should be footing the bill), the question is whether the flight out of Europe's periphery will become a flight out of the euro full stop.

Irrationality or delayed realisation? Empirical evidence on contagion

But are financial markets behaving 'irrationally' or – following a long period of benign neglect – are they simply rediscovering market fundamentals (Manasse 2011b)? And crucially, what policies should southern Europeans, Italy in particular, implement to maintain market access?

In order to address some of these questions we look at the recent evidence on contagion across EU sovereigns CDS spreads. Our empirical model builds on Bekaert et al. (2009) by using time-varying factor loadings and market indexes in order to proxy the dynamics of common and specific risk factors. In the empirical model the daily change in a country sovereign's spread depends on four elements:

• The change in a global risk factor, measured by an index of the most important (non-European) sovereigns' CDS,
• The change in a European risk factor, measured by an index of Western European sovereigns' CDS;
• The change in a financial risk factor, measured by an index of the CDS on private European Financial Institution;
• A (time-varying) idiosyncratic component captures the market participants' assessment of the individual country sovereign risk.

We proceed in two steps. First we estimate the model on daily observations (1630) from 1 January 2006 to 29 march 2012, separately for 15 European countries, 11 of which belong to the Eurozone (Germany, France, Italy, Spain, Belgium, Greece, Portugal, Ireland, Netherland, Austria, and Finland), and four of which who do not (Sweden, Norway, UK, and Denmark). Unlike the previous literature, we run a series of rolling regressions, on a moving window of 200 observations, estimating 1427 regressions for each country and retaining the time series of parameters relating the spread change to the Global, European and Banking indexes. The evolution of these parameters is quite interesting in itself, as it reveals comparatively when and to what extent each country reacted to 'external risks' through the recent waves of crises (we do not discuss these results here for reasons of space). In addition, our approach allows us to trace the systematic movements in the country-specific risk, the drift in the CDS spread daily change. This captures the idiosyncratic component that is unrelated to the remaining 'external' factors accounted by the model. When this parameter spikes simultaneously for many countries, we have an indication of 'pure contagion' in the sovereign CDS market, possibly resulting from herd behaviour, a rise in risk aversion, agents' coordination on a 'bad equilibrium'.

'Pure' idiosyncratic sovereign risks during the US subprime and the Greek crises

Figure 1 in the appendix plots the evolution of the systematic change in the idiosyncratic risk component (only when significantly different from zero at 5%) for the countries in the sample. The US subprime crisis (September 2008 and March 2009) and the Greek crisis (around November 2009) are evident in the data, as jumps in risks are clustered around these episodes. As regards to the crises' impact, countries naturally divide themselves into three sizes: Smalls (Finland, Germany and Norway), Mediums (Sweden, Denmark, the Netherlands, Belgium, France, the UK, and Austria on the high side) and Larges (the 'periphery'). More fundamentally, while the US subprime earthquake affected all Europeans, albeit with different magnitudes (Ireland, followed by Austria and the UK being the most affected for reasons due to the role of their financial institutions), the Greek crisis is largely a matter for the Eurozone. Norway, Sweden, the UK and Denmark, which do not belong to the Eurozone, were hardly affected. But differences inside the Eurozone were at least as remarkable, with France, Belgium, Italy, Spain, Ireland and Portugal showing large and recurrent spikes in idiosyncratic risk. Thus an explanation requires more than the one-size-fits-all corset provided by the euro.




The role of fundamentals

In order to understand what makes a country vulnerable to changes in 'market sentiment', we perform a second round analysis. We use panel estimation in order to explain cross-country differences in the model parameters on the basis of each country's (lagged) economic fundamentals (trade openness, the public debt/GDP ratio, the budget deficit/GDP ratio, the current account balance as percentage of GDP, the rate of unemployment, the monthly change in industrial production, the country's sovereign rating (Moody's), an index of market volatility (the VIX), of liquidity-shortage in the inter-bank market (the TED spread). We also include a 'crisis' dummy which takes the value of one from November 2009, when the numbers for the Greek 2009 budget deficit was revised from 5% to 12.7%, and a Eurozone dummy.

Table 1, in the appendix below, presents the results.

The first column shows the effects of the countries' lagged economic fundamentals on the time-varying risk coefficients, outside the crisis. The second column shows the additional effects of each variable during the Greek crisis (e.g. the coefficient of the interaction of each variable with the crisis dummy). It appears that before the outset of the European debt crisis (first column) three variables significantly affect the idiosyncratic risk: the rate of growth in industrial production (which significantly reduces the risk), the budget deficit/GDP (which significantly raises it), and the volatility index (which significantly raises it). However, things change dramatically during the crisis. First, markets sentiments shift against the Eurozone countries, as documented by the fact that the Eurozone dummy becomes significant during the Greek crisis with positive sign; second, the systematic change in the spread is higher in countries where the public debt-to-GDP ratio is higher, as this variable now becomes positively associated to the systematic risk. Moreover, the real economy matters more inside the crisis: idiosyncratic risks respond positively and significantly to the rate of unemployment, and the coefficient for the rate of growth of industrial production becomes larger during the recent crisis. Another difference with the pre-crisis period is that countries' systemic risks become sensitive to credit rating: this variable, which was not significantly different from zero outside the crisis, becomes positive and significant. Overall, our measures for economic fundamentals explain more than 50% of the cross-country variation in idiosyncratic risks.



Conclusions

Our evidence supports the conclusion that after a long period of benign neglect in the Eurozone, financial markets have rediscovered that fundamentals and structural fragilities matter for sovereign risks.

• In the crisis, markets have increasingly focused on the public debt (8), on the real economy, and on the labour market in particular.

The implications for the appropriate policy response required in order to become more resilient are straightforward:

• More emphasis should be placed upon the employment and growth so that fiscal consolidation does not backlash by plunging the economy into recession.

Here the reason it is not because the recession widens the deficit through the automatic stabiliser. The effect works via a direct link from lower employment and growth to spreads.

• Although not necessarily the panacea for solvency (Bekaert et al. 2011), privatisations should be accelerated, not only because they do not adversely affect the economy, but also because they may well work to calm fears of debt insolvency;
• Labour market reforms that reduce unemployment should have priority.

However, structural reforms aimed at increasing flexibility and reducing firing costs – such as the one currently being voted by the Italian Parliament – may backlash if they raise unemployment in the short run. They should be accompanied by reforms in the wage bargaining system in order to make real wages more flexible (Manasse 2011a).

• The evidence seem to reject the naïve 'credibility' view of multiple equilibria and sunspots, according to which 'credible promises' of future reforms may be all that is needed to select the 'good equilibrium' of low interest rates and solvency (Manasse 2012).

If this were true, past economic fundamentals should not explain cross-country differences in 'fear perceptions'. However, to a large extent, they do.

[Sheilbh]

Apparently Monti's said that if they don't get Eurobonds and an immediate change of Eurozone policy, then he'll resign. 

Of course Berlusconi still has a majority

I think Berlusconi's come out in favour of a new Lira too.

Edit:  Monti's office is now denying that's what he said.

As an aside Barclays have released a report saying that Spanish banks need a bailout and, in addition Spain and Italy need bailouts.

In potentially good news which is again unconfirmed, apparently Germany's planning to give way and remove seniority from the ESM.  That would be a big help to Spain.

Edit:  Also from the CDU meeting, apparently Germany's considering allowing the ESM to funnel money directly into national bank resolution funds - so basically the bodies governments set up to hoover up bad debt, recapitalise the good banks and so on.  That would also be a hugely positive move.

[Jacob]

http://www.nytimes.com/2012/06/27/opinion/germany-the-euro-winner-hardly.html?_r=1

[Zanza]

http://www.nytimes.com/2012/06/27/opinion/germany-the-euro-winner-hardly.html?_r=1

Sounds plausible.

[citizen k]

In potentially good news which is again unconfirmed, apparently Germany's planning to give way and remove seniority from the ESM.  That would be a big help to Spain.

A Change To ESM Seniority Status Is Not Coming

In a world desperate for any positive news, today's borderline idiotic rumor du jour, of course after Monti's gambit blew up in his face literally in minutes, comes from Germany where interested parties leaked that Germany is considering changing the seniority status of the ESM, obviously to ameloirate subordination concerns of Spanish and soon, Italian, bonds. To wit, the headline machine has focused on this part of the recent Reuters report: "A leading ally of German Chancellor Merkel told a closed-door meeting of her conservatives on Tuesday that euro zone governments were discussing removing the preferred creditor status of the bloc's new permanent rescue fund, sources told Reuters." What is very conveniently missed out is what actually matters: "Neither Merkel nor Finance Minister Wolfgang Schaeuble spoke out in favour of such a move at the meeting, the sources said, leaving it unclear whether the idea had the firm backing of the German government." And whatever Merkel (and Schauble, of course), wants Merkel (and Schauble, of course) gets. Because both of them realize that investing €500 billion of what will in the end be purely German cash as more and more countries move from ESM guarantors to ESM recipients, in addition to the hundreds of billions in sunk TARGET2 costs, amount to a number increasingly roughly the same size as German GDP, as we explained last July. Also, as we explained last July, lots of angry Germans are getting angrier by the day.

So... next rumor?

http://www.zerohedge.com/news/change-esm-seniority-status-not-coming

[PJL]

Now where that Venn diagram again.....

[Iormlund]

The NYT article doesn't make any sense. of course exports to non-eurozone grew faster than to the EZ. Newsflash, developing markets grow faster.

The question is how much slower would have exports grown with a stronger DM, and whether exports to the periphery would have increased at all.

[Zanza]

The NYT article doesn't make any sense. of course exports to non-eurozone grew faster than to the EZ. Newsflash, developing markets grow faster.

The question is how much slower would have exports grown with a stronger DM, and whether exports to the periphery would have increased at all.

So your argument is that the German economy would have performed even worse than it did and yet the DM would inevitably have been stronger than the Euro?

[Sheilbh]

This is a slightly worrying chart, from BNP:


This, from the BBC's Robert Peston is interesting:

Why 'encumbrance' and 'forbearance' are crippling banks and the economy

There are two huge and related problems in the global banking system.

First is a growing credit crunch within the eurozone, as weak eurozone banks cut back their cross-border lending and - increasingly - their domestic lending too (there is a chilling analysis today of the so-called Balkanisation of eurozone banking by Morgan Stanley, which is critical of the limited banking union proposed by eurozone leaders as a solution).

This lending constriction worsens a eurozone recession, which in turn exacerbates the weakness of banks: a financing or liquidity crisis morphs into a solvency crisis, as has already happened in Spain and looks set to happen in Italy (yesterday's refinancing of Italy's Banca Monte dei Paschi di Siena augurs ill).

Now that first source of systemic weakness plays into a second source - that the way banks of all developed economies finance themselves has become hideously dysfunctional. Banks in the UK and US, as well as continental Europe, are finding it harder to raise money from conventional, commercial sources and are become excessively dependent on borrowing from central banks.

There are two implications. It is impossible to say when banks, including British banks, will be capable of standing on their own two feet again. And because banks hate being beholden to central banks, they are reluctant to lend as much as the economy needs - even when, as is happening in the UK, the Bank of England and Treasury try to chuck unlimited quantities of cheap money at them.

I am going to introduce you at this stage to two pieces of banking jargon, which help to explain the pernicious trends in finance of our new age of economic stagnation and - in part - why the banking system is in a dire condition. They are "forbearance" and "encumbrance".

Forbearance is when creditors relax their normal lending criteria and conditions, so that their debtors don't go bust. So, for example, up to 8% of all those with mortgages in Britain are enjoying a holiday on payments, or have changed to paying interest only, or are enjoying some other relaxation of normal lending conditions, according to an analysis by the Financial Services Authority for the Bank of England.

And in the commercial property market, the lending terms on some £50bn of troubled loans have been waived.

The idea behind forbearance is a laudable one: if the mortgage borrowers in financial distress had been thrown out of their homes, the social and economic impact would have been nasty. There would have been tens of thousands of people with nowhere to live, house prices would have plunged, losses for banks would have been exacerbated. And if the banks had foreclosed on all the commercial property loans in breach of covenants, there would again have been an acceleration of losses for borrowers and lenders.

But there is a problem with forbearance: it undermines the confidence of those who lend to banks. They fear - rightly - that the banks are not as strong as their accounts would indicate. The point is that forbearance may only defer the pain for the borrower and the losses for the bank, rather than avoid it altogether. So if you are a creditor of a bank, you are legitimately concerned that forbearance is a way for banks to avoid raising the amount of capital the banks need to absorb potential losses.

If you want a bang up-to-date lesson on forbearance as an accident waiting to happen, you only have to look at the £60bn plus capital shortfall at Spain's banks, identified only after independent consultants took a look at the quality of their loans.

Or to put it another way, forbearance is another contributor to the undermining of trust in the integrity and strength of the financial system.

Which brings us on to so-called "asset encumbrance," because it has become the funding trend of this moment precisely because trust in the integrity and strength of the financial system has been wiped.

Asset encumbrance is when a bank has to pledge its assets - the loans and investments it has made - to a creditor when borrowing from that creditor. It is the security or collateral that banks provide to those from whom they borrow.

Now before the great crash of 2007-8, most banks were able to borrow as much as they liked in an unsecured way. To employ the appropriate lingo, liquidity seemed to be unlimited and cheap. Banks could borrow as much as they needed purely on the strength of their names and reputations from other banks and financial institutions without providing any collateral or security.

But that unsecured interbank market more-or-less closed down in 2007 and 2008, and has never properly recovered. And part of the reason it has never properly recovered is that those who control vast pots of money in Boston, Singapore, Geneva and so on are concerned that big Western banks are weaker then they seem (so a big hello again to "forbearance").

Banks have become increasingly dependent on various forms of secured borrowing, especially in what's known as the repo market, which is where banks swap bonds and other assets for loans from hedge funds and specialist parts of banks (yes there are banks at both ends of this market).

Now you may have worked out there is a fundamental problem when - as is happening - the banking industry moves from a system of unsecured borrowing to one of secured borrowing: we move from a world where there is unlimited money for banks to one in which banks can only borrow up to the value of their unencumbered assets (actually they can borrow rather less than that, since lenders always apply a discount or haircut to the assets they take as security).

What is more, the increasing use of secured borrowing by banks becomes self-reinforcing: as any bank pledges more and more of its assets to creditors, so it has fewer free assets, which means it looks weaker, which in turn means that anyone thinking of providing an unsecured loan to that bank will charge a penal rate; so, in effect, the growth of the secured lending market militates against any recovery in the unsecured lending market.

Here are the trends, according to the latest annual report from the central bank's central bank, the Bank for International Settlements: a fifth of all European banks' assets were encumbered, or pledged to borrowers, in 2011.

Please don't take any great comfort from the fact that "only" a fifth of European bank's assets are pledged to borrowers. First that understates the true position, because the statistic is months out of date. Second, some assets can't be converted into a form suitable for secured borrowing. Third, and most important, it would be a disaster if banks pledge massively more than that, because there would be nothing left over to underpin the savings of European citizens.

Here is the thing: we haven't talked about the ginormous elephant in the room, which is that banks borrow most of their money in the form of deposits provided by you and me. And if the banks pledge all their assets to institutional lenders of various sorts, we might worry whether there is anything left to pay us back with.

As you would expect, in stressed parts of the eurozone the growth in secured borrowing has been exceptionally rapid: between 2005 and 2011, the ratio of encumbered assets to total assets increased tenfold for Greek banks, to one third of the total.

That implies Greek banks have almost no spare assets to pledge for secured loans, if they are to keep anything back to cover the money they have borrowed in the form of deposits from ordinary Greek citizens. The pledging of all these assets by Greek banks is a tragedy waiting to happen to Greek savers.

To state the bloomin' obvious, encumbrance has potentially lethal consequences.

Now this vicious contraction of banks' capacity to borrow or fund themselves is exacerbated by the downgrading of their credit-worthiness by ratings agencies.

These downgrades are a treble whammy:

1) when banks' credit ratings fall below a certain threshold, it becomes impossible for them to borrow from certain non-financial lenders, such as some local authorities, sovereign wealth funds, companies and so on (Royal Bank of Scotland, for example, has already fallen through this threshold);

2) after a downgrade, lenders demand that banks pledge even more of their assets for a specified value of loan, so downgrades accelerate the rate at which assets become encumbered;

3) banks that engage in what are known as over-the-counter derivatives transactions have to put up more of their assets as margin or security in these deals.

Here are two indications of the damaging impact of downgrades.

First, Royal Bank of Scotland has disclosed that it will have to pledge an additional £9bn of assets as collateral following its downgrade last week by Moody's (and I'll return to the position of British banks in the coming days).

Second, the European Central Bank took action on Friday in advance of the shocking downgrades on Monday of Spain's banks by Moody's, by relaxing the criteria for the loans that it and Spain's central bank make to Spanish banks.

Or to put it another way, the ECB exercised forbearance on Spanish banks: Moody's downgraded large numbers of Spanish banks to junk; so the response of the central bank was to soften the lending terms on the loans it makes to Spain's banks.

You will have gathered by now that there is a final chapter in this encumbrance story, which is that when banks can no longer raise money by pledging assets to commercial lenders they are forced to raise what they need by pledging assets to central banks in return for loans.

This is when banks go on life support, and it accurately describes the parlous condition of a large number of banks in Spain and others scattered throughout the eurozone.

However, so long as these banks retain assets of sufficient quality, they can continue to claim to be viable, or at least potentially viable - even if they are only alive because of credit they've received from the European Central Bank, for example, or from their national central banks.

But the assessment of requisite quality is tricky. As we have seen in the case of Spain, in response to a verdict by Moody's that the quality of Spanish banks' collateral had deteriorated, the response of the ECB was to lower the quality threshold for lending to those banks - which, in theory, significantly increases the risks for all eurozone taxpayers from the finance provided by the ECB and the Bank of Spain to Spanish banks.

Here is the big imponderable: what will the ECB do at the moment that a big bank runs out of unencumbered assets? This is a very real possibility, according to regulators and bankers. And they simple don't know how the ECB would react - whether it would do something that central banks are never supposed to do, which is provide unsecured loans, or whether it would allow the bank to fall over, and risk a chain reaction of collapsing banks.

All of which is a very long-winded explanation of why many - including the governor of the Bank of England - argue that the fundamental problem of the eurozone banking system is that it is seriously insolvent in parts. And until the requisite capital is raised, the eurozone will continue to live dangerously on the brink of potential catastrophe.

[Sheilbh]

I ask because it seems such a no-brainer for Greece to default on its official debt that I'm led to believe the only reason they don't is fear of getting kicked out of the EU.

Incidentally just to return to this.

Firstly there is no clear way out of the Eurozone, legally speaking, except for leaving the EU.  This was reinforced by the statement of the Austrian Finance Minister.  I'm sure a way out could be found, after all the Treaties explicitly forbid bailouts and the first Greek bailout was done under an article meant for national disasters.

Secondly almost all Greek debt is to official creditors.  It's to the IMF, ECB, ESM and EFSF all of whom claim some form of seniority.  If they default it's difficult to see how the Greeks fund their state given that they'd have burned the official lenders - though, interestingly I've read that Washington, Beijing, London and others have made it clear that they won't allow the Europeans to 'punish' the Greeks.  If they default they want Greece to be treated as a normal country in need of IMF aid, subject to IMF conditions - not to be totally frozen out for political purposes.

Thirdly there's political reasons.  For almost all countries in the EU and EZ it means more than the sum of its parts.  I think the most Eurosceptic countries (UK, Scandis, maybe, increasingly, the Dutch) are the ones with least political investment in Europe as a concept.  For the Greeks I think it anchors them in the West, is a guarantee of democracy not a return of the colonels and I think at times the EU has been seen as an easy route to good government for the Greeks (and possibly Spanish and Italians).  Brussels has been a convenient excuse for good, but necessary decisions (this in my view is how the current crisis should have ended up).

Fourthly I think there's real benefits and fears.  Greece used to have 15% or higher interest rates.  They haven't had that for the past decade, they've also not had the old inflationary problems.  Both of which matter to individuals, now I imagine they've all refinanced at that lower rate and would quite possibly be financially killed if the old Greek financial sector came back.

Really the pretty small development funds and CAP that Greece get are the least of their concerns for defaulting/leaving.  It is worth remembering though that Greece could default and stay in the Euro.  There's no mechanism for them to be forced out, just as there's no mechanism for them to leave.  So depending on how much pain Greeks are willing to suffer, they could stay.

Edit:  Also I think Simon Nixon has a point.  Federalism is absolutely fine and normal for Germany.  But asking the President of the Republic to subordinate himself a Brussels budget czar is never going to work.  I'd also guess that the Eastern European states like Estonia and Slovakia and maybe even Finland would be less keen on a Federal Europe.  I imagine the smaller countries would be suspicious of it and I'm absolutely certain that Ireland would not consider it acceptable.

[Iormlund]

The NYT article doesn't make any sense. of course exports to non-eurozone grew faster than to the EZ. Newsflash, developing markets grow faster.

The question is how much slower would have exports grown with a stronger DM, and whether exports to the periphery would have increased at all.

So your argument is that the German economy would have performed even worse than it did and yet the DM would inevitably have been stronger than the Euro?

The Euro is naturally dragged down by net importers. Take those out of the picture and the currency should go up.

[Crazy_Ivan80]

But asking the President of the Republic to subordinate himself a Brussels budget czar is never going to work.

then maybe that president should not be trying to spend germany's money

[Sheilbh]

But asking the President of the Republic to subordinate himself a Brussels budget czar is never going to work.

then maybe that president should be trying to spend germany's money

Well that's not what's happening.

This does highlight the problem of any further union though.  The sort of federalism Germany imagines makes sense to Germany given her history and political structure, but I don't think it applies to any other EZ, far less EU member, with the possible exception of the Netherlands.  The structure that'll be required to deal with the sovereignty of the 5th Republic (which that writer discovered 50 years too late) far less countries like Ireland or Estonia is probably going to be very different than what Van Rompuy's suggested (which seems madly anti-democratic) or that's acceptable to Germany.

[Sheilbh]

Also the statement on the Spanish bailout suggests it'll be under €100 billion which is, I think, what the markets were expecting after the amount that figure got bandied about.  If it's significantly below that it may be counter-productive.

[Iormlund]

Whether it's 100b or 80b doesn't really matter, since we're going to need a proper rescue regardless. And that's going to dwarf this one.