Europe: The land of promise

As expected the last day's final hours of dealings led to a classic EU Summit solution promising riches though lacking in detail. Some progress was made to secure the future of Europe but there are still plenty of details to be worked out.

The three step plan came through: bank recapitalisation, haircut on Greece and increased firing power for the European Financial Stability Facility. The details are:

Bank recapitalisation

1. 9% core capital after loss on sovereign bonds has been marked to market prices.
2. Europe-wide guarantee of short-term funding probably through the European Central Bank.
   Little details were offered on this part, but the text reads: “"A simple repetition of the 2008 experience with full national discretion in the setting up of liquidity schemes may not prove satisfactory". Consequently, one would want to pursue a "truly co-ordinated approach" to term funding support "at the EU-level". This would be explored jointly between the European Commission, EBA, EIB and ECB”.(Source: Barclays) – Most people see this scheme invoked through the EIB (European Investment Bank) – creating repos on the banks' guaranteed debt with the ECB. The modus operandi however remains floating……(as most of this deal).

The needed recapitalisation was released in brief from the ECB (see more details from the European Banking Authority.)

Haircut on Greece
The expected private sector involvement (PSI) was agreed as a 50 percent haircut on Greek bond holdings, with the objective to lower the Greek debt-to-GDP ratio to 120 percent of GDP. A small surprise was the 30 bln. of additional help provided by European member states. (Again how that will be worked out lacks details.)

EFSF leverage
The insurance model remains however and yet again there are no details or modus operandi for this. It seems the EU is “selling” us the insurance model plus a special purpose vehicle (SPV) on the side which I suppose will be funded by the “friends of Europe” – BRIC countries (Brazil, Russia, India, China) and the International Monetary Fund et al. I have a hard time seeing anyone in earnest committing funds to a European issue, but then again policymakers treat leverage capital as if it was Manna from Heaven.

The problem remains the size – policymakers would “like” to have 800 to 1,000 bln. Euro in firepower, but first they need to establish how much is needed for the banks. The numbers above from the European Banking Authority are well below the level indicated by the IMF. The IMF says European banks needs EUR 200 bln, not the EUR 35-70 bln. range defined by the EBA. Then there is the EUR 30 bln. as part of the haircut to Greece and finally the ECB needs to continue its secondary market support until these “new measures” are in place some time in November or December. Finally, I have said before the true needed number to create a significant buffer and credibility is probably EUR 3,000 bln. not EUR 1.000 bln.

It seems the politicians feel they have bought enough time to actually reach the European Stability Mechanism or yet another Grand Plan post G-20. This plan does not objectively meet any criteria or minimum requirement for being credible. It remains as yet to be announced, which clearly shows the differences in place. It is being sold as a victory but the only thing the EU17 seem to have agreed on is that there needs to be something the market can perceive to be coming. Hardly the stuff changes are made from.

Market reaction
The market will always seek the path of-least resistance and love any kind of indication that “free and cheap money” will continue to flow like honey from bees. What they got is that the banks are getting money again and the funding will in some shape or form be made available to secure leverage.

The EURUSD is higher – the market was short going into it, and the first 24 hours will constitute repositioning – on top of this there could be general repatriation of Euro into the Eurozone due to a need to increase Tier 1 capital, but having said that, this is close to the top of this Euro cycle.

The stock market is higher testing the upside of the range. There is still a chance of 1260/75 - but I feel confident the market will take some profit on this move which is essentially 20 percent of the low in the early days of October. The Italian BTP 10 year is off 20 basis points – slightly disappointing to me, as I see Italy as the line in the sand and should there be “true conviction” in the plain ability to change the state of crisis we would need it much lower. Also observe spreads vs. core Europe and finally how rating agencies deal with France and Belgium in the coming weeks.

Conclusion
Italy remains the line in the sand. When forced Italy did commit to a 2012 budget with an increased pension age but complying remains an issue plus the outlook for political turmoil as PM Berlusconi may step down. (That was the price he had to pay for getting Northern League's support for the pension age increase.)

The deal is short of time in that as always with policymakers, things will happen in the future rather than now. (Note how MF Global, a major US broker has run into trouble in the last 24 hours, and that is an important point.) When you deal with solutions which create more leverage/liquidity rather than solvency you end up constantly fighting fires.

The whole framework of this deal was so illusive and lacking in detail and modus operandi that it is hard to get excited about it. In the next few days observe how the Bundesbank and German opposition deals with this new extend-and-pretend deal.

We were promised a Grand final Plan by last Sunday, that did not happen. We are once again given a plan for a plan, this time not before Cannes, but post Cannes. Let’s hope the plan's new solutions make more sense by then, as I am personally sceptical about the implementation and impact beyond the 24/48 rally we always see post the meetings.