I’m loathe to discuss this, but German nationalism is a factor once more.
There is a growing feeling among a minority of European observers that German leader Angela Merkel is deliberately creating Greek-crisis negotiating havoc in order to help make the case for an EU more strongly run from the centre. The signs are that her strategy is working: but are we going to have a repeat of 1914, when sabre-rattling put into action an unstoppable timetable to Armageddon? The Slog analyses where we are.
In August 1914, Austrian Archduke Franz Ferdinand was assassinated by a Serb nationalist in Sarajevo. The knock on effect went via Austria to Germany and Turkey, then to France and, under the Entente Cordiale agreement, to Britain. Britain’s alliance with Tsarist Russia brought them in, and within a month two grand alliances were at war. European society never recovered.
In 2011, globally connected debt is as potentially unstable as international alliances became in the teens of the Twentieth Century. Even two months ago, there was still a window of opportunity for debt forgiveness to sap the monetary amounts involved, and leave a global financial system very badly shaken, but not shattered. Since then, two things have happened. First, Merkel has put her foot down and said no debt rescheduling….at the same time as the eurobanks (including, in effect, the ECB) have refused to consider serious debt write-offs on their own books. Germany wants a bank crewcut, and the banks want the taxpayers to cough up yet again. Angela Merkel was already yesterday saying that tomorrow’s [Thursday] meeting will fail to arrive at a solution.
Sending the old Archduke to Sarajevo was reckless brinkmanship. Putting down the Greek debt negotiators is just as dangerous. Let me take a closer look at why.
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This morning, the yield on two-year Greek notes rose above 40% for the first time. Spanish and Italian 10-year bond yields have climbed more than 70 basis points since the end of June. The Spanish Treasurysaid yesterday it sold 3.8 billion euros of 12-month bills at a yield of 3.702%, up from 2.695% the last time the securities were sold five weeks ago.
70% of exposure to Portugal, Ireland, Greece, and Spanish debt is from foreign lending institutions. EU systemic risk is nearing certainty of collapse – a point reached largely through bureaucratic smugness, and intransigence during debt negotiations. If Portugal defaults, Spain’s banks will go down – see the giant red block below. Exposure to Spanish debt is in turn around 4-6% of GDP for Switzerland, France, Germany, the UK, and the Netherlands….depending on who you believe. Portugal, in case you hadn’t noticed, has been living on hand-to-mouth cash flow for nearly three months now.
A quick solution for Greece would’ve calmed nerves, kept bond yields lower, and created breathing space. My personal view remains that the defaults would’ve happened anyway – but orderly default is manageable. That crucial 6-8 weeks of snail’s-pace bureaucracy, heel-digging and denial has exponentially increased what the speed of contagion will now be…and the panicked shock that always accompanies it.
You will notice from the table above that Greece, Portugal and Ireland have no foreign lending exposure any more. This is because they have no foreign investment system any more: that’s been shattered by an inability to cope with their own debt. Having taken the hit on Spain, Britain will almost automatically face an Irish default – the actuality of which will evoke little sympathy in Brussels. And that means our banking system will collapse too: there simply isn’t enough in the UK Treasury – or enough UK debt credibility in the markets – to find the money to prop up that system in an affordable way.
Yesterday [Tuesday] the IMF said the latest debt woes in Greece and other nations were “casting a shadow” over the eurozone’s future while European officials struggled to formulate a decisive response. I wouldn’t say ‘shadow’: my phrase would be ‘nuclear winter’. But the IMF played into Merkel’s hands by saying:
‘Despite genuine efforts to strengthen governance and cooperation, the reaction by national authorities and economic agents has been one of retrenchment, threatening to turn back the clock on economic and financial integration.’
Together, the 17 eurozone members account for about 20% of global economic output – the single largest share of world trade. With markets already on edge, a deepening of the crisis will create what the IMF called ‘major global consequences’. Crucially, it added that this called for
‘a series of moves that would effectively reduce national sovereignty and that would likely face resistance from some European nations. Central authorities for the euro zone need to conduct more stringent surveillance of members’ budgets, have more say in national policies, and issue debt’
This is what the Germans wanted before the launch of any common currency ten years ago….and which the French stopped. But a decade on, Germany is stronger, and France weaker. Recently, The Slog pointed out that influential German thinking of an anti-democratic superstate nature was heading in this exact direction.
Unless the British Government wakes up immediately from its Newscorp nightmare, we are all likely to face two nightmares in a row: an EU collapse, followed by a German-dominated Europe. But more concerning in the immediate term is the real and present danger that Merkel’s bid for europower will tip the global economy over the edge.
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Earlier this year, The Slog wrote on several occasions to argue against the German insistence that only full repayment of Greek debt, and massive austerity in that country, could stop global chaos taking hold. I said then and say now that this was chicken-lickenism on Merkel’s part. But the bitter irony is that her subsequent intransigence – coupled with the standard selfish greed of lenders – is now very close indeed to turning her wolf-cries into a horrible reality.
The link to American money is terrifyingly clear.
Altogether the US has $390 billion worth of exposure to peripheral EU debt. That’s not an enormous amount of money – about 3% of total US GDP – although we also need to take the huge level of Wall Street eurobank insolvency insurance exposure into account as well, thought to be another $30billion with French institutions alone. But it’s in the cost of honouring credit ‘bets’ made where the real danger lies.
The value of a credit derivative is linked directly to changes in the credit quality of bonds, notes and bank loans. German intransigence about releasing bailout funds to the Athens Government has helped make a nonsense of credit derivative bets made by US commercial banks during the fat years. And like most things to do with banks selling each other betting slips, the figures are horrendous. Those American institutions now have over $240 TRILLION in derivative exposure on their balance sheets.
In the beginning with derivatives, banks were simply both dealers (selling) and end-users (buying). This made it very easy for each bank’s brokers to check that its bets balanced each other out. But for the banking mentality, this was far too safe and boring: the target-nutters got involved, introducing a wider spectrum of customer transactions via multivariate channels, in order to boost turnover and enhance margins. So things rapidly became more complex, and then eventually almost impenetrable. If you asked Bank of America right now to tell you its net exposure in the derivatives market, it would struggle to tell you inside a week.
In short, today financial derivative players don’t match each trade with the offsetting trade; rather, they continuously manage the ‘residual’ risks of portfolios. But residual risk is a falsely reassuring term: you only need to get one bank in trouble, and two things will happen. First, it will hassle other banks by calling in what it is owed. And second, gossip will then spread like wildfire that said bank is in trouble.
Why might that bank be in debt derivatives trouble? Well, since 2008, the sovereign debt situation has worsened dramatically. Bets made in, say, 2004-5 can’t factor this in. The bottom line is that derivatives expose banks to near unlimited losses, which can cause bank failure. The institution will realise that it can’t sell its bad bets, because bad sovereign debts have made them near-worthless. In turn, it can’t buy new ‘good’ bets, because their price is going sky-high.
Suddenly – through a mixture of fear of bad debt, and greed at the opportunity created by the failure of a competitor – that bank will be targeted.
Opinions vary wildly as to whether you really could get a $240 trillion meltdown all in one go. But what I can tell you for sure is that, far from deleveraging their exposure to bad debts and derivative bets, the vast majority of institutions have increased their risk levels since the near miss of 2008. If one substantial bank fails, other banks bad-debted by it will hassle other banks, more rumours will start….and one by one, the dominoes fall.
In the current situation, the most likely starting point will be French banks – in the event of Greek disaster being rapidly followed by one in Spain. The general dithering about and heel-digging of recent months has virtually wiped out the likelihood of a gap between the two crises. Key German banks would not be far behind the French ones in such a scenario (look at the table above again) and both sets would be in trouble at the same time.
The nightmare situation, then, is one where two sovereigns are going down, seven banks start to phone insurers in New York, rumours, emails and dark pools rapidly drive the value of credit derivatives up or down, one major institution realises it’s got a lot of the down stuff, and the circling sharks scent blood in the water. How then do we stop the sound of dominoes tapping each other over? The answer is, we can’t.
Greece could’ve called this probability out by simple announcing a default three months ago. All of the Brussels, banking, Exchequer and political minds would then have been sharply focused by the prospect of death. But it didn’t – and the IMF, Germany, Geithner and the sprouts led the charge in saying they mustn’t do it.
That sealed the banking system’s fate – probably. But by being obdurate, the latest shadow-boxing in the Merkel v Banks bout has effectively knocked out the life support system. And all for the goal of ein Grossdeutschland, sorry, the United Nations of Europe.
So one way or another, this sort of puts Hackgate into perspective. And as I posted yesterday, it explains why David Cameron has two chances of surviving as Prime Minister in a shaky Coalition.
Related: Van Rompuy’s EU superstate nightmare
Why ignoring advice and EU contagion will do for Camerlot
The Slog 