More than 90 per cent of big banks are expected to take part in a voluntary "haircut" on their holdings of Greek debt agreed with EU leaders, the lenders' chief negotiator says.

Charles Dallara, head of the Institute of International Finance (IIF), which represents large banks, told Germany's Welt am Sonntag weekly: "I am very optimistic that more than 90 per cent of the banks will participate." "I can't speak for the other creditors from the insurance and hedge fund sectors. Here, there is certainly more persuasion work to be done," Dallara added.

In marathon talks on Wednesday, EU leaders, spearheaded by German Chancellor Angela Merkel and French President Nicolas Sarkozy, convinced private investors to accept a loss of 50 per cent on their holdings of Greek paper. The move was seen as crucial to avoid Greece defaulting on its debt and propelling the eurozone crisis, already the worst in the bloc's history, to new heights. The deal aimed to slice a whopping 100 billion euros ($A133 billion) off the 350 billion euro debt pile hampering Greece.

Dallara offered an insight into the torturous negotiations in Brussels that dragged on well into the early hours of Thursday morning. "At first, we did not think we would meet the heads of government. But the state guarantees that were on the table were not enough for us to accept the 50 per cent haircut," he said. "Then Angela Merkel got involved and raised the guarantees from 20 to 30 billion euros. That clinched the deal," he said.

Dallara also expressed optimism that the insurance model in place to attract investors to Spanish and Italian bonds could also be "very efficient". Asked if he believed Wednesday night's gruelling session would be the last negotiations over Greek debt, he replied: "Yes. Of that I am certain."

...."Unfortunately it is not the last crisis because the fundamental issues have not been settled. It is clear that the amount of debt that Greece has accumulated and is accumulating is untenable and the country is effectively insolvent.''

Mr Soros said that many banks might not voluntarily join the deal and as they will want to wait for the insurance offered by the credit default swaps they hold against the debt to be triggered. At present, because the haircut is voluntary, European leaders have said the Greek default is not considered a ''credit event'' that would spark CDS payouts and possibly a new financial crisis.

''Unfortunately, the 50 per cent haircut is effectively less than a 20 per cent reduction in the overall debt [for Greece] because it only involves the private sector and excludes all the debt that is held by the European Central Bank and the other public authorities, and also the debt held by Greece because the banks, of course, will now be insolvent and the pension funds also,'' Mr Soros said.

''It is not at all clear that the private sector will deliver this voluntary cut because many of the banks are hedged by holding credit default swaps and this doesn't trigger the credit default swaps. As a private institution you could argue that it is the fiduciary responsibility of the board to look to the benefit of the bank rather than the common benefit. So, from the banks' point of view, it is better to have a credit event where the CDS become active and protect them from the loss. That is an unsolved problem which may emerge in the next few weeks.

Read more: http://www.telegraph.co.uk

,...... The banks "voluntarily" took a 50% haircut. Voluntary in that Merkel, Sarkozy, et al. told them that the alternative was a 100% haircut. "That's the offer, guys. Take it or leave it." Cue the theme from The Godfather.

And because the write-off was voluntary, there would be no triggering of credit default swaps clauses. Because if it's voluntary it's not a default – capiche?

And that smooth move, dear reader, triggered a rather significant unintended consequence, which resulted in the market "melt-up." Let me see if I can walk you through this rather bizarre world of derivative exposure without exposing too much of my own ignorance.

Let's say you bought credit default swaps on a certain bank's debt (let's use JPMorgan, but it could be any bank) because you think that Morgan is exposed to too much credit default swap risk. Just in case. Now, if (say) Goldman sold you the CDS, they could and would in turn hedge their risk by shorting some quantity of Morgan stock, or perhaps if the risk was sizeable enough, the S&P as a whole. It would depend on what their risk models suggested.

But as of yesterday, the risk evaporated: there would be no CDS event. So why buy CDS? Time to cover. And then the shorts get covered.

Further, the risk to financials was cut by a large, somewhat murky amount. But it was definitely cut, so buy some risk assets. Which puts any long/short hedge fund in a squeeze, especially those with an anti-financial-sector bias. But because of the nature of the hedge, the whole market moves. It involves rather arcane concepts that traders call delta and gamma. (Remember that the recent rogue traders had been at delta trading desks?) Guys at those desks can calculate that risk in a nanosecond. You and I take a day just to wrap our head around the concepts.

And it just cascades. The high-frequency-trading algo computers notice the movement and jump in, followed quickly by momentum traders, and the market melts up. Because a significant risk was removed. But not without cost.

Let's go back to where I noted that Italian interest rates are rising even as the ECB is supposedly buying. What gives? It is clearly the lack of private buyers, and a lot of selling. Because now you can't hedge your sovereign debt. If you ever need that insurance, they will just change the rules on you, so why take the risk?

Destroying the credit default swap market will make it harder to sell sovereign debt, not easier. Those "shorts" were not the cause of Greek financial problems; the Greeks did it all to themselves. As did the Portuguese, and on and on. Now admittedly, rising CDS spreads called attention to the problem, much as rising rates did in eras long past. And that did annoy politicians. And clearly, banks that had exposure to that market got the "fix" in to make their problems go away........

..........I am not against CDS. We need more of them. But they should all be moved to a very transparent exchange. If I buy an S&P derivative (or gold or oil or orange juice), I know that my counterparty risk is the exchange. I don't have to hedge counterparty risk. The exchange tells whoever is on the other side of the trade that they need to put up more money, as the trade warrants. Or tells me if the trade goes against me.

The banks lobbied to keep CDS "over the counter." The commissions are huge that way. If they are on an exchange the commissions are small. This was a huge failure of Dodd-Frank. And we all pay for it in ways that no one really sees.............

Euthanising the euro - Gideon Rachman, Financial Times

As the European ship heads for the rocks, so the officers in charge are being thrown overboard. This week has claimed the prime ministers of both Greece and Italy. But while politicians may come and go, European leaders insist that one thing will remain eternal – the euro. No summit is complete without the ritualistic declaration that Europe will do ‘whatever it takes’ to preserve the single currency. But the repeated vows to save the euro betray a dangerous confusion.

The euro is not an end in itself. The single currency is just an instrument, aimed at promoting economic prosperity and political harmony across Europe. As the evidence mounts that it is doing the precise opposite, it is time to think not about how to save the euro – but about how to scrap it, or at least allow the weakest members to leave.

For reasons of pride, fear, ideology and personal survival, it is extremely hard for European leaders to accept that the euro is a large part of the problem. Instead they search for other explanations for the economic crisis. Countries have failed to stick to the rules. They have lied. Europe needs new political structures. The bazooka is not big enough. The markets are irrational. The people are revolting.

There are elements of truth in all these explanations. But they fail to get to the root of the problem. After roughly a decade we are discovering that a single currency area, uniting different countries with different levels of economic development – and very different political cultures – is inherently flawed.

The euro has helped both to create and sustain the crisis in Europe. First, it caused interest rates to plunge in southern Europe, encouraging countries such as Italy and Greece to go on a borrowing binge. Now the single currency rules out the options that post-war Italy and others traditionally used to cope with high levels of debt: inflation and devaluation of the currency. Neither policy was cost free, but they provided an alternative to the ‘internal devaluation’ (otherwise known as wage cuts and mass unemployment) that is currently being urged on Italy, Greece and much of southern Europe.

The global financial crisis exposed the euro’s weaknesses. When it first became apparent that Greece was in serious trouble, in 2009, the EU set itself two tasks. The first was to resolve the Greek crisis. The second was to convince the markets that Greece is an isolated case that bears no resemblance to the rest of the eurozone. They have failed comprehensively in both tasks.

Economic chaos in Greece is now being supplemented by political chaos. In Italy, meanwhile, borrowing costs go up and up – in a way that will soon make the country’s finances unsustainable. If Italy, the world’s seventh largest economy, applies to the EU bailout fund – or even to the IMF – there simply may not be enough money to meet its needs. It would be like an elephant getting into a life raft.

The markets have spotted that, while Greece is an extreme case, it is not unique – whatever EU leaders say. Italy has many of the characteristics that make Greece dysfunctional: widespread tax evasion, huge government debt, a political system based around patronage and an unhealthily dependent relationship with the EU. It is true that Italian industry has a strength that Greece cannot remotely replicate. But Italy’s Silvio Berlusconi makes the departing Greek leader, George Papandreou, look like Lincoln.

Greece and Italy are not the only problems. Ireland and Portugal have already had to accept bailouts – and may be destabilised anew by the latest crisis. Spain’s vulnerability is clear. France has not balanced its budget since the 1970s and is fretting about its triple-A rating.

Faced with these mounting problems, the ‘whatever it takes to save the euro’ crowd are left advocating solutions that are less and less credible. If all goes to plan – after debt relief and further austerity – Greece will have reduced its debt to a mere 120 per cent of gross domestic product by the end of the decade. And that is the optimistic scenario. Meanwhile, despite the clear evidence that sovereign debt in Europe is risky, Italy will somehow persuade the markets to go back to lending to it at 2 per cent, rather than 6 per cent or more. In the meantime the European Central Bank will buy junk bonds from Italy without limit, for as long as it takes. None of this sounds credible.

On the political side, the long-term fix to the euro’s malaise is said to be a fiscal union, a true political federation. But this is a solution that will take decades to implement, for a crisis that is escalating by the week. The final destination is, in any case, inherently implausible, given the lack of pan-European solidarity revealed by the current mess.

It is true that breaking up the euro would be fiendishly difficult and dangerous. Capital flight and debt default in countries quitting the euro could cause banks to collapse. Economic and political chaos might follow – at least for a time.

A new Italian government with a credible economic program might just buy Europe some time. But given the euro’s design flaws, the respite is likely to be brief.

Some argue the destruction of the single currency will destroy the EU itself. But such alarmism risks becoming a self-fulfilling prophecy. Key European achievements such as the single market, border-free travel and co-operation on foreign policy preceded the single currency and they can survive its demise. Rather than insisting that the break-up of the euro is unthinkable, Europe’s leaders need to start planning for it.

Copyright The Financial Times Limited 2011.

You’ve probably never heard of Taunus Corp., but according to the Federal Reserve, it’s the U.S.’s eighth-largest bank holding company. Taunus, it turns out, is the North American subsidiary of Germany’s Deutsche Bank AG (DBK), with assets of just over $380 billion.

Deutsche Bank holds a large amount of European government and bank debt; it also has considerable exposure to lingering real estate problems in the U.S. The bank, therefore, could become a conduit for risk between the two economies. But which way is Deutsche Bank more likely to transmit danger -- to or from the U.S.?

By any measure, Deutsche Bank is a giant. Its assets at the end of September totaled 2.28 trillion euros (according to the bank’s own website), or $3.08 trillion. In the latest ranking from The Banker, which uses 2010 data, Deutsche was the second- largest bank in the world by assets, behind only BNP Paribas SA.

The German bank, however, is thinly capitalized. Its total equity at the end of the third quarter was only 51.9 billion euros, implying a leverage ratio (total assets divided by equity) of almost 44. This is up from the second quarter, when leverage was about 36 (assets were 1.849 trillion euros and capital was 51.678 euros.)

Even by modern standards, this is very high leverage. JPMorgan Chase & Co. has a balance sheet about 20 percent smaller than Deutsche Bank’s, but more than twice as much Tier 1 capital, an important indicator of a bank’s financial strength. Bank of America Corp., whose weakness is a serious worry in the U.S. today, has twice Deutsche’s capital. (These comparisons use The Banker’s ranking of the top 25 banks.)

Globally, Deutsche’s capital ratios are relatively healthy, judging by the banking industry’s standard measures. At the end of the third quarter, its Tier 1 capital ratio was 13.8 percent (up from 12.3 percent at the end of 2010) and its core Tier 1, which excludes hybrid debt that can convert into equity, was 10.1 percent.

How does such a highly leveraged bank become “well- capitalized”? The answer is that “risk-weighted assets” were 337.6 billion euros as of Sept. 30. But what is a low risk- weight asset in the European context today? Incredibly, it is sovereign debt, which of course is far from riskless at the moment.

Perhaps Deutsche Bank holds mostly German government debt, which still has safe-haven value. But it’s likely that Deutsche also holds a significant amount of Italian and French government bonds.

Still, the bigger risks are probably in the U.S. Deutsche Bank is a significant trustee for mortgages, having been heavily involved in the issuance and distribution of mortgage-backed securities during the housing bubble. Yves Smith, writing on the nakedcapitalism.com blog, says Deutsche Bank is one of the U.S.’s four biggest securitization trustees. Many questions on whether paperwork was done properly and whether the rights of investors have been protected hang over these trusts.

Let’s take a look just at Taunus Corp., named after a range of mountains outside the parent bank’s Frankfurt headquarters. The latest figures (from the Fed data, using the consolidated financial statement at the end of the third quarter) show Taunus with total equity capital of just $4.876 billion. This implies an eye-popping leverage ratio of around 78.

Why would the Federal Reserve and the new council of regulators known as the Financial Stability Oversight Council allow Deutsche Bank to operate in the U.S. with sky-high leverage -- with its huge implied risk to the rest of the financial system? Presumably, in the past, U.S. authorities have taken the view that Deutsche Bank had a strong enough balance sheet worldwide that more capital could be provided to its American subsidiary, if needed.

Such a presumption now seems questionable, at best. Earlier this year, Bloomberg News reported that Taunus needed almost $20 billion of additional funds to meet U.S. capital standards, and that Deutsche Bank was trying to declassify Taunus as a bank- holding company to avoid capital requirements entirely. It’s unclear where this process now stands, but it’s also not obvious how declassification would help U.S. or global financial stability. Financial reform advocates hopefully will press hard on this issue.

All of this raises troubling questions. Have U.S. bank supervisors really satisfied themselves, through onsite inspections, that Deutsche Bank’s risk weights accurately reflect market conditions and the increasing structural weakness of the euro area? Can U.S. regulators document their satisfaction beyond the materials produced for the European Banking Authority, which earlier this year oversaw stress tests that pronounced now-collapsed Dexia as well-capitalized? (Actually, Dexia had stronger capital ratios than Deutsche Bank.)

In their prescient, pre-crisis book, “Too Big To Fail” (not to be confused with the more recent Andrew Ross Sorkin book of the same title), Gary H. Stern and Ron J. Feldman, in 2004 nailed the incentive distortions that encouraged risk-taking and brought the financial sector to its knees. No one else came close to them in getting this right. Included in their analysis are examples of banks that could have been regarded as having moral hazard issues because of their size. Deutsche Bank is No. 4 on their list of large, complex banking organizations by asset size.

This dog did not bark during the 2008 crisis, partly because most foreign governments were seen as having strong enough balance sheets to back their banks’ worldwide operations. But this is no longer necessarily true for euro-area governments.

Even in 2008-2009, this may have been illusory. According to published reports, Deutsche Bank received considerable assistance from the Federal Reserve, including $11.8 billion through the American International Group bailout and $2 billion through the Fed’s discount window. Deutsche was the second- largest discount-window borrower and the largest user of the Fed’s Term Asset-Backed Securities Lending Facility during the crisis.

Deutsche Bank and, if necessary, the German government should be required to inject substantially more capital into Taunus. Allowing business as usual is asking for trouble, particularly as Deutsche wants to remain focused on relatively risky investment banking. Recently it named as chairman Paul Achleitner, the finance director at Allianz SE, the German insurance company, and an ex-Goldman Sachs executive, worrying even some of its shareholders.

This would be a good time for Congress to dig more deeply into the risks that Deutsche Bank poses to financial stability in the U.S. and around the world.

(Simon Johnson, who served as chief economist at the International Monetary Fund in 2007 and 2008, and is now a professor at the MIT Sloan School of Management and a senior fellow at the Peterson Institute for International Economics, is a Bloomberg View columnist. The opinions expressed are his own.)

Models for a Greek Sovereign Default

I am on a plane - long-haul over the Pacific - and someone asked me to spell out what I thought would happen with a Greek sovereign default. As this is drafted on a plane it is designed to outline extreme views (you know the ones after two glasses of wine). If people want to explore more modest views that is for the comments. Still all options look bad.

I see two broad variants - both of course stick most of the losses on Germany and France. Some variants are totally disastrous.

Variant 1 - the Argentine option: Default and de-peg the currency.

When Argentina defaulted not only did the government default but they forced a private default. If you had a debt in US Dollars in Argentina prior to the default you were forced to pay it back in Peso. Indeed it was illegal to make payment in US dollars.

Likewise if you had a US dollar asset you got back Peso. A dollar deposit in Citigroup in Buenos Aires became a peso deposit. If you really wanted to keep your dollars you needed to make your Citigroup deposit in New York.


The forced private sector default was necessary for Argentina. The Argentine banks all had lots of US dollar funding. If you devalued without forcing their default then they would all have uncontrolled defaults (a true disaster) and the country would lose its institutions. Telefonica Argentina would have failed too - failing to replay USD debts.

The same applies in Greece. If the Greek Government were to devalue the new Drachma (to perhaps a third the value of the Euro) then the banks (which are loaded with Greek Sovereign paper) would default. Even Hellenic Telecom would default because they would be forced to repay their billions of Euro borrowings whilst collecting only Drachma phone bills.

The Argentine economy was doing quite nicely after the devaluation. The lesson was that devaluation worked - provided you simultaneously forced private sector default.

If you were Greece you would take this option without hesitation.

However this option has explosive implications for Europe. You see a bank deposit in Athens is going to turn your Euros into Drachma. Overnight it will lose 70 percent of its valuation.

So it has to be done quickly and with an element of surprise (as per Argentina when most people did not get their dollars over the border). Without surprise people will rush their money to Deutsche Bank in Munich.

One weekend we will just find that the Greeks have done it.

But now suppose Greece does pull this trick. The day after we have a Drachma - deposits are in Drachma. We might print a single 10 drachma note and allow it to settle against the Euro - then over time print more. This should work for Greece.

Now if you are Irish or Italian or Portuguese (or even Spanish) you know the rules. You get to get your Euro out of the PIGS and into the core (Germany) as fast as possible. So max all your credit cards (for cash), draw all your bank deposits and load them in the boot of your car and make the drive to Switzerland or Germany. Somewhere safe. Otherwise you are going to lose half the value the day that the rest of the PIGS do a Greece.

And this bank run – a run including tens of thousands of Italians driving their Fiats - will surely blow apart every Italian bank. And their Euro-skeloritic compatriots will sign the death knell for for all their banks too.

If you are going to go the devaluation route you are going to have to do it all at once. Like the big-bank weekend (maybe coinciding with a week long bank holiday) in which all core European countries get their own currency back.

There is a precedent. It is not a pretty one. When the Austro-Hungarian empire collapsed there was a single currency over a huge area covering much of what is now Euroland. In this case the rather Germanic Austrians were in charge (or rather were in charge until their empire collapsed).

What they did was put troops on all the borders and made it illegal to take cash (or wire cash!) across borders. Then all Austro-Marks in each country was stamped - converted to Drachma for Greece, Marks for Germany, Peseta for Spain or whatever the currencies of the day were [If someone remembers the 1918 border splits better than me they are welcome to say...]

In this conception all Spanish debts become Peseta debts. All German debts become Mark debts. All Greek debts become Drachma debts. Unstamped currency goes worthless.

If you are going to split the currency I see no alternative to a big bang - and if you do that I see no alternative to troops at the border stopping transfers (and wire transfers) because shifting cash North looks so profitable against a sudden devaluation. Suddenly – and against all historic hope – its time again to guard the French-German (and every other European border) with troops for a week whilst the money is stamped.

Note however almost every country borrowed in hard currency (Marks) and got to repay in soft currency (Drachma). This is a scheme which shifts the loss home to Germany and with little compensating benefit except that they get their beloved Mark back. Its a scheme that is way better for the periphery because they get to keep their institutions. In two years they should bounce back like Argentina bounced back after their default.

Unilateral Greek default and devaluation without planning for the periphery to do the same - well that is a true mess. Too ugly almost to think about - and it would be unilateral for less than a week. The rest of Europe falls into that abyss with maximum movement of deposits and cash in the meantime.

The second variant on Greek default. Greece defaults and stays in the Euro

The second variant on Greek default is the one that Germany prefers – Greece defaults and stays on the Euro. (Credit Agricole also prefers this.*)

In the second variant Greece has a huge problem after the default - which is that its banks are insolvent. They own a whole lot of Greek Paper. Moreover Hellenic Telecom does not look that great either.

The recession goes from bad to worse and the government deficit goes from bad to worse. The Germans wind up owning the banks and the telephone company as partial offset to their losses lending to them. The Greek Institutions are captured by the Germans. (All your base are belong to us.)

They also wind up getting paid a little more as Greek austerity - as long as it lasts and that might be a long time - partially reduces German losses but at huge social costs.

The Eurozone becomes really dysfunctional - with the whole periphery totally unable to work their way out and having lost all their key institutions to the Germans who neither know how to run them nor really want them.

Moreover Greece stays expensive and unproductive and becomes more socially fractious. The likelihood of them staying the the Eurozone would be pretty low. (After all what have the Germans ever done for me!)

Europe would be held together by a massive and compulsory German aid budget. If they can't get that agreed on on day dot (and Merkel and the German constitutional court are not of that mind) then my guess is that is is in Greece's interest to go the Argentine route and let the rest of Europe fend for themselves.

And for that Europe will need troops on borders. Armed and dangerous.

Bring out the guns.

The head of the world’s biggest bond fund said he sees a more than 1 in 3 chance that the euro zone will break apart and trigger a financial crisis akin to the one that devastated the global economy in 2008.

“It would be the equivalent of a sudden stop” in which financial markets seized up, Mohamed El-Erian, chief executive officer of Pacific Investment Management Co. in Newport Beach, California, said. “It would be really, really messy.”

The global economy suffered its worst recession since World War II after the collapse of Lehman Brothers Holdings Inc. in September 2008 triggered steep falls in global stock markets. Gross domestic product in the U.S., the world’s largest economy, shrank by 5.1 percent.

El-Erian said in a Bloomberg interview that the crisis in Europe is no longer just about what will happen to periphery nations like Greece. “It is now a crisis for the euro zone as a whole,” he said.

He said the most likely outcome -- with a 1 in 2 chance -- is that European policy makers “get their act together” and manage the transition to a smaller currency union. The least likely is that the 17-nation euro zone stays intact: the possibility of that occurring is just 15 percent, he said......

The March of Eurofolly - Eurozone Sovereign Debt Crisis: Causes, Consequences and Solutions

Causes
Monetary unions and single currency areas hold together where and when there is: unimpeded movement of goods, services, capital and labour; a single monetary authority; similar productivity and competitiveness across the area; and a unitary fiscal system, including an effective system of fiscal transfers to overcome the productivity and competitiveness disadvantages of lagging regions. And they fall apart when one or more of these necessary conditions are not met reasonably well over a significant period of time.

The Eurozone has reasonably unimpeded movement of goods etc, and a single monetary authority (the ECB). But productivity and competitiveness vary significantly across the area and it lacks a unitary fiscal system with adequate fiscal transfers. Current attempts to establish a unitary fiscal system (or at least greater fiscal discipline across the area) will take time. The Eurozone’s sovereign debt crisis is now, not in 2-3 years time.
The debt crisis has arisen because EU members with lower productivity and competitiveness have borrowed and spent more than they can sustain: their debt service costs have become unsustainable. Critical debt unsustainability tipping points were reached by several members (Ireland, Portugal, Greece, Spain) during the 2008-09 GFC. Greece is well past that tipping point. Italy is very close to it.

Consequences
The consequences depend on the size and nature of each sovereign debt problem. If the debt was used to build up saleable public assets, then there isn’t a basic solvency problem, but there might be a liquidity problem: it may take longer to sell the assets than the government has to repay the debt. This kind of problem can be handled by refinancing or bridging finance. If so, there need not be serious economic consequences, but there may be political consequences from the transfer of assets from public to private hands.

But the sovereign debt crisis in the Eurozone is not mainly of this kind. Instead it is mainly about the basic solvency, or ability to repay, of the debtor government. What happens in this case is that either the debt is not repaid (a default) or it is repaid, either through forced expenditure switching, or increased revenue (taxes) or a combination of these. Typically, this kind of debt problem is solved by one or more of the following measures (in some combination):
1. the debtor declares a default on some or all of its debts
2. the creditors (or a subgroup thereof) reschedule some or all of the debts
3. the debtor raises more revenue and/or reduces public expenditure to allow (some of) the debt to be repaid
4. the debtor increases its ability to repay through growth (lifting productivity and competitiveness through structural adjustment)
5. a “lender of last resort” comes to the rescue by providing additional finance, usually on condition that debtor pursues fiscal restraint and structural adjustment measures (as in 3 and 4 above).

The current Eurozone debt crisis will be resolved, ie confidence restored in the security of Eurozone sovereign debt, only if a combination of the following happens:
1. ECB plus IMF plus sovereign lenders outside the EU provide sufficient financial backing to ensure Eurozone bonds falling due are honoured
2. Debt levels of the most vulnerable countries (PIIGS) are reduced to sustainable levels through rescheduling and/or refinancing and/or inflation
3. Growth in the PIIGS is revived through structural adjustment and fiscal transfers
4. One or more of the PIIGS is/are allowed to leave the Eurozone in order to devalue to restore external competitiveness
5. A system of fiscal transfers is established sufficient to help lagging regions/countries grow or catch up
6. Taxing/spending /borrowing across the Eurozone is harmonized or at least properly coordinated and monitored.

RBS, Britain’s biggest government-owned lender, posted a wider-than-expected full-year loss after taking a sovereign-debt impairment of 1.1 billion pounds ($1.7 billion). Commerzbank, Germany’s second-biggest lender, booked a 700 million-euro ($1.1 billion) writedown on Greek debt in the fourth quarter. Credit Agricole, France’s third-largest bank, reported a quarterly loss after 220 million euros in impairments on Greek debt.

Jonathan Tepper .. has prepared a 53-page report with the very confident title "A Primer on the Euro Breakup: Default, Exit and Devaluation as the Optimal Solution."


Many economists expect catastrophic consequences if any country exits the euro. However, during the past century sixty-nine countries have exited currency areas with little downward economic volatility. The mechanics of currency breakups are complicated but feasible, and historical examples provide a roadmap for exit. The real problem in Europe is that EU peripheral countries face severe, unsustainable imbalances in real effective exchange rates and external debt levels that are higher than most previous emerging market crises. Orderly defaults and debt rescheduling coupled with devaluations are inevitable and even desirable. Exiting from the euro and devaluation would accelerate insolvencies, but would provide a powerful policy tool via flexible exchange rates. The European periphery could then grow again quickly with deleveraged balance sheets and more competitive exchange rates, much like many emerging markets after recent defaults and devaluations (Asia 1997, Russia 1998, and Argentina 2002).

Key Conclusions

The breakup of the euro would be an historic event, but it would not be the first currency breakup ever – Within the past 100 years, there have been sixty-nine currency breakups. Almost all of the exits from a currency union have been associated with low macroeconomic volatility. Previous examples include the Austro-Hungarian Empire in 1919, India and Pakistan 1947, Pakistan and Bangladesh 1971, Czechoslovakia in 1992-93, and USSR in 1992.

Previous currency breakups and currency exits provide a roadmap for exiting the euro – While the euro is historically unique, the problems presented by a currency exit are not. There is no need for theorizing about how the euro breakup would happen. Previous historical examples provide crucial answers to: the timing and announcement of exits, the introduction of new coins and notes, the denomination or re-denomination of private and public liabilities, and the division of central bank assets and liabilities. This paper will examine historical examples and provide recommendations for the exit of the Eurozone.

The move from an old currency to a new one can be accomplished quickly and efficiently – While every exit from a currency area is unique, exits share a few elements in common. Typically, before old notes and coins can be withdrawn, they are stamped in ink or a physical stamp is placed on them, and old unstamped notes are no longer legal tender. In the meantime, new notes are quickly printed. Capital controls are imposed at borders in order to prevent unstamped notes from leaving the country. Despite capital controls, old notes will inevitably escape the country and be deposited elsewhere as citizens pursue an economic advantage. Once new notes are available, old stamped notes are de-monetized and are no longer legal tender. This entire process has typically been accomplished in a few months.

The mechanics of a currency breakup are surprisingly straightforward; the real problem for Europe is overvalued real effective exchange rates and extremely high debt– Historically, moving from one currency to another has not led to severe economic or legal problems. In almost all cases, the transition was smooth and relatively straightforward. This strengthens the view that Europe's problems are not the mechanics of the breakup, but the existing real effective exchange rate and external debt imbalances. European countries could default without leaving the euro, but only exiting the euro can restore competitiveness. As such, exiting itself is the most powerful policy tool to re-balance Europe and create growth.

Peripheral European countries are suffering from solvency and liquidity problems making defaults inevitable and exits likely – Greece, Portugal, Ireland, Italy and Spain have built up very large unsustainable net external debts in a currency they cannot print or devalue. Peripheral levels of net external debt exceed almost all cases of emerging market debt crises that led to default and devaluation. This was fuelled by large debt bubbles due to inappropriate monetary policy. Each peripheral country is different, but they all have too much debt. Greece and Italy have a high government debt level. Spain and Ireland have very large private sector debt levels. Portugal has a very high public and private debt level. Greece and Portugal are arguably insolvent, while Spain and Italy are likely illiquid. Defaults are a partial solution. Even if the countries default, they'll still have overvalued exchange rates if they do not exit the euro.

The euro is like a modern day gold standard where the burden of adjustment falls on the weaker countries – Like the gold standard, the euro forces adjustment in real prices and wages instead of exchange rates. And much like the gold standard, it has a recessionary bias, where the burden of adjustment is always placed on the weak-currency country, not on the strong countries. The solution from European politicians has been to call for more austerity, but public and private sectors can only deleverage through large current account surpluses, which is not feasible given high external debt and low exports in the periphery. So long as periphery countries stay in the euro, they will bear the burdens of adjustment and be condemned to contraction or low growth.

Withdrawing from the euro would merely unwind existing imbalances and crystallize losses that are already present – Markets have moved quickly to discount the deteriorating situation in Europe. Exiting the euro would accelerate the recognition of eventual losses given the inability of the periphery to grow its way out of its debt problems or successfully devalue. Policymakers then should focus as much on the mechanics of cross-border bankruptcies and sovereign debt restructuring as much as on the mechanics of a euro exit.

Defaults and debt restructuring should be achieved by exiting the euro, re-denominating sovereign debt in local currencies and forcing a haircut on bondholders– Almost all sovereign borrowing in Europe is done under local law. This would allow for a re-denomination of debt into local currency, which would not legally be a default, but would likely be considered a technical default by ratings agencies and international bodies such as ISDA. Devaluing and paying debt back in drachmas, liras or pesetas would reduce the real debt burden by allowing peripheral countries to earn euros via exports, while allowing local inflation to reduce the real value of the debt.

All local private debts could be re-denominated in local currency, but foreign private debts would be subject to whatever jurisdiction governed bonds or bank loans – Most local mortgage and credit card borrowing was taken from local banks, so a re-denomination of local debt would help cure domestic private balance sheets. The main problem is for firms that operate locally but have borrowed abroad. Exiting the euro would likely lead towards a high level of insolvencies of firms and people who have borrowed abroad in another currency. This would not be new or unique. The Asian crisis in 1997 in particular was marked by very high levels of domestic private defaults. However, the positive outcome going forward was that companies started with fresh balance sheets....

Satyajit Das: They are all at it – but side effects of QE may turn out to be highly toxic
Midweek View: Inflation cuts the value of debt. It also induces consumer spending, as people accelerate purchases

The Bank of England is doing it again. The US Federal Reserve may do it again. The Bank of Japan has been doing it for a long time. Even the Europeans are now doing it, secretly. It is quantitative easing (QE), sometimes parsed as "printing money".

With interest rates low, central banks are changing the quantity of money by buying government bonds, injecting cash into the banking system. In theory, QE lowers borrowing costs and creates liquidity, hopefully stimulating demand and inflation.

But lower rates and increasing the supply of money, of themselves, may not boost economic activity.

Crippled by high levels of debt, low house prices, uncertain employment prospects and stagnant income, household are reducing, not increasing, borrowing.

For companies, the absence of demand and, in some cases, excess capacity, means that low interest rates are unlikely to encourage borrowing and investment.

QE has primarily boosted asset values, subsidised banks, weakened the

currency and helped the Government finance its deficit.

Lower interest rates and central bank buying help boost the value of

financial securities. It increases the attractiveness of financial assets producing higher income, such as dividend-paying stocks or corporate debt.

The effect of QE on real economic activity through higher asset prices is based on the wealth effect, whereby people are likely to spend or borrow more when their investments are worth more.

QE provides discreet subsidies to banks in the short run. Lower rates reduce the cost of deposits, which can then be reinvested in low-risk government bonds at a substantial profit. But QE ultimately pushes down yield on bonds reducing returns, decreasing the net interest margin and profits earned by banks.

QE weakens the currency, improving export competitiveness. It reduces the value of a country's debt which can be paid back in devalued paper money.

But it does not work if everyone tries to do it simultaneously. In the relative game of currencies, every nation cannot have the cheapest money.

The ability of QE to generate rising prices relies on the economist Milton Friedman's observation that "inflation is always and everywhere a monetary phenomenon".

Inflation cuts the value of debt. It also induces consumer spending, as people accelerate purchases, anticipating higher prices in the future. But QE's ability to create inflation is doubtful, at least in the short run.

Unfortunately, the transmission mechanism, the banking system, is broken. The velocity of money or the rate of circulation has slowed, offsetting the effect of QE.

The lack of demand due to weak consumption, lacklustre investment and now government austerity, and excess productive capacity in many industries also means low inflation.

Most developed economies have an "output gap", with total demand well below the economy's potential to produce goods.

QE also creates problems for emerging markets and commodity prices. Low interest rates and falling currency values have encouraged investors to increase investments in emerging markets, offering better returns and more encouraging growth prospects. Much of the capital flows into emerging markets are short term. A rapid withdrawal of this money could be highly destabilising, as evidenced by the Asian crisis of 1997/1998.

As most commodities are priced and traded in US dollars, the lower value of the currency causes commodity price rises. In addition, low interest rates encourage speculation in and stockpiling of commodities.

Higher commodity prices and strong capital flows fuel inflation in emerging markets. Given that emerging markets have been a key driver of the tepid comeback of economic activity globally, this risks truncating the recovery.

The side effects of QE may prove highly toxic, in part because of the risk

of retaliation from affected parties. Emerging market countries are openly talking about "currency wars". Some have already introduced controls against short-term capital flows. Such measures could affect the prospects of global economy recovery.

QE resembles fetishes, objects believed to have supernatural powers.

Despite evidence to the contrary, these financial fetishes are predicated on the belief that the theories and models are correct, policymakers know what they are doing and the actions will be effective.

Satyajit Das is author of 'Extreme Money: The Masters of the Universe and the Cult of Risk'

Bundesbank’s Weidmann Says What No EU Politician Wants to Hear By Jeff Black and Tony Czuczka - Apr 23, 2012

Jens Weidmann is no longer his master’s voice. Almost a year into his new job as the head of Germany’s Bundesbank, Weidmann, 44, has matured from Chancellor Angela Merkel’s discreet right-hand man at global economic meetings into one of the few European policy makers warning that governments are failing to do what’s needed to rescue the euro.

Weidmann’s public criticism of measures such as the “fiscal compact” -- hailed by its architects as the first step to economic union -- has pitted him against Merkel and European Central Bank President Mario Draghi as they struggle to hold the 17-nation euro region together. With Europe in recession and rising Spanish bond yields threatening to reignite the debt crisis after a three-month lull, the Bundesbank’s youngest-ever president says greater fiscal and monetary rectitude is the only way to win back investors’ trust.

“When he was appointed, the press pounced on him and cried ‘Merkel’s man’ because he had worked for her for a few years,” said Manfred Neumann, the professor of international economics at Bonn University who supervised Weidmann’s 1997 doctoral thesis and says he still talks with his former student. “He has shown that he isn’t.”

Weidmann’s arrival on the 12th floor of the Bundesbank’s landmark building in Frankfurt on May 1, 2011, may have been more of a homecoming than a departure. From 2003 to 2006, he led the central bank’s monetary policy and analysis division, serving under presidents Ernst Welteke and Axel Weber, one of his former professors and the man who recommended Weidmann to Merkel. He shared what he learned on his first day in charge, referring to the historic German anxiety about inflation that still stokes public mistrust of the joint currency.

“First of all, the Bundesbank stands for a culture of stability,” Weidmann said during his inauguration speech. Welteke, accepting the same post 12 years earlier in the infancy of the euro, said the Bundesbank’s job was to bring that culture to the rest of Europe.

For Weidmann, that has often meant saying no. With Spanish government officials and French presidential candidates pressing the ECB for additional help as borrowing costs increase, his stand may be tested.

Francois Hollande, who is leading incumbent French President Nicolas Sarkozy in opinion polls before elections that conclude May 6, said April 20 that the ECB should cut interest rates and begin lending directly to governments to promote growth. In Spain, where bond yields are soaring, officials have started to call for the ECB to resume its asset-purchase program.

Governments have consistently looked to the ECB to battle the debt crisis and Weidmann has consistently been the man in the way. When the crisis spread last year to Italy and Spain, the euro area’s third- and fourth-largest economies, Weidmann opposed the ECB’s decision to intervene in bond markets and publicly slammed a proposal to allow the region’s bailout fund to borrow from the central bank.

“The idea that the required money will be created through the printing press should finally be brushed aside,” he said in a speech in Berlin in December. “Doing that would threaten the most important foundation for a stable currency: the independence of a price-stability focused central bank.”

He hasn’t spared Draghi or Merkel, who has vowed to prevent a breakup of the currency union and put the most money on the line for bailouts and financial backstops.

When European leaders agreed on the fiscal compact championed by Merkel in late January, Draghi said it was “the first step toward the fiscal union” and would “strengthen confidence in the euro area.”

Weidmann said it fell short. “Obviously in the negotiations, as often in the past, things were watered down,” he said on Feb. 1. “It’s clear that the cornerstone for a real fiscal union hasn’t been laid here.” For Weidmann, putting Europe’s monetary union on a sound footing involves governments either giving up some sovereignty over national budgets or setting stricter fiscal rules and ensuring they’re enforced.

Neither has happened yet, he said during a March 28 speech at Chatham House in London. While charming his audience with humor and a down-to-earth style, Weidmann offered a sobering assessment. “The time has come to move from containing the crisis to resolving it,” he said. “If we have the will to make the right choices, we will be able to rebalance Europe and lay the foundation for a stronger, more stable monetary union.”

A graduate of the 193-year-old Friedrich Wilhelm University in Bonn who spent time in France, Africa and at the International Monetary Fund, Weidmann was lauded for his “firmness and negotiating skills” by then French Ambassador Bernard de Montferrand when he was awarded France’s Legion of Honor at a ceremony in Berlin in 2009.

Yet his habit of serving unpalatable truths to former political masters and fellow monetary policy makers isn’t winning him friends, said Nick Kounis, head of macroeconomic research at ABN Amro in Amsterdam. “I don’t really think that fellow policy makers are happy that he’s coming up with this,” said Kounis. “Disagreements on the Governing Council, especially between the Bundesbank and the president, can create a lot of uncertainty about the future course of policy. It can also lead to credibility issues for the central bank.”

Critics of Weidmann’s approach include billionaire investor George Soros, who said rising tensions in financial markets reflect concern that the Bundesbank is preparing for the end of the euro. The German central bank is campaigning against “indefinite expansion” of the money supply and seeking to limit losses it would face if the euro splintered, Soros said in a speech in Berlin on April 12. “This is creating a self-fulfilling prophecy.”

Things have not gone Weidmann’s way as the debt crisis presented the ECB with challenges few foresaw. He was outvoted on Aug. 4 when soaring yields in Italy and Spain prompted the ECB to resume and expand its bond-purchase program, a decision that prompted chief economist Juergen Stark, a former Bundesbank vice president, to quit. Weidmann later insisted the ECB should reduce its exposure to risky assets, which it was accumulating after allowing banks to use lower-quality collateral for central bank loans. "The balance sheet of the Eurosystem is burdened with considerable risks,” he said on Sept. 13. “I am of the conviction that these should now be reduced and under no circumstances expanded.”

Six months later, the ECB’s balance sheet had swollen by almost 40 percent to 3 trillion euros ($3.9 trillion) after policy makers flooded the banking system with more than 1 trillion euros of three-year loans to help avert a credit crunch. Now there are calls for the ECB to again come to the rescue as concerns about Spain and Italy mount. Spanish 10-year bond yields have risen more than a percentage point since the start of March to 5.9 percent, and Italy’s have climbed to 5.6 percent. Germany’s 10-year borrowing rate has dropped to 1.7 percent.

The ECB “should step up purchases of bonds,” Jaime Garcia-Legaz, a deputy minister in Spain’s Economy Ministry, said in an interview published April 14. Weidmann is meanwhile pressing the ECB to come up with an exit strategy for its stimulus measures and shift the burden of crisis-fighting back onto governments. He seems to be winning that battle for now, said Christian Schulz, an economist at Berenberg Bank in London who worked at the ECB from 2008 to 2011.

“In the short term, the Bundesbank can create enough fear of humiliation within the ECB that it leaves the pressure on the governments,” he said. “But the crisis has reared its head again and eventually, that might force the hand of the ECB.”

Country .. Total … Households .. Nonfin corps .. Financial Insto's .. Government

Japan ......... 512 ......... 67 ............ 99 ........... 120 ............ 226
UK ............. 507 .......... 98 ........... 109 ........... 219 ............ 81
Spain ......... 363 .......... 82 ........... 134 ............ 76 ............ 71
France ....... 346 .......... 48 ........... 111 ........... 97 ............. 90
Italy ........... 314 .......... 45 ............. 82 ........... 76 ........... 111
S Korea ...... 314 ........... 81 ........... 107 ........... 93 ............ 33
USA ............ 279 .......... 87 ............ 72 ........... 40 ............. 80
Germany ...... 278........... 60 ........... 49 ........... 87 ............. 83
Australia ...... 277 ......... 105 ........... 59 ........... 91 ............. 21
Canada ........ 276 .......... 91 ........... 53 ........... 63 ............. 69