“…At the end of the day, Germany would have run a bigger deficit (i.e. coming from the losses reflecting the guarantees), higher interest rates, lower ratings, a weaker financial system with bigger deposit runs…”
Click here to read this article in pdf format: May 29 2012
In our last letter, we dealt with the issue of (EUR/USD) liquidity in the capital markets and although we described some facts, we did not mention a relevant one: That while the 3-month EURUSD swap basis has not risen, the 3-yr (and longer term) has. In other words, the spread between the two bases has widened, as the chart below shows (source: Bloomberg).
This steepening, in our view (and we welcome readers’ feedback), is caused by the existence of the 3-yr LTROs (Long-term refinancing operations), established by the European Central Bank (ECB) at the end of 2011, beginning of 2012, coupled with the 3-month Fed currency swaps. As is also visible from the chart, in the past, the widening (i.e. steepening) of this spread of the EURUSD basis curve was corrected with (i.e. preceded) interventions. Is there one coming soon? A long-term currency swap? For three years? We doubt it, given we’re only a few months away from the US presidential election, and not only do we doubt it: We also think that should there be one, its effect would be very marginal.
During the past week, one rumored alternative intervention was a blanket guarantee on euro denominated deposits, across the European Union. We will explain why we think it would not work:
A guarantee is a contingency. According to generally accepted accounting principles, they way to record a loss contingency is to show a liability, against a loss. This means that in the balance sheet of the corporation issuing the guarantee, liabilities will rise and the value of equity, by the same amount, will fall.
In corporate finance, these contingencies must be shown every time that the following conditions are simultaneously met:
a) Information available prior to issuance of the financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred,
b) The amount of loss can be reasonably estimated
Indeed, national accounting is not corporate accounting. But principles are principles and at the end of the day, it is the private sector, people, that end up holding euros to be guaranteed by Bunds.
Should, as the rumor spread, Germany and others from core Europe, offer the guarantee to the ECB to back liquidity, the value of their own liabilities would fall, helped by the corresponding downgrade of the ratings agencies. In other words, the benchmark rate of the Euro zone, the bund yield (i.e. German sovereign bonds), would increase. The asset, the Bunds, would have been impaired, as condition (a) states. This would fuel the ongoing recession within the Union, possibly buffered a bit by the fall in the value of the Euro and capital gains (stock gains) in Euro financials.
An answer to this would come from the ECB, via purchases of Bunds. With them, the expansion of Euros would be driven by the purchase of Bunds and all and any support left for Bunds from the private sector would be lost, just like it was lost for the long-term US Treasury bonds: As you may know, under Operation Twist, the Fed purchased 91% of all 20-30 yr gross issuances!!
At the end of the day, Germany would have run a bigger deficit (i.e. coming from the losses reflecting the guarantees), higher interest rates, lower ratings, a weaker financial system with bigger deposit runs (now affecting core European banks), and a currency of lower value….The question is…..What makes you think Germany will want to go for this?
Martin Sibileau
