In an early South Park episode, desperate for help on a school project requiring them to formulate a business plan, Stan, Kyle, Kenny, and Cartman enlist the aid of their jittery friend Tweek’s Underpants Gnomes (h/t KW). The Gnomes’ foolproof plan?:
- Collect Underpants
The Gnomes see to have taken their brilliance to Europe, because the vaunted rescue scheme hatched over the last few days looks like:
- Announce grandiose plan
- End Crisis
Each major element of said grandiose plan has many “?”.
Take the bank “recapitalization”–please. How do the Eurognomes know that banks will respond to the capital requirement by adding equity capital, rather than dumping assets and contracting their balance sheets? If the banks do decide to raise capital, who is going to invest? Is compliance with the capital ratio going to be determined using legit asset valuations–particularly on Euro debt, or some mark to fantasy accounting? What happens if the banks don’t meet the new requirement?
Next consider the “haircuts.” The IIF (a banking industry group) cross-its-heart-hope-to-die promised that banks would volunteer to take a 50 percent haircut on Greek debt. Will the banks actually respond to the call? Is 50 percent really adequate to address Greece’s problems? Recall that just last week it was revealed that 60 percent reductions in Greek debt were necessary to put the country on a sustainable path: 50 percent of 50 percent of Greece’s overall debt is less than 50 percent of the way to 60 percent. And is it really 60 percent? There are evidently “sweeteners” in the deal: where is that money going to come from? And doesn’t every Euro in financial HFCS just reduce the amount of Euros the vaunted EFSF has to backstop other countries? If Greece gets a 50 percent haircut (OK, 25 percent), what effect will that have on the Portuguese, Italians, etc.?
And speaking of the EFSF, let us turn to “leveraging” it. Where is the additional money going to come from? Where is the money going to come from? Where is the money going to come from? (Repeat as needed.) ECB money–out. Sarkozy is going to China, hat in hand. The Eurognomes are hinting broadly that the BRICs, the IMF, your Aunt Fanny, are all welcome to invest in some CDO/SPV contraption that will buy debt from shaky Euro countries. The EFSF will take the first 20 percent of the default losses. But investors could buy debt in the secondary market or at auction at prices that reflect estimates of default probabilities and recovery rates. What is the real benefit of getting involved in the Gnomes’ financial engineering scheme?
No, this entire scheme is aspirational. It defines the end state that the Euros would like to achieve, but does not specify an even remotely credible path to get there. Just like the Underpants Gnomes’ dreams of profit.
Nonetheless, the equity market and the Euro staged a euphoric Tinker Bell rally yesterday–one of the most frenzied yet. Ominously, however, today’s Italian bond auction was not a success, with low participation and yields on the 10 year at over 6 percent.
Betting on the Eurognomes foolproof plan is, IMO, foolish. They are failing to grapple with the fundamental arithmetic, and the fundamental choices: amputation or gangrene, socialization or monetization. Until they do, you’re better investing in Tweek’s Gnomes’ strategy for financial security.