TLGP for the Eurozone

The background to the Eurozone fiscal crisis that began with Greece needs no introduction, but the constant "will they or won't they" aspect of recent press reports has added significantly to uncertainty around the end-game. This is a case of too many policymakers, too many journalists, over-reliance on algorithmic translators such as Babelfish and the impatience of the market with respect to a resolution.

The universal view of market participants has been that a resolution of the Greek issue would only cause speculators to move onto the next victim. This was a lesson learned in 2008 as the way in which Bear Stearns was bailed out provided a relatively low risk way for speculators to create a synthetic run on a bank (creditors were bailed out, equityholders were wiped out - so buying protection in CDS and shorting the bank equity was at worst a dirty hedge in the end game, and at best a home-run). As the chart below shows, this has indeed happened as speculators have moved onto Portugal and Spain.

Of course, with respect to Eurozone debt, the scenario is somewhat different. The most obvious is the lack of "equity" (how do you short the "ownership" of a country?). Market participants have therefore (rationally, perhaps) shorted the EUR and European equities (especially those of the peripheral) and these have obviously performed very poorly. The second major difference is that market participants expect this scenario to play out and are thus positioned as such. The payoff profile of these trades is thus very different from the bank scenario (despite the protestations of many Americans, the EUR cannot go to zero), and what was at worst a Mexican Hedge (i.e.-not a very good one) is more like a Texas Hedge (i.e.-double the risk). This means that a policy response which deals with the system-wide problem will be far more potent.

Many have argued that it is unfair that Germany should pick up the tab for the profligacy of other Eurozone nations, and also that it is unfair that Ireland has embraced austerity in the name of restoring credibility and sustainability, while other states are bailed out. They have also argued that Germany will refuse to pick up the tab as it would introduce Moral Hazard and raise Germany's borrowing costs.

All of these points are very true. But they miss some, in my view, very important points. Firstly, Germany is aware that Greece will struggle to introduce austerity and, as a result, requirements attached to assistance only need to appear stringent to a domestic audience. Secondly, the experience of Lehman Brothers demonstrated what happens when an entity is sacrificed on the alter of Moral Hazard - there is no interest in Europe to ignite yet another financial crisis when the Eurozone bank balance sheets still hide significant losses. Thirdly, according to the BIS survey of banking claims (http://www.bis.org/publ/qtrpdf/r_qa0912.pdf ...page 62/63), to Greece alone, there are $245bn of claims, $39bn of them from Germany and $73bn from France.

This is a side effect of the Eurozone as a whole running a balanced Current Account. Forthly, contagion has already begun as speculators have moved onto other nations - Germany hates speculators. Finally, Germany is a "hard money" country, with a desire for a strong currency - it does not want a currency that trades like the Drachma, it wants one that trades like the Deutschmark - this is a matter of national pride.

The Wall Street Journal last night ran an interesting story (http://online.wsj.com/article/SB10001424052748704182004575055292744721172.html?mod=WSJ_hps_LEADNewsCollection) reporting that Germany and the EU are considering loan guarantees for Greece and for other troubled nations. This is interesting because it clearly demonstrates that EU policymakers have taken on board the lessons regarding the domino effect on banks in 2008. Secondly, it does not cost anything upfront apart from, perhaps, a small rise in German CDS as the market moves to price in the reality that there really is a single fiscal authority in the Eurozone. In many ways, if enacted (I believe it is inevitable that it will be), this shows striking similarities with the TLGP (Temporary Liquidity Guarantee Programme) announced by the FDIC at the height of the panic in October 2008. This was a loan guarantee program for bank debt and marked the point at which the wholesale run on the banking system ended (see the below chart of Libor-OIS spreads). This strongly suggests that such an announcement would lead to a very sharp tightening of Sovereign spreads.

This move, of course, would also serve to hurt speculators. The French & Germans must be rubbing their hands with glee.