As Europe's exuberance from the LTROs fades (with Italian banks now negative YTD, Sovereigns wider than LTRO2 levels, and financials desperately divided by the LTRO Stigma) Jefferies David Zervos uncovers the sad reality that faces peripheral creditors and Northern Europeans. The 'success' of the LTRO monetization scheme (as opposed to EFSF/ESM transfer debacles) is what enabled the Greek restructuring, and as Zervos notes, the losses that the big boys (Spain and Italy) need to take will not be taken via a haircut but a monetization as the number 1 rule is we must always assume that losses will be taken in a way that protects the large northern banks, northern jobs and most importantly Northern politicians. If the loss realization is not managed correctly (and losses there will be), then the ugly truth will escape but the North's large-scale vendor-financing scheme with the periphery will have to continue - even in the knowledge that the debt will never get paid back.

The income and savings of Northern workers must be ploughed (directly or indirectly) into the rest-of-Europe or the entire structure becomes insolvent and the breaking of that social contract (that they will be looked after when they are old) will inevitably lead to revolt and nasty nationalist political forces being unleashed. The hope to avoid this is the 'wealth illusion' as the workers of the north can never be allowed to realize they have only 50% of their worth in reality. Ireland will be next on the loss-realization-monetization path but as we move from relatively small and containable sovereigns to the big-boys, the idea that Spain and Italy will roll over and accept a decade of austerity in exchange for a haircut is pure folly. These countries hold too much clout in the Eurozone and their threat of exit is a material threat to the northern jobs and hence northern politicians. The only way the northern politicians will be able to save face when it comes to Spain and Italy is through massive monetary policy accommodation. Inflation will rebalance Europe; but let's hope that the process of restating northern wealth and wage rates does not lead to revolt in the northern streets. The politicians will need to carefully execute this trade.

The Ugly Truth - Northern Europeans Have Worked For Naught

While writing at Jefferies over the past few years, I have rarely put forward a bullish case for European investments - bonds or stocks. I recall in the summer of 2011, as sentiment soured quickly in Italy and Spain, I argued vehemently that the Europeans would not let a single country default until they had an effective backstop/firewall in place. Implicitly, that may have been short term bullish, but it was just a bet that chaos would not be unleashed without a proper mechanism to control the side effects in major northern European markets.

The LTROs were the firewalls, and as their success was realized, the case for a managed Greek default could clearly be made. We have now moved past a successful haircut process in Greece. And the poor saps who bought Greek debt anywhere from par down to 30 cents had their clocks cleaned. I don't know how many times I heard from talented money managers around the world that Greek bonds at 70 or 60 or 50 were a great investment. For them, Greece would never be let go - sovereign European debt had the Trichet stamp of "money good". Worthless!

Of course, in the end, it was just a matter finding the right firewall structure before the creditors were torched. And going forward, the rest of the loss realization process in Europe MUST commence - starting in Ireland and then onto Spain, Portugal and the big Kahuna, Italy. In some fashion, creditors to these nations will ultimately be stuffed - either through inflation or a haircut. These countries will never be able to pay off their debts in “real” euros. And as I will argue below, for the big boys, the losses will never be realized via a haircut, but only through monetization.

The most important factor to consider as we go through the remainder of this loss realization process is politics – we must always assume that losses will be taken in a way that protects the large northern banks, northern jobs and most importantly northern politicians. That is the number one rule! German and French leaders can never go back to their voters and tell them the truth. The northern working classes have jobs, pensions, insurance contracts, annuities and wealth that are all tied to the peripheral market's ability to pay back its debts. If the process of loss realization is not managed carefully, then the workers/voters will immediately see the ugly truth.

And what is this ugly truth? Simple - that in order for the mercantilists of the north to have these jobs, and to sell their wares, they have had to put large portions of their income into savings that was backed by the worthless debt of their target export markets. The north has executed a classic vendor finance structure, with no chance the financing will ever be paid back. The northern voters have basically been working for a fraction of their stated wage rate - their politicians have lied, but so far they have not been caught. The masses have jobs, and a social contract that says they will be well-looked after when they are old. That contract however is ultimately null and void.

In the event of a mass default, euro break-up or EMU unwind, this ugly truth will become immediately transparent. The entirety of the northern financial system will be insolvent - pension funds, annuities, insurance contracts, and most importantly, jobs will be destroyed. The workers/voters of the north will quickly realize that all their toiling and saving over the last few decades was for naught. There will be revolt in the streets and some very nasty nationalist political forces will be unleashed. This is by far the most frightening risk in the European debt crisis evolution process.

While there is always a chance that such a horrific outcome could come to pass, it is certainly NOT the most likely path forward. Northern politicians have no incentive to come clean with what they have done. They will instead use every means necessary to ensure that "wealth illusion" is preserved in northern Europe. The workers of the north can never understand that they really only have 50 percent or less of their real current wealth.

As stated above, the best way to predict the way forward in Europe as a whole is to look at the political process in the north. Greece was cut off and eventually let go because it suited the political goals of the north. Vilifying Greek largess was much easier than blaming corrupt northern lenders and defense contractors. Greek debt was the fuel that generated many northern jobs - but no northern voter wanted to hear that. They wanted to blame someone else for their financial sector woes. Importantly, the leaders of the north concocted a way for Greek debt to be extinguished without transparently destroying northern wealth or jobs. The EFSF, ESM and LTROs were all part of the obfuscation process. And the transparency of the transfer process in the EFSF and ESM never took hold, it was only the monetization process of the LTRO that finally did the trick. That is important! Monetization works well and sells well – transfers do not.

The next loss realization will take place in Irish sovereign debts that were originally racked up by Irish banks - remember the ones that require payments of 2 percent of GDP in perpetuity back to northern creditors. If the Irish play ball, and insure that their economic competitiveness is shredded via the fiscal compact in this coming referendum, then maybe they will get some payment relief. In other words if they agree to policies that ensure northern jobs are not threatened near term, then their debt service will be reduced. That trade off works for northern politicians – they keep the northern job market healthy and slowly take the losses associated with bad peripheral lending. Again, Irish debt haircuts can probably be contained like the Greek ones were – they are small enough in the grand scheme.

What the north cannot have is immediate losses in voter wealth followed by a surge in competitiveness from the south. If that happens en mass the northern politicians are dead - the jobs and hence the votes are lost. They need to keep Greece, Ireland and the remaining peripherals uncompetitive while they go through this loss realization process. That is the only way northern jobs are preserved. This is why we see a non-stop obsession with austerity in exchange for debt relief.

But as we move away from Greece and Ireland, the loss realization process becomes much more complex. In Greece, the north was able to control the political process - but others will recognize the benefits of a competitive devaluation. Maybe Ireland steps up, and wrestles control from the Euroarea leaders. Maybe the voters recognize that those debts at Irish banks were the fuel that created German jobs. Or maybe the Irish fall down like Greeks and let the Euroarea leaders hold their economy hostage for the next decade. It could go either way frankly. But the idea that Spain and Italy roll over and accept a decade of austerity in exchange for a haircut is pure folly. These countries hold too much clout in the Eurozone and their threat of exit is a material threat to the northern jobs and hence northern politicians. A Greek, Portuguese or Irish threat is simply not relevant.

The only way the northern politicians will be able to save face when it comes to Spain and Italy is through massive monetary policy accommodation. The ECB will yell and scream, but the loss realization process will have to go through the Euro, inflation and the traditional forces of financial repression. Italy will not exchange a haircut for a decade of austerity. They don't have to! In addition, an Italian or Spanish haircut will make the debt for jobs trade too obvious. It will hit the northern saver transparently and aggressively.

The north cannot allow their financial system and their voters' wealth to be transparently destroyed via Italian and Spanish haircuts. The process of default break-up and exit cannot escalate - it will be political suicide in the north. As we have argued many times, there is a reasonable chance Greece, Ireland or Portugal exit. In fact, political forces in north may benefit strongly if they leave.But the idea that Spain, or especially Italy, could leave is another matter entirely. Euro area inflation will almost certainly be used to solve Italy and Spain's competiveness and indebtedness problem. Of course the side effect will be wealth destruction and inflation in the north.

One way or another wealth will be transferred from the north to the south. And the most important point is that stated northern wealth is simply a mirage. They never really had it and they have been working for many decades for a wage rate that is a small fraction of the advertised level. The only way a northern worker was able to be paid such a high "stated" wage is that a big chunk of the paycheck went to feed a pension and savings structure which was recycled into worthless peripheral debt. Inflation will rebalance Europe; but let's hope that the process of restating northern wealth and wage rates does not lead to revolt in the northern streets. The politicians will need to carefully execute this trade.

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Selasa, 03 April 2012

Can you say Transfer Union ?

The Ugly Truth For Northern Europeans

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