The First Bondholders In Europe Have Faced A Haircut And It May Not Be The Last

The European Central Bank (ECB) has been focused entirely on saving as many insolvent countries as possible since 2009. 

Its bond purchases and bailouts are solely focused on financing each troubled sovereign until they can either solve their own problems, or the Eurozone economy heals itself enough to begin reducing debt loads through growth. 

This is the European form of “extend and pretend,” and is similar in many respects to the US version.

Where the two diverge is the favoured growth engine.  The US Federal Reserve is trying to encourage consumer spending through a stock market wealth effect.  Europe’s hopes lie in exporting goods to those same US consumers.

In bailing out “peripheral” countries the ECB has to maintain some form of stable currency to protect against capital flight.  Fleeing investors almost destroyed the Euro in mid-2010 as money poured out of the Euro and into the Swiss franc.  That triggered massive currency interventions by the Swiss central bank.  This kind of capital flight is still occurring in Ireland, forcing that country to continually bail out its banks and seek help from Brussels.

The instability in the European financial system brought the value of the Euro down in terms of most other major currencies, particularly the US dollar and Swiss franc.  That currency movement ignited the “German miracle”.

Eurozone economic strength in 2010 was almost entirely a product of German export prowess.  Strength in the German economy has brought enough hope to the entire continent that “extend and pretend” seems to be succeeding.  Yet the economic strength and seeming financial stability may be upset by recent events.

First, the German export economy may be slowing dramatically.  German industrial production fell by a large 1.5% in December, after seeing a 0.6% drop in November.  While many have blamed snow for the declines there was no increase in energy output that should have occurred if cold weather conditions were really to blame.   In reality it is likely that any lost momentum is due to currency readjustments – fourth quarter GDP slowed considerably to 0.4% from 0.7% the previous quarter. 

Second, the Danish government was forced to takeover Amagerbanken, the country’s eighth largest bank.  While this was not really notable in and of itself, the fact that it will force senior bondholders to take losses is very notable.  This represents the first major losses for bondholders and depositors alike.  It is estimated that the losses could be as high as 41%.

Amagerbanken itself has been bailed out more than once, and yet still sees its assets at only 58% of liabilities (this is an astounding imbalance and gives new meaning to the term insolvent).  The fact that such a horribly run bank could pass last year’s European stress tests only adds to the distrust over the entire regime of bailouts.  If Amagerbanken passed with flying colours only to fail and create hefty losses for bond investors, it makes other investors of questionable banks begin to rethink their holdings.  And there are literally hundreds stuffed with Greek, Irish, Portuguese and Spanish debt.

If this bank failure creates the first stirrings of unease the ECB will find itself in a terrible place.  In order to keep the financial system afloat it will have to expand or initiate programs for banks that may keep the Euro artificially high, or at least keep capital from fleeing the zone.  In doing so, it will be undermining its only source of economic strength.

The ECB and financial officials in Europe have been warning that bondholder losses would lead to turmoil. 

The last thing they need is to be faced with a choice of saving the banking system at the expense of economic growth or allowing the banks to domino to keep German exports afloat.  Such is a world awash in intervention.

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