Goldman Sachs On The Perverse Feedback Loop That Caused Italy To Explode

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Excellent points from Goldman on some recent decisions from policymakers in Europe that have made the Italy crisis worse:

  • Italy undoubtedly has large responsibilities for not being ‘ahead of the curve’ in its fiscal strategy, especially after the central bank stepped into the fray in early August. But the sharp widening in Italian BTPs started in mid-June, after the introduction of ‘substantial’ private sector ‘burden sharing’ (PSI) in the restructuring of Greek debt (which had previously been ruled out by policymakers). The ECB itself had cautioned that PSI would lead to contagion in a deeply integrated financial area, and was proven right. Aggravating problems, policymakers have been unwilling to allow sovereign CDS to be triggered, perhaps out of concern of unintended effects. But, on learning that a severe bond restructuring would not be considered a credit event, many investors apparently judged that they had less risk protection than they thought, and reduced bond exposures.
  • The recent decision by the European Banking Authority (EBA) to oblige EU commercial banks to strengthen capital positions by building up a ‘temporary’ capital buffer against sovereign debt exposures, including those of Italy, has set in motion a perverse chain of events. Banks sold sovereign securities, preferring to park money with the ECB, and have reluctantly participated in the primary market. The resulting decline in prices following these bond sales perversely led to more sales, and a progressive destruction of demand. As a result, 5-yr BTPs, for example, are now 10 points below where they were at end-September, when price marks were recorded for the recapitalization exercise, illustrating the adverse loopback effects that policy decisions have introduced.

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