You Lick Mine First

This week, the German Constitutional Court ruled that Germany’s role in supporting the EU’s periphery was not unlawful.  The market’s knee-jerk reaction was to blast higher on the news, as the alternative would have been a total disaster.  Upon closer inspection, it appears that smooth sailing into the future is far from certain. The court stressed that the decision was not a “blanket” approval for future bail-outs and demanded that the German Government “ask permission” of the Budget Committee before handing out any more cash to their southern neighbors.  At the end of the day, this means that future bail-outs will be even more difficult to execute as the process is slowed further by administrative tape around afternoon siestas.

This is important.  Time is quickly running out for the EU. The lack of a comprehensive solution after two years of “can kicking” means that the periphery’s disease has infected the core and the odds of a disorderly default have increased substantially. Rather than proactively addressing the challenges in the region – restructuring debt, recapitalizing banks, promoting growth, etc. – policymakers have waited for market’s to force their hand and only then, did they plug another hole in the periphery with their finger.  With one year Greek debt within spitting distance of 100% yields, they are now running out of fingers.  With Italian and Spanish yields back on the rise, the holes are getting too large to plug.  Something’s gotta give.

Unfortunately, this is not just a government debt issue.  The debt overhang encompasses households, corporations and financial institutions as well. Many European banking systems are two to three times larger than their respective economies.  European banks have raised roughly half the capital raised by US banks since March 2009 and are much more reliant on volatile wholesale funding, particularly with deposits steadily drifting to Swiss safe-havens.  So yes, we adamantly agree with new IMF Head, Christine Lagarde’s tough message, “Banks need urgent recapitalization. … If it is not addressed we could easily see the further spread of economic weakness to core countries, even a debilitating liquidity crisis. The most efficient solution would be mandatory substantial recapitalization — seeking private resources first, but using public funds if necessary.” If it is not addressed, the coming sovereign debt crisis will make Lehman look like a walk in the park. It is actually quite sad that most folks in Europe are ready to throw her under the bus for even hinting that banks might be a tad undercapitalized.  If European banks held sufficient capital, one would think that they would have written down the value of impaired sovereign debt on their balance sheets.  That is not the case.  As the FT highlights in, Auditors Under Fire Over Greek Debt, these banks are marking their books more or less arbitrarily, with write-downs ranging from more than 50% to less than 20% on Greek debt.  These are not obscure, difficult to value assets.  They are government bonds.  The price of which is crystal clear, yet the range of carrying values is as absurd as the perception that these banks are solvent.

Source: Financial Times

While the rest of the world has put all its chips on the creation of a “Eurobond,” the German Court appears to have shattered those hopes for now, stating that the German Parliament “is prohibited from establishing permanent mechanisms . . . which result in an assumption of liability for other states’ voluntary decisions.” Granted, this could change quickly should markets begin to riot, but speculating on the outcome of backdoor politics has a success rate only matched by economists. It is difficult to handicap American politics. Next to impossible to do so for the multiple constituencies across Europe. But for some background on the Germans, we can turn to one of our favorite financial author’s, Michael Lewis, who explains, It’s the Economy, Dummkopf!  The full Vanity Fair article offers fantastic insight into the German people and at a minimum makes for entertaining weekend reading.  Per Lewis, “Germans longed to be near the shit, but not in it. This, as it turns out, was an excellent description of their role in the current financial crisis.”

For better or for worse, the Germans now own Europe.  They have essentially accomplished economically, what they failed to accomplish militarily decades ago.  The geopolitical implications of this shift in power are of great consequence.  This analysis from the folks at Stratfor provides additional insight into the origins of the Eurozone and implications of the “New Europe.” Lewis makes an excellent point that for the Germans, the Euro isn’t just a currency.  It’s a device for flushing the past. “There is a common German expression . . . which translates directly as “Lick my ass.” To this hearty salutation the common reply is “You lick mine first!” Fitting, given German public-opinion polls against the Greeks. Get the popcorn ready.  We are approaching the grand finale of this slow motion train wreck.