Europe's debt problems can be split up in three blocks:
Bank Solvency; Sovereign Stress and Bank Funding Assets.
All of these elements are self-reinforcing which is why it
is so hard for politicians to break the vicious cycle.
Sovereign stress in mainly due to excessive debt to GDP
ratios such as Italy's at 120 percent. Normally, such
ratios can be maintained for quite a number of years as
long as the economy is growing at a healthy pace. In most
of the Eurozone countries, especially in Greece, Italy,
Spain and Portugal, the economy has been stagnant and
slow to recover - mainly due to high taxes, stifling
regulation and excessive spending on welfare and other
government projects. For example, the average retirment
age in Greece is 53, much lower than EU or US averages.
In the market place, those deteriorating fundamentals lead
to a fall in the price in the underlying debt of the
troubled countires, as investors require a higher risk
premium in the form of increased yield for the risk that
they are taking. The risk is higher, because GDP needed
toservice the debt is generated at a slower pace.
If positions in these bonds are dispersed and concentration
is low, this is not a problem. Even an outright default
can be managed, as it was seen with Argentina in 2002.
Private investors take the losses on the bonds (up to 70%)
and that country can restructure and grow again as Argentina
demonsrated form 2003 onwards.
In the case of the Eurozone, however, this is not the case.
Most of the trouble sovereign bonds are held by a small
number of big banks. If those bonds keep losing value, the
banks in question will suffer losses.
The next building block is bank solvency. If the banks ar
adequately capitalized to absorb losses in bad investments,
the crisis would stope here. But since their holdings are
so large and the potential write downs so big ($554 Billion)
the European banking system would not be able to sustain a
full-scale default of only a small number of countries. THis
is also due to the high leverage to equity of the whole
sector, which some estimates place at 25 to 1. This means
that a 4% loss in value of all the banks assets (including
sovereign bonds) would wipe out their entire equity capital.
When a bank defaults, its equity becomes worthless but
unsecured creditors who loaned the bank money will lose at
least some of their principal. Since the funding that
banks provide to each other in the money market is mostly
unsecured and short-term, banks will reduce their lending
activity to each other as they know about the added risk
that concerns themselves and their counterparties. This
is bank-funding stress and again in Europe it highly
concentrated and systemic but some external players from
the U.S. and Asia could also lose their investment.
When banks can not fund their longer-term investments
(govenrment bonds) with short- term funding (Money Market),
they need to sell those assets to repay their funding.
This will put further stress on the bonds and the cycle
starts again.
In order to break this cycle,politicans need to present a
credible soluton for all three problems at the same time.
This is why the market's eyes will be fixed on EU leaders
once again on Wednesday when a credible and practicable
solution finally needs to be put forward.