Global Liquidity

Benoît Cœuré, Member of the Executive Board of the ECB has penned a speech (and argument) on global (excess) liquidity. Izabella likes it and I agree with her that it is a good piece. I am not sure though that it is that much different than the Savings Glut argument put forward by Bernanke, but I may be missing the fine print (i.e. need to read it more carefully). The biggest problem I have is that he assumes that the lack of safe government (i.e. AAA rated assets) is cyclical and due to market failure or other "temporary" factors. Izabella interprets it as follows, 

What’s the solution to this vicious liquidity circle? Simple, says Cœuré. The euro area needs to regain its role as a global supplier of safe assets. Something which could be achieved by a) ensuring that Eurozone countries have become fiscally sound and b) diverting excess liquidity from other zones back into “programme countries” by way of the IMF.

I disagree. The failure of euro zone economies and indeed large parts of the OECD edifice in general to provide "safe haven" assets is deeply structural and tied to population ageing. Unfortunately, there is little prospect that the euro zone economies will be able to supply AAA rated securities for a long time and herin lies the rub. Of course, if we are talking euro bonds, but then again. I will believe it when I see it. 

Japan and the currency wars 

A recent Bloomberg article suggested that Japan has been "secretly" selling JPY to try to stem the tide and force through depreciation of the Yen.

Japan used so-called stealth intervention in November as the government sought to stem yen gains that hammered earnings at makers of exports ranging from cars to electronics.Finance Ministry data released today showed Japan conducted 1.02 trillion yen ($13.3 billion) worth of unannounced intervention during the first four days of November, after selling a record 8.07 trillion yen on Oct. 31, when the yen climbed to a post World War II high of 75.35 against the dollar. The currency’s strength has eroded profits at exporters such as Sharp Corp. and Honda Motor Co., just as faltering global growth undermines demand. 

Open market operations to sell domestic currency are so old school. Didn't they get the memo in Japan? In a world where all major central banks are either at or very close to the zero bound, it is central bank balance sheet expansion (quantitative easing) that matters. On this note, both Japan and the Fed are being left decisively behind by the ECB and BOE (at least in the past six months). Of course, even the usage of "standard" measures in Japan is being contested and as long as this is the case, the Yen will continue to strengthen.

Don't bet on deflation with the current team of global central bankers 

Elsewhere, I am wondering where all the deflation, let alone disinflation, is. I am a sworn deflationist and I believe in the main thesis of the deleveraging/depression/deflation crowd. However, I have the utmost respect for the inflationist bias of global central banks and with the current batch of policy makers at the helm, deflation is a very remote risk.

The latest data show that inflation in China recently quickened as well as producer prices in the UK increased in the week that the BOE announced another round of QE. Of course, this is not all clear cut. Chinese real M1 (YoY) recently moved into negative territory for the first time since 1996 and in the UK, it is noteworthy that core inflation (ex food, beverages, tobacco and petroleum) came in noticeably lower in January. 

I will change my views on the basis of changing data, but I am beginning to think that the bout of global headline disinflation we are expecting as a result of the global slowdown will reverse itself much, much quicker than many (including me) have expected. Arguably, we still need decisive easing in emerging markets and QE3 from the Fed, but it is more a matter of when and not if this happens and as such, global central bankers remain fully committed to creating inflation.

The main problem so far for those arguing for strong central bank action (including me) is the absence of nominal growth in output in excess of consistently rising headline inflation. Could this be a result of doing too little, perhaps, but at the moment stagflation remains the best way to describe our current economic situation and thus inflation in all forms is a drag on growth. Should the genie finally come out of the bottle in the form of consistent wage increases central bankers may find that they got more than they bargained for even if the alternative is equally painful.  

The Greek experiment is about to end

Greece remains the main talking point and also the only thing that appears to prevent equity markets ripping to new highs. Greece is bankrupt and while I understand that the patience of the rescue committee will run out at some point, I am astounded that anyone expects this hideous experiment to end well. Greece will see its fifth year of contraction this year and for what? A membership of a currency union that does not work anyway?

We are told by the Troika, the EU and the IMF that failure to reach a deal would be catastrophic and thus that Greece has no way out but to take the medicine. However, Greece has a real choice and the stronger she is pushed the more obvious the end result is. Internal devaluation and decades of austerity don't work; not in Greece and not elsewhere. This remains the KEY issue that the euro area politicians and the ECB have not understood. The social fabrics of society won't stand the pressure and strain. Textbooks tell us that the cure is simple when you can't devalue, but practical experience have now shown otherwise. 

I am neither on the Greeks' nor the IMF/Troika's side, but I simply point out the obvious destiny of current events; failure! Even if Greece manages to appease its creditors with austerity, the end result in terms of Greek macroeconomic balances is still unsustainable and thus the underlying problems will not have been solved.

The ECB and the IMF will likely face significant drawdowns on their Greek bondholdings regardless of whether they use such drawdowns as  "carrot" for Greece to push through austerity measures. This is what the establishment has not yet understood.  

MF Global investigation fails to uncover illegal activity?

Megan McArdle has an amazing article suggesting that the investigation on the failure of MF Global is finding it difficult to uncover anything illegal. 

Megan quotes a piece from Reuters (no link available)

Lawyers and people familiar with the MF Global investigation of the firm that was run by former Goldman Sachs head Jon Corzine say that even though the hunt is still on to find out whether or not officials at MF Global intended to pilfer customer money in a desperate bid to keep the brokerage from failing, the trail at this point is growing cold.

This seems very odd to me even if I have not followed the aftermath in detail. I completely agree with the sentiment expressed by Megan. 

I don't understand how this could be true. To be clear, I am not saying that it couldn't be true-only that I don't understand how such a thing could have happened. There is more than a billion dollars missing from supposedly segregated client accounts. I understand that it was chaotic, but what kind of chaos causes you to accidentally move money out of money that any moderately sophisticated compliance system should have automatically flagged for approval?

While my professional responsibilities are confined to the smooth running of a macro research product I sit in an office, and work, with asset managers and ever since the failure of MF global I would imagine that their general level of concern has increased. This is understandable. If your main counterparty as an asset manager (i.e. your prime broker) essentially decides to steal your deposits and/or allocate them to losing trades against the principle of segregated accounts, it really does not matter what you do. No matter the tightness of the shop run on the asset managers' end, he will face significant and perhaps even fatal losses. 

Obviously counterparty risk is as old as finance itself and any decent asset manager today will deal with more than one broker and even have a strategy on how to manage counterparty risk. Ultimately though, mutual trust between asset managers and their prime brokers is a commodity which has been severely impaired by the MF Global failure and this is an issue for all players in financial markets. 

Dealing with vintage data in economic forecasts using instrument variables (wonkish!)

A recent note from the George Washington University points to an interesting study from Warwick University on the forecasting of data vintages in the context of US output and inflation forecasts. The problem is as follows; 

Consider a simple benchmark autoregressive model that a forecaster might use to forecast an economic variable yt. In order to estimate the parameters to be used for the forecast, typically the forecaster will obtain the most recently updated data on yt (i.e. the vintage of yt available at that time) and estimate the model using those data. However, the data in this single time series may in fact be coming from different data generating processes. The data some time back in the series have gone through monthly revisions, annual revisions, and perhaps several benchmark revisions. The most recent data, however, have been only “lightly revised,” as Clements and Galvão term it. Therefore, Clements and Galvão argue that the data in a single vintage are of“different maturities.” Forecasters may want to forecast future revisions to data as well as exploit any forecast ability of data revisions to improve forecasts of future observations. In their article, Clements and Galvão suggest that a multiple-vintage vector autoregressive model (VAR) is a useful approach for forecasters working with data subject torevisions. This comment discusses the importance of taking revisions into consideration and compares the multiple-vintage VAR approach of Clements and Galvão to a state-space approach.

This is a significant issue but remember; if the following holds, we need not worry too much about it. 

If the revisions are unpredictable and the early data are efficient estimates of future data, then we may not need to be concerned about the different vintages. 

Most economists assume that the statement above is true and simply force through their model. Being a great believer in practical usability when it comes to empirical economics, I would argue that in most cases this will not cause too many problems in most cases. However, a growing body of evidence suggest two important issues to consider. Firstly, revisions are predictable and thus provide important ex-ante information which should be incorporated into the the forecast. Secondly, even if revisions are unpredictable, the manner in which data is revised may itself provide important information on future data readings. 

I agree, but the problem is potentially much more severe. Another issue then concerns that situation where you try to forecast Y(t) as a function of X(t) where both variables may be subject to revisions. Normally, we would solve this issue by restricting X(t) to variables where revisions are minimal (or absent alltogether). One way to do this is to use market based data (market prices, closing values of securities etc) which are, by definition, not revised. However, in the context of the e.g the classical leading indicators framework pioneered by Geoffrey H Moore, this issue re-emerges X(t) is cast in the form of real economic variables (themselves potentially subject to revision).

We have replicated and refined many of the LEIs described by Moore et al and applied it to various economic data series with specific fitting of a time series regression in each case. However, such an approach may still suffer from vintage data issues (as described above. One solution that I been thinking about is to imagine two forms of right hand variables. X(t, economic) and X(t, market based); if the latter is unrevised it might be possible to find an instrument for X(t, economic) (final revision!) using a variation of X(t, market based). This would, in my opinion, constitute an elegant way to solve the issue of data revisions in your explanatory variables.

In practice, you could also try to replace Y(t, economic) with Y(t, market based), but this is probably too a-theoretical and ad-hoc. 

Yes, my dear reader. This is how quickly you move away from the apocalyptic abyss and back to normal. My base case is that we are close to excess complacency in equity markets and a sell off is overdue, but it is exactly also under these circumstances (where smart money start to hedge) that the market may deliver one final run up to get everyone and the postman in before hosing everyone. 

In the short term, one of the only remaining stumbling block in the form of the ongoing default proceedings in Greece seem to be no match for the ongoing positive animal spirit of the equity market. Only a week ago, we got news that talks in Greece had stalled, but most recently we have been reassured that talks are back on track. 

The main niggle on the first occasion appeared to be what kind of interest rate that investors would get on their new bonds and thus, ultimately, the loss of face value currently said to be 50% but also, by some, claimed to be as high 62.5%. Another issue would be whether Greece would pass legislation that forces investors to participate in the debt swap if a majority of investors agree to the PSI terms. This was specifically being discussed in the context of a particular group of investors holding both CDS contracts and the underlying bond and who would maximize their payout on the former by forcing through a hard default. 

None of the terms seems have changed massively in the past week, but time is running out with March the 20th set as the final deadline as this is when Greece would otherwise have to make a payment of 4.5 billion-euro ($18.7 billion) on maturing debt. The general consensus is that if no agreement is reached, this date would mark the hard default. The reason for the optimism is then that we are very close to full surrender in the form of a 90% participation rate of creditors and, we are told, it is only a matter of time before the final 10% agrees. 

The details reported so far are as follows;

Quote Bloomberg (21 Jan 2012)

The parties are near an initial agreement under which old bonds would be swapped for new 30-year securities carrying a coupon that would begin at 3.1 percent, reach 3.9 percent and go as high as 4.75 percent, Athens-based newspaper Proto Thema reported on its website yesterday, without saying where it got the information.

The desired macroeconomic outcome of all this is obviously well advertised. In 2020, Greece is supposed to have a government debt to GDP ratio of 120% and presumingly some form of growth that would allow this level of debt to stay stationary or perhaps even decline over time. 

Let me be clear absolutely clear here. Within any conceivably realistic macroeconomic model, there is no way that Greece can reach a stable debt level with moderate growth under these conditions. Under the interest rate scenario noted above (let us with a average interest rate of 3.8% on the new debt) the nominal interest rate would still be substantially higher than the growth rate of the economy. The only way, the nominal debt level could then be kept stationary is by forcing the fiscal balance into surplus. However, the problem is that this affects the denominator in the debt/GDP calculation by sucking out demand (growth) from an economy already structurally impaired (within a currency union and all that).

The implications are obvious I think . The promises of stability that the PSI currently holds (even if it comes with considerable pledges of IMF money) are bound to disappoint. 

First act of several to come

First of all, let us be clear. Despite, politicians' mortal fright to use the D-word and the media's acceptance of this fact on the basis that CDS contracts are not activated under the PSI, this is a stone wall default [1]. Anyone, who bothered to take merely a scant look at the history of sovereign defaults will see that the current Greek situation fits well within the framework. Indeed, the proposition that this is not a default because CDS contracts are not activated is ludicrous since in the vast majority of sovereign defaults, the debtor country begins negotiations with creditors well before the actual default is forced upon it. The fact that insurance contracts bought to protect a creditor involved in such negotiations have now been rendered useless says more about the nature of the our modern financial system than it does about the definition of a sovereign default. 

Hence, we come to the real nature of this game. 

The deal which now seems to be close to completed by no means closes proceedings. It is very likely in my opinion that private creditors who are currently the only ones being forced to take a haircut due to seniority of the IMF and the ECB will face a near 100% loss on their holdings. The argument is simple. Given the amount of debt held by the ECB and the IMF and the fact that these two institutions are senior debt holders the debt held by private creditors becomes juinor debt and thus the tranche which takes the first (and in my opinion likely complete) loss in the event of a default. 

Of course, once we reach this point the issue of CDS contracts will rear its head yet again since if a 50-60% haircut can be considered voluntary anything beyond this becomes very difficult to characterize as such. Any rating agency would find it difficult not to classify further losses as a default and thus begins the fun in earnest. And then comes the ECB and IMF's share. It will be politically dynamite if the ECB had to print on the liability side to cover losses on the asset side on Greek sovereign debt [2] or if the IMF had to ask its contributors for extra cash to cover for losses on loans made out to Greece or any other economy. Obviously, much will be done to prevent this, but just look at the numbers of Greece's economy and you will see that it is not that outlandish, especially if Greece opts to stay in the euro zone. Finally, Greece only represents the starter here. Any deal agreed  in Greece will be ardently watched in Ireland and Portugal who will feel they are entitled to the same deal with their private creditors. 

Most tragedies have several acts, twists and turns. Investors should expect no less from the one currently being played out in the European sovereign debt markets. 

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[1] - I know that the legal smarty pants will wade in now noting that default is only used when a payment is missed, but fact of the matter is that sovereign debt restructurings and defaults throughout time have always been a long process. Claiming that the Greek situation is different because it is allegedly voluntary and CDS contracts not activated is pathetic in my view, nothing less really. 

[2] - In practice the ECB could do nothing and see its balance sheet shrink with the amount lost on the asset side (i.e. reduce lending to the banking system (delevering) with the amount lost on the bonds). However, in the event of a large loss beyond provisions (if any) it is likely that the ECB would "need" to credit reserves with the amount lost on Greek bonds (hence printing money) it would do this by increasing open market operations (the LTRO essentially) on the asset side. I mention the liability side first though since the mechanism would essentially be deleveraging. Whenever a bank takes heavy losses on loans it usually responds by raising capital AND reducing lending. Since the ECB can't really issue debt in the same way as commercial banks, it would need to either reduce lending OR if that is not possible issue liabilities to match the loss of which it is, as a central bank, free to do at its lesure. 

Here is the relevant part;

Another area where the transfer of liquidity doesn’t show up as a change in aggregate excess liquidity is when banks offload their wholesale liabilities to other EuroArea banks and refund via the ECB. Here again, if they do it smartly, they can even earn a bit of “quasi carry” in the process, by buying back their debt at well below face value from those who are anxious to exit the periphery, and then refinancing at the ECB without writing down the underlying asset. This could be termed a liability “write down”, and again the procedure earns the bank a nice bit of income which can subsequently be used to help the recapitalisation process.

Take the Portuguese Bank BPI (the country’s fourth largest), which is making public tender offers to buy back its debt. If all concerned tender their bonds to BPI, BPI will pay something short of  €1.5bn cash to investors. Mortgages which were previously sitting in one of their SPVs will return to their balance sheet, and ECB money will now be on the other side financing them allowing significant profits (and capital) to be reported. In this particular tender the smallest discount is 35% and the largest is 65%. Investors may initially balk at the offer, since they will nurse a heavy loss (equal, naturally, to BPI´s profit) but ultimately they will probably be only too happy to be able to walk away from Portugal, and  with some cash in their pocket to boot.

Iberian banks were already aware of  the benefits of this kind of restructuring during the 2009-2010 liquidity wave, and went about quietly repurchasing their bonds (bank capital, securitizations, senior bonds) on a selective and private basis at a discount. Much of their reported profits in those years in fact came from either the ECB carry trade or this kind of  transaction.  So when we read that another Portuguese bank – Banco Espirito Santo – has just had €1 billion of debt guaranteed by the Portuguese state (a sovereign which can’t itself go to the markets) it isn’t hard to imagine that the process going on in the background is something similar to that seen in the BPI case, and that the debt is being guaranteed so it can  go over to the ECB to be posted as collateral.

The National Bank of Greece has been doing something similar. They recently offered to buy back some €1.5 billion in covered bonds and preferred securities,offering 70% of face value for the covered bonds and 45% for the preferred hybrids. As the bank itself says, “The purpose of the offers is to generate core Tier 1 capital for the group and to strengthen the quality of its capital base….The offers would generate a gain for the group.”

And Italian banks would seem to be doing something similar, since they issued around €40 billion in government backed bonds specifically to take to the ECB. The bonds are held by the banks themselves and stay on their books to maturity, their only purpose being to provide collateral for use at the ECB. In fact Italian banks took something like €116 billion from the LTRO, or almost 25% of the total. Perhaps this is why Unicredit CEO Federico Ghizzoni and other European top bankers met ECB officials in Frankfurt back in November, to discuss new rules for collateral.

In Spain securitised mortgages sitting on the balance sheets of the bank-ownedFondos de Titulizacion de Activos could also be recycled in this way (here’s a complete list, although note that these Funds are regulated by Spain’s CNMV and not the Bank of Spain, which is why their presence is relatively unknown and people are able to accurately say that the central bank has been very strict on SIVs, since they weren’t their responsibility).

That something like this may be happening, with the ECB “buying into” public and private  Euro Periphery debt  while investors are discretely getting out is suggested by this report in Bloomberg:

The euro is losing the relationship with riskier assets that underpinned the currency in 2011 as the deepening sovereign debt crisis reduces the creditworthiness of even the biggest economies in the region. The 17-nation currency has fallen 8.7 percent against the dollar since October, while the Standard & Poor’s 500 Index has gained 3.4 percent, and the correlation between the two dropped to 58 percent from a record 91 percent in November, according to data compiled by Bloomberg. The euro had moved almost in lockstep with investments linked to growth, including stocks and the Australian dollar, since January 2011.

This decoupling is taking place as European Central Bank President Mario Draghi cuts interest rates and promises banks unlimited cash for three years to rein in soaring borrowing costs for governments… Strategists also anticipate more losses as the US economy improves while the euro zone shrinks, driving international investors away from the region’s assets.

So if the first two objectives were to help the struggling sovereigns, and enable the commercial banks to refinance their debt, then to some extent these objectives have been met. But what about the third objective, moving credit on the periphery to get the real economy moving again? Well, here the ECB’s measures are likely to have far less effect, and indeed what effect they do have may be in some way a mixed blessing, since the banks seem far more worried about demonstrating they have an adequate level of core capital than they are about participating in solutions to real economy problems.

While I would, in general, be hesitant in taking anything from Zero Hedge at full face value I think the following story on Unicredit adds flavor to this by providing further evidence on the points Edward mentions above. 

The story is clearly speculative but gets backing from Edward's accout above. The following seems to be a part of the general process which in itself is, in my view, absolutely mad.

Banks in weak countries have been issuing debt, getting a government guarantee, and then posting them as collateral at the ECB. There are examples of this for Greek banks for sure, but my understanding is it has also been occurring in Portugal and Ireland. It is the only way banks in Greece (and the other countries) can raise money.

The article then goes on to make this more alarming point (but really does not have evidence to back it up) that it appears that about €40 billion of the first LTRO was done by Italian banks (Unicredit?) that issued bonds to themselves and got a government guarantee, and then posted this asset as collateral for liquidity through the LTRO.

So, here is how I understand it.

Unicredit issues a 3m bill and gets a government guarantee so that whoever chooses to buy this bill knows that it will be backed by the sovereign (after all, this is still better than the bank even if the two are joined by the hip). The only problem is that it is being issued to itself with a permanent guarantee from the government.

From an accounting perspective this must be close to illegal in any meaningfully lawful jurisdiction, but I defer to experts here of course. The issue here is not then that the sovereign is guaranteeing a liability of a bank, we have seen this plenty of times and it is indeed the only way that some financials can issue debt, but rather that the bond never gets marketed to third party buyers. 

It is absolutely astonishing that this 3m bill is then being posted as collaterall at the ECB. But you must understand that it has to be posted as such as far as I can see since you can't hold your own liabilities.  So, the banks posts a bond issued to itself and posts it at the ECB and get freshly minted fresh euros credited to its bank account at the ECB. After the process, Unicredit still has the bond as a liability but instead of the same bond on the asset side (which is impossible) it has a deposit asset with the ECB.

If this is true, and the ECB is agreeing to this I must admit that it amounts to a serious bout of banking follies in the European banking industry. 

The main thing is to realise that this is an unprecedented global monetary experiment. 

My message to investors in 2012 would then be not to underestimate this inflation bias by part of global central banks. Inflating your way out of too much debt won't work in the long run without considerable defaults and/or economic stress (hyper inflation). Events since 2008 are ample evidence of this, but the simultaneous inclination to create inflation and debase your currency (to generate more inflation and exports) by all major central banks will continue to exert a profound effect on asset prices and the global economy. 

In so far as goes the idea that an investors' interest in asset prices is conditioned on return and volatility we can say that central bank policy will affect both. Financial assets will certainly benefit from excess liquidity, but the unravelling of too much debt through inevitable defaults and the central bank policies themselves will generate volatility. Whether the combination of such volatility and return means that you should stay out of the market entirely is a question for the individual investor. 

From a macroeconomic point of view, the downbeat assessment remains however that it is difficult if not impossible to paint a picture of where sufficient growth is going to come from and on the investment side of things, the higher level of volatility will tend to shake the foundation of investors even if money is to be made for short periods of time. 

Most attention has been centered on the ECB, whether the 3y LTRO represent QE and whether the continuing rejection to buy government bonds outright means that the ECB is a laggard among global central banks (see this excellent report by Hinde Capital for additional analysis relative to the points below). 

750 Billion USD,  and counting ... 

Europe remains the center of the global debt crisis, a role the continent has now decisively taken over from the US which stood at the forefront in the initial phases of the crisis in 2008. Apart from the almost endless summits and meetings among government officials the significant measures continue to be the ones coming from the ECB.

In my view, the European interbank market is virtually dead and dusted, and the ECB and the Fed are now effectively the only thing between Europe's banks and large scale failures. Since early September 750 billion USD worth of liquidity has been provided to the European banking system of which 100 billion sits on the Fed balance sheet through USD swap lines.

Who will bet against the final 3y LTRO auction to take this beyond one trillion USD?

Spanish and Italian curves are now nicely steep again after a brush with inversion which obviously was one of the main objectives even if it was always debatable whether banks would buy government bonds with the liquidity taken up at the ECB.

The question is; how do you unwind all this? 750 billion USD to roll short term liabilities with the ECB and the Fed seems to me to be one of the biggest gamble in monetary history. 

While the BOE and the Fed have been transparent in their QE efforts and the BOJ never really having left the zero bound the ECB has been more covert. However, it is my contention that with the expansion of the securities market programme (SMP) in 2011 to buy considerable amounts of government bonds (1) as well as the 3y LTRO the ECB is now fully engaged in quantitative easing.

I base this on two points. 

• The ECB has acted as a sovereign debt buyer of last resort in times of crisis. It is common knowledge in the market that the ECB has been Italian and Spanish bonds in times of particular stress on the notion that these two economies in particular could not be allowed to fatally succumb to the debt snowball dynamics.

• ECB support for the banking system in the form of collateralised liquidity and wholesale funding is not temporary but structural and permanent in nature. The interbank market in Europe is not working and has not been working since the crisis started in 2008.

The ECB will of course vehemently deny this but investors should understand that such denial is mainly out of political reasons.  When Draghi unveiled the ECB’s attempt to backstop the crisis in Europe by offering full allotment liquidity on a 3y basis, the market was disappointed because the central bank president also reiterated that the ECB would not step up its purchases of government bonds.

I think that the ECB will be forced into a much more direct and active role where unsterilized purchases in the primary market (monetisation) will be needed, but I fully appreciate the political issues. We are currently in a delicate situation where new governments in most of the involved countries are saddled with forced mandates to impose austerity. It is very difficult for all parties involved to push this agenda if the ECB had stepped up a full backstop. Moral hazard risks are consequently paramount here.

As such, investors must content with the ECB’s attempt to shore up the European banking system which is no little feat given the bank rollover schedule in 2012  as well as new Basel II regulation which will further impair already shaken balance sheets. The ECB’s initiatives then follows the steady deterioration of conditions in the European (indeed global) banking system which initially culminated in the coordinated action by global central banks to supply dollars through Fed swap lines and which found its European answer in the ECB’s decision to provide unlimited liquidity yet again.

The problems look ominous for European banks and the global financial system in general. No matter what, European financial institutions will have to delever significantly which will spread its tentacles wide and far due to the high penetration by European banks in emerging markets (Eastern Europe in particular). 

Behind the scenes however, significant ink has been spilled to debate and speculate on to the exact significance of the ECB’s liquidity operations.

John Hempton for example suggests that the ECB’s policy move is an open invitation to play the carry trade game using almost free liquidity to buy higher yielding government bonds. 

Well the Euro fix is in. Whether it works - that is another question. But the fix is this: European banks can borrow unlimited amounts for three years to buy Euro government debt. The debt often yields 5 percent. The money costs 1 percent.

I agree that the incentives are certainly there for the banks to play this game especially in the context of government bonds as zero risk weighted assets. The problem is that many European banks have spent more than a year and two stress tests to get rid of substantial amount of peripheral government debt (which do not count as zero risk weighted assets according to Basel III) and as such weak governments are unlikely to benefit from this. 

The flip side of this is that most of the liquidity taken up by banks go straight back to the ECB at the deposit facility which is now standing higher than at any time between 2008 and 2010. 

Quote Reuters

The euro zone banking system starts the new year awash with record levels of liquidity but few signs that institutions are prepared to lend to each other, leaving money markets frozen.Most of the near half trillion euros of three-year funds borrowed from the European Central Bank in the last week of 2011 have made their way back to the ECB's overnight deposit account.

The Reuters piece goes on to argue that most of the liquidity will probably go to aid the large refinancing need banks face in 2012 and thus effectively as a replacement for a non-functioning interbank market that would normally be able to roll this financing. If this does nothing to solve the problem of sovereign insolvency and illiquidity it will work wonders through the fact that banks won't act as a drag on their respective sovereign's balance sheet as long as the ECB is involved. 

I would note though that even though the liquidity is mainly reflected in reserves held at the ECB, it still represents excess liquidity as noted by Danske Bank. 

Some market commentators have argued that the first 36 months long-term refinancing operation (LTRO), in which banks took EUR490bn in total, has so far not worked as planned because the extra liquidity has simply been placed on the deposit facility at the ECB. However, this argument is false.The sharp increase in outstanding open market operations (MRO+LTRO) increases excess liquidity (defined as open market operations plus recourse to the marginal lending facility minus autonomous liquidity factors minus reserve requirements) and this excess liquidity shows up as deposits at the ECB in just the same way as it did in 2008-10. 

However, nothing is easy and despite the fact that collateral can be posted for liquidity the sovereign is still on the hook as my friend Edward Hugh points out. 

Banks are being encouraged to keep rolling over what are basically NPLs by financing them at 1% at the ECB (foreclosing on them in Spain and keeping the property on the books may cost something like 8% in comparison). But the ECB isn't assuming the risk here, the national sovereign implicitly is, and is getting in deeper by the day. 

This is certainly true by the letter of the law but one has to wonder whether the ECB will ever get paid back here. I mean 3 years is an awful lot of time. The ECB can roll these loans as long as need be (it has already effectively been rolling bank funding since 2008) while maintaining the figue leaf that it is not funding sovereigns. This may be true, but it is effectively funding the sovereign's banks and postponing the day of reckoning which is bank failures or nationalisation or both.

If the ECB is then forced take a hit on the collateral or the loans themselves, it will need to create the money to pay for these loans by printing euros. This sounds as a plan to me except that it does not solve the funding risks of governments which may or may not be able to ask their banks for help. The likely answer is that they won't be unless the ECB and EU decide to wield the ultimate weapon of financial oppression which would be to penalise reserves over a given level with negative interest rates at the same time as banks would be forced, through regulation, to hold government bonds. 

But Edward makes another interesting point;

Looking at the Greek PSI, what they would try and do (if all this gets that far, I mean if the Euro holds together long enough in this Byzantine world) ) is load up the private sector share of the haircut, and keep the ECB as untouchable official sector. At the limit they can use ELA to keep the banks afloat while the sovereign restructures and then recapitalises.

(...)

Why would any ex Eurozone third party want to be counterparty to anything which might end up being subordinated to ECB exposure later on down the line. The more I think about it the more it seems to me that the 3 yr LTROs might end up choking the European banking system to death.

It is difficult to disagree on the gist of this point, namely that the ECB is digging itself a very big hole. If banks can exchange under water assets at the ECB for a deposit asset at the ECB (albeit with a negative carry) the ECB is running the risk that it becomes the sole counterparty of bad assets in the euro zone in which case seniority will mean very little. 

The Greek situation is a good example. Private creditors face an almost certain 100% wipeout exactly because they represent such a small tranche of the total stock of debt. In such a situation the asymmetric relationship between subordinate and senior debt holders mean that the latter essentially become equity holders. But once subordinate creditors are wiped out the turn comes to the senior debt tranches and the further the ECB goes along the road of providing full allotment liquidity the higher will be its implicit direct claim on assets of all sorts of qualities.

In conclusion, it is my view that the ECB is now the only thing between the economy and widespread bank failures, but I also concur that the consequence of this is a permanent outsourcing of the interbank market in Europe to the ECB's balance sheet and, quite possibly, Fed's USD swap lines. 

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(1) - Even if such purchases have been fully sterilised. 

Hello everyone. Here is to a Merry Christmas and a great new year. As you might have noticed, posting has been a little less frequent this year, but such is life when work comes in the way. We are working on some very interesting initiatives at Variant Perception regarding blogs and online presence which will allow me to post more content here. 

For now though, have a great Christmas weekend.

best

Claus

Obviously, skilled and hardened readers of econ blogs would point out that the last thing the internet needs is another information aggregator. I would agree, and even in the world of economics and finance there are already considerable aggregators and umbrella sites which collects and gathers information.

However, and biased as I naturally am, I would argue that the VP Trusted Sources blows most of the other"passive" information aggregators in the financial industry away.  I would point to three reasons for this. 

1. We provide macroeconomic and financial news in its most pure format and if you are a consumer of such information you will be extraordinarily well served. This is high powered macroeconomic news, from one passionate macroeconomic researcher to another. 

2. The VP Trusted Sources is essentially a custom made/all inclusive macroeconomic RSS reader. You don't need to create one; we have done it for you. 

3. Its versatility. the VP Trusted Sources hub can be used either as the equivalent of a financial/economic Arts and Letters Daily or as a fast and efficient way to learn about a given topic. 

I would particularly emphasize the balance between blogs, news and bank/investor research (1) which means that the VP Trusted Sources becomes a potentially very valuable gateway for information. You will also note that each entry (referring back to an original article) has both primary and secondary tags. I dare you to do research on a specific/generic topic where the VP Trusted Sources cannot lead you to instant and valuable information which will make your life easier. 

Well, I think that this must be enough self-promotion for one day. Since it is free I encourage you to have a look and if you don't like it, feel free not to return. If you do, tell all your macro friends and fellow macro geeks about it. 

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(1) - Obviously some links will lead to walled content as some providers may not give free access to their content, but the vast majority of links goes to free resources. 

So, what to believe? 

I don't know, but it is interesting that Reuters are now reporting France and Germany to be in an agreement on a fast track move towards fiscal union as well as allowing the ECB to aid sovereigns more forcefully (i.e. unsterilised intervention). 

I want to see this before I believe it. Germany is certainly sending conflicting signals. Yet, this may be because they are truly unsure how long they can play this game of chicken with the rest of Europe. Clearly, Merkel has a point in refusing to issue euro bonds and/or letting the ECB step in since the periphery needs to put their house in order or at least show a credible plan to balance the budget. This is essentially quid pro quo as Merkel knows that Germany needs to pay in the end. 

But there is a rub. One issue is surely the fact that public finances across the eurozone are unsustainable but another is how these economies are going to achieve anything near the growth needed not to collapse (default) anyway. 

We keep on coming back to two main points. 

1) It was clear for all that pain was coming in the periphery already in 07/08 and that this would be a substantial period of negative growth/deleveraging consolidation. 

2) But the question was always whether such pain could be administered from within the euro zone. We are steadily coming to the conclusion that this is not possible and Germany knows this. But the solution is not clear since jettisoning the euro would have grave implications for the EU too and therefore there is a very strong lock-in mechanism here which it is difficult to get out of. 

Finally, there is always the risk that one or many of the Southern European economies will simply "get" enough and make some quick and devastating decisions. It is important to understand my point on this.

I am sure it would be catastrophic for Greece or another country to leave by their own accord and do a messy default, but at some point the rest of Europe and the market will simply corner whatever government that might be in place and they will start taking their own independent decisions.

I note that there are calls for the new government in Spain to play "hardball" with Germany. In this situation, Germany has a distinct interest in just letting the market squeeze the periphery, but of course the rest of the "core" is getting dragged down too and the whole banking system is now at risk of a major liquidity/solvency crisis. In this sense, I only agree conditionally with Felix Salmon: 

El-Erian is very good at explaining the problem which needs solving:

"Europe must still stabilize its sovereign debt situation. But this is now far from sufficient. Policymakers must also move quickly to contain banking sector frailties, and do so using a more coherent approach to the trio of capital, asset quality and liquidity."

It seems to me, though, that sequencing matters here. Liquidity is — always — more important than capital/solvency. Give an insolvent bank enough liquidity, and it can live indefinitely. Remove liquidity from a bank, and it dies immediately, no matter how solvent it might be or how high its capital ratios are. And as for asset quality, we’re pretty much talking a zero-sum game here: when the banks’ dubious assets are the sovereign’s liabilities, the real solution is inflation, not nationalization.

I agree that liquidity is a key issue at the moment in the euro zone banking system, but let us not kid ourselves. Europe has not had a functioning interbank market since 2008 and we are just now seeing the accumulated effect of this. 

I just read a big and very detailed BC report on deleveraging among EZ banks and I am extremely concerned. It is clear to me that not only sovereigns are battling with solvency issues but so are many banks and the extent to which they are fighting it means that they will have to cut lending and asset growth substantially. As such, I am afraid that the problems in the euro zone are beginning to resemble a widespread solvency problem both amongst banks and sovereigns, a combination which, to boot, will feed off each other. Especially Eastern Europe are going to have big problems in 2012. They are going to see an almost complete stop of credit flows through the banking system due to parents cutting cross border lending.

I think  that we will see a wholesale and government driven process of bank nationalisations and restructuring in the next 6 months in the euro zone. I also think that most southern european economies are ultimately facing both public and private insolvency issues which will need balance sheet write-offs to get solved. It seems to me that, as so many times before, euro zone politicians are once again getting caught out by reality.

(see source of image at end of post)

I have recently spent a few days in New York talking to clients as well as sneaking in a bit of marathon watching and a visit to the Guggenheim museum. Flying across the big pond also means that there is plenty of time to catch up on movie watching. I opted for the action pack on the way out and went for a bit more intelligence and depth on the way home. 

I especially liked the last movie I saw, the Adjustment Bureau (The AB), starring Matt Damon (David Norris) and the lovely Emily Blunt (Elise Sellas). The AB is an interesting metaphor on the idea of fate and the extent to which you are your own master or whether there is grand plan that we are all bound to follow. The movie works mainly because of the interaction between David and Elise. Especially the second chance meeting (in the bus) between Elise and David after the latter had been riding the same bus for 3 months to try to see her convinced me that these two persons are meant to be with each other. Any grand plan that the illusive Chairman and his caseworkers are trying to enforce in order keep these two people from being together is surely unfair and wrong. 

The premise and drive of the movie then becomes Damon (David Norris) and Blunt's (Elise Sellas) fight against the fate imposed on them by the Adjustment Bureau. And I would argue that anyone with but a shred of romantic fiber will be cheering for David and Elise on this one. 

Does this sound familiar? I think it does and as I thought about the movie I realised that it mimics the attempt by eurozone policy makers to force through a grand plan of monetary cooperation despite obvious signs this is not working.  

Enter Monti and Papademos. You could hardly find a better expression of the EU's attempt to keep things according to plan than the appointment of two eurocrats as leaders of Italy and Greece respectively. On the face of it, you would think that their appointments have been a success. Both have recently won approval in parliament for pushing through just about any agenda that their new government may see fit. 

Quote Bloomberg

Italian Prime Minister Mario Monti won a final parliamentary confidence vote, granting full power to his new government after pledging to spur growth and reduce debt in the euro-region’s third-largest economy.

(...)

Greece’s new government unveiled a budget for 2012 with a deficit shortfall dropping by almost half, thanks to pension and wage cuts and a Greek debt swap that will slash interest costs. (...) The fiscal plan, which will be approved by the Greek Parliament before a meeting of European Union leaders in December, is designed to regain the confidence of creditors and secure resumption of international financing. Prime Minister Lucas Papademos, appointed last week, is racing against a three- month deadline until elections to secure international loans and avert a collapse of the economy.

Look a little closer however and you will see that the market is still calling the shots as focus has swiftly shifted from Italy and Greece over to Spain where borrowing costs last weeks reached all time highs. It seems that as one hole is plugged and the plan put back on track another problem emerges and throws it off track again.

In Greece and for all the talk of Papademos preventing collapse, it is important to emphasize that he is there mainly to manage a default process.

Quote Bloomberg

The Greek government started talks with banks on the terms of the voluntary debt swap that is part of the country’s international bailout agreement, the Finance Ministry in Athens said.The debt swap -- part of a second rescue package for Greece -- aims to put the country on a path to cut its overall debt load to 120 percent of gross domestic product by 2020. The discussions in Athens are expected to take weeks to conclude, a European official said today on condition of anonymity. 

120% in 2020 while probably realistic is still too high for Greece and the issue of non-paying CDS will continue to complicate matters. The point is not so much the obvious issue that a 50% haircut can never be considered voluntary, but two additional factors. The first is that there is still considerable risk of Greece sliding back even with Papademos at the rudder and as the ECB have rejected to participate in any restructuring with its bonds (implicit seniority) any further haircut will have to fall on private creditors. Thus, any further haircut from this point and we are looking at a near full wipeout. Secondly, if the sovereign CDS market turns out to be a red herring, it is likely to lead to a sharp repricing of all exposed sovereign risk as potential buyers will realise that the only real insurance they have is to pay a lower price (i.e. demand a higher yield). Let me re-emphasize. Putting together a deal that gives banks a 50% "voluntary" haircut so that CDSs on Greek debt are not activated only to string together, on the same meeting, a deal to allow the EFSF to issue CDSs on Italian and Spanish debt is amazing to me. 

In Italy, trend growth is essentially 0% if not negative and if you factor in the government's proposals for austerity from here to 2015, the debt snowball will be difficult to avoid. It is unlikely that Italy's new government will provide stability as the task facing them is impossible without financial help. Italy is likely to be asking for support at some point and here it is quite unlikely that the IMF or EFSF will be able to step in. This leaves the ECB which is already being forced into the fray by market conditions pushing up Italian yields. 

There is strange focus on primary surpluses in Italy and the fact that the country managed to bring in the debt to gdp ratio in the 1990s due to ongoing primary surpluses. At the moment the point is obviously that it is exactly the high interest rates/low growth environment which is choking of growth. Eliminating interest rates from the analysis makes no sense at all. A simple rule of thumb states that if your nominal growth rate is below the weighted average nominal rate of interest on your debt, then the debt snowball will roll. Obviously, fiscal austerity undermines growth and thus exacerbates the debt snowball. Frontloading fiscal austerity when yields are rising and growth is going down will end in a vicious circle a la Greece. 

A severe credit crunch is developing in Europe with Morgan Stanley estimating the total shrinkage of eurozone banks' balance sheets to the tune of 1.5 to 2 trillion euros. This is between 15% to 20% of eurozone GDP (2010 values).

There are three components here.

• When sovereigns' funding costs increase it becomes impossible for local companies and banks to finance themselves in the short term liquidity markets as well as long term funding becomes more expensive. Many European banks are essentially dependent on the ECB's liquidity window for survival.

• Banks prefer to shrink their assets rather than raise new equity/debt because the latter is almost impossible at this point. We essentially need a euro-TARP to solve this. This forced shrinkage of the asset side is the main transmission mechanism of the credit crunch to the real economy.

• Deposit/funding flight from the weakest banks and countries. Essentially, the market can and will discriminate and the weak will get weaker.

I am not getting paid by the European Banking Association. I am merely trying to convey the idea that when you ask banks to take a significant hit on the asset side at the same time as they remain unable to adjust the liability side a credit crunch is exactly what you end up with. 

Especially Eastern Europe is important as the region faces significant roll over and financing risk in 2012. Hungary and Ukraine will need to start paying back the IMF loans and Hungary faces, to boot, significant funding risks in the banking sector. Hungary is in a very tight spot because the foreign banks are essentially shutting down lending due to the fact that Hungary has pushed through a deal which allows homeowners to pay back CHF mortgages at a, for them, favourable exchange rate.

Hungary is essentially caught in a vice which perversely forces the central bank to raise interest rates in times of volatility to protect the currency and thus foreign currency borrowers as well as to help keep inflation in check. Whether the central bank will move in with aggressive interest rate hikes (as e.g. the 300bp hike in 2008) is debatable and outright intervention probably more likely. The sad irony about Hungary's situation is that just as the country faces the pressure of paying back the first installment of IMF loans received at the initial phases of the crisis, there is talk about the fund coming back in. Details are sketchy at this point, but e.g. Morgan Stanley suggests that such talk may already be ongoing. 

In addition, Romania and Latvia will come off the IMF/EU taps and return to market based financing which will further put strains on supply even if these economies are small. Essentially, many economies and corporates in CEEs have pushed forward financing to 2012 in hope of better times. The problem is however that the good times seem to be somewhat further away than initially expected and any economic agent having postponed tough financing decisions to 2012 in hope of relatively more calm markets is about to be disappointed. 

Adjustment Needed? 

We are then back to square one with ECB bond buying and the Franco/German disagreement about this very question representing the main issue which holds back markets. It is furthermore important to emphasize the underlying current here in terms of global credit markets as a whole. Almost all credit spreads are widening and wholesale funding markets are virtually non functioning which means that banks, especially in Europe, remain dependent on the ECB's funding window more than ever.

In practice, the ECB is already buying considerable quantities of Spanish and Italian bonds, and this will continue until there is a credible plan on the table for a eurozone wide recapitalisation of the banking sector.

For the chairman and the case officers it gradually becomes clear that it is too difficult to keep David and Elise from seeing each other and the archives are consulted which reveals an interesting fac. In earlier versions of the plan, Elise and David were meant to be together and it is concluded that this is probably one of the reasons that the plan keeps deviating from course. 

As a result, the case officer originally tasked with keeping David and Elise is taken off the case and Thompson, aka the Hammer, is brought in to handle David's "adjustment". As he confronts David with the irreversibility of the plan he conveys the ultimate arrogance of an architect unwilling and unable to deviate from the original set course. In this sense, Thompson displays the same inflexibility as European politicians in their claim that the world would unravel if the plan is not strictly followed. 

As Dan accepts Thompson's argument that he and Elise are not meant to be with each other if only because Thompson promises to destroy Elise's dancing carreer he leaves Elise and all seems lost. Yet, in the frantic closing stages of the film as David takes a final leap of faith running the risk of being "reset" we learn that the idea of adjustment is a double edged sword. Things can be adjusted according to plan, but the plan itself can also be adjusted. 

There are very good reasons why events keep on deviating from plan in the eurozone and it is misleading when we are told that it would be a disaster if the status quo is not maintained in the eurozone. Indeed, it would be a disaster if it is. There is plenty of evidence and good arguments as to why the eurozone in its current setup was always going to fail and why considerably adjustments would need to be made as we moved forward. Such adjustment were never made however and all we we were told was that the convergence would happen by default as time passed.

I am not, and have never been, advocating a break-up of the eurozone, but it seems to me that obvious decisions are being avoided because they are deemed to conflict with an underlying plan that I find it difficult to see the meaning of. An adjustment is needed in Europe and like with Dan and Elise, the adjustment should be to the plan itself.

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Source of image are http://moviescreenshot.blogspot.com/ and Universal Pictures. All pictures above are courtesey of http://moviescreenshot.blogspot.com/ and Universal Pictures and specifically this entry. The Adjustment Bureau is produced by Universal Pictures. 

Quote Bloomberg

Fed Vice Chairman Janet Yellen said yesterday that a third round of large-scale asset purchases “might become appropriate if evolving economic conditions called for significantly greater monetary accommodation.” A day before, Governor Daniel Tarullo said buying mortgage-backed securities “should move back up toward the top of the list of options.”

They join Charles Evans, president of the Chicago Fed, and Boston’s Eric Rosengren in calling for consideration of further stimulus to boost growth and bring down a jobless rate stuck around 9 percent or higher for 30 months. A stock-market rally and gains in manufacturing and retail sales may convince the Federal Open Market Committee, which meets Nov. 1-2, to decide that it’s too soon for a third round of bond purchases.

You see, the recent initiative of the Fed in the form of Operation Twist is not quantitative easing since it does not involve an expansion of the balance sheet. In stead, it is what we refer to as qualitative easing as the bonds the Fed intends to buy on the long end (to move long rates down to help the mortgage market) will be paid for by proceeds of selling bonds on the short end. 

The biggest problem for the Fed here is not necessarily that Operation Twist is a bad idea. Indeed, to the extent that it fixes the effort squarely on halting the slide in the housing market and supporting volume and price in the primary and second market for mortgage securities I think it is an excellent idea. 

But we are forgetting the auxiliary objective of QE by the Fed; to weaken the USD. Make no mistake that this is an important objective for the Fed even if they have never declared this formally. And herein lies the rub.  Quite simply, with the recent announcement by the BOE of another round of QE worth £75 billion, with the ECB now willingly or unwillingly being forced into increased support of peripheral debt markets and with the BOJ also pledging more stimulus, the Fed is starting to look like the conservative central bank in the G4. [1].

In my opinion, this is very significant and also one of the reasons why Fed officials are busy ensuring markets that they have plenty of ammunition left should economic conditions merit it. But investors should not take anything at face value I think. Before the Fed actually starts to buy those MBS and/or moves to lower interest rates on excess reserves there is a real chance that especially the JPY will start to act more like the JPY of old, a.k.a global carry trade anchor of choice. Of course, this requires the BOJ to back up all the pledges with real action. For now though, the only thing we can say is that the Fed looks set to be outgunned by its peers in the G4. 

EMU Outflanked 

Is Europe now finally getting down to serious business or is it just another round of fudge from the fudge factory that investors have learned to respect for its ability to produce relief rallies out of nothing. Looking at the evidence I am thoroughly inclined to go for the latter even if each failed attempt to shore up market confidence brings Europe closer to full fiscal union. 

Even if Merkel and Sarkozy, and rightly so, appear most concerned with putting pressure on Italy, the most significant issue remains Greece. The country is now in default, a fact that was un-sanctimoniously confirmed by the leaked bailout document which has the Troika admitting that the medicine they were mandated to administer would only make the patient worse and not better.

Quote FT

Greece’s economy has deteriorated so severely in the last three months that international lenders would have to find €252bn in bail-out loans through the end of the decade unless Greek bondholders are forced to accept severe cuts in their debt repayments.The dire analysis, contained in a “strictly confidential” report by international lenders and obtained by the Financial Times, is more than double the €109bn in European Union and International Monetary Fund aid agreed just three months ago. 

The most recent estimate of haircut has now risen to 60% and this, mind you, would only reduce the debt to GDP to 110% and this without any consideration on how Greece is supposed to grow itself out of this level of debt while simultaneously dealing with the default. In addition and only adding to my disdain for the ECB, Reuters reports that the central bank opposed a 60% haircut on account that it  the private sector would refuse likely refuse this leading to a "fullscale" Greek default. 

I am continuingly amazed by the denial here. Ever since the first Private Sector Proposal (PSI) was put on the table, Greek has been in default and figuring out who would pay for recapitalising banks as a function of how large the final haircut ends up are merely steps in the actual default process. 

The second issue on the table is what to do with the increasingly freakishly looking EFSF. There has been no shortage of suggestions on how to increase the scope of the fund using the same guarantee by the same countries for the same amount of money (currently €440 in effective capital). The suggestion that might actually work came from France which has aired the suggestion that the EFSF be turned into a bank which would then allow it to access liquidity from the ECB. Both Germany and the ECB however have vehemently denied this which indicates that there is still notable reluctance to allow the ECB to wield the full arsenal of quantitative easing. 

The proposal which currently seems to have most traction is to turn the EFSF into a monoline insurer which would essentially use its capital to insure anything from 10% to 30% on any new issuance of sovereign debt by Italy and Spain. Crucially, the idea is that this "leverage" would bring calm to markets as this insurance could cover as much as 2 trillion worth of debt. 

I really struggle to find adequate words here. I think this is madness and if any Eurozone politician were afraid that an equivalent of AIG would certainly enter the scene, they now seem content on creating one. The first and most widely flagged issue is this would obviously create a two tier bond market. 

Quote Reuters 

This would create a division between insured and non-insured debt, that could split a country's investor base and suck liquidity out of the market unless new bonds were carefully constructed to allow them to trade on a par with existing debt."The issuer would have to create a new curve of insured debt, limiting the liquidity in both curves with risks that investors would dump the old non-insured bonds," said Commerzbank rate strategist Christoph Rieger.

Based on a 20 percent insurance model, JPMorgan estimates that insured bonds issued by Italy would trade at a yield around 100 basis points below existing debt with new, insured Spanish debt likely to be priced 80 bps lower than existing bonds.

I think this is significant, but we are missing the main point here. If this is set ut Spain and Italy will likely never be able to issue un-insured debt again and the contingent liability here is not only complex but will lock in future capital commitments to this aim of providing first loss insurance. For me, this is a horrible way to spend already scarce capital. 

Another issue is obviously that it assumes that it will make the Spanish and Italian problem go away which it clearly won't. However, much more fundamentally; while the idea is to ring fence Italy and Spain it almost guarantees painful haircuts in the case of Ireland, Portugal and Greece and once again, who will pay for those I might ask. 

The only silver lining I have seen in the latest reports is that it seems to me that while the imminent obejctive is to fiddle with the EFSF, there has also been serious talk about bringing forward the ESM which would have a much stronger mandate and essentially constitute a first step towards socialising of sovereign risk in the euro zone. Until that happens, the EMU and her politicians will be continuously outflanked by economic realities. 

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[1] - I repeat that with the ECB not formally in ZIRP mode, the Fed still has the yield disadvantage here but do we really expect the ECB not to lower going forward?