Marathon Asset Management - European Sovereign & Financial Crisis Paper - 2Q11

7/28/2019 Marathon Asset Management - European Sovereign & Financial Crisis Paper - 2Q11

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THE EUROPEANSOVEREIGN &

FINANCIAL DEBTCRISIS

EVOLUTION, SOLUTIONS,AND OPPORTUNITY

WHITE PAPERSecond Quarter 2011

Not for redistribution. Not an offer to buy securities.


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TABLE OF CONTENTS

1. EXECUTIVE SUMMARY ..................................................................................................................................... 2. INTRODUCTION................................................................................................................................................... 3. PRESENT EUROPEAN SOVEREIGN DEBT CRISIS........................................................................................... 4. BUILDING BLOCKS OF THE EUROPEAN SOVEREIGN DEBT CRISIS .........................................................

EXCESSIVE PUBLIC AND PRIVATE DEBT........................................................................................................ WEAK BANKING SYSTEMS AND EXCESSIVE LENDING GROWTH............................................................ INABILITY TO CONTROL MONETARY POLICY .............................................................................................. DECREASED COMPETITIVENESS AFTER EURO ADOPTION ........................................................................ INCREASING DEPENDENCE ON GLOBAL CAPITAL MARKETS................................................................... WEAK GDP GROWTH.......................................................................................................................................... FINANCING WITH SHORT-TERM DEBT ............................................................................................................ LARGE FISCAL DEFICITS AND EXPANDING GOVERNMENT....................................................................... RATING AGENCY DOWNGRADES.....................................................................................................................

5. EUROPEAN SOVEREIGNS OF PRIMARY CONCERN...................................................................................... GREECE..................................................................................................................................................................

The Rescue of Greece .......................................................................................................................................... IRELAND................................................................................................................................................................

The Rescue of Irelands Banks............................................................................................................................. The Rescue of Ireland ..........................................................................................................................................

PORTUGAL ............................................................................................................................................................ The Rescue of Portugal ........................................................................................................................................

SPAIN...................................................................................................................................................................... ITALY ..................................................................................................................................................................... BELGIUM ...............................................................................................................................................................

6. GOVERNMENTAL ENTITIES AFFECTING SOVEREIGN DEBT MARKETS.................................................. EUROPEAN UNION .............................................................................................................................................. EUROPEAN ECONOMIC AND MONETARY UNION (EMU).............................................................................

EUROPEAN CENTRAL BANK (ECB) .................................................................................................................. EUROPEAN FINANCIAL STABILITY FACILITY (EFSF)................................................................................... INTERNATIONAL MONETARY FUND (IMF) ..................................................................................................... EUROPEAN STABILITY MECHANISM (ESM)...................................................................................................

7. HISTORICAL SOVEREIGN CRISES, RESTRUCTURINGS, AND LESSONS.................................................... MEXICOS TEQUILA CRISIS OF 1994 AND 1995.............................................................................................. RUSSIAN DEFAULT OF 1998 ............................................................................................................................... ARGENTINEAN DEFAULT OF 2001.................................................................................................................... URUGUAYS DEBT EXCHANGE OF 2003.......................................................................................................... THE BRADY BOND PLAN...................................................................................................................................

8. CRISIS SOLUTIONS AND RISKS........................................................................................................................ THE PREFERRED EUROPEAN SOLUTION: INCREMENTALISM................................................................... RESTRUCTURING SOLUTIONS .......................................................................................................................... OTHER SOLUTIONS.............................................................................................................................................

9. INVESTMENT CONSIDERATIONS ..................................................................................................................... 10. CONCLUSION...................................................................................................................................................... APPENDIX: CREDIT DERIVATIVES........................................................................................................................ GLOSSARY ................................................................................................................................................................ INDEX OF FIGURES AND TABLES......................................................................................................................... REFERENCE LIST......................................................................................................................................................


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DISCLOSURE STATEMENT

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1. EXECUTIVE SUMMARY

This research paper will discuss the multi-faceted dynamics of the European sovereign and financial debwith a comprehensive discussion of the background, status, potential solutions, and the ramifications foeconomies, citizens, and investors. We also will discuss the countries of concern, key government-relatedand lessons from historical sovereign crises and defaults. Fears of default and difficulties in sourcing affinancing for countries resulted in rescue packages for Greece and Ireland in 2010, the pending rescue pacPortugal, and contagion threats for Spain, Italy, and Belgium. The rescues have addressed near-term liquresolving the fundamental solvency issues of the sovereigns and banking systems will require subcoordination of government policies, capital raising, and financial support to restore long-term market coand avoid debt restructurings. The foundational problems for each country are idiosyncratic in natuvarying ties to years of over-leveraged and under-capitalized banking systems, real estate bubbles, exgovernment debts and spending, and fundamental economic weakness. Additional contributors to thecrisis included limited control of exchange rates and monetary policy, as well as declining competitivenesglobal stage, further accentuated by the financial, real estate, and economic crises that began to emerge iThe reactions to these crises included banking support and government-funded stimulus, resulting in the of private debt to public debt. The present crisis has significantly increased financing costs and restruprobabilities for Greece, Ireland, and Portugal; however, concerns have decreased regarding contagioperipheral Europe seriously affecting the much larger economies of Spain and Italy, though they tosignificant challenges. The solutions to the European crisis with progressive efforts led by the governmGermany and France will likely require preserving the common currency, providing incremental liqusupport the weaker countries and banking systems, and restructuring sovereign debt. Similar historical emerging markets have been resolved by restructuring banking systems (now underway in Ireland and Spsovereign debt, which cannot be ruled out within Europe given the scale and complexity of the challengeSovereign debt restructurings could include negotiated and market-friendly approaches such as discountrepurchases, exchanges, and/or a Brady Bond Plan tailor-made for Europe. As the sovereign and bankinare resolved, the volatile and uncertain economic environment will provide numerous alpha-genopportunities for experienced and flexible investors.

Credit Stress in Developed Europe Serious Concerning


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2. INTRODUCTION

The amount of sovereign debt outstanding has soared in recent years, with particularly alarming increasesof the developed world. This research paper analyses the causes, effects, and potential outcomes of the ileverage for European countries, with a focus on the peripheral countries with increasing probabilrestructurings among sovereign debt and banking systems. Our analysis could have encompassed other demarkets such as the U.S. and Japan given their broadly recognized fiscal challenges and increasing lehowever, these countries have much less default risk than certain European countries due to their diveconomies, low funding costs, and monetary policy flexibility. Not since 1948, when Germany defaulteNazi-era debt, has a developed country defaulted on its sovereign debt. Meanwhile, during this period (63 years), there have been 68 sovereign defaults among emerging market issuers. In the present soverebanking crisis, Greece faces the greatest challenges in terms of excessive leverage and required fiscal refoas a result, could be subject to the first debt restructuring in a developed market in multiple generations. faces similar challenges due mainly to long-term declines in competitiveness, while Irelands difficultimostly from an over-leveraged banking sector tied to a collapsed real estate industry. Avoiding defacontagion threats from these three peripheral European countries will require near-term solutions coordinvarious European authorities to address liquidity, with longer-term solutions entailing fundamental fiscal and restructurings of sovereign debt and banking systems. The multinational coordinated efforts to contagion from reaching larger economies and banking systems facing similar challenges are critical to prEuropes Economic and Monetary Union (EMU) since Spain and Italy represent a larger combined econoGermany.

Deterioration within certain European economies following the recession and near collapse of the major UEuropean banks in 2008 and 2009 has led to major concerns about European sovereign credits and their fsystems. The present sovereign and financial debt crisis is focused on liquidity, sustainability, and sissues confronting the European periphery, defined as Greece, Ireland, Portugal, Spain, and Italy. Histwitnessed many similar sovereign debt crises, though concentrated in emerging rather than developed mwith a wide range of causes and outcomes. Like other sovereign debt crises, the troubles facing peripheraresulted from high sovereign and private debt loads, large government deficits, declining global competiof labor and industry, lack of control over domestic exchange rates and monetary policy, price deflationestate and corporate securities, and liquidity and solvency issues within the banking system following lending standards during prior strong economic environments. However, Europes situation is differeprior crises in terms of absolute scale, the intertwined nature of its governments and banking systems, thimplications for trade and competitiveness from upholding the common currency, the absence of bankcurrency runs, the lack of currency devaluation options, and the complexities across political and sociaThese sovereign issues will take many years to resolve, requiring long-term political coordination andetermination in order to avoid defaults as each respective peripheral European country struggles to maeconomy more competitive while deleveraging their banking system and administering austerity programs

The economic and financing crisis affecting peripheral Europe has challenged the founding philosophy ofmember European Union (EU): the desire for closer political integration and coordination. This noble gcomplicated by attempting to simultaneously allow for continued fiscal and legislative independence countries with varied economic and social regimes while surrendering control over monetary policy and erates. The lack of monetary controls affects the 17 countries in the EMU, which established the euro (common currency (fully rolled out in 2002) and empowered the European Central Bank (ECB) to coomonetary policy among members, with the explicit and singular mission of controlling inflation. This paof governmental powers, along with the divergent economic and fiscal performance of sovereigns, has resthe slow and convoluted incremental responses to the deepening crisis. This crisis has produced major iin bond yields and spreads for credit default swaps (CDS) for more questionable sovereigns and major institutions.


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The five-year CDS spreads for Greece and Ireland increased from roughly 150 basis points (bps) in late peak above 1,000 bps and 600 bps, respectively, during 2010. The liquidity vacuum that began to develop2010 resulted in the 110 billion bailout for Greece (with stringent preconditions for fiscal reform), whlong suffered from weak economic and competitive standing, over-zealous fiscal spending and entiprograms, and a weak tax collection system. Concurrent with the Greek rescue, European governmentannounced the formation of a 750 billion stability package to address future sovereign financing needfunding from the EU, European governments (through the 440 billion European Financial Stability FacEFSF), and the International Monetary Fund (IMF). Although these rescue packages were supposed to siquestions about the liquidity support for heavily indebted European sovereigns, this left unanswered theissues of economic competiveness and health of financial systems, and ultimately the solvency of gove(Greeces bond yields and CDS prices have recently risen to record levels).

After the Greek rescue, credit markets recovered but the renewed focus on fundamentals brought Irelanforefront of concerns, though for very different reasons than Greece. Ireland had been one of the great esuccesses in recent decades, but the Celtic Tiger over-indulged in the optimism of perpetual prosperity fothe euros introduction and strong economic results, producing a real estate bubble and a related grosssized banking system. The largest Irish banks were soon crippled by enormous levels of troubled loanproperty values inevitably turned, which prompted the Irish government to provide guarantees for deposiinvestors to prevent banking runs. However, the enormous scale of banking losses overwhelmed the govand triggered the October 2010 sovereign rescue financing package, with the government forced to European support programs created in May 2010. This 85 billion rescue package required the Irish govto accept numerous conditions involving the implementation of austerity measures and other structural rthese were deeply unpopular and inevitably contributed to subsequent political turnover. During Irelections in February 2011, with declarations from Gerry Adams (leader of Irelands Sinn Fin party) echpopulist sentiment that citizens should not have to pay for the sins of bankers, the Fianna Fil partysdecade rule of Parliament came to an end. In addition to changes among leaders, the government has alsoforward a much needed restructuring of the banking system. They are winding down two of the largest dbanks already taken over by the government (Anglo Irish Bank and Irish Nationwide Building Socitransferring assets to the governments bad bank, then divesting the depositor base and selected assets to tPillar Banks (Allied Irish Bank and Bank of Ireland), which also are largely government owned. Irecent stress tests for banks, which excluded Anglo Irish, showed they require 24 billion of additional ctop of the 46 billion already provided. Irelands struggling economy and need for additional bankinghave prompted its leaders to soften their rhetoric regarding tax rates (suggesting their low corporate tcould be increased) and burden sharing among senior bondholders in troubled banks (though losses are for subordinated bondholders).

The rescues of Ireland and Greece evolved from quite different situations, which also differed from the rfor Portugals recent 78 billion financial assistance package. Portugals difficulties resulted from loneconomic and competitive weaknesses along with excessive government spending and leverage. continued insistence by government officials that internally driven austerity measures would be suffimanage their finances, increasing bond yields made financing costs unsustainable. Given Portugalborrowing costs, the government will need to finalize the rescue package before the 5 billion of bond min June 2011. The lack of market confidence shown by the Portugals escalating bond yields was furtheregovernment missing budget deficit targets for 2010 and admitting prior debt and deficit figures were und(reminiscent of Greeces earlier admissions). As highlighted in the following table, the high leverage, weperformance, high bond yields, and high implied default probabilities of Greece, Ireland, and Portugthreatened other countries with contagion that authorities recognize must be countered.


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Summary of Western European and Reference Credits(in trillions of )

Credit Rating 10 Year 10-Year CDS Implied 2010 Public Public Fiscal

Moody's / S&P Bond Yield Probab. of Default GDP Debt Debt Private Debt DeficitRescued CountriesGreece B1 / BB- 14.9% 83% 0.23 0.33 142% 330% -9.6%Ireland Baa3 / BBB+ 10.3% 59% 0.15 0.15 96% 293% -32.2%Portugal Baa1 / BBB- 9.5% 61% 0.17 0.14 92% 379% -8.6%

Contagion ConcernsSpain Aa2 / AA 5.5% 34% 1.06 0.64 60% 389% -9.2%Italy Aa2 / A+ 4.8% 24% 1.55 1.84 119% 268% -4.6%Belgium Aa1 / AA+ 4.3% 23% 0.35 0.34 97% 385% -4.6%

Reference CountriesGermany Aaa / AAA 3.3% 11% 2.50 2.00 80% 287% -3.3%France Aaa / AAA 3.6% 16% 1.95 1.64 84% 324% -7.7%

U.K. Aaa / AAA 3.5% 12% 1.69 1.31 77% 453% -10.4%U.S. Aaa / AAA 3.4% 16% 11.06 10.13 92% 355% -10.6%Australia Aaa / AAA 5.5% 10% 0.93 0.21 22% 237% -4.6%Japan Aa2 / AA- 1.2% 15% 4.12 9.08 220% 477% -9.5%China Aa3 / AA- 3.9% 15% 4.43 0.78 18% 163% -2.6%Brazil Baa3 / BBB- 12.8% 19% 1.57 1.04 66% 142% -2.9%

% of GDPPublic +

Source: IMF and Bloomberg

The troubles of Greece, Ireland, and Portugal have caused global investor concerns about the liquidsolvency of other countries in the developed world, thus requiring imperative corrective and decisive acauthorities to avert contagion beyond these peripheral European nations. Greece, Ireland, and Portugal relatively small and similar in scale, accounting for a combined 6.1% of gross domestic product (GDP)EMU and under 5% of the EU, but the threat of contagion spreading to the financing markets of larger couthe critical concern. Spain represents the line in the sand for Europe, as its economy is 1.9x larger tcombination of Greece, Ireland, and Portugal. Spains problems are complex, with a real estate collapse, capitalized and uniquely structured banking system, high unemployment, and overall challenges in eccompetitiveness. Any failure of Spain, while increasingly unlikely as market access has improved andbanks have made progress in recapitalizing, could jeopardize the survivability of the entire EMU and fulof the EUs intentions for political and economic integration. Further, any required rescue of Spainoverwhelm the capacity of the headlined 750 billion financial stability package, which has actual capacito 365 billion due to estimated utilization by Ireland and Portugal and constraints in creating AAAliabilities. Since Italy is even largely than Spain, and considered the next most at risk, financial rescue rannounced to date could be quickly exhausted well before the unique difficulties facing Belgium come int

The resolution of the European crisis will require the complex balance of calming markets, financial staband agreement among multiple governments to avoid default among sovereigns and their intimately comajor banks. Due to the inadequacy of the present financial aid packages and their temporary nature (exJune 2013), the markets have communicated that a much more significant financing and resolution packabe created and implemented in order to restore investor calm and restore reasonable costs for sovereign fin order to minimize the chances and costs of sovereign debt restructurings. Given the choice to resolve tby economizing or agonizing, borrowers will surely choose the former, at least as a first attempt, rathdeal with the potential political and economic agony of default. The European Stability Mechanism (ESpermanent financing facility under construction that is intended to replace the aforementioned 750 bilpackage upon expiration, will play a critical role in providing troubled countries the time to economimplementing fiscal austerity and structural reforms, while also rebuilding investor confidence and d


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potential restructurings. The ESM is intended to allow countries to work through economic weaknesscould help stabilize the EMU by maintaining the present membership and preserving the euro. The prpreserving the EMU was exemplified by German Finance Minister Wolfgang Schaeuble stating We are defending a member state but our common currency, and EU Council President Herman Van Rompuy wthat debt contagion was a survival crisis that threatened the existence of the euro and the wider EU. Anup of the EMU would be unacceptable to Germany and the other strong economies within Europe as iresult in a deep economic recession, devastation for weaker euro countries like Greece, and certainly indefault scenarios that would imperil Europes banking system and other investors. In addition to preserEMU and the status of the European financial system by adding liquidity facilities such as the ESMproductive solutions to avoid default could involve allowing countries to directly or indirectly purchase bdiscounts (e.g. with an expanded and extended EFSF), additional support from the ECB, reforms of fisocial policies, privatizing industries, selling assets, and/or issuing debt with ranking senior to existinThese are all preferential to countries dropping out of the EMU, which has a remote probability since ilikely lead to debt restructurings.

Default concerns are justified over the long term for any country with excessive fiscal deficits and leverweak economic growth and competitiveness. Greek Finance Minister George Papaconstantinou has hinsovereign reforms could be paired with debt restructuring: The issue of burden sharing by the private secprinciple absolutely right...because taxpayers cannot continue to pay the bill and bondholders also neeresponsible for their actions. The likelihood of a Greek debt restructuring is the focus of present debatongoing crisis, with vastly differing opinions ranging from impossible to inevitable. The numerrelatively recent defaults of emerging markets illustrate the restructuring possibilities and dangers of coforegoing control of their currencies and monetary policies, and hence potentially their economic competand stability. The defaults of Russia (1998), Argentina (2001), and Uruguay (2003), along with the 17 cthat restructured using Brady Bonds (1990-1997), highlight the variety of factors contributing to default adifferent restructuring solutions that could prove prescient in any future sovereign restructuring.

The historical emerging market solutions have included a variety of restructuring alternatives includreductions, coupon reductions, rescheduling maturities, currency devaluation, inflation, and economic, fiand fiscal reform. While the economic and financing recovery of these emerging market countries posexemplify sovereign survivability, the present crises is less likely to produce broad-based defaults for including the absolute scale of the problem, the resulting global economic implications (especially for Gethe interlocking and inter-dependent borrowers and lenders between countries, the inability for banks tolosses on sovereign debt positions (which would entail even larger required rescues given their enormous of troubled sovereign debt), and recognition of the danger of contagion spreading to larger econombanking systems. The European authorities are keenly focused on exploring contained sovereign restrufor certain peripheral European countries given their unsustainable debt structures and borrowing costs, bto ensure that actions taken are bank-friendly. For example, Greek sovereign debt holders could be offoption to avoid default by exchanging into 30-year bonds with lower coupons; this could allow Europeathat hold Greek sovereign debt to avoid write-downs even though they would receiver lesser payments ovWhatever the form and timing of eventual sovereign restructuring, there is no question that restructuringEuropes banking systems are occurring with greater haste (as seen in historical emerging market crisestheir dependence on market access and customer confidence. Ireland and Spain, the countries with tsignificant banking industry troubles, have each taken significant steps to restructure banks thnationalizations, forcing mergers, segregating lower quality assets, divesting assets, and raising Additional capital is needed by banks to restore solvency, as seen by Irelands recent banking stress tesupcoming announcement of the European banking stress tests in June 2011 by the European Banking Acould substantiate market estimates that Spanish banks need 50 billion to 100 billion of new capital, in to revealing potential capital shortfalls for German Landesbanks and others. However, it remains to be


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these stress tests will presume losses on any sovereign debt, despite the increasing risk of sovrestructurings.

The resolutions to the European sovereign problems which are most severe in Greece, Ireland, PortuSpain will require incrementally working through a combination of initiatives over time that will prchallenging and rewarding environment for astute investors. Portfolio flexibility, shorting capabilities, abilities, restructuring expertise and experience, and thorough knowledge of CDS will all be important ato produce attractive investment returns. Importantly, these uncertain times share commonality with hcrises, with potential opportunities across sovereign credit, CDS trading, bank capital structures, long posin assets and portfolios divested by banks, and potentially distressed sovereign and corporate bonds.

By way of organization, this research document will review the present European sovereign debt crisis in3, detail the historical building blocks of the crisis in Section 4, review the more concerning countries rescues to date in Section 5, discuss the critical governmental and supranational players in Section 6, examples and lessons of prior sovereign debt crises in Section 7, and review the potential near-term andterm solutions and outcomes in Section 8, before detailing the considerations and opportunities for inveSection 9. This is followed by an Appendix reviewing CDS and a glossary of the numerous acronyms anused throughout the document.


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3. PRESENT EUROPEAN SOVEREIGN DEBT CRISIS

Prior to the global credit crisis that began in 2007, all European countries could access sovereign debt ma

yields implying miniscule credit risk. However, one of the greatest lessons of the financial collapse in 2that enormous companies and institutions are not immune from the laws of economics, especially when bwith high leverage. The downside of excessive leverage, particularly when combined with weakening coand asset bubbles, was well encapsulated by Yale Professor Irving Fisher in 1933: Over-investment anspeculation are often important; but they would have far less serious results were they not conducteborrowed money. In the financial crisis, despite repeated reassurances from management teams throughighly leveraged financial industry that losses from sub-prime mortgages, other mortgages, trading exposucommercial bad debts would be contained and manageable, and that stock dividends would couninterrupted, investors suffered extraordinary wealth destruction as the banking and economic crisis dand managements claims proved entirely false. This led to the failures, bailouts, and/or take-overs of somlargest financial institutions in the U.S. and Europe: Lloyds Banking Group, Royal Bank of Scotland, AllBanks, Anglo Irish Bank, Fannie Mae, Freddie Mac, AIG, Washington Mutual, Wachovia, Bear Stearns, Brothers, and Merrill Lynch. This reawakening to credit risk among high investment-grade institutiinvestors wary of other heavily indebted entities that claim all is well when facing major and unappchallenges, which perfectly describes many sovereign credits. This wariness led to new metrics for soverpricing, with virtually all sovereign bonds in Europe now including various degrees of idiosyncratic credit

The present European debt crisis has long been building for the certain countries, for reasons includinability for each country to control its own currency exchange rates and monetary policy, a history of government deficits and debt loads resulting from weak economies and dwindling competitiveness, expenunderfunded government entitlement programs, difficult debt maturity schedules, dependency on capital mstructural imbalances in their economies, and banking system fragility. These issues were exacerbateddowndraft in real estate prices following the multi-year build-up of prices in the early 2000s, which contria liquidity crisis for banks beginning in 2007. Numerous government initiatives to stem the banking lcrisis, with much of the burden assumed by sovereign entities through guarantees for depositors and inproved insufficient to match the scale of the severe economic recession during 2008 and 2009. The defasset and securities prices during the recession, along with the burst real estate bubble, highlighted that banot only liquidity problems, but also solvency problems. The explicit and implicit governmental supporbanks conjoined with justified concerns surrounding excessive leverage, fiscal discipline, majorefinancing requirements, and a weak economic outlook then contributed to heightened investor csurrounding sovereign credits and their worsening balance sheets. These challenges, among othesummarized in the following table for European and other reference countries. Although the most chaEuropean countries are relatively small, larger markets such as the U.K., the U.S. and Japan share some troubling signs. However, the subjective graces of the market and other more justifiable differences in fmethods and economic outlook have kept these larger developed markets off the troubled list of credits,for now. However, any country is subject to default risk without conscientious and sustainable fiscmonetary policies, particularly when ignoring Professor Fishers lesson above.


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Sovereign Credit DeficienciesCriteria U.S. Japan U.K. Greece Ireland Portugal Spain Italy Belgium

Excessive total debt X X X X X X X X X

Excessive private debt X X X X X X X

Excessive public debt X X X X X X X X

Maturity profile of sovereign debt X X X Rescued Rescued Pending X X X

Strong dependence on global capital marketsX X Rescued Rescued Pending X X Less currency flexibility (ability to devaluecurrency / reserve currency status) X X X X X X

Less competitive economy X X X X

Less ability to deliver on fiscal austerity X X X X X

Significant banking system concernsX X X X X X

Rating agency downgrades X X X X X X

Source: Deutsche Bank, Marathon

Concerns about government balance sheets escalated during 2009 after Greece increased its budgetforecast for 2009 to 13.6% of GDP (the final figure was 15.4%); this resembled the negative revisions forexpectations and dividends that preceded the banking financial crisis. This deficit was far beyond the 3%allowed for the 17 countries in the EMU (though most other members have also breached this requiremtime). Investor sentiment toward Greece soured again in early 2010, with bond yields spiking afgovernment was found to have repeatedly and intentionally misreported the countrys economics Leading investment banks were associated with arranging transactions that assisted Greece in manipulreported debt levels, which masked the actual budget deficit and allowed the government to continue boand spending freely. Investor concerns quickly spread from Greek sovereign debt to other countries in peEurope, producing higher yields for bonds of Ireland and Portugal (see following charts), and also imfunding costs for Spain, Italy, and Belgium.

Apprehension grew about Greece and other European countries increasing debt levels and governmentthrough 2010, as reflected by a series of sovereign debt downgrades by rating agencies (Standard & PoorMoodys lowered ratings on Greece, Portugal, and Spain in April 2010). With markets becoming more voMay 2010, the IMF and governments in the EMU attempted to contain the spreading crisis by granting G 110 billion financial support facility (80 billion from the EMU countries and 30 billion from the IMdiscussed further in Section 5, this rescue provided 45 billion immediately but required the Greek governimplement a series of austerity measures including strict budgetary and structural reform. In conjunction Greek rescue, the IMF and European leaders also approved the 750 billion Financial Stability Package tfinancial stability and address market uncertainty across Europe and prevent the crisis from spreading The 440 billion European Financial Stability Facility (EFSF) was the largest element of this package, wremainder consisting of 60 billion from the European Commissions European Financial Stability Mec(EFSM) and 250 billion from the IMF (or up to 50% of the combined contribution from the EU). As dfurther in Section 6, the EFSM is funded under the EUs budget, and thus can provide immediate fundinof the 27 EU members; in contrast, the EFSF supports only the 17 Euro-Zone members and requires sigapprovals before funding.


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Yield Curves for Greek and Irish Sovereign Debt March 2011 versus March 2010

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

3M 6M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 12Y 15Y 30Y

Ireland 3/31/10 Ireland 3/31/11 Greece 3/31/10

Greece 3/31/11 Portugal 3/31/10 Portugal 3/31/11

Source: Bloomberg

Yield Curves for European Sovereign Bonds

0%

4%

8%

12%

16%

20%

24%

1 2 3 5 7 10 15 20 30Years to Maturity

Greece Ireland Portugal Spain Italy Belgium Germany

Source: Bloomberg

The IMFs involvement in Greeces recent rescue was a novelty in the sense that the IMF had never redeveloped market, much less a member of the Euro-Zone. It had, however, been active in many hiproblems in emerging markets and even other Western and Eastern European states in the recent past, providing loans to Hungary, Latvia, and Ukraine during 2008 and Romania in 2009. The IMFs involvemGreece was initially viewed with skepticism by many, including the U.S. and Euro-Zone members; the


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and Spanish governments viewed the Greek troubles as an internal Euro-Zone matter, with IMF invoconsidered humiliating for the Euro-Zone. On the other hand, Germany actively lobbied to involve the IMtheir expertise in managing fiscal adjustment programs. From a practical standpoint, Germanys position interpreted as either (i) signaling they are unwilling to be serve as the Euro-Zones lender of last resort, wimportant in the light of significant internal political opposition in Germany, (ii) their dedication to proteceuro and local banks to help the German economy, since German banks have the largest debt exposure to European sovereigns and banks, and their export markets (roughly two-thirds of exports are within Europbenefitted tremendously from the cheap euro (a stand-alone German currency would be valued muchmeaning their exports would suffer from higher prices), or (iii) strengthening its negotiating position to stricter Euro-Zone budget discipline, since the IMF is seen as tougher on enforcing austerity than the ECommission.

The Greek rescue, the EFSF, and other rescue initiatives did not quell investor concerns about peripheral which also faced challenging ramifications from ongoing economic weakness and questionable solvency banks. Ireland was the next country in the markets cross-hairs. This resulted from the countrys major rand fiscal damage from pledging to support depositors and bondholders of over-levered domestic banks,the fact that their main banks were collectively much larger than the entire economy and far beyogovernments ability to rescue (domestic assets of Irelands banks were 484% of GDP, and much larger innon-domestic assets). The bond market turned on Ireland after its major banks reported losses in Octobthat exceeded even morose expectations. This prompted the Irish government to effectively take over itdomestic banks, including Allied Irish Bank, Anglo Irish Bank, Bank of Ireland, and Irish Nationwide BSociety. However, the crisis continued to build. The overwhelming obligations from supportingoutweighed the governments claim that their fiscal budget was fully funded through most of 2011, whichthem to request a bailout package in November 2010. This 85 billion package consisted of 17.5 billiinternal reserves, 4.8 billion of bilateral loans, 22.5 billion from each the IMF and EFSM, and 17.7from the EFSF. As with the Greek package, the relatively high interest rates for these rescue loans haincreased the countrys interest burden.

As investors connected the dots between Greece and Ireland, contagion fears threatened to consumcountries, similar to the repercussions of Argentinas debt crisis ten years earlier. This risk aversioninvestors often justified for countries running major budget deficits, subject to increasing debt loapending maturities can quickly increase interest costs and deepen a governments fiscal deficit. Such problems can prompt a liquidity crisis, potentially leading to further concerns surrounding sovereign soThis was the fear as investors turned to Portugal as the next most concerning sovereign credit. The cregarding Portugal were not punctuated by a banking crisis (as in Ireland) or acute fiscal mismanagemdeception (as in Greece), but resulted mainly from its escalating debt burden paired with long-termeconomic growth and competitive positioning. Although the Portuguese government insisted it could haupcoming refinancing requirements and fiscal deficits without external aid packages by implementing aand stimulative measures internally, the markets lack of faith produced unsustainably high refinancinThese costs increased sharply after the government missed the 2010 fiscal deficit targets and admitteearlier economic statistics were incorrect, and Parliament rejected the austerity plan presented by theMinister Jose Socrates. In the ensuing turmoil, the Prime Minister resigned (though still serving replacement is appointed), the President called for early elections (to be held on June 5, 2011), agovernment officially requested financial assistance. Terms of the resulting 78 billion rescue financing for Portugal remain to be determined, though stated goals from the likely capital providers include redubudget deficit as a percent of GDP from 9.1% in 2010 to 3% in 2013. Other terms of Portugals rescue winclude harsher austerity measures than the rejected plans from the Prime Minister. Given the upelections, securing the rescue package will be complicated by the potential unwillingness of lenders topledges from outgoing politicians.


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The main intention of the rescue financing packages to the smaller countries of Greece, Ireland, and P(collectively 6.1% of Euro-Zone GDP) is to preserve liquidity and short-circuit the contagion fearspreading to larger and more systemically important countries that could threaten the broader European eAny contagion fears affecting Spain, Italy, and/or Belgium which account for 12%, 17%, and 4% of thZones GDP, respectively could substantially increase their refinancing costs and therefore jeopardize thof the euro and impair the broader economies and banking systems within Europe. Also, any fundaminvestor-driven rescue needed by these larger economies could easily require hundreds of billions ofbringing into question if the 750 billion Financial Stability Package (intended to handle the scope foreseeable crisis) is sufficient to support such larger countries while also providing a sufficiently large cuappease markets. The scale of available rescue financing is especially concerning given that EFSF borrowintended to be rated AAA, meaning the practical limit of the EFSFs size is governed by funding countriAAA (e.g. Italy and Spain account for over 30% of the EFSF funding, but are rated below AAA). Thconstraint resulted in the 440 billion EFSF having a more practical limit of 256 billion (with roughbillion undrawn), and limits the total Financial Stability Package to 474 billion rather than the 750headline. Further, availability under the plan decreases as countries need financing or participadowngraded. The AAA rating constraints, in addition to estimated commitments for countries that have rerecues (which also effectively eliminates their commitment to the EFSF and the related 50% macommitment from the IMF), have reduced availability on the Financial Stability Package to roughly 36(see following table). That availability amounts to only 57% and 20% of the public debt balances for SpItaly, respectively. Government leaders increasingly recognize that the present financing prograinsufficient, yet they must restore confidence and stop contagion in its tracks. Any serious difficulties larger countries would apply great pressure on France and Germany to support the entire region.

Summary of Commitments and Availability under Europes Financial Stability Package

(in billions of )Exclud e Exclude Exc lude Re scue Est . Resc ue Est . Undra wn Est. Un drawn f rom

Funding Sou rc e C ommitm ent Gre ece Portugal Ir eland Ire land Port ugal Comm it me nt AAA- rat ed Cou nt riesEFSF 440.0 12.3 11.0 7.0 17.7 30.0 361.9 225.9EFSM 60.0 22.5 20.0 17.5 17.5IMF 250.0 6.2 5.5 3.5 22.5 25.0 187.3 121.7

Subtotal 750.0 18.5 16.5 10.6 62.7 75.0 566.8 365.1Internal 17.5 0.0Bilateral 4.8 3.0 % of Spain's Public Debt: 57%

Total 85.0 78.0 % of Italy's Public Debt: 20%

Investor concerns and contagion worries have produced increased sovereign bond yields and major divergyields among the higher and lower quality European sovereign credits (see following graph), in contrahistorical tight clustering of yields. In recent months, the spreads of sovereign yields above the low-risk government bonds (i.e. the bunds) have reached all-time highs for Greece, Ireland, and Portugal althoughhave remained more stable or slightly decreased for Spain, Italy, and Belgium. While this latter grcountries continues to experience elevated bond spreads and face longer-term issues, the decreased reficosts have improved near-term liquidity prospects.


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10-Year Sovereign Bond Spreads to German Bonds (bps)

0

200

400

600

800

1,000

1,200

Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11

Greece Ireland Portugal Spain Italy Belgium

Source: Bloomberg

10-Year Sovereign Bond Yields

1%

3%

5%

7%

9%

11%

13%

15%

Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11

Greece Ireland Portugal Spain Italy Belgium Germany

Source: Bloomberg

Another indication of market confidence and default expectations is the pricing of credit derivatives such default swaps (we discuss CDS in the Appendix); the pricing of such default protection mirrors the socredit spreads versus Germany, which reflect concerns about a given countrys ability to service its debtpricing for European sovereigns (see following chart) has implied increasing probabilities of default forcountries. The implied cumulative default probability on 10-year CDS is 83% for Greece, 59% for Irelafor Portugal, 34% for Spain, 24% for Italy, and 23% for Belgium; this compares to 10% for Australia, Germany, 12% for the U.K., 15% for both China and Japan, and 16% for the U.S. and France, which arethe worlds lowest. Elevated default concerns contributed to the 15% depreciation in European stocks (u


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Euro Stoxx 50) and the euro (versus the U.S. dollar) from December 2009 through June 2010, when cbegan to mount. However, equity markets across Europe have largely recovered as the shock of the cwaned, though bank equities and CDS levels continue to reflect grave concerns, especially with bank stresults due in June 2011, the pending negotiations for the rescue of Portugal, political uncertainty, aprospect of sovereign restructurings.

CDS Curves for Selected European Sovereigns

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

6M 1Y 2Y 3Y 4Y 5Y 7Y 10Y

C D S S p r e a d s

( b p s

)

Greece Ireland Portugal Spain Italy Belgium France Germany

Source: Bloomberg

The recent market stabilization in equity prices throughout Europe and stabilized CDS prices for Spain, ItBelgium have paralleled the ECBs increasing salvation efforts. These efforts have expanded well beyECBs traditional means of fulfilling their price stability mandate. The ECB has been actively purchasingsovereigns, debt of banks, providing more access to financing lines, and expanding acceptable collaimprove bank liquidity. The ECB will have to play a more significant role than its standard to help stabbanking system, which is the largest holder of the troubled sovereign debt. The ECB will need the assisthe more stable sovereign governments, the IMF, and a reassured investor base to contain the crisis. Tterm risk to sovereigns primarily arises from the potential failure to refinance these debt maturities at rearates. However, with the recent market stabilization, the ECB has curtailed earlier stimuli, decreaspurchases in recent months, constricted eligibility criteria for collateralized ECB financing, and eveninterest rates in April 2011 (the first increase since June 2007) in response to increasing inflation.

Beyond the near-term stabilization and potential triggers from refinancing requirements, the more fundrisks concerning long-term solvency of sovereigns and certain major banks remain largely unansweresolvency questions arise from the legacy and outlook for rising sovereign debt loads, major fiscal ddepreciation of real estate, and high unemployment. Also, the limited sovereign ability to control mpolicy, inflation, or exchange rates impairs any single governments ability to influence the weak comstance and troubling outlook for economic growth, especially with the recessionary and deflationary ameasures being implemented. Given the breadth and depth of the crisis, near-term and longer-term solusuccessfully emerge from the current crisis will take substantial, coordinated efforts among political dmakers and possibly require consent and certainly some degree of cooperation from the global financial m

Multiple pathways exist to lay the foundation for a potential recovery from the unprecedented peadeterioration among European developed nations. In the near term, European governments and supra


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entities will utilize all available stop-gap measures to delay any restructuring of sovereign debt given therepercussions across financing markets, economies, banking systems, and potentially the currency regimextent of such efforts has been proven in the rescues of Greece, Ireland, and Portugal. The rescue prograbeen funded by internal reserves and external financial support including the EFSF, ECB, IMF, and bloans. The external support generally requires significant austerity measures and fiscal reforms. These financing programs will have to be supplanted shortly by a more comprehensive and sizable rescue ficommitment due to (i) consumption from announced rescues, (ii) the inadequate scale of the current EFother programs to finance or refinance all obligations of the rescued countries, much less support larger c(iii) their inherently temporary nature, with the Financial Stability Package expiring in June 2013, and repercussions of contagion spreading from the smaller peripheral European countries to larger sovereignsSpain, Italy, and Belgium. The near-term solutions will also have to address the liquidity and healthbanking system, since further banking troubles could result in even more liabilities transferred from the ppublic sector through nationalizations, bail-outs, and/or guarantees. The troubled sovereigns will also hatheir part to promote progress and solutions internally, which will involve a major overhaul of long-sfiscal, social, and economic policies. These fiscal commitments will be difficult to maintain given the ecimplications (austerity requires higher tax rates and/or collections paired with reduced spending) and prepercussions (austerity is unpopular and likely produces shifts in political willingness to stay the courspoliticians are to maintain their positions). Another supplemental, not to say replacement, element to a nsolution could include debt buybacks for sovereigns and/or banks. For example, the ECB has reputedly 50 billion of Greeces long-term debt at average price near 70% of par; if this debt could be refinaexchanged for new debt at the ECBs cost (with the 30% haircut forgiven), the Greek government woulddebt by roughly 5% (17 billion). However, all of these initiatives still fall short of resolving the long-terof fundamental solvency and projected fiscal deficits.

The long-term solution to the credit crisis must involve means of reducing the unsustainable debt requirements for suspect sovereigns and banks. In order to prevent default the least desirable solutiodifficult economic, political, and reputational repercussions fiscal and monetary policies must peconomic growth in excess of debt growth to regain investor confidence in each countrys debt secapabilities. This can be partly addressed internally by reducing fiscal deficits and reforming entitlemewith external assistance if (albeit unlikely) the ECB promotes inflation. Other long-term solutions coentail asset sales, privatizations, or new capital infusions (e.g. collateralized debt for sovereigns or juniofor banks). Assuming no positive exogenous events correct the current account deficits of the over-lesovereigns, and the existing solvent Euro-Zone countries do not substantially increase their support commto buttress the present incrementalist approach, there is a higher probability that some form of debt restrwill eventually be required.

The numerous restructurings of emerging markets have proven that reducing debt service obligationsaccomplished via IMF-assisted voluntary exchanges to reduce principal and/or reduce coupons (thereby rthe net asset value of obligations), along with rescheduling maturities. However, such a sovereign defauldeveloped market could produce investor flight, heightened contagion fears, and necessitate a restructurinbanking system as well. The removal of troubled countries from the EMU (even though voluntary witand involuntary expulsion are not permitted) would not provide a solution since the likely outcome wmassive losses on debt held by other EMU members, not to mention that a devalued currency would substantial economic confusion and contraction (this would also hurt trading partners by reducing exportcountry). The default repercussions could potentially be lessened by creating a new support mecreminiscent of the Brady Bond Plan which was used so effectively to restructure emerging market debtcountries from 1990 to 1997. While these ultimate solutions are likely to be postponed by the political pplace for as long as possible, any market attack or withdrawal of fundamental liquidity could force theseto take place sooner rather than later.


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4. BUILDING BLOCKS OF THE EUROPEAN SOVEREIGN DEBT CRISIS

The present European sovereign debt crisis is the result of many factors, including structural and cyclical

The cyclical downturn among economies and real estate markets have impacted government finances lower tax receipts, fiscal spending to stimulate the economy, and higher spending on unemployment. Hcertain European countries also suffered from structural issues such as excessive private and public debunsound banking systems, negative consequences from delegating monetary policy to the ECB, weak ecgrowth and competitiveness, poor records of fiscal spending well before the recession, and dependence onmarkets for ongoing financing (especially when facing major debt maturities in the near term), as well as in investor sentiment and exposures following downgrades by rating agencies.

EXCESSIVE PUBLIC AND PRIVATE DEBT The difficulties for many European countries have been fueled by a decade of debt-fueled macroecpolicies pursued by local policy makers and complacent central bankers. A long period of low interest rcredit spreads, abundant liquidity, development of real estate bubbles, and globalization of banking foster

and substantial credit growth. This was particularly evident among peripheral European countries, whicsurge of debt-financed consumer demand and capital inflows following their adoption of the euro. The exof private debt in the 2000s coincided with increased public debt in several mature economies (notably exGermany and Switzerland).

While the level of public and private debt by itself is not enough to predict a crisis which requires granular analysis of other macroeconomic factors, budgetary analysis, investor sentiment, and interest coamount of debt relative to a countrys economy can provide insights related to the debt burden, impacts ogrowth, and quality of the sovereign credit. As shown below, the high levels of public debt as a percent (highest in Greece, Italy, and Belgium) should be added to private debt including household and corporateunderstand the total leverage within a country, especially since certain private debt could be transferregovernment in a crisis (as shown with Irelands banking rescue by the government). Debt among househighest in Portugal, the U.S., and Ireland; debt for financial institutions is highest in Spain and the U.Snon-financial companies have the highest relative debt loads in Belgium, Spain, and Portugal. These debhave long been creeping higher, particularly with the deterioration of lending standards in the 200contributed to housing bubbles in several countries including Spain, Ireland, the U.K., and the U.S.

Debt by Sector as Percent of 2010 GDP

105% 77% 55%97% 70% 83% 53% 79% 52%

139%157%

137% 76%

58%

104%

59%66%

58%

84%54%

95%91%

60%

52%

85%61%

39%

60%97% 92%

92%

142%84%

96% 80%119%

0%

50%

100%

150%

200%250%

300%

350%

400%

450%

Spain Belgium Portugal U.S. Greece France Ireland Germany Italy

Financial Businesses Non-Financial Businesses Households Government

355%330%

293% 287%268%

324%

379%385%389%

Source: Central Banks, IMF, Deutsche Bank


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Although the mix of public and private obligations varies by country (see graph above), many have tolevels considerably greater than GDP. Growth of public debt has accelerated since the start of the bankinand economic downturn due to stimulative initiatives, banking rescues, and larger government budget This increased debt corresponds to the conclusion by Carmen Reinhart and Ken Rogoff that, after crises, government debt rises, on average, by about 86% within three years. As presented below, public debt legrowth as a percent of GDP stand out for Greece, Italy, Ireland, and Belgium. All of these exceed 90% the level generally corresponding with lower future economic growth rates, according to Reinhart and Roreduce this ratio, European countries need economic growth to exceed debt growth, which can be infthrough trade policies and budgetary measures such as fiscal austerity in spending and changing tax ratecollections. However, such fiscal changes often are politically hazardous and difficult to implement. doubly difficult if countries lack the most powerful sovereign weapon to lower relative debt levels: contexchange rates and monetary policy. EMU members have transferred this power to the ECB (as discusubsequent pages). Also, any country unable to effectively manage their budget and debt maturitiediscover investors unwilling to advance additional capital, with potentially catastrophic consequences.

Public Debt as % of GDP 2010 versus Average from 2000 to 2008

103% 106%96%

32%

62% 58%64%

47%

142%

119%

96%84%

92%80%

60%

97%

0%

20%

40%

60%

80%

100%

120%

140%

160%

Greece Italy Belgium Ireland France Portugal Germany Spain

Average 2000-2008 2010

Source: IMF, ECB, European countries central banks

Debt levels for many European countries coming into the crisis were already elevated due to sizable deficits that accumulated over time, which were partly attributable to extensive and expensive social systems. Crucially, the official debt figures, although already high, entirely exclude massive off-balanobligations such as contingent liabilities and underfunded pensions. These obligations are especially onecountries with large populations of government employees (including civil service, administration, utransportation, teaching, security, and defense). These types of issues certainly apply to Greeces bloatemployee base and the huge unfunded pensions in the U.K. (estimated at 78% of GDP) and unpensions/other liabilities in France (330% of GDP), Germany (190% of GDP), and Italy (130% of GDPliabilities can only remain hidden for a limited time, as mounting actuarial requirements to fund penshealthcare obligations can overwhelm a countrys or companys ability to pay.

In addition to excessive public debt, the troubling growth of European private sector debt has built oveyears. As shown in the preceding and follow charts, Spain, Belgium, Portugal, and Ireland have thconcerning levels of private debt and household debt. Growth of borrowings within the financial secanother critical component of the increased private debt, as discussed in the following pages. High co


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leverage can contribute to financial distress, reduced competitiveness, employee layoffs, damage to inthrough restructurings or bankruptcies, and turmoil among suppliers and customers, among other nconsequences.

Similarly, over-leveraged households not able to fulfill their debt obligations could impart significant dalenders, particularly lenders highly leveraged themselves. Household debt is mostly non-revolving debtmortgages, with a lesser share from revolving debt such as credit cards and home equity lines. Exhousehold debt was strongly evident in European countries that experienced real estate booms, such as SIreland. Households increased their borrowing mainly through home mortgages, which fueled rising prices and encouraged more borrowing. In Spain, the leverage increased mostly among the poorer houwith little savings, resulting in significant credit losses during the crisis. The resulting collapse in housinand economic activity led to surging defaults, high unemployment, inability among banks to recruit financgovernment bail-outs and take-overs of banks damaged by mortgage and other losses. Any banking sysuch a weakened condition can impair overall economic activity by restricting credit, producing nfeedback loops of higher unemployment that strain household debt servicing capabilities. The unemploymis expected to remain high in certain European countries, with Spain seemingly stuck at a troublesome 20%

Consumer Debt and Unemployment for 2010

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

110%

Portugal U.S. Ireland Spain Germany Belgium France Greece Italy

C o n s u m e r

D e b

t %

o f G D P

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

22%

Un e m

pl o ym e n t R

a t e

Consumer Debt % of GDP Unemployment Rate

Source: Central Banks, IMF, Deutsche Bank

Historical data shows that deleveraging has followed almost every major financial crisis in the past half-contributing to painful GDP declines or slow growth for years. Reducing debt-to-GDP ratios requirgrowth to lag GDP growth. This can include (i) GDP growing due to higher inflation, and/or (ii) debt refrom defaults, lower deficits (potentially aided by decreasing interest rates), lesser credit availability fromincreased consumer or corporate savings or decreased spending, and/or companies pursuing asset sales equity financing. Historically, a significant increase in net exports often helped support GDP growthdeleveraging, particularly following currency devaluations, though peripheral Europe will find this sostretch given their limited competitiveness and the ECBs control of monetary policy.

The deleveraging required for sovereigns is mirrored by the requirements for the private sector acrosscorporates, and households. While media has thoroughly excoriated banks and bankers for their ag


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practices before the crisis, the following chart highlights that many individuals across the globe also signincreased leverage during the boom years.

Household Debt to Disposable Income

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

I t a l y

F r a n c e

B e l g i u m

A u s t r i a

F i n l a n d

G e r m a n y

J a p a n

S w e d e n

S p a i n

P o r t u g a l

U . K .

U . S .

N o r w a y

N e t h e r l a n d s

I r e l a n d

D e n m a r k

1997 2007

Source: Federal Reserve Bank of San Francisco

WEAK BANKING SYSTEMS AND EXCESSIVE LENDING GROWTH The financial sector was an enormous contributor to the growth in private debt balances discussed abovincreased scale of borrowings in the financial sector was paired with increasing leverage (i.e. under-capitaand more dependence on short-term funding, all of which were troubling signs. The excessive leverage room for error, while the increased assets magnified the scale of the problem, as financial debt to GDP very high levels (see following chart). Further, as discussed later, the over-concentration of short-term and small deposit bases also made the banks susceptible to asset-liability mismatches.

The increasing bank leverage was unfortunately applied during strong economic times. As shown following chart, the strong economic conditions were conjoined with property bubbles in many areainflation-adjusted real estate prices increasing cumulatively from 1997 to 2007 by roughly 270% in Irelanin the U.K., and 210% in Spain. Such performance dwarfed the U.S., which is known to have experieown massive real estate bubble (with commensurately large losses for homeowners and invests),cumulative real price increases over the same period closer to 150%. Much of the real estate price inglobally were driven by increasingly aggressive mortgage lending practices, in addition to changes in sentiment. The optimistic sentiment also contributed to significant over-building of real estate. The pbubble and aggressive lending produced over-sized banking systems with inadequate capital cushionbanking credit losses due to weaker lending standards, the sliding economy, and real estate price erosiodeclines from record highs aided by excessive unsold inventory) quickly eroded major portions of bankcushions and pushed bank leverage towards unsustainable levels. This phenomenon was seen clearly inand Spain, which relied on considerable increases in property prices to support economic growth priocrisis.


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Inflation Adjusted Real Estate Prices by Country

50

100

150

200

250

300

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

I n d e x L e v e l

Ireland U.K. Spain Italy U.S. Germany Japan

Source: Federal Reserve Bank of San Francisco

With expanded real estate lending, the assets of Irelands banks reached 736% of GDP (see following chadomestic assets roughly tripled from 160% of GDP in 2003 to 484% of GDP in 2010. The U.K. also haratio of domestic banking assets to GDP at 465%, although unlike Ireland, U.K. bank assets are inflated drole as a global financial leader. Much of the lending growth within Ireland and the U.K. (as in Spain U.S.) came from lower quality borrowers such as homebuyers and real estate developers with overcollateral (as real estate prices spiked), resulting in immense bad debts as property depreciated and consceased. The Irish government attempted to rescue its banking sector by injecting 7 billion of equity intolargest banks (Allied Irish Banks and Bank of Ireland), establishing a bad bank to handle the troubledand providing guarantees to bank depositors and lenders. These actions transferred the banking sectorthe Irish government, forcing the countrys rescue in late 2010 as banking losses and investor cooverwhelmed even the governments efforts (the ongoing restructurings within the Irish banking systdetailed in Section 5).

Domestic Bank Assets to 2010 GDP

484% 465% 449%

311%

244%277%

178%

103%

736.22%

0%

100%

200%

300%

400%

500%

600%

700%

800%

Ireland U.K. Spain Portugal Italy Greece Japan U.S.

Domestic Asse ts Tota l Assets

Sources: Deutsche Bank, Bank of England, Federal Reserve, Central Bank of Greece, Bank of Italy, Central Bank of

Ireland, Bank of Portugal, Bank of Spain, IMF


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Clearly, any over-sized banking system that lacks funding access, market confidence, capital and liquidprecipitate a sovereign crisis. As with Ireland, this factored into earlier sovereign defaults of Russia, MexUruguay (discussed in Section 7). Spanish banks have withstood the economic downturn and heavy reexposure thus far, though investor concerns and market pressures continue to mount. Such large bankingare now more interconnected to global financial markets and neighboring countries than in the past, pothreatening fast and severe contagion and multiple extraordinary considerations in producing a solutiocrisis. For example, among foreign lenders, the banks and governments of Germany and France are thlenders within Greece, Spain, and Italy; those of Germany and the U.K. are the largest within Ireland; andSpain and Germany are the largest within Portugal (see cross-border financing relationships below). since the European banking system is loaded with domestic sovereign debt and the governments effectivebehind their major banks, a failure by either a government or major bank could imperil the other.

European Borrowers and Lenders by Nationality(billions of U.S. dollars as of September 2010)

Creditor Country

Borrower* Greece Ireland Portugal Spain Italy Belgium Germany France U.K. U.S.Greece -- $8 $11 $1 $5 $2 $40 $63 $15 $7Ireland $1 -- $22 $13 $15 $55 $154 $45 $160 $60Portugal $0 $6 -- $85 $5 $2 $40 $37 $25 $5Spain $0 $27 $26 -- $29 $20 $201 $183 $116 $52Italy $1 $44 $4 $33 -- $25 $177 $449 $65 $42

*Borrowers include public, bank, non-bank private, and unallocated; does not include derivatives contracts, credit commitments, or guarantees.Source: Bank for International Settlements Quarterly Review, March 2011

Given this risk of contagion, the ECB has assumed the position as a limitless provider of liquidity to aEuropean economy and major banks, though they have yet to pursue significant monetary stimulus. In faECB lending (i.e. the size of its balance sheet) actually declined over the course of 2010. This is in

contrast to the U.S. Federal Reserve, which has significantly increased its balance sheet over the same timNovember 2010, the ECB had lent 400 billion (see following graph); Ireland accounted for over 22% borrowings, despite accounting for under 2% of the EMUs economy, which prompted the ECB to disadditional fundings and push European governments and the IMF to craft a rescue financing package.

ECB Lending in 2010

0

100

200

300

400

500

600

J a n -

1 0

F e b - 1 0

M a r - 1

0

A p r - 1

0

M a y - 1

0

J u n -

1 0

J u l - 1 0

A u g - 1

0

S e p -

1 0

O c t - 1

0

N o v - 1

0

B i l l i o n s o f

Source: Central Banks, Wall Street Journal, and Deutsche Bank


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However, the ECB has also applied other pressures for banks to deleverage, including changing corequirements as of January 2011 to borrow from the ECB. These pressures, plus investor concerns aboulosses to come (particularly from real estate exposure among Spanish banks), have produced funding probbanks; this has produced surging issuance of covered bonds (i.e. collateralized bonds, usually bacmortgages) to make up for limited demand for senior bonds, which effectively subordinates other bank len

INABILITY TO CONTROL MONETARY POLICY The ECB has also been a critical factor in the Euro-Zone with its exclusive authority over monetary Normally, monetary policy is among a countrys most powerful tools for competing in international marcontrolling interest rates, money supply, and influencing foreign exchange rates. By devaluing the dcurrency, a countrys services and goods become more affordable in the global markets, thus promotincompetitiveness and more exports, which improve current account balances, stimulate economic growimprove government budget balances. On the other hand, an over-valued currency tends to decrease a cinternational competitiveness, prolonging and intensifying recessions and currency crises.

Common ways to devalue a currency include (i) switching from a fixed or pegged exchange rate to floating rate set by the foreign exchange markets, (ii) increasing money supply through a National Centrand (iii) lowering interest rates to decrease demand for the currency. The downsides to currency devaluainclude higher inflation, copy-cat moves from competing countries, and if mismanaged, political insCountries in the EMU have no currency devaluation options to improve trade or budget balances, whichthem with only painful fiscal adjustments, such as increasing tax rates or austerity spending programs.

DECREASED COMPETITIVENESS AFTER EURO ADOPTION The euros broad implementation in 2002 as the common currency for EMU members, though transferringof monetary policy from countries to the ECB, was greeted warmly by the weaker peripheral European mdue to opportunities to expand trade and reduce interest rates. This was aided by higher consumer and confidence that boosted incomes and domestic demand, much of which was fueled by borrowings that cowith an influx of foreign capital. The growing confidence and leverage boosted imports among weaker cproducing weak trade deficits and current account deficits (see following chart) for Spain, Ireland, Greecand Portugal (SIGIP for short).

2010 Current Account Balance and GDP Growth

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

Greece Portugal Spain Italy Ireland France Belgium Germany

2 0 1 0 C u r r e n t

A c c t

B a l a n c e a s

% o

f G D P

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

2 0 1 0 GDP

Gr o w

t h ( % )

Current Acct Balance as % of GDP 2010 GDP Growth

Source: IMF, ECB, National Central Banks


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The strong demand increased prices for housing and financial goods not historically exposed to interncompetition, detracting investment from export industries. Between 1997 and 2007, an average of 4% within SIGIP shifted from industrial entities to financial services and real estate; this was twice as mucshift among countries in Northern Europe (Austria, Belgium, France, Germany, and the Netherlandseconomic shifts increased demand for financial and construction personnel, with labor cost increases ouproductivity growth, a dynamic further reinforced by rigid labor markets within SIGIP. SIGIPs emcompensation grew at an annual average of 5.9% from 1997 to 2007 (compared to 3.2% for core Europproductivity increased only 1.3% annually. SIGIPs unit labor costs grew 32% over the same periodNorthern Europes grew 12%. The decrease in SIGIP competitiveness was further felt with the rise of low-cost labor force and increases in productivity within the U.S., Germany, and Japan. The lcompetitiveness varied across the SIGIP countries, as presented below.

Change in Competitiveness Ranking from 2000 to 2010 (among roughly 130 countries)

-60

-50

-40

-30

-20

-10

0

10

20

Greece Ireland Portugal Italy Spain Belgium France Germany Source: World Economic Forum

INCREASING DEPENDENCE ON GLOBAL CAPITAL MARKETS With the high debt loads, high fiscal deficits, weak GDP growth, and weaker banking systems, many Ecountries have become increasingly dependent on capital markets for financing. The increased optimconsumer demand within weaker countries after joining the EMU contributed to debt accumulation, whlargely provided by external sources (especially via capital markets) as foreign investment increased.factors greatly increased the exposure and reliance of several European countries to external funding, withholders increasing from 33% of public debt in 1999 to 54% in 2009, according to the ECB.

Excessive reliance on foreign lenders increases sovereign funding risk and can signify low domestic savin(i.e. banks are financed by external borrowings instead of deposits). Such strong dependence on sourcinginvestors through capital markets increases a countrys susceptibility to investor sentiment, which can change during crises to reverse capital flows. Such a change in foreign investor sentiment was critical historical sovereign debt crises for emerging markets. This was shown again in 2010 with the rapid escabond yields and CDS spreads for Greece, Ireland, Portugal, and Belgium, as each have a hefty proportionpublic debt in foreign hands (see chart below). Spain and Italy are better positioned with a larger portiondebt controlled internally. This single factor has permitted Japan to long support the worlds highest debt


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Share of Public Debt Held Abroad or Domestically

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Greece Portugal France Belgium Ireland Germany Spain Italy

Held Abroad Held Domestically

Source: IMF- Global Financial Stability Report April 2011; and BIS-IMF-OECD-World Bank Joint External Debt Hub.

WEAK GDP GROWTHThe inability to control monetary policy and the resulting decreased competitiveness, combined with deleveraging and large government debt loads and fiscal deficits, have suffocated GDP growth forEuropean countries. GDP growth is also hampered by lacking well developed export industries as inflexible labor markets with high wages and low productivity in comparison to other economies. With a

monetary control and current account improvements (normally driven by an improving trade balance), ecgenerally shrink, credit profiles deteriorate, and budget improvements depend more on rigid fiscal policshown below, real GDP of many European countries has declined in recent years and is expected to remafor some going forward, including declines during 2011 for Greece and Portugal.

Real GDP Growth from 2007 to 2010

Country 2007 2008 2009 2010

Belgium 2.8% 0.8% -2.7% 2.0%

France 2.3% 0.1% -2.5% 1.5%

Germany 2.8% 0.7% -4.7% 3.5%

Greece 4.3% 1.0% -2.0% -4.5%

Ireland 5.6% -3.5% -7.6% -1.0%

Italy 1.5% -1.3% -5.2% 1.3%

Portugal 2.4% 0.0% -2.5% 1.4%

Spain 3.6% 0.9% -3.7% -0.1% Source: IMF, ECB, European countries central banks


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FINANCING WITH SHORT-TERM DEBT National debts are rarely ever repaid, but rather just refinanced. This refinancing or roll-over risk remainlong as sovereign fundamentals are reasonably strong and investor appetite is sufficient. However, cusing excessive short-term debt are highly exposed to changes in investor sentiment, which can be parvolatile among foreign lenders for reasons including domestic concerns, currency changes, and globalconditions. Any inability to refinance maturing debt can quickly become a liquidity crisis and producerisk. According to Deutsche Bank, EMU countries needed to refinance debt equating to 26% of GDP2010, and will continue to face major maturities in coming years (see chart below). The combined fineeds for just Italy, Spain, and Portugal exceed 500 billion in 2011, with 350 billion required in the reof 2011 (roughly 220 billion for Italy, 117 billion for Spain, and 16 billion for Portugal). Note thatand Irela

Documents

Marathon Asset Management - European Sovereign & Financial Crisis Paper - 2Q11