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European Debt Crisis: Is This the Beginning of the End?

Almost exactly two years since the onset of the Greek debt crisis, the European Commission has set out to create a comprehensive strategy to rein in the crisis and return to a viable path of economic prosperity. The deadline: Sunday, October 23.

With fiscal instability and credit contagion continuing to rock markets internationally, the world’s leading economies emphasized the need for immediate action at the recent G20 meeting. The group of finance ministers and central bankers pressured Europe on Saturday to “decisively address the current challenges,” and complete a plan before this weekend to resolve the sovereign debt crisis.

Japanese Finance Minster Jun Azumi asserted that: “Europe needs to get its act together because unless the crisis is put to an end, it will start to affect emerging economies which have enjoyed strong growth.”

The ambitious deadlines for the new comprehensive plan presentations fall on October 23 for the EU summit this weekend, and again on November 3 for the G-20 ministers.

The proposal, still in the development phase, outlines areas of action “designed to break the vicious circle between doubts over the sustainability of sovereign debt, the stability of the banking system and the European Union’s growth prospects,” the EU commission explained.

The plan will “chart Europe’s way out of the economic crisis,” Commission President Jose Manuel Barroso said.

The so-called “comprehensive plan” involves three areas: Dealing with the Greece bailout, recapitalizing the banks (so that they can withstand future problems), and eliminating the current credit contagion that is beginning to infect more and more countries in Europe.

Urging the 17-nation Euro-zone to “maximize the impact of the EFSF (bailout fund) in order to address contagion,” officials are saying that the most likely option is to utilize the € 440 billion EFSF fund to offer “partial loss insurance” to buyers of stressed member states’ bonds. The goal is to stabilize the bond market and allow countries to borrow at more reasonable rates than the market is currently dictating.

Reuters reports that Eurozone leaders are likely to agree on the leveraging of the EFSF on Sunday by allowing it to act as an insurance company by guaranteeing a portion of newly issued European debt. Reuters says that under the scheme, the EFSF would promise investors who purchase Spanish, Italian or other high-risk Eurozone debt that it would cover a portion of any losses suffered if the country were to default.

The idea is by guaranteeing the first portion (assumed to be 20-30%) of any losses incurred by a sovereign default, the EFSF could cover three to five times as much debt than if used on a one-to-one basis. With approximately €300 billion of its original €440 billion capacity still available, the EFSF could be potential “insure” more than €1 trillion.

Reuters suggests that one trillion Euros would be enough to support the refinancing needs of Spain and Italy for a least a year or longer.

Another part of the plan will involve recapitalizing European banks. The first step is to identify the problem areas. Thus, the banking authority will force the banks to rerun stress tests – and this time, sovereign debt will be marked to market. (Recall that in the most recent round of stress tests, sovereign debt was held at par on the books of the banks.) According to one reported estimate, as many as 66 banks in the EU would at this time, likely fail such tests.

With the stress tests identifying how much capital each bank will require, the banks will then be told to go out and raise the capital in the open market. If unable to cover shortfalls, banks will be given the ability to dip into the European Financial Stability Facility.

Analysts also see potential economic risks to the recapitalization plan. By forcing the banks, who are the primary source of investment in Europe, to raise more capital, the thinking is that less capital will be available to the private sector, thereby hindering growth.

Then there is Greece. The new comprehensive plan will develop a game plan for how to deal with the Greek situation. Recent reports suggest that private sector investors (PVI) will be asked to take a much larger haircut on their current bonds. Current talk is that bonds may be rewritten so that private bondholders see an effective haircut as high as 50%, as opposed to the original 21 percent agreed upon in July.

However, it is important to recognize that the banks holding Greek bonds are not exactly jumping for joy over the prospect of additional haircuts on their bonds. Remember, if the value of the

bonds held by banks is reduced (which is the purpose of the rewrites), bank capital levels will also be impacted. And then to avoid a “messy” default, the bond rewrites must be “voluntary.”

So far at least, the plan, which is still taking shape, is receiving good reviews. U.S. Treasury Secretary Timothy Geithner told reporters that the latest EU action toward a debt solution “contained the right elements, [most] notably [the] recapitalization of European banks.” …”I am encouraged by the speed and direction in which they are moving.”

“The IMF has a substantial arsenal of financial resources, and we would support further use of those existing resources to supplement a comprehensive, well-designed European strategy alongside a more substantial commitment of European resources,” Geithner added.

With a plan taking shape and hopes running high that confidence in the Europe bond markets can recover, the markets are also giving the idea a “thumbs up” as witnessed by the impressive rally seen since October 4.

Here’s hoping it’s the beginning of the end…

by Gigi Sukin and David Moenning of Top Stock Portfolios

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  • Anonymous on October 20 2011 said:
    Any five-year old child knows that if you put ten marbles into a tin can, you can only take ten marbles back out. Private central bankers issuing the public currency as interest-bearing loans operate on the belief that they can put ten marbles (dollars) into a tin can (the world) and magically get 11 marbles back out. Thus, we may conclude that the bankers are dumber than five-year old children! Economies are like tin cans. Before you can take a marble out, you must have put a marble in. The problem with all modern reserve banking systems is that the moment the first bank note goes into circulation as the proceed of a loan at interest, more money is owed to the banks than actually exists. Ten marbles have been put into the tin can, but the bankers see 11 marbles owed back to them. This evil magic of creating money out of debt was a fraud all along, as fraudulent and silly as the idea that one can put ten marbles into a tin can, and take out eleven.

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