...Ambrose Evans-Pritchard: German 'nein' leaves Italy and Spain in turmoil

By Ambrose Evans-Pritchard
The Telegraph, London
Monday, July 11, 2011

http://www.telegraph.co.uk/finance/8631219/German-Nein-leaves-Italy-and-...

Italian and Spanish bond yields soared to post-EMU highs in a fresh day of credit turmoil after Germany blocked any meaningful measures to defuse the crisis.

Chancellor Angela Merkel called for more "frugality" in Italy, sticking to her script that Rome can solve its woes with an austerity budget. Her finance minister Wolfgang Schauble said any boost to the EU's E500 billion (L440 billion) bailout machinery was "out of the question."

Mr Schauble denied reports that Berlin was ready to empower the fund to purchase Spanish and Italian bonds pre-emptively on the open market, a move seen by experts as vital to halt dangerous contagion to the larger economies.

The market's verdict on EU foot-dragging was instant and brutal. Yields on 10-year Spanish bonds smashed through the 6pc barrier for the first time since 1997, made worse by warnings from the Castilla-La Mancha region that its deficit had become "extremely serious."

Italian yields jumped 44 points to 5.7 percent, a level that starts to threaten the sustainability of the country's finances. Markit's iTraxx SovX Western Europe, Europe's sovereign stress gauge, saw the biggest one-day rise ever. "Contagion was the word on everybody's lips," said Gavan Nolan, Markit's credit chief.

EU leaders seem unable to keep pace with the fast-moving events. Eurogroup finance ministers focused yesterday on details of "burden sharing" for banks that lent to Greece, no longer the most urgent matter. A summit of top EU officials ended with no hint of how the crisis could be contained.

"We've painted ourselves into a corner. At this point, either someone -- Germany, the European Central Bank -- has to fundamentally shift position or everything blows up," an EU official told Reuters.

Berlin has resisted any move to buy or guarantee the bonds of distressed debtors, viewing it as a slippery slope towards a fiscal union and a breach of Germany's Basic Law. The ECB in turn has refused to buy Spanish and Italian bonds, saying it is the task of EU governments.

The euro tumbled over two cents to under $1.40 against the US dollar. Gold rose to $1,556 an ounce on safe-haven flows. Italy's stock market led the rout of global bourses, dropping 4 percent despite moves by the regulator Consob to curtail short-selling. Italian bank shares were pummelled again. Unicredit fell 6 percent, and Intesa SanPaulo fell 7 percent. London's FTSE 100 fell 1 percent, while the Dow was off 1.3 percent in early trading.

Escalating woes in Italy and Spain raise the stakes dramatically. The pair have E6.3 trillion of total debts between them. Jean-Claude Trichet, the ECB president, said Europe is now at "the epicentre of a global problem."

Yet EU attention remains focused on curbing the rating agencies, a campaign that is turning shrill. Viviane Reding, the EU Justice Commissioner, said the authorities must "smash the cartel of the three US rating agencies." Fitch is, in fact, French-owned.

Barclays Capital said EU leaders must recognise that Greece is insolvent and prepare for an orderly debt restructuring, perhaps one that shares the pain between private creditors and the EU taxpayer and gives Greece a way out of its trap by easing the debt burden by 60 percent.

Such a move requires back-stop defences to prevent contagion, perhaps by using the EFSF bailout fund to shore up Club Med bond markets. The solution is elegant; what lacks is political will.

Gary Jenkins at Evolution Securities said the EU cannot keep stalling. Italy's borrowing costs are ratcheting toward the fatal line of 7 percent. "It is worth remembering how quickly bond yields can get out of control by looking at what happened to Greek, Irish and Portuguese 10-year yields. What would keep me awake at night if I was a European finance minister is that we are only about 2 percent from potential disaster," he said.

...and from David Einhorn...

“According to current banking regulations, sovereign credits are considered “risk-free.”   This means that banks can take on as much sovereign credit risk as they like without setting aside any capital.  Under such a structure, selling short CDS protection is akin to free money for the banks.

Likely, the real worry is that the first default will expose the fiction that sovereign debt is risk-free.  If the authorities permit one default, their credibility to prevent additional defaults will be lost.  No one knows how much aggregate exposure to sovereign debt and CDS is hidden in the banking system, and no one is itching to find out.   The European regulators are trying to calm the market by conducting “stress tests” on the banks.  This might be comforting if the stress tests included testing the possibility of a sovereign default.  They do not.  What is the point of a stress that fails to test the most obvious and visible risk facing the banks?"

- David Einhorn,  Greenlight Capital     July 7, 2011