Bridgewater
Bridgewater
Bridgewater
Daily Observations
November 15, 2011
(203) 226-3030
Ray Dalio
Nick Reber
Jason Rotenberg
Sean Macrae
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Plan B-2 is to pursue the Plan A direction of trying to save almost everyone and to get around the
limitations arising from not having enough resources by leveraging up the EFSF commitments.
We won't digress into the ways that this leveraging can happen, but we will highlight the big, obvious
implications of this path. Most importantly, this is the least risky and least disruptive path over the short
term, it will not provide enough buying power to fill the gap for more than a year or two, it will leave all
parties more indebted over the long term, it will not leave the parties adequately restructured to move
forward so they will remain "zombies" and, if done via the ECB doing the leveraging, it will require the
ECB to stretch or break from its mandate for managing monetary policy so that it can be a big structured
lender.
Before going into why we believe Plan B-2 will not work (we describe our rationale below), we first
describe our thoughts on Plan B-1.
Holdings and Required Funding Needs for Peripheral Sovereign Debt Holders (bln)
Core
Holdings of
Peripheral Gov't Debt
Periphery
Other
Core
Periphery
Other
Total
Banks
Large
Small
236
204
32
1,101
418
490
98
70
28
1,395
662
540
116
116
0
420
270
150
0
-
537
387
150
Insurance Companies
137
112
83
332
15
42
58
Pension/MF/Central Bank
363
820
245
1,428
EU/IMF
90
ECB
130
736
2,032
426
3,375
131
462
595
521
125
646
736
2,032
426
3,375
652
587
1,241
Below we go entity by entity and describe their ability to take losses and the necessary backstops
required.
Banks
The banks represent the lions share of the necessary backstop in the event of a sovereign default with
1.2trln of peripheral sovereign exposures (120% of capital). Of course, not all banks would need to be
treated in the same way. Large, systemically-important banks would need to be recapitalized and kept
operational to maintain a reasonable functioning of domestic lending markets; smaller banks are of less
systemic importance and could have their equity wiped out and be wound down (though for all banks it
would likely be necessary to pay depositors in full to avoid bank runs). In both cases, it is likely that the
ECB would need to play a role in providing a liquidity backstop to prevent funding issues in the short to
medium term. This is similar to the role the ECB is playing in Ireland and Greece. Through very relaxed
collateral standards (most notably in their ELA facilities), the ECB and national central banks are both
plugging the hole made by domestic deposit outflows and providing the implicit guarantees necessary to
prevent a complete bank run. This process allows for a more orderly wind-down or recapitalization of
insolvent entities. We would see a similar path but on a larger scale as a necessary component of
ensuring bank stability through a sovereign default.
Large European banks (here we define large as greater than 100bln in assets or greater than 10% of a
countrys banking system) would require the largest amount of recapitalizations. These institutions hold
622bln of peripheral exposures (100% of capital). On top of this, they already have insufficient capital
given the new Basel III standards. In aggregate we estimate that even before sovereign debt defaults,
large European banks will need 177bln over the next two years. For example, the Spanish banks
(particularly the large cajas) are likely to need 48bln in capital mostly due to legacy residential and
commercial mortgage exposures made during the boom. A sovereign debt restructuring would cause
another 284bln of losses to large European banks, causing a total capital hole of 387bln. Of this,
270bln would be borne by the peripheral banks and 116bln would be borne by the core banks. It is
worth noting that for this analysis we assume that banks must meet an 8% core tier I capital requirement
as outlined in the new Basel III standards, which we would view as a relatively aggressive assumption.
The required capital raise could very possibly be lessened either by relaxing these standards or by
allowing banks to write down their sovereign exposures over a long period. Furthermore, for the purpose
of this exercise we assume that all non-depository liabilities (e.g., debt securities, covered bonds) would
be paid in full; to the extent that these securities were allowed to default the required capital raises could
be substantially less.
European Bank-by-Bank Exposure to European Periphery & Capital Adequacy: Large Banks (bns)
Risk Weighted
Assets
Core Tier 1
Capital
Total Periphery
Exposure
Loss on
Sovereign
Bonds
7,414
3,044
1,085
1,365
203
208
183
4,369
1,197
1,914
657
253
215
13
43
54
21
3
627
225
80
99
21
15
11
402
111
161
70
29
18
2
5
4
1
0
622
418
171
184
35
17
11
204
67
84
14
30
2
3
0
5
0
0
284
191
80
86
12
7
5
93
30
38
6
14
1
1
0
2
0
0
Capital Needed
Total Capital
From NonRaises Needed
Sovereign
Exposures
Default
Total Euro-Area
Total Periphery
Italy
Spain
Greece
Portugal
Ireland
Total Core
Germany
France
Netherlands
Belgium
Austria
Luxembourg
Finland
Cyprus
Slovenia
Malta
177
137
36
48
5
20
29
40
22
13
1
0
0
0
0
2
1
0
387
270
103
105
16
22
25
116
43
50
7
10
0
1
0
4
0
0
As noted above, small banks in Europe require less capital than large banks both because they represent
a smaller share of the banking system and because it is likely not necessary to recapitalize and keep
them operational to have a functioning lending market. For example, it would be possible for
governments to simply guarantee depositors, wipe out equity and then either roll the institution into a
larger, healthier entity or take over the bank and wind it down slowly over time. Small banks in the core,
particularly those in Germany and France, tend to hold very little peripheral government securities.
Therefore, the majority of the problems are likely to arise in the small peripheral banks. Combined these
entities hold 490bln of peripheral sovereign debt against 152bln of capital. We estimate that these
banks have made non-sovereign loans that will cause losses in excess of earnings in the amount of
73bln. If we then add in sovereign losses (we estimate 228bln), the total losses for peripheral small
banks would be 302bln, which would create 150bln of negative equity that would need to be
replenished in order to make depositors whole.
Note that we have included in these numbers the Italian postal bank which holds 193bln in Italian
government bonds (nearly all of its assets) and has only 12bln of capital. While this institution operates
like something of a mutual fund for Italian households, it is organizationally a bank, employing high
leverage and getting nearly all of its funding from retail deposits. We suspect that these deposits would
need to be backstopped just like other retail deposits, though the postal bank itself could be wound down
given that it has no other systemic impact. As such, it could likely be treated like other small banks that
would need to be wound down.
European Bank-by-Bank Exposure to European Periphery & Capital Adequacy: Small Banks (bns)
Risk Weighted
Assets
Core Tier 1
Capital
4,143
1,870
965
589
95
158
63
2,273
814
769
88
69
389
16
85
12
5
26
354
152
81
45
10
12
5
202
77
65
9
8
31
2
6
1
0
3
Total Euro-Area
Total Periphery
Italy
Spain
Greece
Portugal
Ireland
Total Core
Germany
France
Netherlands
Belgium
Austria
Luxembourg
Finland
Cyprus
Slovenia
Malta
Necessary
Total Periphery Sov Loss w/50% Loanbook Losses in Total Losses in
Capital to Avoid
Sov Exposure
Loss
Excess of Earnings
Excess of
Unwind
Earnings
522
490
340
101
18
28
3
32
9
11
5
2
2
0
1
0
0
0
242
228
160
47
6
13
1
14
4
5
2
1
1
0
1
0
0
0
102
73
17
34
5
10
7
30
16
8
3
1
2
0
-
346
302
178
82
11
22
9
44
20
13
5
3
1
0
2
1
0
0
150
150
98
37
1
11
4
0
-
Insurance Companies
Insurance companies are large holders of sovereign debt (290bln). Were a default of these exposures
to occur without a backstop, there would be capital inadequacies throughout the insurance industry that
would result in insurance contracts being broken and policies going unpaid. Given that there is some risk
of policy-flight in insurers (though not as severe as deposit-flight in banks) and the social and political pain
associated with a breakdown on the insurance system, it seems more likely than not that the insurance
companies cannot be left to default. The toll for this backstop would be relatively minor (we estimate
58bln total, of which 15bln from the periphery).
One reason why the backstop would be relatively small is that policy holders bear some of the risk of
declining asset values at insurance companies. Insurance companies often guarantee their policy
holders a small minimum return over the life of their policy, and it is only when the return is below this
threshold that the company takes losses. So the policy holder is on the hook for the first amount of loss
and the insurance company is on the hook after that. Of the 145bln in total losses at insurance
companies, we estimate that policy holders would bear 39bln and the insurance companies would bear
105bln. Furthermore, given that most insurance companies currently hold an excess of capital, the
backstop necessary would be only 58bln by our estimates.
European Insurance Company Exposure to The Periphery
Peripheral Holdings
Total
Core
Germany
France
Netherlands
Belgium
Austria
Other Core
Periphery
Italy
Spain
Ireland
Greece
Portugal
Direct
For Policy
Holders
Borne by
Insurance Co
Borne by Policy
holders
Total
Capital
Capital in
excess of
Required
Required
Capital Raise
PIIGS Defualt
92
197
105
39
145
256
47
58
39
99
49
20
69
171
34
15
22
12
1
1
1
1
36
50
5
4
3
1
22
21
2
2
1
1
7
10
1
1
1
0
29
31
3
3
2
1
68
64
25
7
4
3
14
15
2
2
1
1
8
6
0
0
1
0
40
73
42
15
56
40
42
32
4
4
-
59
7
7
-
34
4
4
-
12
1
1
-
45
5
5
-
33
5
2
-
2
0
-2
-
32
4
6
-
Government Deficits
As previously mentioned, on top of the cost of bailing out systemically important institutions, bailout funds
will still be required to cover budgetary shortfalls even in a post-default world. We estimate that even with
a debt restructuring (which for the purposes of our calculations we assume alleviates near-term interest
rate debt service burdens altogether), every periphery country will still be running a deficit that needs to
be financed, the cost of which will be 125bln over the next two years.
Estimated 2-year Peripheral Budget Deficit, bln
Total
Interest Expense if
No Default
Italy
149
142
Spain
129
43
86
Primary Deficit
Portugal
18
11
Ireland
29
11
18
Greece
34
27
Total
360
235
125
As mentioned these calculations are meant to be broadly indicative rather than precise. They are meant
to make the point that restructurings can occur without being systemically threatening and at costs that
are materially less than those arising from trying to prevent restructurings. We believe that it is both
preferable for the overall economic conditions of Europe that this general path is followed rather than that
of taking on more debt and printing more money in an attempt to push the problems down the road. The
manner in which this managed restructuring should occur should not be abrupt. For that reason,
temporary guarantees and other mechanisms should be employed.
To arrive at our estimate that the EFSF will need 5x leverage, we first calculate that the EFSF has about
276bln in available bailout resources remaining. At inception, the EFSF received guarantees from the
17 members of the Eurozone of 780bn. However, available capacity has fallen due to modest outlays
and the exclusion of Greece, Ireland and Portugal as participating states. Further, it is at least somewhat
likely investors will reject Italy and Spain as effective guarantors, since both will likely soon be primary
beneficiaries of the EFSF support. If this does turn out to be the case, then the effective pre-leverage
equity capacity of the EFSF is reduced to 480bn. The EFSF has also made a number of future
commitments which tie up capacity. Specifically, we estimate that 50bn has been earmarked for Ireland
and Portugal, and, based on our best interpretation of the EU communiqu, we believe that an additional
135bn will be set aside for the second Greek package. Since it is unlikely that investors will provide
leverage to the EFSF on loans to bailed-out states, this 185bn needs to be deducted from the
leverageable capital, leaving the EFSF with 276bn to stretch for Italy and Spain. Note that the remaining
capacity is a bit lower if the EFSF seeks to maintain its AAA rating due to the way the rating agencies
view individual country credit support.
EFSF
Total Guarantees
AAA Guarantees*
780
440
-9
-9
-7
764
431
-53
- Italy Contribution
-138
- Spain Contribution
-92
480
431
-135
-135
- Commited but not yet disbursed funds to PRT, IRL & potential Cyprus Bailout*
-50
-50
-19
276
246
11
11
Unused Capacity
We estimate that this 276bln in equity will have to cover about 1.510tln in government funding needs,
making for a leverage ratio in excess of 5x. Even if the ECB continues to support peripheral bank funding
needs (which are climbing rapidly), we estimate that peripheral sovereign funding needs in excess of
what has already been allocated by existing EU bailout packages will be 596bn between now and the
end of 2012, 470bn in 2013, and 444bn in 2014. We roughly estimate that a backstop should be equal
to three years of funding needs so that the sovereigns have time to demonstrate their ability to make the
necessary fiscal adjustments in the interim. The vast majority of these needs come from Italy and Spain.
While we believe that Portugal, Ireland and Greece will require more money (or default) when their
current packages run out, this is not likely to occur over the next 12 months.
Sovereign funding needs are the sum of government debt rolls, government deficits and money for bank
recapitalizations not provided by the private sector. While our numbers for required bank recapitalizations
are much larger than the EUs (our estimates of total European bank recaps are 375bn vs. 100bn for
the EBA), for the next 12 months needs we plug through the numbers from the EBAs stress test
because that is what the banks will be required to raise by June 2012. However, over the longer term, we
believe the banks will be forced to raise additional capital, which we have penciled in for 2013-4.
Spain
Portugal
Ireland
Greece
Total
Next 12 Months
Government Debt Rolls
Fiscal Deficit*
of which Primary Balance*
of which Interest Expense*
Bank Recaps (from EBA)
Already committed**
409
348
47
-47
94
15
0
185
100
58
31
27
26
0
3
38
6
0
7
8
-49
0
17
18
10
8
0
-35
0
43
12
-2
14
30
-85
596
545
141
-8
149
79
-169
2013
Government Debt Rolls
Fiscal Deficit*
of which Primary Balance*
of which Interest Expense*
Bank Recaps (BW Estimate)
Already committed
238
177
14
-89
103
46
0
164
79
51
19
31
35
0
41
18
7
-2
9
17
0
27
10
15
5
10
9
-7
0
10
8
-5
13
0
-18
470
293
94
-71
165
107
-25
2014
Government Debt Rolls
Fiscal Deficit*
of which Primary Balance*
of which Interest Expense*
Bank Recaps (BW Estimate)
Already Committed
211
170
10
-120
123
31
0
152
79
49
8
41
23
0
42
23
8
-3
11
11
0
40
20
14
1
13
6
0
0
12
9
-8
17
0
-20
444
304
89
-122
212
71
-20
858
500
86
66
1510
* Negative = Surplus
Note that we are assuming that the EFSF will meet Portuguese and Irish funding needs when their bailout packages run out,
and that this funding will not be leveraged.
Mar-11
May-11
Jul-11
Sep-11
Nov-11
Below, we pencil in some numbers to see how much capacity the EFSF has to provide various amounts
of protection vs. the amount of debt that Spain and Italy need to issue in the next several years. As you
can see, each turn of leverage that the EFSF can get adds about six months to the capacity of the EU
bailout fund.
Funding Needs Through 2014
Italy
Spain
Portugal
Ireland
1600
1400
1200
1000
800
2.5x Leverage
600
400
No Leverage
200
0
11/11
2/12
5/12
8/12
11/12
2/13
5/13
8/13
11/13
2/14
5/14
8/14
11/14
10
Potential
8%
6%
4%
2%
0%
-2%
-4%
-6%
-8%
-10%
00
01
02
03
04
05
06
07
08
09
10
11
12
Output levels at the core are roughly neutral, while output levels in the periphery continue to be quite
depressed. At current growth rates conditions should no longer be tightening at the core.
Output Gap
Core (Germany + France)
6%
4%
2%
0%
-2%
-4%
-6%
60
65
70
75
80
85
90
95
00
05
10
More up-to-date surveys have been indicating a sharp slowdown in underlying conditions for several
months, but the sharp contraction in production stats in September was one of the first confirmations from
real economic stats that conditions were weakening. Both business and consumer surveys continue to be
quite weak. German and French manufacturing PMIs are indicating an outright contraction, while
Frances services PMI reading of 44.6 is as weak as any time since the beginning of 2009. Consumer
confidence measures have also weakened sharply since earlier in the summer. Retail sales measures for
both Germany and France are extremely choppy, but looking at August and September together it looks
like household spending has been weakening.
11
October
Sept
August
July
June
May
Statistic
--
-0.7%
0.0%
0.2%
0.6%
-1.2%
--
0.4%
-2.7%
0.3%
3.9%
-1.7%
--
-0.5%
0.2%
-0.3%
0.8%
-0.1%
46.4
48.8
51.5
51.6
53.7
56.0
50.6
49.7
51.1
52.9
56.7
56.1
62.5
44.6
51.5
56.8
54.2
56.1
-1.1
-1.0
-0.6
0.1
0.3
0.3
0.5
0.7
0.9
1.7
1.9
1.8
-0.7
-1.2
-0.9
0.0
0.1
0.1
--
-2.0%
1.4%
1.0%
-0.6%
0.2%
--
-2.7%
-0.4%
3.2%
-0.8%
0.8%
1.8%
--
-1.7%
0.5%
1.5%
-1.6%
47.1
48.5
49.0
50.4
52.0
54.6
49.2
50.3
50.9
52.0
54.6
57.7
48.5
48.2
49.1
50.5
52.5
55.0
Consumer
confidence has
fallen substantially
over last several
months
Production growth
weakened sharply
at the end of Q3,
in line with
deterioration in
surveys
Business surveys are pointing toward a sharp contraction in German production. The Zew survey of
economic sentiment released this morning was as weak as any time since 2008, and while other
business surveys are not at quite such weak levels, they have been deteriorating sharply for several
months.
German Business Surveys
Ifo Business Climate
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
-1.0
-1.5
-2.0
-2.5
-3.0
Zew
Manufacturing PMI
Non-Manufacturing PMI
65
60
55
50
45
40
35
30
00
01
02
03
04
05
06
07
08
09
10
11
12
The French purchasing managers surveys are also pointing toward a sharp weakening of conditions.
Since August when financial conditions began to tighten rapidly, the services PMI has fallen by over 10
points and is at its weakest levels since the beginning of 2009.
12
PMI (manufacturing)
PMI (services)
5%
70
4%
65
3%
60
2%
1%
55
0%
50
-1%
45
-2%
40
-3%
-4%
35
-5%
30
00
01
02
03
04
05
06
07
08
09
10
11
Household demand is sensitive to financial conditions through a number of channels, but most directly
through borrowing conditions and the impact on household wealth from price changes in financial assets.
The sharp deterioration in conditions since August is impacting households along both these channels, as
banks are less likely to make loans and households feel the pain from falling equity prices. The chart
below gives a rough sense of how collapse in equity prices and blowout in spreads compares to what
occurred in over the last several years. The August collapse has been extreme.
Core Euroland Stocks/Spreads Index
5
0
-5
-10
-15
-20
-25
The tightening in private financial conditions
has been significant, even relative to 2008
-30
-35
-40
May-08
Nov-08
May-09
Nov-09
May-10
Nov-10
May-11
Nov-11
Household spending in Germany was already quite weak in the second quarter, and while it appears to
have recovered somewhat in the middle of the summer, the most recent retail sales data points toward a
slowdown. Historically, retail sales havent tracked consumption particularly well (they only make up
around a third of what goes into personal consumption), but the weakness is also in line with the PMI
services and consumer confidence figures.
13
20%
6%
15%
4%
10%
2%
5%
0%
0%
-2%
-5%
-4%
-10%
-6%
-15%
-8%
-20%
-10%
-25%
00
01
02
03
04
05
06
07
08
09
10
11
Like in Germany, household spending in France was particularly weak in the second quarter. Some of
that weakness was driven by an end to auto stimulus plans, but even excluding autos consumption
looked quite weak. Through September household spending looks like it has weakened, although only
modestly. Like in Germany, up-to-date surveys such as the services PMI and consumer confidence point
toward much weaker household spending.
RPCE
6%
16%
5%
4%
12%
3%
8%
2%
1%
4%
0%
0%
-1%
-4%
-2%
-8%
-3%
-4%
-12%
00
01
02
03
04
05
06
07
08
09
10
11
Consumer confidence measures have been weakening fairly sharply in France, while the deterioration in
Germany has only been modest so far. Underlying conditions for German households remain fairly
healthy, with relatively low levels of debt and healthy employment. If the weakness in production and
business spending continues and begins to weaken the labor market, confidence will likely weaken
further.
14
04
06
08
10
INSEE
EU
115
110
105
100
10
8
6
4
2
0
-2
-4
-6
5
0
-5
-10
-15
-20
-25
-30
-35
-40
95
90
85
80
75
12
02
04
06
08
10
12
October was the first month since June 2009 that German unemployment increased. Employment
typically lags and demand has been weakening for a few months now so we will likely see some softer
labor data going forward. While this should be a negative for household demand, German labor
conditions remain pretty tight and it would take a fair amount of firing to shift that picture materially.
200
12%
Unemployment still near secular
low s, but has recently show n
some signs of w eakness
150
11%
10%
100
9%
50
8%
0
7%
-50
6%
-100
5%
95
97
99
01
03
05
07
09
11
September saw a sharp deterioration in both German and French production figures, in line with
weakening demand in and out of the euro-zone. So far the slowdown in production hasnt been severe,
but there are indications that production will likely slow further, such as the more volatile but sometimes
forward-looking factory orders report. Surveys are also pointing toward a significantly larger slowdown
than we have seen through September.
15
60%
40%
20%
0%
-20%
-40%
-60%
00
01
02
03
04
05
06
07
08
09
10
11
12
While it recently looks like the picture of US growth has improved, some of the slowdown in core
production is likely still stemming from weaker global growth. Strong export growth, fueled by surging
demand from the emerging world along with ongoing competitiveness gains in Germany, has helped
provide a significant boost to the rebound in the core. While competitive export industries should
continue to be supportive to exports regardless, the slowdown from weaker export partners should be a
drag of almost 1%.
Germany + France Trade Partners Export Weighted Grow th
8%
30%
6%
20%
4%
10%
2%
0%
0%
-10%
-2%
-20%
-4%
-30%
-6%
-8%
-40%
00
01
02
03
04
05
06
07
08
09
10
11
12
Germany and France will also both begin to face larger headwinds to growth from fiscal tightening going
forward into 2012. The pace of fiscal cuts in 2012 is hard to know with any precision at this point, but
according to current government plans it appears that Germany and France will both accelerate their cuts
in 2012.
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Core growth has been the primary driver of the recovery in Euroland over the past two years, but has
clearly slowed over the past several months. Tightening financial conditions and weaker external demand
both appear to be significant drags on growth over the past several months, while the ongoing fiscal cuts
continue to weigh on demand as well. The stressed financial conditions will likely continue to weigh on
household spending and credit growth, which should be a drag on production at a time when external
demand, which had been a support for much of the past two years, has weakened.
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