Italy! Italy! Italy!

Disclaimer: These last four pieces on the impact of Italy’s potential insolvency on the sovereign debt crisis are not advocacy pieces. They are analysis – predictions of what I see as likely to occur.

The euro zone periphery was a sideshow. This stuff with Italy is the real deal. With yields at 6.7% and rising, it’s game over for the euro zone. The extend and pretend stuff ain’t gonna work.

And if you are an investor, this is the moment of truth. Everything – every asset class – depends on how the euro zone performs in the Italian Job. There are only two outcomes, here. If Italy blows up, a Depression is upon us; banks would be insolvent, CDS triggers would implode the system, bank runs would begin, stock markets would crash, and you will would see sovereign debt yields go to unbelievable lows for nations with a lender of last resort. If Italy survives, I would expect a monster rally in periphery debt, stock markets, and bank shares and a selloff in CDS at the minimum. However, the euro zone is already in recession so that rally will not be sustained.

Forget about Berlusconi and austerity in Italy. That’s a sideshow too. Austerity is not going to bring Italian yields back down. These days are over, folks.

Here’s the real problem: Italy needs to run a primary budget surplus (excluding interest payments) of about 5 percent of GDP, merely to keep its debt ratio constant at present yields. That’s never going to happen. So the yields for Italian bonds must come down or Italy is insolvent. More than that, a stressed Italy means a stressed euro zone and a deepening recession with all of the attendant ills that means: Ireland would suddenly start missing deficit targets for example. Bank shares would be under stress, triggering more Dexia’s. So even if Italy limps along at 7 percent yields, we will see a nasty double dip recession and bank failures. And we know that yields will rise. Last November, we were discussing Ireland in the same way with its yields at these levels. Soon, the yield went to 9% and Ireland was forced into a bailout – one that Italy is to big to give.

So we are definitely facing a real financial Armageddon scenario here. That’s why questioning Italy’s solvency leads inevitably to monetisation. I’m not the only guy who knows what would happen. Policy makers know that Italy owes German banks 116 Billion euros.  They know that Italy is too big to fail and they will respond. But, policy makers are faced with a simple either or here. Small bond purchases won’t do. We see that already because Italy’s yields are well above 6% for 2-year debt. Credible lenders of last resort use price, not quantity signals. For the ECB, it’s not about buying up Italian debt. It’s about credibly defending Italian government bonds as the monopoly supplier of reserves with a specific target price. Central banks are price-targeting monopolists. They can only be effective if they realise this affects everything they do. The role of the lender of last resort is about price, not quantity.

I expect the ECB to cave and target a maximum yield or a maximum spread to Bunds for Italy. Until they do, things will only get worse. In fact, they can get just bad enough to start bank runs and a severe global double dip recession. And I expect the ECB to dither. The cognitive dissonance is too large. Unless the ECB stops dithering soon, we could see a depression even before the Italian Job goes into action. All of the risk now is to the downside in my view. The number of upside scenarios are limited by how quickly the ECB can do an about face – and that’s not going to be quick.

Investors should shun risk and take out whiplash insurance via out of the money calls because there are only two options on this one. One is a Depression, the other is a delayed ECB response preceded by turmoil, followed by a brief euphoria and then double dip.

P.S – remember, my motto is hope for the best, prepare for the worst and expect something in between. I like to be optimistic. So if I am telling you point blank that a European double dip is the absolute best you can hope for, you know there are a lot of worse outcomes.

  1. Joe Cowan says

    This is quite sensational.

    Basically if what you are saying is correct we are in a VERY SERIOUS situation, with the world about to be changed beyond recognition….!!

    1. David Lazarus says

      Yes but this has been mismanaged by leaders both sides of the atlantic. The policy of extend and pretend is reaching its logical conclusion. A major depression is coming and the 30’s are a very good guide as to what will happen. Though we still have the debt write downs to come, which will mean bank closures. This will mean big losses all around.

  2. Bruce says

    “Here’s how it works. The Fed announces a target and stands at the ready to defend that target via repos or reverse repos if the market doesn’t move to the rate. But the market does move because punters know that the Federal Reserve can literally print unlimited quantities of money to make good on their policy rate commitments.”

    And that works for the FED, because people believe their commitment. My question is, will it work for the ECB? I’m not convinced that people will believe the ECB (Germany!) has the same commitment, and how far will the ECB have to go to prove it, and will Germany balk as they watch the ECB being tested.

    There’s just not enough credibility to believe that the EU will do what it takes, and I think that credibility deficit maps pretty good to the reality (if past experience is any indicator of what to expect in the future).

    Big big problem!!

    1. Edward Harrison says

      Agreed. The credibility is key. I think the ECB can only establish it by buying bonds at the target rate until some speculators are wiped out. The target rate should be low enough to help Italy have a veneer of solvency and to wipe out anyone who tries to short at these levels against the arsenal of money from the ECB. And the rate should be high enough to attract punters who want a nice yield pick up. How long before those punters pile in? Not until the ECB’s backstop is credible.

  3. pjfny says

    good analysis! I see one problem however: holders(banks) of italian debt at current 480bp over bunds, who are staring at an existential threat now, will be very happy to dump them at the ECB at let’s say 200-300, with no other takers, which will make the ECB one of the only holders (at artifially low yiels)…..not tenable and the germans (who has to bail out the ECB) probably will not go for it?

    1. Edward Harrison says

      Are you saying Italy defaults then? That’s the only other realistic scenario. There aren’t a lot of options. No one is going to buy Italian bonds at a low yield without a backstop, irrespective of austerity now that the insolvency genie is out of the bottle. With a backstop, some people will.

      The question is a political one and, hence, unpredictable. The Germans (and Dutch) either allow the backstop or face Depression. It’s as simple as that.

      1. David Lazarus says

        I agree, when it comes to political decisions you can never predict the outcome. Though I do hope for common sense and self interest of the Germans and everyone else for that matter to back Italy and even sort out organised exits for the periphery in a way that is what is best. Otherwise I fear the second part of your response is certainty.

  4. esb says

    “CDS triggers would implode the system”


    The CDS triggers would just be reinterpreted and would not trigger at all.

    This is part of what is happening in Italy right now, the relaization that the CDS protections are not really protections at all.

    File under “unintended consequences of the Greek ‘deal.'”

    1. Edward Harrison says

      You’re assuming you can do a deal for Italy like the one they are planning for Greece. I don’t think that’s a good assumption.

      1. James T. says

        I do believe that ´esb´ is generally correct in his assumptions; even leaving the Euro and rednenominating in (New?) Lira should not be a problem. CDS contracts generally state repayment in a currency of one of the G8 members. Italy is G8.

        1. Edward Harrison says

          esb is saying the CDS would not trigger at all, meaning no default would be declared. That is only possible if you do a deal for Italy like the one they are planning for Greece. And I don’t assume this.

          As for leaving the euro zone, repayment in depreciated Italian currency is MORE onerous than in euros. The only way to get around that for Italy is to have the Italians convert to the new Lira one for one. But the German, French and Dutch banks would then have to take foreign currency losses through the balance sheet and suffer huge losses.

          Look, there is no way around it for the hard currency banks: if Italy does a voluntary debt writedown, pays back in depreciated currency, or simply defaults, they are out of pocket in a massive way.

          1. frank c says

            Their are now two known risks to CDS. As previously mentioned the blatant fraud of “voluntary exchange”. The other risk is the counter party risk ie. is the other party solvent. We saw that AIG need over 100 Billion from the FEDS to payoff the Goldman & Credit Suisse CDS. We know the government should never do that again.

            (Anybody who has made a big sport bet with an unknown bookie knows the feeling.)

            The recent weakness in the Italian debt is that people are selling their current positions because they don’t think they are truly hedged with a CDS.
            A large money manager recently stated he has no intention of buying CDS. The insurance is a parachute that may not open when deployed.
            If the markets do freeze a CDS is just a lawsuit in a bankruptcy court.
            How the equity markets continue to rally is mindboggling. The recent failed ESFS auction for $3 billion is frightening. And if the ECB have already spent $100 Billion on Italian bonds with little results they don’t have a lot of ammo left before the Germans pull the plug. The French banks are sellers to the ECB and will take the current loss.

            What is really incredible is that Germany has effectively taken control of the budget, and the government in Ireland, Greece and now Italy. Spain and Portugal government are next. And Germany has done this without firing a single bullet.

    2. ChrisBern says

      Well if CDSs once again don’t trigger, then you can switfly expect holders (esp. banks) of EZ bonds who think they are hedged by CDS to start dumping both the CDS and the underlying bonds. That would be a catastrophe in and of itself and would lead to rising yields across the entire EZ, not just in Italy.

      1. David Lazarus says

        If that were the case the bonds would be dumped but they would then claim back the CDS premiums if they were not going to be honoured and sue for any losses. If they are never triggered then I would anticipate that they sue on the basis of fraud. Selling something that was worthless. That said it would also be like admitting that the masters of the universe who bought these were nothing of the sort and got fleeced like Joe Public.

  5. PLB says


    I believe you are right… the ECB is now cornered into that monetisation path or else “Timberrrrrr”…

    But as Pettis says in his post:

    “The reason peripheral European governments cannot get financing is not because there is a lack of capital or liquidity but simply because their solvency is questioned by investors, and correctly so in my opinion. They don’t need Chinese capital. They need someone foolish enough to lend money to countries that probably won’t repay. Why should China lend to someone who won’t repay? Europe needs growth, not capital.”

    So assuming Italy gets all the “rate relief” imaginable from ECB monetisation(if/when it comes), how will Italy grow sufficiently to make the payments? For that matter how will Ireland, Portugal, Spain, Belgium… If they, as I imagine, will get fully backstopped by the ECB…

  6. pjfny says

    I do not think there is any political capital left in Germany, to trow more good money after bad, given that italy and all the piigs), have a real solvency problem (i.e no or little chance to pay it back.
    Let me propose and alternative, that is unlikely and that nobody is talking about: Germany ( and maybe france/the netherlands and finland) leave the euro and the euro will then devalue and the piigs default and start from anew (a’la argentina etc) germany can have their hardcurrency and keep inflation at bay? any thoughts?

    1. Edward Harrison says

      Default equals massive losses for German and Dutch banks. Any scenario in which there is an Italian default leads to a Depression with a capital ‘D’.

      1. David Lazarus says

        Also if you factor in the fact that so many countries have far too much debt in the private sector. That should benefit Italy. The current crisis is simply a matter of who looks the weakest. The inability of individuals to pay back their debts quickly enough is a consequence of lax past lending standards and regulation. I think Depression will hit Europe and the US, the fundamentals are simply so weak.

  7. Ben says

    Edward, Great work as always. I am hoping to clarify what you meant regarding “whiplash insurance.” When you said out of the money calls did you mean puts? Because otherwise, why not wait before buying OTM calls since both possible scenarios you outline begin with downside (depression or dithering).

    1. Edward Harrison says

      That’s right, the whiplash insurance is to be bought when things are at their worst when calls are cheap. I would expect a large bounce if the ECB comes in. And the calls would appreciate a lot. Right now, we are in black swan territory and the right thing to do is to prepare for fat tail scenarios and take a trading position in ways which can benefit from those tails irrespective of your primary holding position.

  8. ChrisBern says

    Great analysis as always. I’d say that even the best-case scenario (ECB backstops Italy leading to a short rally prior to double-dip realizations) has another other major downside to it, and that is that we’ve only discussed backstopping Italy and nobody else. This won’t stop the other “danger” countries’ yields from rising, and so backstopping Italy ONLY helps contain Italy’s yields–not everyone else’s. Remember the EFSF has only been increased in theory or on paper at this point–it would seemingly only take a few more countries on the dole before EFSF capital concerns downgrade France’s credit rating, etc., a possibility which isn’t even very high on most people’s radar right now.

    This may be the precursor to eurobonds or this may just be plugging one leaky dam hole after another until the entire dam collapses. Either way I completely agree that the market is not even close to pricing in these possibilities/probabilities, which is why I have zero long positions right now.

  9. James T. says

    What about a Euro breakup scenario? This seems to be the one you haven´t mentioned.
    Sure, 116bn owed to Italy does seem scary, but the total of guarantees for Germany amounts to ~200bn if I´m not mistaken?
    From what I´ve read they´ve just “discovered” about €50bn in funds they thought to have been spent already.
    Given that they spent between 1.5 and 2 trillion for what was essentially a stupid idea(German reunification; 2 German states in the EU would have been a lot cheaper for W. Germany & Europe), what makes you think that Germany won´t just bite the bullet and take the losses?

    1. Edward Harrison says

      The euro area will eventually break up. But what about forcibly breaking it now? Again, an Italian default would bankrupt Italy’s banking system and throw Europe’s fourth largest economy into Depression. You don’t need CDS triggers for that to cascade across into trade partners and panic in the financial system. There is no way around it, James, a default in Italy means Depression.

      Are some willing to take it on? Could it happen? Maybe, sure. But I see this as a situation that leads to systemic collapse, extreme levels of economic nationalism and geopolitical/military tensions – a very unpredictable outcome.

      1. James T. says

        Interesting, whilst I don´t quite share your pessimism(after all there´s quite a few ways to get out of the current bind, provided the political determination to implement them (from pushing the introduction of the ESM forward to 2012 and granting it the same rights(seniority) as the IMF even for existing loans(Portugal/Greece/Ireland) to the introduction of capital controls(the Eurozone overall is in balance after all what the capital account is concerned)).

        But presumably all these facts are known, at the very least to the economists at the Bundesbank, why is it that they seem to block all sensible measures to preserve the Euro(granting a banking license to the EFSF, using central bank funds to enhance the EFSF via the IMF, discouraging purchases of gvnt. bonds via the ECB,…), whilst the head of the German government breaks a taboo by proposing the possibility of a Euro exit?

        1. Edward Harrison says

          Two theories:


          “human psychological traits have evolved to maintain an existing order until its utility has completely disintegrated. Deference to authority, the inertia of commitment, compulsion for consistency, the allure of confirmation bias, the norm of reciprocity, social proof, deference to authority – these are all psychological norms that aid the maintenance of order and the status quo.”


          “As political horizons get shorter (in a crisis, governments tend to be unstable), leaders choose short-term fixes at the expense of medium-term solutions. Since they are unlikely to be in office to benefit from the medium-term improvement, they discount its effect at much higher rates than they discount short-term policies. The result is that the crisis gets worse, not better.”

  10. Dave Holden says

    If true the ECB is playing a mighty game of chicken with Berlusconi!

    1. David Lazarus says

      Against a man who has seen off countless court cases in Italy! My money is on Berlusconi on that. ECB should never try bluffing someone willing to stand his ground. They will only get exposed and that will weaken the credibility of the ECB. Poker is a dangerous game if played badly.

      PS I do not play poker.

  11. enrico says

    I think the idea of the ECB targeting (but not buying) sovereign rates below market but still punitive over German Bund’s rates is brilliant. I see a “but” though, namely that any “political price” (such as any other rate set over german benchmark) could open a Pandora’s Box in terms of natianalistics claims. It seems a great temporary “transition” card. The question then become: transition toward where?

  12. Eric F says

    Dear Ed,

    I agree with everything you wrote.

    However, why are you buying the status quo policy prescription that instead of recognizing insolvencies by default, we need to fill them with money-printing?

    Do you believe that it is appropriate government policy to target risk asset prices? Won’t rewarding owners of financial assets by reducing the value of money and risking inflation punish the poor most of all in the long run?

    1. Edward Harrison says

      See the disclaimer at the top now copied over from the last post on Italy. This is about making actionable macro predictions not advocacy.

  13. K T Cat says

    An interesting post that I think misses the broader point. Either way this goes, whether the ECB buys enough Italian bonds to convince bondholders they still have a way out and they can keep their holdings safely or if Italy leaves the Eurozone or if the place blows up, the societal game is over.

    Socialism has failed again and finding mechanisms to bail out 2011 Italy ignores the underlying problem that you’re going to have to bail out 2012 Italy and 2013 Italy and 2014 Italy and …

    Whether it’s Berlusconi in charge or if the ECB buys bonds or not is irrelevant. The Italian (and Greek and French and American) problem is solved when the Italians figure this out and stop turning to politics to solve their personal problems. Free college, government healthcare, massive government pensions, that’s all gone. For good.

    1. David Lazarus says

      It is nothing to do with socialism. There was a TV program here in the UK about the Greek problems last night about how people can retire early if they were in a hazardous career. What it highlighted was that the entire political system is corrupt. There is no safety net of any worth there except for the pension and that has been abused by politicians effectively buying votes. It was eye opening. This affected the government in Greece regardless of the party in power. The same for Italy, which is run by a right wing government. Even the Italian communist party was nothing like the Soviet version. For decades US citizens were funding the IRA, a terrorist group whose main aim was a united SOCIALIST Ireland. So the US were funding socialist freedom fighters. Oh the irony. So I take US criticism of European politics very lightly.

      Yes there are problems with the system but far less than the American public is facing. It is looking like retirement will be abolished by default for the majority of Americans when the GOP fails to allow proper funding for its safety net. Greece’s pension problems are down to corruption, insufficient pension contributions and demographics which are not unique to Greece.

      The UK has pension problems. Most which can be laid at the foot of politicians with their tax raids on them, and the Pension sector, with appalling actuarial advice and investment decisions. Contributions here in the UK are and were far too low in an era of low growth and low interest rates. It was extend and pretend by the financial sector. Retirement ages need to rise rapidly in line with life expectancy regardless of the leanings of the government. Contributions need to rise to cover the costs of retirement and make up for the fall off in investment returns obtained, no matter what government is in power, and that applies just as much for UK, Greece or the US.

      In Europe we decided that social welfare was a better system to cope with the ups and downs of life, and for stability of the nation. In the US you are literally one pay check from destitution, and that is life for 90% of Americans. With a substandard safety net it only takes a resumption of the depression and you will find that the US will be the news item with Occupy taking over the streets of every city in America.

      1. Oldrich says

        Hear, hear ! -:)

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