Why a German Gurantee of the PIIGS Destabilises the Entire EuroZone

ZeroHedge has a solid take on the situiation:

Now that some sort of Greek bailout is imminent, most likely in asset guarantee form, it is high time to evaluate the full impact of Europe's decision to jettison monetary prudence at the expense of patching a crumbling fiscal dam holding back trillions in bad investment decision cockroaches, accumulated over the years. Relying on a presentation by ML's Jeffrey Rosenberg1, we observe that by providing loan guarantees to the periphery, the core (Germany/France/Benelux) may have well destabilized the core problem for the Eurozone, namely a whopping €1.6 trillion (that's in euro) in total 2010 financing needs, a number which consists of €400 billion in 2010 bond maturities, €700 billion in rolling short term debt and €530 billion in combined 2010 fiscal deficits. Germany has just taken an acute liquidity crisis in the periphery, and courtesy of action we already saw earlier in Bund rates, has sown the seeds for a funding crisis of none other than the very heart of the Eurozone....

What Germany has done is merely to buy some time and moderate the near-term "solvency" crisis in the PIIGS, while exacerbating the true fiscal weakness underlying the European economy. Paraphrasing Merrill: "In the current episode, the focus of risk among Greece, Portugal, Spain and other peripheral members of the Eurozone is not a currency crisis. With their debt denominated in Euros, this crisis is a long term “solvency” crisis precipitating a short term liquidity crisis. Hence, the short term solution lies in addressing the liquidity crisis."...

the immediate test, as expected, is once again focused on the PIIGS (or GIPSI if one is so inclined) acronym: it is not surprising that a decision came out today - after all there is an auction scheduled for Portugal just tomorrow, while Italy will test the market with a €6-8 billion auction this Friday. Absent today's (dis)information campaign, the Portuguese auction would have certainly been another failure. Yet by and far the country with biggest near-term risk is Spain, which will need to finance €30 billion in February. Subsequently, critical auctions follow in Portugal for €3.9 billion in March and in Greece for €12.4 billion in April....

But why stop here: now that all European debt will be brought to the lowest common denominator, namely the demand for German securities, which is at the heart of the backstop plan, it implies that global European funding requirements have to be evaluated in total, and not piecemeal as we did until today. When compiling this data, we attain a shocker: the Eurozone will need to finance, roll and fund deficits to the tune of €1.6 trillion in 2010 alone...

What this means for Bund rates... is not all that complicated....

It is sheer lunacy if the ECB and Germany believe that the guarantee program will not wreak havoc on their plans to quietly fund this massive hole. And there is more.

Merrill notes:

The greatest near term risk is a policy error. One likely candidate is attacking the symptoms of the crisis rather than the causes. Banning short selling during the financial crisis had little impact in stemming the declines, and similar calls may emerge in the current sovereign risk scenario. As in the financial crisis, policy interventions do not come without cost. The moral hazard of supporting poorly disciplined government finances only encourages bad performance in others. But the alternative likely will be a greater and uncertain outcome. Near term, we expect further weakness in periphery sovereign debt spreads to German benchmarks, further weakness in the Euro and continued headline risk out of the sovereign risk story before ultimately these accelerating liquidity concerns and rising debt refinancing costs prompt a greater policy intervention to arrest the liquidity crisis. That will buy time for governments to address their long term solvency crises ultimately behind the current sovereign risk uncertainty.

As always, extend and pretend, while not one economist or politician has provided any answer to the real question that needs addressing: how will marginal treasury revenue, be it in Greece, in the EU, or in the US, increase in light of massive and neverending end-consumer deleveraging, and a bubble that is set to pop in China, taking away trillions in virtually free capital with it. Today the crisis just went global, yet we bought ourselves another 6 months of imaginary time in which the surface will be calm but ever greater disconnects between valuations and fiscal realities, not to mention monetary distortions, will develop, ultimately all resulting in an unraveling on a historic scale.

I will continue to be amazed if the German people allow the hijacking of their strong credit rating by official global financial con-men, but it appears it may be so. It's going to be an interesting few days as PIIGS bailout talks continue.