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Europe Bailout Fund Expansion: Now, the Bad News

With the vote from Slovakia, the EFSFexpansion is now real. That's the good news.

The bad news:

1) the talk is now turning to recapitalization, where there is potential for significant dilution. There is talk of committing 100 to 200 billion euros to recapitalize the major banks. Whether this would come from private sources over a number of months, or through a TARP-style injection, or both, is still being debated, but it certainly means dilution.

Banks are pushing back: some are insisting they can sell assets rather than dilute existing shareholders.

2) even if a reasonably coherent plan to address the debt overload is forthcoming from the EU, fundamentals are still poor. The ECB Lending Survey released yesterday indicate that credit conditions have deteriorated during Q3. Many banks — particularly southern European banks — appear to be very dependent on funding from the ECB. That points to more deleveraging down the road, and it points to a tightening in credit standards for both household and corporate loans.

Next up: the G20 minister meeting Friday in Paris, the EU Summit October 23rd (where leaders will attempt to speak with one voice on bank recapitalization, Greek debt, and tighter fiscal integration), and the G20 Cannes Summit November 3-4, where the G20 heads will likely try to speak as one on the issues around the global economy.

Now that the EFSF expansion is real, let's recap: the EFSF provides loans (at significantly below market rates) to financially troubled euro-zone countries. It funds itself by issuing bonds that are guaranteed by EU member states. Two big changes are being made:

1) The size of the fund available to buy bonds is being increased to 440 billion euros; and

2) they will now be able to buy bonds in the secondary markets.

They will also likely play a role in recapitalizing Europe's banks. What role is still being debated.

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