With Crucial Details Missing, Will EU Deal Euphoria Last?

After a long night of negotiation, EU leaders announced an agreement aimed at easing the two-year old debt crisis shortly before dawn in Brussels.


The agreement will make it possible for the European Financial Stability Facility (EFSF)and its successor the European Stability Mechanism (ESM) to lend directly to euro zone banks and, via the European Central Bank (ECB) , buy euro zone bonds in the primary and secondary markets.

The conditions of any support remain unclear, with the European Commission talking about “very strict conditions” but Italian Prime Minister Mario Monti saying any support would not require those accepting it to accept similar bailout terms to those offered to Greece and Portugal.

"In order to ensure an efficient management, the EFSF and ESM will buy and sell in the bond market” with the support of the ECB because the central bank has the "knowledge of market conditions and an operational capability that the bailout funds don't have,” Monti said in Brussels.

A 20 billion euro ($25.1 billion) growth fund was also agreed, but analysts were quick to point out that many questions remained unanswered.

“The 120 billion growth pact, based on better use of structural funds and on additional capital for the EIB (European Investment Bank) is not a surprise, nor is it likely to be seen as critical,” said Jens Larson, chief European economist at RBC in London.

“But the agreement to waive seniority on EFSF/ESM loans to recapitalize Spanish banksis critical, addressing a current key market concern,” said Larson in a research note published after the deal was struck.

Larson saw progress towards a banking unionbut noted the establishment of a single supervisory mechanism, with the full support of the ECB, will only be considered by the end of the year by EU leaders.

“After the establishment of such a supervisor, the ESFS/ESM will be able to provide support to banks directly, without going via national governments balance sheet. That suggests that Spain’s public finances may eventually be freed of some of the burden associated with recapitalizing its financial system, and the statement also makes clear that a new deal for Ireland might be in the making,” said Larson.

“We would interpret this agreement as undoubtedly good for banks and potentially good for Tier 2 sovereigns. In keeping with established summit tradition, some crucial details seem to be missing from the brief statement,” said Larson. He also questioned where the money would come from following comments from Monti indicating the ECB would act as an “agent” for the EFSF and ESM.

Charles Diebel, head of market strategy at Lloyds Banking Group said the progress on directly supporting the banking sector should be seen as a positive and “help in weakening the linkage between banks and sovereign."

"This is further aided by the removal of subordination issue. This removes one of the key accelerators in the recent spike in yields in Spain and Italy," he said.

“The ability to access EU funds is also significant in that it will allow support without being put into a bailout program as long as countries are meeting their EU agreed targets,” said Diebel in a research note following the agreement.

“These are all positive steps but equally remain subject to numerous risks in terms of implementation and likewise we as yet to not have a clear outline on how peripheral bond markets will benefit from direct support in the near term,” said Diebel.

Analysts at Commerzbank say the deal effectively creates a Eurobondvia the back door.

“Not many technical details are known. The reference to the ECB “serving as agent to EFSF/ESM” in conducting market operations suggests that the measures are supposed to involve mainly secondary market interventions. Hopes about such intervention should give near-term relief to peripheral yields with spreads to Bunds tightening from both ends,” said Commerzbank analyst Christoph Rieger in a research note.

“It should not be too long, however, until market participants will begin to contemplate the limitations of this approach. First, unlike the ECB, the EFSF/ESM do not have the means to intervene in size. Unless ECB repos will become possible the markets will question how the EFSF/ESM will be able to raise the money for meaningful Interventions” said Rieger.

“Second, even if the ESM would have the means, its firepower is limited. With more countries applying for regular/banking aid, the theoretical ESM capacity of 500 billion euros could also quickly reach its limits amid sizeable secondary market interventions for non-program countries” said Rieger, who believes today’s relief rally could be short lived.