J une 2010 For professional investors and advisers only

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What do you get for 750 billion?

Jamie Stuttard, Head of UK and European Fixed Income


750 billon is a lot of money. It could buy you 3.19 million homes in Ireland (1.9 times the entire Irish
housing stock) or 1.25 billion cases of Tuscan Brunello di Montalcino. You could buy Real Madrid
football club 881 times, or if you so wished you could buy tickets for your 2,000 closest friends to the
Eurovision song contest for the next 1,875 millennia (although admittedly you might be taking a view
and some counterparty risk on the survival of either Europe or its annual cultural event). We all have
different perceptions of value.
Equally, 750 billion could buy you just over one third of the southern European government bond
market in par value today, just under a third of the southern European government bond market by
par value three years from now, or just under a fifth of the total debt (public and private sector) of
southern Europe in par value today. Note these figures exclude the obligations of the Republic of
Ireland, in addition to countries often described by the marketplace as core Eurozone for reasons
which seem without any robust analytical foundation such as France or Austria. There are ways of
making even 750 billion look small.
At 3am on Monday 10th May, Elena Salgado of Spain and Olli Rehn announced the second
Eurozone bail-out package of the month of a total of 750 billion. The move was perceived variously
as a success of intra-Eurozone coordination, of EU and IMF joint policy, of immediacy and of action,
and of averting near-term southern European sovereign liquidity crisis. Equally, it was perceived as
a knee-jerk and desperate attempt (after the failure of the first 120 billion package from earlier in
May) to throw money at a web of intractable long-term structural issues, committing taxpayer money
(in Europe via the EU and in the US via the IMF) without any representation or parliamentary
approval, with no detail, with no constitutional accountability and with no plan for how to address
potential consequent balance sheet losses should the central bank make anything other than a profit
on every market intervention.
Fridays comments from Youssef Boutros-Ghali, Chairman of the IMFs policy committee, that:
" If we are going to start including funds made available to Europe, then the IMF is not
properly resourced,"
and yesterdays comments from Republican Cathy McMorris Rodgers in Congress that:
In truth, the cost to U.S. taxpayers goes up every few weeks were talking at possibly $100
billion or more. This has got to stop
suggest that not every i is dotted and not every t crossed on the apparent coordination success
behind the package. This is before we examine concerns from within the Eurozone from powerful


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guardians of monetary policy ideology, such as the Bundesbank, or vocal comments from German
Professors with constitutional concerns.


So what has 750 billon bought for Europe so far?
One month on, the market impact of the policy is as follows. First of all, 750 billion is worth
US$63 billion less after the EUR/USD price action of the last 30 days. It is worth a further 3.45% less
in gold terms.

Looking at the successes first, it is true that the Greek curve has seen bull steepening, with a sharp
fall in 2-year yields back to 7.6% (from 18% 1-month ago). However 2-year Greek yields were at
2.38% just 12-months ago (see Chart 2) and 2-year German yields today are just 0.45%. So despite
the brief period of success of the last 30-days, Greek 2-year bonds are still more than 3 times higher
than their level of 1-year ago, and more than 14 times higher than German 2-year yields today.
Further, Greek long bonds are actually barely changed in yield with the 2040 issue still trading at just
59 cents in the Euro. The European Central Bank (ECB) has disclosed that it has spent 35 billion of
funds buying southern European debt so far (away, that is, from all the southern European debt it
holds as collateral). This would seem a somewhat muted impact for 750 billion.

Chart 1 - Greek yield curve changes from 2
nd
European bail-out to today




























Source: Bloomberg, Schroders



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07/05/2010 08/06/2010
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Chart 2 - But no change to long-term trends in Greek short dated yields over a more
strategic horizon





















Source: Bloomberg, Schroders


Similarly in Portugal and Ireland, policymakers can claim optical short-term success, with 2-year
Portuguese bond yields easing back to 3.22% from a peak of 6.04% and 2-year Irish yields easing
to 2.44%, from 4.56%. Still, before the champagne is poured too liberally, Portuguese 2-year bonds
are still double their level of J anuary 2010, Ireland is over 20% higher in yield year to date, both are
still a long way from that 2-year Bund level of 0.45% and worse still 30-year Portuguese bond
yields are higher since the bail-out.
Those are the areas where the bail-out package has had a positive impact. Now let us turn to the
markets where the impact has been less positive.
In a period where German government yields have fallen 30bps across the curve, we find the price
action in many of Europes larger government bond markets has not only lagged the recovery, but
has even seen outright increases in borrowing costs (see Chart 3 over the page).
In the 380 billion Spanish government bond market, yields have risen across the curve. The 10-
year Spanish government bond spread to Germany has widened far beyond its pre-bail-out crisis
peaks (see Chart 4 on the next page). If the bail-out was formed in order to prevent contagion to
larger and more serious peripheral economies such as Spain, then the package seems to have had
no meaningful impact at all and potentially even a negative impact given the further hits to
credibility that European policymakers have taken this quarter.
A similar picture can be seen in the 1.3 trillion Italian government bond market and, worryingly, the
945 billion French government bond market. All of a sudden the successes in Irish 2-year bonds
appear somewhat irrelevant. Irelands public sector debt at 90 billion is not really the problem it is
the private sector debt that is of most immediate concern there.

Greek 2-year Government Bond Yields
0
2.5
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7.5
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12.5
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May 09 J uly 09 Sept 09 Nov 09 J an 10 Mar 10 May 10
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Chart 3 - No sign of lower borrowing costs in the larger Eurozone peripheral markets



Source: Bloomberg, Schroders


Chart 4 - If anything, borrowing costs have accelerated higher in Spain since the
package





















Source: Bloomberg, Schroders


So much for government markets.

Eurozone government bond yields pre & post support package
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
2yr 5yr 10yr 2yr 5yr 10yr
As of 7th J une Close As of 7th May Close
Spain
Italy
France
Austria


750 billion
bail out announced
Spain 10 year spread to Bunds
0
0.5
1
1.5
2
2.5
05/08/09 07/08/09 09/08/09 11/08/09 01/08/10 03/08/10 05/08/10
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European banking sector since the bail-out
Like Spain, Italy and France, the banking sector has seen spreads widen aggressively since the May
10th bail-out. Spreads on the iTraxx Senior Financials Index have topped +200bps for the first time
since March 2009 the only other time in the indexs history that spreads have breached this level.

Chart 5 - The price of European bank risk now riskier than all of 2008


















Source: MarkIT, Schroders

As such, the market perceives today that European banks are riskier than at any point in 2008. It is a
surprise that markets outside of credit are behaving so benignly (with most risk assets trading far
from their Autumn 2008 levels) given this present systemic risk.

Finally, what of primary markets since the bail-out?
One of the current pressing concerns in the Eurozone is the large refinancing requirements that
many governments and banks have. Whereas the corporate sector in Europe and elsewhere
learned its lesson in 2001-2 that short maturity debt profiles create refinancing risk, banks and
governments have woken up to this potential (and age-old) source of instability late. This means that
(as discussed in previous notes), refinancing requirements and debt rollovers are onerous in 2010
and 2011 for European banks and for governments. European banks are estimated to need around
700 billion in financing in 2010, yet have achieved barely 40% of this. With the World Cup set to
keep primary markets quiet for a full four weeks and the seasonal lull in primary markets in August,
there is a very brief window for a full functioning primary market from 11th to 31st J uly. So how has
the primary market fared since the bail-out?


iTraxx Senior Financials Index
0
50
100
150
200
250
01/06/06 07/06/06 01/06/07 07/06/07 01/06/08 07/06/08 01/06/09 07/06/09 01/06/10
Bear Stearns
crisis
Lehman crisis
Europe 2010
crisis
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Chart 6 - Senior financial supply in the Eurozone



















Source: Societe Generale



Unfortunately, the news is not encouraging. To keep up with a steady annual run-rate, around
150 billion of supply has to be issued in the brief funding window this summer. Since the May bail-
out however, less than 1 billion of senior financial supply has been placed. The conditions are in
place for a potential bank funding crisis this summer / autumn.

Conclusion
The second European bail-out of May 10th has seen only brief and patchy success in
selected areas of some of Europes smaller government bond markets (Ireland, Portugal).
Much more worryingly, the bigger bond markets of Italy, Spain and France with between
them over US$3 trillion of government bonds outstanding have seen their spreads
(borrowing costs) to Germany explode to new wides. This represents an escalation and
broadening of the crisis.
The European financial primary market remains effectively closed, setting the conditions for a
potential bank funding crisis this summer / autumn.
Finally, the capacity of European policymakers to use shock and awe announcements to
enforce market stability is now diminished. Another 750 billion package would not have the
same (weak and eroding) impact as the first 750 billion. As Hank Paulson learned in
Autumn 2008, bail-outs and government interventions are subject to a law of diminishing
returns. More money buys you less market rally, less stability and less time.
Strategies to preserve liquidity and protect against volatility will continue to be prudent near-
term, before the inevitable recovery trade ensues post-crisis.

Denominated senior financial suppl y
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Snr Financial Supply Non-Govt Guaranteed Govt Guaranteed
J une 2010

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The views and opinions contained herein are those of Jamie Stuttard, Head of UK and European Fixed Income,
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