European Debt Deal

US stocks closed sharply higher in reaction to a deal amongst European leaders to bolster the region’s bailout fund, and also a deal with banks and insurers to accept 50 per cent losses on Greek bonds.

With two trading sessions left before the end of October, the Dow is nearing its largest monthly percentage gain in 25 years, largely on optimism from the European debt agreement. The sharp gains brought the Dow above the 12,000 points level for the first time since early August, and the index is up over 1,200 points, or 11 per cent, in October.

A late-night deal that aims to stabilise Greek finances and avoid a sovereign default, while strengthening European Union mechanisms to prevent any more contagion, charged the markets that for weeks were on edge over a possible collapse of the single-currency zone and a banking meltdown.

Some Key Highlights:

•The leaders of the EU have concluded a deal with private Greek debt holders that will see them take a haircut of 50% in the face value of their bonds. 11 hours of negotiation in the 14th meeting in 20 months has also included the bonus of a new EUR130 billion bail out package in a combined strike attack by the EU and the IMF.

• Authorities initial modelling indicates this will reduce Greek debt levels to 120% of GDP by 2020. Forecast 2012 debt to GDP level is 189%.

• There will be an increase to the EUR440 Billion in the EFSF (European Financial Stability Facility) to a figure north of EUR1.5 Trillion in the way by what the EU has dubbed “risk insurance”. Bonds that are issued by peripheral “at risk” nations (this will include Italy) will be covered by this insurance package, although the amount of losses to date are not specified. However, of the EUR440 billion currently sitting in the EFSF, only EUR250 Billion will be available after the second Greek bailout, so it is anticipated that the new leveraged EFSF will only pack a EUR1 Trillion punch. Ireland, Portugal and Greece have already tapped the balance of that EUR440 billion in past months.

• Greece’s new bailout package of EUR130 Billion will see EUR35 billion that was used to back Triple A rated bonds is now going to be traded for debt holders current bonds.

• The Institute of International Finance has said that final elements of the debt deal will be “…agreed by all relevant parties in the coming period and implemented with immediacy and force”.

• Certain components of the deal are pushing the boundaries of faith in the Greek solution. Greece has agreed to reinvest EUR15 billion raised from its privatisation program back in the EFSF. It looks unlikely that Greece will be able to raise the EUR50 billion from previous privatisation promises earlier in the year. It may take them up to 4 years to return that EUR15 billion.

• Incoming ECB President Mario Draghi has nominated that they (the ECB) will continue to purchase struggling peripheral countries’ sovereign debt to “prevent malfunctioning in the money and financial markets”.

• Yields on Italian 10 years have fallen 3 bps to 5.89% whilst German 10 year bunds are circa 2.02%.

• Polish prime minister Donald Tusk on bank capital quality discussed during the meeting: “The key issue was the issue of high quality capital, the 9 percent ratio that was adopted that we need to maintain this ratio. And we also adopted certain elements of the way we should proceed to attain this goal. An emotional element during this debate, was the fact of making this exceptional circumstance and not permanent element… so this will not be a permanent solution for the future.”