The Debts of the Spenders: EU Nations Establish Emergency Fund to Defend the Euro

Faced with a total collapse of the Euro, Eurozone leaders vowed to create a stability fund to save their currency. The bureaucratically stodgy institution was shocked to its core after months of haggling over the Greek bailout turned out to be for naught. Leaders believed the 110 billion Euro bailout package for Greece would be the backstop required to return confidence to the markets.

The ECB's normally placid meeting on Thursday failed to create confidence after ECB President Trichet refused to discuss the "nuclear" option of pulling a Bernanke (e.g. having the ECB buy sovereign debt). The lack of any meaningful price action in PIIGS market debt has forced 2 year yields to double digits this week. While attractive at first glance to junk buyers, the high yield reflects the market's concern that the Greek government will be forced to re-structure - e.g. pay less than face value - on government debt.

Instead, their actions served only to produce the largest rise in implied volatility ever - exceeding 2008 levels.

Now, Eurozone leaders are working furiously over the weekend to create a continental bailout package. Notably absent from the table however was any mention of buying government bonds. Failure to do so would result in European financial institutions - banks, pension funds, and insurance companies - facing enormous losses. There are no easy solutions here. Even a re-structuring of government debt obligations would result in further write offs. But at least it would be amortized over time instead of vanishing in a blink of an eye (e.g. kicking the can down the road for another generation to handle).

Some notable quotes:

“We will defend the euro, whatever it takes,” European Commission President Jose Barroso told reporters early today after the leaders met in Brussels.

“When the markets re-open Monday, we will have in place a mechanism to defend the euro,” French President Nicolas Sarkozy said. “If you don’t think that’s significant, you haven’t been to many EU summits.”

Europe will send “a very clear signal against those who want to speculate against the euro,” Merkel said.

All agreed on “the need for a clear, timely and strong response,” Canadian Finance Minister Jim Flaherty, who chaired the call, told reporters in Ottawa. “We hope to see a strong, early policy response in Europe.”

Europe’s unprecedented lending pledge has “proven insufficient to stop market contagion to the rest of the euro- zone periphery,” Michael Saunders and other economists at Citigroup Inc. said in an e-mailed note before the summit.

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