On Greek CDS

I am quite a strong advocate of the most recent European bailout package. However, there is one aspect of it which I cannot countenance: European policy makers' pathological obsession with avoiding triggering Greek CDS.

By keeping the 50% writedown of privately held Greek debt strictly voluntary, it appears that this absurd fixation will be satisfied - the ISDA has indicated that they will not consider this a credit event. Beyond 'punishing the evil speculators', I am struggling to figure out why this issue is a focus of the Eurocrats.

I have detailed DTCC's numbers for the net notional exposures outstanding to various European countries (here), and they have fallen further (to $3.67 billion) since that post. Compared to the size of the 'voluntary writedowns', this is peanuts, so these exposures are not the motivation. I suppose it is a possibility that there is a huge over-the-counter exposure (ie not accounted for in DTCC's figures) held by some sort of European AIG, but I cannot imagine this is the case, as who would purchase non-standardized contracts if they had the choice of their centrally cleared counterparts?

The hushed-up incident of the suppressed European Commission policy paper which indicated that CDS provided liquidity to sovereign debt markets (here) erased any credibility policy makers had, leaving me to assume that it is in fact as simple as 'punishing the evil speculators'.  That is insane. What about the (presumably stupid) speculators who took the long side of these contracts when Greece was clearly bankrupt? Shouldn't they be punished? Or, what if the long side recognized Greece's insolvency but placed a bet that any bailout package would not include a CDS trigger - for some reason I find that deeply unsettling.

More important than the motivation are the ramifications, and with some guidance from Macro Man (here) and FTAlphaville (here), I have isolated what I consider to be the three most significant implications:

1. This will spell the end of the sovereign CDS market. When a 50% haircut doesn't trigger payout, then who will trust these credit products moving forward? Macro Man has suggested long-term bond futures as a viable alternative to CDS for hedging purposes.
2. If sovereign CDS cannot be trusted as a hedge, any holders of peripheral sovereign debt who had hedged via CDS will now be second-guessing the safety of their positions and will be incented to sell their remaining peripheral sovereign debt holdings, thereby pressuring funding costs for these countries.
3. What will this mean for the capital positions of banks which have hedged positions via CDS? Basel II gave relief on capital requirements positions hedged with CDS, but if the hedges are now (arbitrarily) bunk, this becomes a serious question. 

And that is only what immediately comes to mind; there may be more (as yet invisible) implications. The bottom line is that this policy is both populist and reactionary. Those three words in a sentence make me shudder. The thought of financially-illiterate European policy makers attempting to fine-tune financial markets should be reserved for my nightmares.

All the King's Horses and all the King's Men

Appear to have put the EMU back together again.

I outlined in a previous post (here) what I thought would be necessary to put a (medium-term) end to the European sovereign debt/banking crisis. Overnight announcements out of Europe present a rough draft of what I was looking for: a considerable "voluntary" write-down of Greek debt, plans to recapitalize Europe's banks, and an expanded EFSF. The details are sketchy and need fleshing out, but all of the requisite pieces are there. While this package does nothing to address the longer-term structural issues in the EMU (see previous post here), it seems to be sufficient to give that can a good punt down the road.

Markets appear to agree with my analysis. Credit spreads dropped, and equities rallied fiercely - the Eurostoxx index was up 6%! The marginal moves in short-term European bank funding costs were somewhat unsettling (sorry no imbedded charts, but you can see the one-year EUR-USD basis swap here, couldn't find a chart of the 3-month Euribor-OIS spread), but I expect these to tighten as the mechanics of the bank recapitalizations emerge and are implemented.

Smooth sailing for now. Let's forget the pending European recession and the childish partisan politics being played on the American deficit super-commission - those are concerns for another day.

A Europlan that Works

Winston Churchill once remarked that "American can always be counted on to do the right thing... after they have exhausted all other possibilities." While the veracity of this statement is certainly up for debate, it seems  to apply to European policymakers in today's context.

Over the last 18 months a litany of ineffective plans have been drafted and implemented to deal with the sovereign debt crisis. Leaving various nuances aside, these plans are pretty effectively summed up by the following: (1) Provide country X with Y billion euros in loans at below-market rates, (2) force austerity on country X, (3) declare that country X is illiquid rather than insolvent and reiterate commitment to no bankruptcies in the euro area (4) on the basis of illiquidity rather than insolvency, have the ECB purchase country X's bonds. Keen minds in financial markets saw through each of these plans (Macro Man has offered a concise analysis of the failings of each plan), and the market disruptions they were designed to end always re-emerged.

The most recent bout of market instability differed from those which preceded it in that it posed an immediate existential threat to the European banking sector. This seems to have finally woken European policy makers up to the scale and severity of the problem. A series of meetings (and subsequent statements/announcements), as well as various leaks have offered observers a glimpse of the plan being negotiated. It appears to include the following:

1. A forced Greek default, with a haircut of 40-50%.
2. A commitment that no other countries will be allowed to default (this will require either a larger EFSF or more bond purchases by the ECB to be credible).
3. Bank recapitalizations. There is to be a new round of stress tests including a much harsher set of assumptions surrounding sovereign debt valuations. Where the estimated 200 billion euros necessary to get all European banks to the targeted 9% tier 1 capital under the stressed scenario will come from is to be determined, but it seems that there are enough good credits in Europe to raise the money.

The current expectation is for the final details to be ironed out by the end of the meeting of the G20 on November 3-4. Should the plan emerge as a credible version of the points above, I would consider it sufficient to contain the European sovereign (banking) crisis for a considerable period of time.

It is important to point out that the plan, in the form outlined above, would not address the longer-term structural issues I outlined in my earlier post. However, it would mitigate the more immediate threat, giving policy makers time to make the necessary adjustments to the legal structure governing the euro area (I am not particularly optimistic that the necessary changes will be made, however that is a discussion for another day).

So Much for ECB Independence

One of the fundamental tenets of effective central banking is independence from meddling politicians.  While in most countries, a nominated head of the central bank must be given confirmed by the national legislature, it is generally regarded as detrimental for the government to be meddling in the decision making process of the central bank. That being said, high-level political oversight of central bank operations is a necessity.

After yesterday's shock and awe announcement from Europe's leadership which includes: 60B euros in government bond purchases by the ECB; 440B euros in loans or guarantees; as well as potentially 250B euros from the IMF (read America), I have yet to read any reaction to the apparent loss of ECB independence from Europe's politicians.  Just last Thursday, Trichet stated unequivocally in a Q&A period that ECB purchases of government bonds had not been discussed at the most recent rate decision.  Then in a complete 180 on the issue, on Sunday evening the ECB announced that they will be buying government bonds (along with the reintroduction of a number of liquidity facilities).

Admittedly, market volatility was very high Thursday and Friday, and the liquidity facilities existed during the earlier financial crisis.  That being said, I am having an awfully hard time believing that the ECB did a complete 180 on the topic of QE over the course of one and a half trading days without enormous pressure from Euro zone politicians.  If my convictions turn out to be rooted in fact, such overt political meddling does not bode well for the future of effective central banking.

This Week in Europe

Okay, so a lot of things have happened since I last checked in with the situation in Greece. Where do we start? The upsized EU-IMF bailout is a good place. For those who have been under a rock for the last week, Sunday the EU and the IMF issued a statement detailing a 110 billion euro package of loans (at around 5% interest) for Greece, effectively removing them from private funding markets for the next two and a half years. The loan schedule was contingent on Greece implementing a strict set of austerity measures. Also included in the plan were much more realistic economic forecasts, in which the debt to GDP ratio peaks at 149% in 2013, falling from that point. Other bloggers/sites have told the story of last week better than I could here, so I will only comment on the broader issues behind this package.

It strikes me that the package announced by the EU/IMF will only serve to stave off a default by Greece (which would occur when their next bond matures on May 19th without the package). Why is default still inevitable? To answer this question, we must revisit our math on sustainable soveriegn debt loads. Assuming that Greece achieves trend growth of 2%, and that their average cost of debt is 5% (resulting in interest payments of 7.5% of GDP), it would be necessary for Greece to achieve a primary surplus of 5.5% in order to stabilize the debt/GDP ratio. Greece has never achieved this. So why lend them money at all? Well it appears to me that the idea was to prevent contagion until the other peripherals (who’s debt/deficit statistics aren’t as ugly as those of Greece) got their collective acts together and stabilized their fiscal situations – essentially to buy time for the other peripherals. I hope nobody at the EU-IMF summit was kidding themselves about Greece’s ability to achieve the fiscal consolidation necessary to avoid a debt spiral. The calculus appears to have been that the loss which will results from the restructuring of Greek sovereign debt (more on this later) will be outweighed by the ‘cost savings’ of preventing similar crises in Spain, Italy, Ireland and Portugal. This struck me as a relatively reasonable approach to mitigating the impacts of the crisis, despite the enormous agency problems it introduced for the peripherals. Too bad the Greeks ruined it all by rioting and shaking the market’s confidence in Greece’s ability to implement the austerity program and thereby putting enormous market pressure back on the remaining peripherals, with the chaotic results we witnessed in markets this week.

Greece Sliding Towards Oblivion

Given the time-honoured trend of bailouts and deals being made during the two day respite from the whims of the markets (also known as the weekend) I was quite surprised that no meaningful news regarding the progress of the Greek bailout was released on Sunday night.  Late last week Greek PM Papandreou formally requested aid and the EU and IMF representatives finally arrived in Athens after being held up by the European resulting from the volcanic eruption in Iceland.  I consider this (lack of news) to be very bad news, and it appears the market agrees with me.  Greek bond yields have exploded (see images below) over the last few trading days, with the 2-year now yielding north of 15 percent! Despite the pledge of 45 billion euros in EU-IMF loans at 5 percent or less, the markets seem concerned that the cash will not be forthcoming quickly enough to prevent a Greek default when their 8.5 billion euro redemption comes due 19 May.  Of particular concern is the provision that the EU portion of the funding must be unanimously approved EU member states, effectively granting each state a veto.  Angela Merkel, in particular has been forced to play hardball in the face of sharp domestic opposition to the bailout, as her party is facing elections in Germany's most populous state on 9 May.  At a recent rally, she was quoted as saying she "want[s] to see the program" before any proposed funds are released.  It is likely that she is simply playing the populist card and looking to score some easy political points with a harsh sound byte and who can blame her?  When as many as 80% of your constituents are against anything, you must at the very least pay lip service to their concerns.  It is reasonable to expect that Germany will not approve the aid package until after this crucial election, leaving very little time for the implementation of the program.

Timing issues and political maneuvering aside, what exactly Mrs. Merkel meant by her comment confuses me, as Greece has already offered a detailed deficit-reduction program to the EU.  Market participants seemingly had a similar reaction.  Then, throwing salt in the wound, S&P downgraded Greece from BBB- to BB+ and Portugal from A+ to A-, both with outlook negative (indicating the possibility of further downgrades in the 12-18 month space).  Not surprisingly PIIGS bond and CDS spreads, especially those of Greece and Portugal, blew out on this combination of news.  With time being of the essence, it appears that the Greek goose is all but cooked.  Restructuring strikes me as the only possibility short of a totally open-ended promise of funding from the EU/IMF - politically a near-impossibility.  If you haven't had the (dis)pleasure of seeing graphically the widening in peripheral bond and CDS spreads, please see the charts below.  Now the discussion over the broader impacts of a Greek default and how to best mitigate them begins...

What About Greece?

With all the furor surrounding the SEC's case against Goldman, a lot of people have lost sight in Greece.  There is has been an interesting wrinkle in the ongoing epic surrounding Greece's debt crisis.  Thanks to the volcanic eruption in Iceland, delegates from the EU and the IMF have been unable to fly to Athens, presumably to negotiate the details of the bailout, which is becoming more necessary by the day.  CDS and Greek government bond spreads to bunds are trading at all-time highs, effectively forcing the Greek government to tap the liquidity program agreed upon the weekend before last.  As I mentioned before, any bailout package will have to be much bigger than what has been agreed upon, as well as much cheaper.  It should be interesting to see what happens through the course of the week/end.

Greece Gets Bailed Out

In a nod to the late-2008 era of the weekend bailout, it has been announced that Greece will receive up to 45 billion euros in financing over the coming 12 months.  30 billion of this will come from the EU in the form of 3-year loans at 5%, about 2% lower than the current yield on 3-year Greek debt, and the other 15 billion will come from the IMF, presumably at even lower rates.  This is approximately double the size of the previously announced package.  In agreeing to this package, the EU leaders have effectively said "here is the financing you need to get over the hump until you get your deficit under control, thereafter you should be able to obtain reasonably priced financing in the private markets".  I can only imagine the tug-of-war that must have gone on behind closed doors to get this done.  What happened to the talk of "financing at market rates"?  German representatives must be fuming.

Anyways so the million dollar question is what does this change?  According to Bloomberg this figure will not entirely cover Greece's financing needs over the coming 12 months, but clearly the lion's share of financing needs are spoken for.  The Greek's are playing it cool, with Finance Minister George Papaconstantinou claiming that they are going to go ahead with financing as planned - including the rumored 10B USD dollar that Greece is preparing the roadshow for.  It will certainly be interesting to see how much lower Greek yields/CDS open tomorrow.  I don't have time to run all the numbers, but assuming that they do tap this financing at 5%, they will effectively save 2% of 45 billion euros annually.  Savings of 900M euros annually for an economy of circa 250 billion euros (forgive me if I err here, I am in a rush and pulling these numbers from memory), that equates to annual savings of less than .5% of GDP.  My initial reaction is that this package is a band-aid rather than a game changer.  More tomorrow when I have had a chance to think/read a little more about it.