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.

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.

Other News

The Canadian dollar closed above par with the US dollar for the first time since June 2008 today.  Next stop $1.05?

Also, the market has spoken on the big fat Greek band-aid offered by the EU.  Some commentators tried to talk up massively over allotted 6 and 12 month T-bill auctions.   Is over allotment surprising, considering that the EU/IMF has package has effectively guaranteed Greek financing for the next 12 months?  Oh did I mention the yields were extremely rich at 4.55 and 4.85 percent respectively?  Isn't the current ECB rate at 1%?
After dropping significantly Monday, Greek spreads to bunds and CDS spreads widened Tuesday and Wednesday, closing above Friday's levels Wednesday.  This is the market screaming from the clock tower that while addressing the prospects of a liquidity crisis, the announced package does nothing to address the (much larger) solvency issue.  More on why the Greek situation is hopeless to come this weekend.

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.

So Apparently It's Not Just Me

I honestly did not create this blog to rant about a Greek default, but sovereign debt is certainly the theme of the year in financial markets (an excellent call by the Economist at the end of 2009).  Anyways, by this point, my internal dialogue has moved past the discussion of whether or not Greece is going to default to over what time horizon I should expected it to happen (I am currently thinking 3-7 years), what the ramifications will be, and where the EU authorities will be forced to step in.  Bloomberg ran a story today detailing the opinions of one Mr. Stephen Jen (formerly of the IMF), now a manager at BlueGold Capital. Jen apparently is even more concerned than I am.  He says that without an aid package several times the size of the one tabled by the ECB/IMF, Greek default is inevitable, possibly before the end of the year.  The article also discusses the esteemed Mr. El Erian's gloomy outlook on the Greek situation. 

I also recently came to the realization that I have yet to flesh out all the arguments for why a Greek default is an inevitability.  Stay tuned.

Commentary on Greece's Latest Bond Issue

Yesterday Greece sold 5 billion euros worth of 7-year bonds via syndication.  The deal priced at mid-swaps plus 310 basis points to yield 6%, a level double what Germany would pay to borrow at the same tenure.  The bid-to-cover ratio was only 1.4, compared to more than 3 for Greece's 5-year, 5 billion euro auction held on 4 March.  Foreigners bought 57% of this deal, versus 77% in the aforementioned 5-year offering.

While the jury is out to some extent (see linked story), the perception around my office was that this syndication went quite poorly, especially considering that issue's yield widened 24 basis points in the secondary market today.  Additionally, today there was an unannounced reopening of the Greek 12-year of up to 1 billion euros, which only managed to attract 390 million euros in orders.  Unsurprisingly, Greek CDS spreads were wider on the day.

Many people were looking to the 7-year auction as a gauge of markets' perception of the EU plan for offering financial assistance to Greece. Some of the finer details still need some fleshing out, but broadly, there is to be a pool of 20-22 billion euros available from the EU and the IMF (providing 2/3 and 1/3 respectively) for Greece to tap in the situation that it cannot raise funds via the private market.  While an effective bridge for any short-term financing issues, this does nothing to address the fact that if Greece continues refinancing in the private markets at 6%, they will end up be paying more than 7% of GDP in interest payments alone.  Does anyone else see a dizzying debt spiral?  See my previous post for a longer discussion of what constitutes sustainable a debt burden.  Also, perhaps the ability of any euro zone country (read: Germany) to veto any potential action removes some of this bill's legitimacy?

Regardless of what aspect(s) of the bill the market did not like, this auction shows that investors are still very skeptical of Greece's ability to right the ship - arguably more so than in early March (the time of the preceding, better received syndication).  Greece has a tough slog ahead of them if they are to avoid default.  I am generally an optimist, but the realist in me is saying that Greece doesn't have what it takes.