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.

Inflation vs Austerity

When facing unsustainable sovereign debt dynamics, a country which is a currency printer* may response with any of the following three approaches (ranked from most to least common): fiscal austerity, a period of heightened inflation, and default. The conventional wisdom is that default is so devastating that it should be avoided at all costs, and while this may not necessarily be reflective of reality (see Iceland, among others) I do not intend to challenge that assumption here.

I would like to debate inflation versus fiscal austerity as approaches to unsustainable sovereign debt. Once again, conventional wisdom (which weighs in overwhelmingly on the side of austerity) appears to have stifled any real discussion in this direction. I suspect that this is due to policymakers’ memories of the stagflation era, and the extraordinary efforts of Volcker et al required to get inflation under control. This has led to a “don’t let that rabbit out of the hat again” mentality, effectively removing a period of heightened inflation from  policymakers’ toolkits.

Not being old enough to remember the aforementioned era removes leaves me more suited to engage in a measured assessment of inflation as a sovereign debt policy tool. The way I see it, the fear of inflation becoming ingrained is misplaced. I am a subscriber of the balance-sheet recession theory (is there really any debate left here?) which posits that the private-sector deleveraging we are witnessing causes considerable deflationary pressures in the economy. In such an economy, if monetary authorities generate elevated inflation, inflation may be brought back into target ranges simply by scaling down or reversing the inflation-stimulating policy.

Sticking to more conventional economics, concerns over ingrained inflation are still misplaced. Inflation-indexed wages negotiated by unions have been identified as a major driver of the persistence of inflation in the 1970s. Due to the sustained downtrend in union density in developed economies, this simply would not be a factor this time around, implying much less inflation "staying power."

A final argument against persistent inflation is the credibility that policy makers have attained in 15 to 20 years of largely successful inflation targeting. If policy makers were to explicitly target a given level of inflation until government debt fell to a predetermined level (or for a pre-specified period of time), and commit to a reversion to more traditional policy thereafter, I suspect that such commitments would be viewed as credible by the private economy.

Having established the reversibility of heightened inflation in today’s context, let’s consider its effects. With the exception of inflation-linked notes, all debt is denominated in nominal currency units, which means that inflation of say 5% is a very effective method of reducing the national debt burden. Who suffers from such a policy? Two demographics: (1) creditors (ie the rich), who have the real value of their savings eroded, and (2) the poor, who feel the most acute pressure from rising price levels. The middle class also feels the squeeze of rising prices, but not to the same extent as the poor. While no solution to unsustainable government debt is pleasant, these consequences are arguably more efficient than those of austerity.

In the case of austerity, the brunt of the pain is borne by the lower and middle classes. This is because, when compared with the rich, this area of the income curve is more reliant on government programs than the rich. Naturally, the poor again are the hardest hit, as they are the most reliant on government programs. Given that they are not as reliant on government spending the rich are left relatively unscathed. Additionally, fiscal austerity tends to lead to sustained periods of below-trend growth (or more usually, widens and sustains an existing gap between trend and realized growth), which has serious ramifications across the income spectrum.

Furthermore, taking the cynical view, inflation is also arguably more efficient from a social unrest perspective. While inflation leads to a slow burn of discontent (via slow, steady increases in price levels), government austerity has much more recognizable, tangible effects, such as the cutting of wages in the public sector, or a reduction in welfare benefits. Such identifiable consequences may come to represent rallying points for social unrest.

The reasoning above leads me to conclude that elevated inflation should at least enter the policy arena, although admittedly it would have to be precluded by an integration of monetary and fiscal policy, similar to  that advocated by Cullen Roche at The Pragmatic Capitalist (here).

*Currency printers (ie the US and UK) differ from currency users (any member of the EMU) in that they determine their own monetary policy, and therefore inflation.

Why the Euro Doesn't Work

Currently there are two existential problems in the euro area. The first is a relatively recent development and must be dealt with immediately, while the second has been building for about a decade and requires longer-term solutions:

1. The positive feedback loop between insolvency in the European periphery and stresses in the European banking sector.
2. The long-term structural divide between unit labour costs in the north and the south of Europe.

Let’s start at the beginning – ironically the second problem above. Before anyone gets pedantic, I realize that what follows quite a stylized story (ie short on details) but I am simplifying for the sake of clarity.

Before the nations now known rather pejoratively as the European periphery joined the euro area, their workers were kept competitive with those industrious Germans through a regime of flexible exchange rates. For example, if the Portuguese were not innovating as quickly as the Germans, the Portuguese escudo would depreciate against the German mark, making Portuguese products relatively cheaper (all else equal) and thereby allowing the Portuguese to compete with the Germans in international trade.

When the euro was introduced, this mechanism disappeared and the European periphery rapidly lost competitiveness with the core.

Seems like a raw deal right? Well not entirely. The upside for these chronically uncompetitive countries was that, despite all of structural differences between the economies, the bond markets began treating debt issued by any European government as essentially the same credit (assuming an implicit mutual guarantee). This allowed these countries to fill the gap created by the erosion of their domestic private sector with government spending financed by cheap debt issuance.

This was all good until it wasn't. Once people woke up to state of the sovereign finances in these countries (initially just Greece), they rushed for the exits. With European policymakers refusing to take bold action to resolve the crisis, it spread and evolved to the point where we stand now - uncomfortably close to the abyss.

The next post will describe in more detail why policy fixes introduced have been insufficient, and detail the policy prescription necessary for Europe to extricate themselves from the mess they have found themselves in.

Note: I have not included Ireland in this discussion because I consider both its path to fiscal ruin and the steps to recovery be considerably different from the nations detailed above.

European Blow-Up Risk - Hedge Edition

If you were looking to hedge European meltdown risk in the CDS market, who would be your reference entity of choice?

Parsing CDCC data gives us an indication of how others are hedging this type of exposure - French CDS. Initially, I found this surprising: if you are worried about your exposure to Italy or Spain, wouldn't it make sense to go long their respective CDS? On second thought though, this move appears quite rational. Assuming that Italy and Spain are too big too bail out (that is certainly the perception on the street), then it is reasonable to assume that if either of their bond markets collapse, the French government would be the next domino. So why pay a higher spread for Italian or Spanish CDS when French CDS provides essentially the same hedge? I think that my interpretation is strengthened by the fact that net notional exposure to France took off in July and August, as Italy teetered on the brink

Another interesting nuance of the data is that CDS exposure to Greece and Portugual have fallen substantially this year. Could it be the case that all those lawyers that the EU have hired to avoid a technical default are undermining market confidence in whether Greek/Portuguese CDS will actually payout in the event of default?

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.

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.

Great SocGen Piece on Sovereign Debt

Okay, I know I am a little late to the party when it comes to discussing sovereign debt, but I read an article a while back that really struck a cord and I thought should be shared. Fear not, I am not here to rattle off a bunch of platitudes about the causes of and potential solutions to the situation in Greece.  What I want to discuss is an excellent piece from SocGen's Popular Delusions series which honestly examines the bigger picture, specifically, western countries' sovereign debt situations.

The authors begin with an examination of people's (and governments') tendency to put off tough decisions and responsible action "for later", within the context of irresponsible government spending.  The discussion then transitions to an examination of government off-balance sheet obligations, before moving to the arithmetic of sustainable government debt. Summarizing the (extensive) literature on the topic, the authors assert that "maintaining a stable debt to GDP ratio requires governments to run a primary balance [surplus before interest] proportionate to the difference between interest rates and GDP growth" - a rule of thumb so logical it is irrefutable. This rule is applied to various countries' debt situations based on the very conservative assumption that current costs of financing will persist in the future.  Their findings are summarized in the following bar chart.

For those with a thorough knowledge of governments' recent fiscal histories, this graph is all that is necessary to differentiate the sinners from the saints.  For those not as familiar with this history, the next chart summarizes it nicely for you.

Putting the two together is the real show-stopper...

This series of charts make it clear that a number of countries in the West (and Japan) have a lot of fiscal consolidation to do in the coming years - not a particularly original insightful.  Now consider what will happen when this year's deficits are added to the governments' respective mountains of debt and government funding costs tick upward as monetary policy tightens - whenever that may be.  If a host of countries couldn't get their finances in line over the last decade, what is there to make us believe that they will be able to do so in the "New Normal" economic environment of high unemployment and sluggish growth? Hope may spring eternal, but the latest CBO baseline forecast - and its analogues from other developed countries - aren't cause for much optimism.

The entire SocGen report is definitely worth the 20 minutes.