Eurozone Sovereign Debt Crisis

So there we have it! A new election will take place in Greece next month. The winner gets the prize of telling the EU leadership they will not stick to the terms of the €130bn bailout. The Greeks have yet to reveal whether they intend to pay up on the €436mm foreign law FRN due today. If they pay, there will no doubt be an outcry from bondholders who took the ritual 55% belly cut. But imagine the anger amongst the locals whose pensions and wages are being slashed. All so “evil” hedge funds get paid in full. Politically, this would be a no go. If they don’t pay today, the Greeks are likely to take advantage of the 30 day grace period which coincidently will end just before the new elections take place. So, no immediate default. No solvency! We remain in the twilight zone for a few more days! 

As the announcement was made, guess who took it on the chin? Why of course, it was Spain, where 10-year bond yields jumped to 6.30% and its CDS is now at 535bps, all of 20 bps tighter than ... Hungary! I suspect the big loser out of this is likely to be Germany as they remain the supreme benefactors of the single currency. Their economy after all grew five times the projected rate of 0.1% (!!!) in Q1.

Look for rumours of ECB intervention, FED easing, ESFS/ESM firewalls and all other acronyms that form part of the cavalry. This market needs some props to keep it up.    

GREEK FINANCE MINISTRY TO PAY EU435 MLN BOND [8:10 PM BST]

This just in...

If you are a foreign law bond holder that held out against the PSI, you have just made a killing. Presumably, the act of not paying, even with the benefit of the grace period typically afforded to the Issuer, would still have triggered a hard default. I wonder if bondholders who accepted the PSI may resort to legal action? Recall, Greece had warned the holdouts of a worse deal than those exchanging under the PSI.  

As markets brace for an imminent Greek default and exit from the Eurozone, the Greeks quietly made good on a ¥900m (US $11.3m) coupon payment due on the ¥40bn 4.5% bonds due in 2016. Investors in this foreign law bond had held out against the PSI restructuring. On May 15, another €450m FRN documented under foreign law bond is due to mature. If paid in full, those who did participate in the restructuring will come out with their machetes. If they don’t pay, Greece will officially default for the first time in this crisis. JP Morgan has raised the odds of a Greek exit to 30-50%. The fallout of a hard exit will be painful with estimates of €400bn+ being discussed in the press.

Meanwhile, the weekend’s antics have shown that the Greeks want the Euro but don’t want austerity. The Germans, it appears after Sundays State elections, need the Euro and want austerity - but only for others. The Spanish don’t want austerity and based on the most recent bank bailout plan last Friday, remain in denial on the size of exposure to the still overpriced real estate market. The French are rooting for President-elect Hollande in his negotiations with Merkel on the austerity measures agreed in the fiscal compact. They are about to find out he is as influential as President Sarkozy was. The Italians watch and wait for their time in the spotlight!     

You could not make this stuff up! 

France has a new President. Or, more importantly, Europe has a new first couple, “HoMer”. Is this a reminder from the Gods that Europe is spiraling through its own Greek tragedy? A central theme in tragedy is moral conflict. Well, we certainly have conflict in Europe—austerity versus growth. The people of Europe have overwhelmingly rid themselves of leaders who asked them to die a little now in return for a happy after life. Growth is in. Austerity is (on its way) out. With the political structure in Europe breaking down and the masses rebelling, brash new leadership will likely attempt to renegotiate the fiscal agreements regarding budget and debt that the EU nations signed barely five months ago. No one has asked how over-leveraged economies will fund this growth. But that is a question for tomorrow.

Although the headlines this week have been about Greece and France, the action continues to play out in Spain. In spite of claiming that no more banks would be bailed out, Spain bailed out its 4th largest bank yesterday. Looks like the sovereign carry trade is not working out. Spanish banks have increased their holding of sovereign debt between December and February 12 by €70bn. Given the spike in Spanish sovereign yields since, it is likely that on a mark to market basis, these trades are now under water. It is equally likely that whatever asset was pledged to get the cash under the LTRO is also under water, requiring further margin calls.    

Overall market technical sentiment is poor. Moody's threat of a mass downgrade of European financial institutions does not help. In spite of all the liquidity measures, Counterparty risk in the interbank market is rising. The spread between three-month Euribor rates and overnight indexed swap rates is over 40 basis points.

Another theme of tragedy is a certain inevitability of what is likely to follow. With no tangible support forthcoming from the ECB, are the markets staring into the abyss?

QEu2 anyone?

Ever since the ECB hinted that LTRO3 was off the table, the principal European markets have fallen between 10-20% in the following four weeks. Spain in particular is in a tough situation. Apart from two of its premier teams likely to make it to the Champions Cup Final, little else appears to be going its way. With youth unemployment at 50%, 10-year bond yields having spiked to 6% and the IBEX trading barely 100 points above the March 2009 low, the immediate future looks bleak. Although sovereign debt / GDP ratios for Spain are better than Italy, total private sector debt is nearly 300% of GDP. Spanish banking loans alone equal 170% of Spanish GDP. With no sign of the property market recovering, troubled loans at Spanish banks just hit an 18-year high of over 8%. Spain appears to be following the Japanese model in the 90’s of solving the banking crisis. They will soon realise that merging two bad banks simply gives you an even larger bad bank. What is astounding is the level of general complacency in overall market sentiment. If Spain were to require a bailout, and early signs point to this, watch out as risk investors head for the exit. With French and Dutch voters fighting against strict austerity measures, it is only a matter of time the so called “fiscal compact” agreement now falls through. Without the fiscal compact, it is unlikely Germany will back a common Euro Bond. IMF requests for more funds from Europe have already been rejected. German stocks fell over 3% yesterday as the prospects of Germany leaving the Eurozone just became more likely. 

After three months of non-stop partying, the risk markets appear to be taking a breather. Europe in general—and Spain in particular—looks to be losing its mojo. The Ibex is trading slightly above the November lows. In spite of all the liquidity the ECB and Fed could throw into the pot, bond yields are at 5.50% (lower than the peak of 7%, but high nonetheless). The discontent on Spain can be tracked to the comments made by Rajoy, who minutes after signing the fiscal compact treaty, revealed that Spain will not be able to meet its 2012 debt/GDP target. With soaring unemployment already causing deep stress to the social fabric of the nation, the austerity cuts will only add fuel to the growing fire of anger amongst the masses. In this backdrop, it is only a matter of time before the politics skews towards less austerity and puts the nation in direct confrontation with those that are administering the bitter pills (i.e. Germany, Netherlands). 

It appears from the various signals given by the ECB that we are unlikely to see more QE type liquidity injections. Notwithstanding the positives of having averted a funding crisis, they have drawn a fair amount of criticism on the weak collateral they have allowed to be deposited. Furthermore, they have allowed banks to “create” assets that can be repo’ed into the scheme – such as Government guaranteed bonds (where a bank issues bonds to itself, gets a guarantee from its Sovereign, borrows under the LTRO and uses the funds to buy Sovereign debt) which undoubtedly creates a moral hazard around “gaming the system”. Unlike the Fed, which is going to QE into perpetuity, the ECB appears to be more sensitive to the fallout of too much liquidity being injected into the system. 

This leaves Europe with a major problem. With no further liquidity injections, the solvency concerns around Spain and Italy are likely to grow. The increase in EFSF / ESM to around a €1 trillion (for 2012) will help, but is no “firewall” against a panic in the markets around these two nations’ ability to fund.  Italy has been issuing bonds at a clip, but mostly with a three months – three years maturity and in some cases, in the form of zero coupon bonds. The can is being kicked but not too far down the road.

The question at my last posting has been answered – we continue to party!

The Greece restructuring was completed last week. As expected, CAC’s were forced on all non-consenting holders of Greek law bonds triggering a long anticipated CDS “Credit Event”. The ISDA Auction that sets recovery price is due on March 19. The deliverable obligations submitted by investors include €100bn+ of structured bonds and guaranteed obligations (mostly non-Greek law obligations) that were not known until now. That means that there are a further €80bn+ of losses (assuming Greece recovery is set at 20%) to be absorbed by the market. Provided the obligations have been marked to market and collateral has been posted regularly, these ought not to be a concern. However, this is a big “if”. One European Bank announced last Friday they would need another € 1bn of funding to cover their losses on Greece. Is it possible that there are more skeletons in the Eurozone cupboard?

Non-Greek law bond holders still have a few more weeks to agree to the exchange. Many are resisting – some through legal routes. The newly exchanged Greek bonds are trading at prices that indicate a > 80% probability of another Greek default. A hard default would cause further losses to the new holders (mainly Central Banks) that will feed through to Joe Public’s pension.

Greece is teetering on a default, Portugal credit spreads against Germany remain at 1400bps, Italy and Spain still have their issues. But that’s for another day.

Tons of liquidity injected through QE and LTRO, low inflation and interest rates and a becalmed Eurozone. These headlines and the fear of losing out on what appears to be the most ideal risk investing scenario we have seen in years are pushing stock markets to multi month highs. The credit markets are sanguine but sovereign credit spreads, as represented by SOVX have rallied over 100bps to 225bps.  

In the US, most of the Banks passed stringent stress test results that included scenarios of US unemployment 15%, equity losses of 40% and negative GDP in the next few quarters. As a prize, many of these banks were allowed to announce share buybacks and increased dividends, goosing up the stock market just before its close.

The bulls are set to claim victory – the bears go into spring time hibernation. Politicians and Central Bankers have demonstrated that they can play God and set prices for everything.  With many retail investors frantically jumping into the market, could this be the optimal time for yanking the beer soaked rug underneath.  Be careful out there!

So the big day for Greece has arrived. The PSI results due tomorrow will determine if we continue to party or if we go back into intensive care, in so far as risk markets are concerned. Given the propaganda and game theory being played out - IIF (same chaps who have already signed up to the Greek exchange) has come out with a study stating that Armageddon beckons— 1 trillion + losses for Eurozone, Contagion, Counterparty risk blow ups, recession, negative spiral back to the dark ages—the stakes are indeed high. The message is clear: hold out and you will be blamed for the financial equivalent of World War III.

In the midst of this, a bunch of GGB holders have held hands at a stance organised by a US law firm known for its propensity to launch law suits. The logic again is simple, divide and be conquered - stay unified and we can prevail...in court.

The equation itself is simple:

< 75% acceptances and the deal is off - hard default for Greece.

>75% < 90% PSI goes ahead with the help of CAC's, CDS triggered and the game will move onto recovery value of the new bonds, what is deliverable etc. At best, a muddle through but likely to be viewed as positive.

>90% PSI goes ahead, no CAC's required. All those who hold out are either defaulted or paid out (two guesses which one Greece will propose).

Given the widening of periphery credit spreads in the last few days, it appears that Spain and Italy are being targeted. For Italy, with more than €250bn of funding requirements in 2012 with roughly 10% completed so far, there is a concern that apart from from Italian banks, no one in their right mind will fund them. Foreign funds have already reduced their BTP holdings from 50% to 40% and given the risk of further downgrades, many real money investors will not touch this debt with a barge pole.

Sovereign risk used to be seen as a rates product and is now a credit product. The universe of investors for the latter is significantly lower than the former.

The forthcoming LTRO is being bandied around as Europe’s version of “cash for trash”. With the list of ECB-acceptable eligible assets getting longer by the day, the weakest of the banks can now access the LTRO. The next drawdown on February 29 could be a blowout success – unless of course you take the view that insolvent banks borrowing against worthless assets and using the funds to lend to insolvent sovereigns is not “success”.

Clearly there are strains in the market – or else the ECB will not continually be on standby to open the spigot. The elephant in the room could be the unintended consequence of the default rating soon to be issued on Greece by S&P, Moody’s and Fitch. Although a fair amount of media attention has been on the relatively small amount of “net” CDS that will settle (once the retroactively introduced CAC’s force the Greek restructuring down the throat of all dissenting bondholders), less is known about the impact it would have on other OTC derivative contracts that will also get triggered by a rating agency default. Given the uncertainty, the ECB is likely playing safe and ensuring that any bank (literally) can draw unlimited amounts of liquidity (literally) to protect itself. This also provides a mouth watering prospect for banks to buy risk assets against the very low cost of funding available through the LTRO.

So why is it that some banks have explicitly opted out of the next round? There is of course the stigma that continues to be associated with going to the central banks with a begging bowl – although Mario Draghi has been explicit in his endorsement of the scheme (it is his brainchild, after all) and has encouraged all banks to show up for the “feast”. There is also a perceived risk that should banks participate in the LTRO scheme, the EU and ECB could impose retroactive handcuffs around compensation, financial transaction tax and who knows what else, once the dust settles on this stage of the crisis. If you don’t need it, why bother? The fact that a number of banks are willing to walk away from the “free Euro lunch” says something about the whole affair. However, USD term funding to match-fund assets on bank books is getting tight again and market chatter is that should the Fed come up with a similar scheme for USD, it would be heavily subscribed to – stigma or not.  In the old days, banks could structure “regulatory arbitrage” securitisations, or set up SIV’s to “remove” assets off their balance and appear healthier. However it appears that regulators are no longer playing ball and it is left to the central banks to instead flood the banks with money to deal with inventory overhang– both on and off balance sheet.

Meanwhile, spare a thought for poor old Greece! They have had to sign up to a massive internal devaluation through wage cuts, job losses and various austerity measures that will make living and working in Greece (if you have a job) a pretty depressing experience for years. They also have the Troika permanently parked in Athens looking over the shoulders to ensure they “keep their promises”. Portugal and Ireland are no doubt watching. So much for the Maastricht pledge of equality within one Europe – we appear to be headed towards one Germany!

Click here to watch Pawan Malik’s interview about a proposed Collective Action Clause for Greek debt and credit default swaps with Owen Thomas and Linzie Janie on Bloomberg Television’s “Countdown” (2/24).

In another twist to the Greek tragedy, the ECB decided to subordinate remaining bond holders by choosing not to participate in any restructuring of Greek Debt. As a market participant, their disregard for basic contract law appears incredible and deeply flawed. Any savvy bond investor should be ridding themselves of all periphery Eurozone bonds as the risk reward ratio has changed materially. What has been amazing is the lacklustre response from the market to this momentous change to securities law. Or perhaps the market response is yet to reveal itself. A tweet from Bill Gross of Pimco suggests that the smart money gets "it".

Meanwhile, we wait with bated breath on details of the Greek bailout, which has now dragged on for over a month since the release of an "imminent announcement". Well, today's FinMin meeting in Brussels is supposed to be "the one". It is widely expected that a roadmap of getting the Greece Debt/GDP ratio to 120% (from 160%), the mechanics of the bailout and PSI restructuring will all be announced this afternoon. The funds will come from the EFSF, which will have to publically raise the funds to finance the bailout, which has risen from €130bn to €145bn.  

According to Greek Mythology, all the good and evil that befalls you is woven into your destiny and controlled by the three fates. Does fate have a plan for Greece? Irrespective of what transpires today, most market participants now firmly believe that Greece will default and leave the Eurozone. Market murmurings suggest this will happen a few days after the next bond payment falls due on March 20. If you listen to some of the leading politicians from Germany and Netherlands, you get a sense that the delay in the Greek bailout is less to do with Greeks resisting the conditions of the package but that the EU have strategically pushed them to the wall, with the intention of pushing them over. I suppose they have worked out that Greece will be a bottomless pit of handouts without any certainty that they will come out of this alive. After all, what do they produce that others might want to buy? Also, the negative spiral of deep austerity cuts to pensions, healthcare, jobs will likely render any growth forecasts and estimates of tax collection redundant. One month into 2012, Greece has contracted by 7% versus an expected expansion rate of 8.9%. What the politicians underestimate is the likely impact of a Greek default. The consensus is that the impact would be limited, the markets are better prepared and the banks are sufficiently liquid to absorb any such eventuality. I recall this was the chattering the week before Lehman defaulted. In fact, the market rallied on news of Lehman’s default. And we know how that storyline went, don’t we? There are several unknowns in this market, especially those in the domain of OTC derivatives and counterparty risk. A contagion cannot be ruled out.

In our posting dated December 12, 2011, we mentioned that with the various liquidity schemes introduced, "the ECB and the Eurozone governments have orchestrated a cunning plan that should support markets over the next few months". Just over two months have passed and the markets have raced higher to multi-month highs. All news is now considered to be good; any possible bad news is viewed as an opportunity to buy the "dips". The logic, as we understand it, is that the LTRO and other liquidity measures have effectively saved the Eurozone banks from default, which in turn will fund the Eurozone Sovereigns. Furthermore, the US economy appears to be recovering, and as such, risk assets are considered to be "cheap". In a more recent post on January 16, we also mentioned “Watch out for under-invested funds and the retail investor getting sucked into the bullish whirlpool." I suppose we are at that point now - the next few weeks will reveal if the measures are healing the patient or are they simply more drugs to hide the pain of a dying patient.

The liquidity injected into the banks through various mechanisms appears to have calmed the risk markets in 2012 (all of one month old). Recall, the ECB has provided nearly €500bn of repo funds under the LTRO scheme. The unlimited Fed swap lines transform Euros into USD which allows banks to continue funding their USD assets. It is hoped that Banks, flush with liquidity, will be impelled to buy Sovereign Bonds and capture the (still) material “carry” with the added comfort that politicians and central bankers will not let the major Eurozone Sovereigns collapse. The ECB recently revealed that their balance sheet expanded to nearly €3 trillion demonstrating their commitment to keep the juice flowing– not bad for a central bank that refuses to print.

The effect has been clear to see this month. Italian two year bond yields (chart 1) have fallen to 3.15% from 7% at the end of November 2011. Itraxx Cross-Over Index (CDS spreads on 50 junk rated European Corporates) has fallen to 600bps p.a. from 850 bps p.a. (Chart 2). European Stock Markets hit a six month high yesterday. Even Portugal, widely believed to be the next Greece, has seen its bond yields drop by 2-3% as hedge funds attempt to lock in the wide spread through the infamous negative basis trade (buy bonds at say 20% p.a. and buy CDS protection at 14% p.a., theoretically lock in 6% p.a.). As for Greece, well, the restructuring resolution is imminent (as it has been for more than two weeks now).

With about 25% of the European Sovereign funding calendar successfully completed, a potential ECB rate cut next week followed by another window for Banks to stuff their pockets with LTRO funds at the end of February, the authorities appear to have “solved” the immediate issue of confidence in the Eurozone (and given themselves a fighting chance to fund the balance of Italy and Spain’s refinancing needs). Helped by the US Federal Reserve’s promise to hold rates down till 2014 and beyond, the palpable fear that was evident in the markets late last year has transformed into a euphoric panic amongst asset managers, hedge funds and banks not wanting to miss out on the “low hanging fruit” being dangled.

Wall Street certainly knows how to have a great party with €3 trillion in the kitty. But, what about “Main street”?

Unemployment levels in Europe are at all time highs (see FT chart below). The level of pessimism amongst the educated unemployed is at its highest (Gallup). These youth are considered most likely to leave and find opportunities elsewhere. Spaniards are moving to Argentina, the Portuguese to Brazil & Angola and the Greeks to Germany (there is an irony there somewhere). A mass exodus of educated human capital will have long term implications to the growth prospects of these nations. In order to become competitive (and without the ability to devalue the Euro) these countries will either have to import workers or export production to emerging countries. None of this is likely to be politically palatable to those who remain. Once the dust settles on this liquidity induced rally, the markets will once again start paying attention to the real cost of this crisis. But for now, we party!

The amnesiac pixy dust sprinkled by the central banks over the year end had barely started to work when the two headed “fly in the ointment” - S&P decided to gate-crash the party. The fact that they chose Friday, January 13 to downgrade several European Sovereigns is ironic. Until then, markets had been kept buoyant without any major bad news (Europe was on holiday until the 2nd week of January) and moderately successful Italian and Spanish auctions. The downgrade of France, Italy and Spain will ultimately have a negative impact on the rating of the leveraged CDO we fondly know as the EFSF. Whether rating will drive the funding costs wider, we shall have to wait and see. The political response from the EU to the downgrades by S&P has been swift and scathing. In a speech, Ms Merkel confessed she would consider legislation to bar institutional investors from selling bonds when ratings were downgraded, or fell below investment grade. Comforting news – you can buy, but can never sell!  

The timing of the Italian three-year bond auction was interesting, if it transpires that Italy knew of its two notch downgrade, but chose not to share this material information with investors. They may have figured that since buyers were Italian banks, who have in turn been funded by the Sovereign anyway, there is no risk of litigation. After all, family is everything. Whilst the buying action was in the short end, the long end of the Italian bond market is under pressure after LCH hiked initial margins (again, having lowered margins just a few weeks ago) to 18% on the 15-30 year duration bonds and 8.30% on the 7-10 year. The Italian curve will get steeper as the long end is sold off to satisfy margin calls and funds flow into the LTRO inspired three-year (and less) maturities. The ECB is also reputed to be buying BTP’s around the Bunds + 500 bps level.    

Meanwhile, the Greek restructuring saga continues with investors fighting to avoid substantial write-offs, especially in light of the reprieve provided to investors of all other Euro-zone debt. Recall that much of the secondary Greek Government Bonds (GGBs) have recently been snapped up by activist hedge funds who will not play by the rules. To counter this threat, the Greeks (or their puppeteer, Germany) have unveiled their secret weapon – the Collective Action Clauses (CAC) that can retrospectively cram majority decisions onto the rebel minority. But what if the minority are now the majority?  

Further, only private investors are in line to take a haircut and the ECB is off the hook for its €50bn+ of GGB purchases. This structural subordination will have longer term repercussions for funding the Euro-zone. Many investors would refuse to participate or demand higher yields, which in turn will keep the cost of funding for the peripheral nations prohibitively high.   

As I write, the market is looking to shrug off the downgrades as “old news” and as “news already priced into the market”. Stock markets are stabilising and Wall Street rhetoric is telling us that the “surprise” could be to the upside in 2012. The plumbing of the financial system – funding – appears to be secure and tightening bank CDS spreads (see chart below) simply that the risks of a major default are receding.   

A wise man once told me that people only want to see the value of things they own go up – even if it’s an optical illusion. The sell side of Wall Street remains the greatest illusionist of them all. Watch out for under-invested funds and the retail investor getting sucked into the bullish whirlpool, before the illusion is revealed for what it is. As we have witnessed in the past: receding waves can often be a warning sign of a building Tsunami wave.

Following the long-term refinancing operation (LTRO) of €489bn, there was a bated sense of anticipation that banks will binge on their national sovereign bonds, earning "carry" to boost profits. Net of refinancing due by the banks in 2012, it is expected that around €210bn of net new funding is available. Assuming the average sovereign issuance is at 5% and funding is 1%, there is a maximum potential for annual carry profits of €8bn per year or €24bn over 3 years.  Given that banks have to raise €115 bn of net new capital by July 2012, the annual €8bn is clearly a drop in the bucket. This partially explains why the bulk of the €210bn surplus (€167bn to be precise) was re-deposited with the European Central Bank (ECB) at rates of 0.25%. So, instead of positive carry from buying sovereign bonds, banks are prepared to earn a negative carry of 0.75% to keep their balance sheet (appear) strong. Perhaps this is simply a year-end effect and banks will bring their cheque books into forthcoming sovereign auctions as quid pro quo for all the liquidity and guarantees they have been provided.

As an example, LTRO requires banks to deposit quality collateral - although the ECB recently relaxed the rule so that even the proverbial kitchen sink could be repo-ed against LTRO.  Even so, it appears that some banks with balance sheets in the € trillions did not have unencumbered assets to pledge.  Some Italian banks, who have in total borrowed around €40bn in the LTRO, have cunningly issued bonds to themselves, had them guaranteed by the Republic and then pledged these with the ECB to LTRO. Not quite cricket, I hear you say, but then this is Europe - they don’t know the rules of cricket (or care for that matter). This is survival.

This should warn us that 2012 is going to be a scary year. In spite of all the liquidity injected into the banks, banks will remain focused on survival and unprepared to lend to main street in a material way. In fact, sovereigns are busy lending to banks who are lending back to the sovereigns. Main Street is not even in the picture. Instead of cash, expect bullish rhetoric from the sell side to keep the market afloat.

Welcome to 2012, the year history books will likely tell us that the ECB officially launched (Quantitative Easing Euro) QEu, the Federal Reserve conducted (Quantitative Easing Three) QE3, the Euro went to Parity, Greece was thrown out and the curtains finally came down on the single Euro-zone experiment.     

Following last week’s fiscal “lite” agreement in Brussels, markets are behaving like a cat with furballs – lots of coughing, gagging and then when you think something really bad will happen, reverting to a sense of eerie calm. With all the liquidity injected into the system, dealer desks anticipate no major bank default in the horizon. That said, they may be “talking their book” and with the headlines in Europe getting worse by day – punitive yields, substantial near term refinancing walls, political bickering, strikes – there is an impending sense of doom and gloom in this usually festive period.

The arithmetic around Europe is not inspiring. If your debt/GDP ratio is close to 100%, your funding costs are 6% and growth is predicted to be zero, then your debt can only go up – not down. If the markets refuse to lend to you or keep charging higher yields, you eventually go bust. The markets pray for Santa to turn up in the guise of the ECB and buy Euro-zone Bonds in size. This would transform default risk into inflation risk and we should see a spike in nominal value of risk assets. After all, inflation has been the chosen vehicle for solving debt crises of most governments since the early 20^th century, ironically coinciding with when the FED was created in 1913. The question you must ask is if the ECB or indeed the FED will come in with further QE at these market levels. Suspect they will wait for much lower levels and a greater sense of panic before they act.

If you believe we are in strange times so far as Europe is concerned, please see the chart below which shows bond yield spreads of the core Euro countries against Germany. Could it be that period 2000- 2008 was the outlier and these are more normal times?

I must be dreaming for it all looks so different or I have just woken up and everything before was a dream?

The ECB and the Eurozone governments have orchestrated a cunning plan that should support markets over the next few months. Last Thursday the ECB declined to buy Sovereign bonds in bulk, and instead delivered some key liquidity measures.  Interest rates were cuts, the collateral haircut was reduced and they agreed to accept a wider range of collateral (“kitchen sinks” may be acceptable).  This would make it easier for European banks to fund over the next 1-3 years.  On Friday a promise of a fiscal union was duly delivered, with potentially 26 of the 27 countries likely to ratify.  The UK has vetoed and left the table; although it is unclear if there was anything to veto in the first instance. More funds were allocated to the various acronyms - IMF, EFSF and ESM - which will support the Eurozone bond prices. The fiscal union should prevent the next crisis and adds a bit of firepower to deal with the current one. 

Even though there is no Bazooka solution, the technicalities of how this rescue might work showed up in a Bloomberg headline late Friday. The EBA (European Banking Authority) announced that BNP Paribas had sold $2bn of credit default swaps on France.  You may wonder who in their right mind would buy CDS protection on France from France’s largest bank. Surely if France were to default, the bank would default and the credit protection would not be worth the paper on which it’s written.  However, there are plenty of banks  that would participate on the other side of the BNP trade. Two theories abound as to BNP’s motives; the first is that banks are selling down their sovereign exposure and their related hedges, which would mean selling bonds and selling the previously bought CDS protection.  This could be driven by banks selling their Bond / CDS packages once they realized their bonds can be restructured without triggering CDS protection (as evident in the Greek restructuring).

The second, more likely, reason is that the “all or nothing” trade is back in vogue.  Banks can earn high Sovereign CDS premiums available by selling protection on their sovereigns.  If things go well, as the banks and governments will hope, spreads will tighten and they will make profits.  If sovereign spreads widen, it’s likely the banks’ credit spreads will widen further.  As such, the PV of the mark to market is unlikely to look too bad.  In the worst case, the banks will default; in which case the traders don’t really care anyway.   The regulators have given France a 0% risk weighting, so selling CDS on the sovereign does not require any regulatory capital.  It is possible as spreads widen they may have to post margin calls or take mark to market losses.  However, the cost of funds for banks (from the ECB) has been reduced to just 1%, and is expected to fall further.  There are similar stories of Italian Banks selling CDS protection to Italy.  As it stands, Italian Banks can currently borrow funds at 1% and buy five year Italian Bonds yielding almost 7%.  Risk On!

This is a roundabout way for convincing banks there is money in the “Carry Trade”. Borrow cheaply from the ECB and buy Sovereign Bonds and lock in the spread.  This could also explain why the ECB (for now) has resisted the idea of being the lender of last resort to sovereigns.  The reasoning must be that there is another leg to the panic (sometime next year) and they can preserve some of their options to tackle then. There is, however, no long term solution except to cut debt and shrink the economies. This is medicine that no politician can prescribe, so it will have to be left for the “invisible hand” of Adam Smith to do the job. 

Meanwhile, we have yet another crunch meeting on December 9 to “finally resolve” the Euro-zone crisis.  The proposal on the table is “fiscal union”, which essentially means that the Bundestag will analyse a country’s budget before its own parliament gets to vote on it. Ireland had a sneak preview this week of how this might work. The belief is that with a fiscal union in agreement, the ECB will bring out its bazookas to buy all sovereign debt and keep yields in check. Essentially, this means the ECB will print money like the US, Japan, Britain and China already does.

Interestingly, one of the proposals agreed during the Merkozy summit yesterday (December 5) was the decision not to “force” private sector bondholders to take any further write-downs on future sovereign bailouts. Two things come to mind; first, bondholders may still “volunteer” to take a haircut (visualize the scene from the Godfather when an offer “you cannot refuse” is made) and second, guaranteeing all sovereign debt was actually what blew up Ireland (Read Michael Lewis’s recent book, Boomerang). One of these days people might just figure out that cheapening the cost of funding is no solution to a problem of solvency. But for now, we party. 

Although it’s not over until the fat lady sings (in this instance, a rendition of Wagner’s Wedding March might be appropriate), we have come a long way from the days of Europe’s leadership blaming “irresponsible, greedy hedge fund traders for targeting (fundamentally sound) Euro debt”. In order to help them focus on finding a solution, the rating agency S&P has placed all the Euro-zone countries on watch for a potential mass downgrade (50% probability that a downgrade will happen in three months). This will certainly dissuade Germany and France to provide further guarantees or funds to the EFSF leveraged scheme (which was heralded as the grand solution all of four weeks ago). Notwithstanding the deep scepticism with which S&P is viewed by Europe’s leaders, it appears justified. Italy alone will have to issue up to a third of the €350bn it needs to raise in 2012, in the first three months.

Angela Merkel continues to resist the idea of a common Euro-zone bond as it increases the bailout burden on Germany. This has to be a bluff as the alternative would be an exit from the Euro. In addition to the utter chaos and years of dysfunction that a collapse of the Euro will bring to the financial markets, the return to a very strong Deutsche Mark (DM) would effectively kill Germany’s competitive advantage within and outside Europe in the long run.   

Recently, the debate around how much Germany should do has morphed into a concern over whether Germany itself risks being caught in the contagion. This follows a “failed” 10 year auction last week where only 65% of the supply was taken up*. If Germany is having trouble funding, how long will it be before the market stops lending to the US? After all, the US is more in debt than core Europe combined. Italy, Spain, France, Germany and the UK** have roughly $8trillion of debt, whereas the US alone stands at over $10trillion. It may well be that the “can” (of debt) that has been kicked around for the past few years has started to kick back. 

However, today, the markets are rallying strongly on rumours that the IMF will lend Italy some $600bn at 4-4.50% (well through their current market yields north of 7%) for a couple of years, to allow the EU leaders to put in place a longer term solution. For this rally to continue the rumour has to come true and there have to be concrete sensible measures from Germany for a viable Eurobond financing regime. If there is further dithering, we may well see a severe market puke that will drive risk asset prices down markedly. Given Ms Merkel’s reputation of shifting 180 degrees on a stated political position, this may well be on the cards. 

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*Last week’s failed Bund auction (where buyers bid for only 65% of the 10 years Bunds offered at 2%) was not an isolated event. In a typical German primary auction, the debt agency retains 15-20% of the debt all the time. Since 2008, Germany has seen uncovered auctions in one out of five times, however last week’s retention was larger than usual. Germany also does not grant dealers the “green-shoe” option that allows dealers to buy bonds at the auction price up to three days later. These factors indicate that “failure” is perhaps a harsh term to use for the auction results. Clearly the low yield of 2%, year-end concerns and general illiquidity also had a part.  

Given the mood of the markets and the media, the auction results have immediately been interpreted as the “credit crisis reaching Germany”. Stock markets across the world fell further, bond yields have risen across the board and the world was firmly in the “risk off” mode. This is how “fear” works—it not only makes you see the glass as half full, but makes you “feel” that someone else will drink the rest. Please bear this in mind as you start filling your mattresses with cash withdrawn from the banks.

So far, the “failed” auction has not led to a relative widening of German CDS spreads (with the UK). To the extent, Germany does not sign up to the Eurobond proposal or continually guarantees the Euro zone, bunds will likely remain safe haven investment.   

Source: IFR

**The UK technically is not part of the Euro-zone but a big fire in your neighbour’s estate is hardly going to stop outside your gates.

Having brushed past Italy and more recently Spain, the bond vigilantes have now targeted France. French yields have spiked over the past few days with five year CDS trading at 235bps (from a 157bps less than one month ago). Assuming a recovery rate of 50% if France defaults, the implied probability that France will default in the next five years is above 20%. 

The CAC 40 Index is down 15% since the euphoric highs of three weeks ago, when the grand Euro-zone solution was presented. Moody’s has recently warned France that if the Euro-zone heats up further, their AAA rating will be downgraded. S&P has already downgraded them once last Thursday (Nov 10).  “Oops”, they claimed later, it was just a test and the rating remains intact.

The only willing buyer of Euro-zone bonds, it would seem, is the ECB, although their intervention has been to the tune of €20bn weekly, a drop compared to almost €5 trillion outstanding debt of France, Italy and Spain. Frankly, it has always been about these three. The others, Greece, Portugal, Ireland combined have debt of €850bn and are now just noise in this problem. 

It seems eerily similar to what happened in 2008, same players, similar funding issues, different assets. You may recall the sub-prime issue was “resolved” by sovereigns recapitalising their banks (through borrowed money). Sub-prime debt became sovereign debt, which under Basel guidelines, was considered effectively risk free (i.e. no risk capital allocated). More recently, the European Banking Authority (EBA) has reminded us that sovereign debt is not risk free and requires haircuts.  

Who will bail the sovereigns out? The markets want the ECB to be the lender of last resort. Germany stands alone in refusing to allow this to happen – makes sense as they are the only apparent solvent entity left.

The EU agreement last week was applauded by the “risk on” investors with 4-6% rally in most markets. So are we on the way to solving the crisis or is this another example of kicking the can down the road?

The salient features of the announcement and a brief analysis are as follows:

• Bondholders to take a haircut of 50% on Greece Debt 
  
  • Outstanding debt was €200bn so that’s a €100bn relief to Greece. 
  • With the various predictive models that have been employed, it is now posited that Greece Debt to GDP ratio will come down to 120% in 8 years' time! Nod, if you believe this will happen.
  • ISDA has confirmed that as this haircut is “voluntary” (visualise the look on their faces as they read the statement, “I am delighted to confirm that I have decided to write down 50% of my loans to Greece out of the goodness of my heart”).
  • Previously the haircut was 21% and Greece had problems getting the 90% consensus they required to proceed with the plan. It does not take a genius to see that getting all the debt holders to accept a 50% haircut will not be easy.
• Banks to be recapitalised by €100bn plus by June 2012 take into account a mark to market of their sovereign risk books
  • Banks have the option of selling assets, raising more equity (through profits or rights issues), reducing lending, or a mix of the three.
  • Cunningly, some hybrid forms of capital will now count as Capital for this exercise, which will dilute the purpose of this exercise.
• The EFSF will be leveraged to become a €1 trillion plus SPV
  • The leverage will take place either through ESFS guaranteeing the first 20% of new debt issued by countries such as Italy (thereby providing a 5x leverage to the fund) or by setting up a new SPV with equity from EFSF and senior debt from the IMF, G20, Sovereign Funds and of course, China. 
  • The new SPV will in fact be a jumbo CDO.
  • Given that Italy is a founding member of the EFSF, it would partly be guaranteeing its own debt.

For now, markets are relieved that the Eurozone seems to be speaking with one voice and there seems to be plenty of (oral) support from G20, USA, and China. The devil will be in the detail. If you believe that a problem that has been created by borrowing too much money can be solved by borrowing even more money, you should be relieved. If you believe that market forces will see through this smoke and mirror charade, watch out: 2012 could well turn out to be a historical year which we would look back in years to come as the “Year the Eurozone blew up”.