Wednesday, 16 June 2010

The writing is on the wall...

Sovereign CDS for Spain is now trading at 257 bps for 5 year, and Portugal has now joined the highest default probabilities list from CMA DataVision. Portugal 5 year CDS trades at 312 bps. The cumulated probability of default for Portugal now equates 22.91%.

Greece Sovereign CDS is trading at 835 bps for 5 year, with a CPD (Cumulated Probability of Default) of 49.72%, just behind Argentina, which trades at 1073.17 bps and has a CPD of 50.06%.

Greece is not like Argentina, it is in a worse shape.

In this post, we will look at some solutions coming from the man who was at the helm of Argentina's finances in 2001, Domingo Cavallo as well as leverage still in the system and the ongoing discussions around banking reforms.

Domingo Cavallo, the fomer minister of finance of Argentina gives a good analysis of what should be followed by Greece, Spain and Portugal to restructure their economy:

"Greek debt woes could spark contagion within and beyond Europe. Argentina’s former finance minister and co-author draw four lessons from Argentina’s crisis: devaluation/exit is not the answer; orderly debt restructuring involving a ‘Brady Plan’ now is better than a disorderly one later; fiscal consolidation that improves external competitiveness is a must; all these must be done simultaneously."

Domingo Cavallo gives in this article make some good points on what should be done:

Three Lessons
"The main lessons for Greece stemming from Argentina are, in our opinion, as follows. First, devaluation (exiting the eurozone) is not the answer, particularly since the post-crisis world outlook is unlikely to be as benign with Greece as it was with Argentina. Re-adopting the drachma and letting it fall in value relative to the euro would cause a sharp deterioration in the balance sheets of both the government and the private sector. On the other hand, a forcible conversion of euro-denominated financial assets and liabilities into drachmas (a replication of what Argentina did in 2002) would, in all likelihood, set in motion a perverse devaluation-inflation spiral, as people would want to substitute away from drachmas into euros to avoid losing purchasing power if they stay in drachmas.

Second, any sovereign debt restructuring must be planned and executed in an orderly manner, with bilateral discussions between creditors and debtors, and with an active support from the international financial organizations, both in Europe and Washington DC (i.e., the IMF). These organizations can get more bang for their bucks if instead of trying to bailout Greece’s creditors over the next two years, they use their limited financial resources to enhance, a la Brady plan, new bonds that are swapped for the old ones in exchange for haircuts in principal, interest or both. A default followed by unilateral and incomplete debt restructuring several years later, as done by Argentina in the previous decade, would be the wrong model to follow.

Third, there must be fiscal consolidation. But, this cannot be limited to cutting spending and raising taxes. It must also include fiscal measures designed to improve external competitiveness so as to ease the fiscal adjustment.

Last but not least, the three ingredients of the recovery plan (fiscal consolidation, debt restructuring, and the enhancement of competitiveness) must take place simultaneously."

Furthermore, Domingo Cavallo raise a very interesting point in relation to VAT versus Payroll Tax:

"In a previous article, we suggested that Greece could achieve the same effect on competitiveness that could be achieved under a 20% real exchange rate devaluation by raising the collection of the value added tax (VAT) while simultaneously reducing payroll taxes. We think that this is an idea that merits consideration not only in Greece, but also in Portugal and Spain. Given the importance we give to this subject, we devote the rest of this note to explain our proposal in more detail.

One characteristic of taxation in many countries—typically in Continental Europe, but also in Latin America and other regions—is that payroll taxes, which finance social security, are extremely high (see Table 1). Of course, this is due to the fact that social transfers are also very high. However, there is no reason why these transfers have to be financed by payroll taxes, especially if there is room to increase other, more neutral, taxes.

Take the VAT, for example. Unlike payroll taxes, which are levied on labour income, the VAT is levied on final consumption. This has two main advantages: it promotes formal job creation and it stimulates private saving. In countries like Greece, Portugal and Spain, this can kill three birds with one stone by helping to reduce unemployment, informality in the labour market, and the current account deficit. Furthermore, the fact that the VAT is levied on final consumption and not on investment or exports (capital goods purchases are deductible as VAT “credits” and exports are tax exempt) makes the substitution of VAT for payroll taxes a competitiveness-enhancing tool. As such, it is like devaluing the local currency, but without the inflationary pass-through to domestic prices or the disrupting balance sheet effects."

In addition to these proposed measure, one could also argue that Spain need to drastically reform its labour market which is critically hindered by its very rigid system.

Many economists blame the high jobless rate in Spain on the high cost of firing workers. This makes employers quite reluctant to hire staff and encourages the use of temporary contracts that have few benefits and rights. 24.3 % of Spanish employees are currently on temporary contracts.

In Spain, workers on full contracts are entitled to severance pay of as much as 45 days per year worked, one of the highest levels in Europe. Under the Spanish government reform it would be reduced to 33 days for some contracts.

Although the Spanish government is pushing ahead with the labor reform plan, it has so far failed to calm markets as reflected in the continuous widening in Sovereign CDS spreads.

Spanish 10 year bonds yielded an all time high against the German 10 year Bund today at 4.87%. This is 2.23% more than German 10 year Bund.

Three-month dollar libor rates rose to an 11-month high of 0.53894% , while euro rates edged up to 0.65563%, exceeding levels reached last week to set a six-month high.

The situation for European banks is getting difficult as highlighted by Georges Soros comments in this article from Reuters:

"European banks had bought large amounts of the sovereign bonds of weaker euro zone countries for a tiny interest rate differential, Soros said.

"That's one of the reasons why the banks are so over-leveraged and why the German and the French banks own Spanish bonds," he said.

"Now ... they have a loss on their balance sheets which is not recognised and it reduces the credibility of those banks so the banking system is in serious trouble," he said.

"The commercial paper market, for instance, in America is now refusing to lend to European banks so there is even a funding crisis and the ECB (European Central Bank) has to step in and the banks are unwilling to lend to each other," he said."

European banks are getting punished for their greed in trying thier quest to capture more yields on riskier government bonds.

Too much greed can be dangerous because it clouds good judgement and good risk management. We have already witnessed the devastating results in the US where the hunt for yield (due largely to Alan Greenspan's low rates environment) led to the financial debacle. Investors in supposedly AAA securitized products (CDOs, etc.) showing promising yields, were wiped out.

A report published by the BIS reviews the role leverage played in the crisis:

"Leverage in structured products and the US housing market downturn
Structured credit products referencing US subprime mortgages exposed investors to much higher leverage and losses than the stress scenario modelling they performed had implied. First, an investment in a subordinated tranche of a subprime residential mortgage-backed security had a leveraged exposure to the underlying subprime mortgage loans (embedded leverage).
Second, re-securitisation compounded the multiplier effect of embedded leverage. For example, mezzanine tranches of mortgage securitisations (which themselves have embedded leverage) were often purchased by CDOs, which in turn issued senior and subordinated tranches, creating additional leverage on top of that embedded leverage in subordinate tranches.
The magnitude of this embedded leverage was estimated by investors with models using assumptions about the likely future path of house prices. Hence, investors could not always be certain about the degree to which their exposure to the mortgage market was leveraged at the time of investment. When delinquency assumptions associated with subprime mortgage securitisations of 2005–07 proved to be far too low, the leverage and losses experienced by investors were much greater than anticipated."

Now European Banks are sitting on hefty losses on their balance sheets, because of their exposure to the weaker parts of Government bonds in Europe. So much for good risk management...

In addition to this behavior, leverage in some European Banks is still higher than their American counterparts which went through the painful process of deleveraging and had to raise massively capital to shore up their impaired balance sheets.

“In the early days of banking, liability was not just unlimited; it was often as much personal as financial. In 1360, a Barcelona banker was executed in front of his failed bank, presumably as a way of discouraging generations of future bankers from excessive risk-taking."

Bank of England Financial Stability executive director Andrew Haldane

"From the earliest times, the relationship between banks and the state was often rocky.
Sovereign default on loans was an everyday hazard for the banks, especially among states vanquished in war. Indeed, through the ages sovereign default has been the single biggest cause of banking collapse. It led to the downfall of many of the founding Italian banks, including the Medici of Florence."

Andrew Haldane describes as well the current issue with State Support:

State support stokes future risk-taking incentives, as owners of banks adapt their strategies to maximise expected profits. So it was in the run-up to the present crisis. In particular, five such strategies were clearly in evidence:

• Higher leverage: The simplest way of exploiting the asymmetry of payoffs arising from limited liability is to increase leverage. For example, if the capital ratio of the hypothetical bank were to halve from 10% to 5%, the beta of the bank’s equity would double (Figure 2). In that event, the imbalance between privatised gains (above the zero axis) and socialised losses (below the zero axis) would increase. Private investors would harvest more of the upside and export more of the downside.
There is clear evidence of this strategy being pursued over long sweeps of history.
UK banks migrated North-West over the past ten years, with balance sheet expansion financed by higher leverage. Because UK and European banks were not subject to any regulatory restriction on simple leverage, there was no effective brake on this leverage-fuelled expansion.Higher leverage fully accounts for the rise in UK banks’ returns on equity up until 2007. It also fully accounts for the subsequent collapse in these returns.

The high-leverage strategy pursued by UK and European banks rather effectively privatised gains and socialised losses.
• Higher trading assets: An alternative means of replicating the effects of higher leverage is to increase the proportion of assets held in banks’ trading books. Trading assets are marked to market prices, thereby increasing their sensitivity to aggregate market fluctuations (beta). To illustrate, assume that a bank holds 90% of its assets in the banking book (with a beta of zero) and the remainder in the trading book (with a beta of one). That gives an asset beta of 0.1 and an equity beta of unity (Figure 1). But if the size of the trading book is doubled to 20% of assets, this doubles the equity beta of the bank."

Andrew Haldane also indicates how to reduce the risk taking habits for banks in his paper

What options best tackle excessive risk-taking incentives? A number suggest themselves, some modest, others more radical.
• Introducing leverage limits: One simple means of altering the rules of the asymmetric game between banks and the state is to place heavier restrictions on leverage. European banks were not subject to a regulatory leverage ratio in the run-up to crisis. They exploited that loophole. Closing it would bring about a clockwise rotation in banks’ payoff schedule, lowering the beta of banks’ equity returns and reducing risk-taking incentives.This is an easy win. Simple leverage ratios already operate in countries such as the US and Canada. They appear to have helped slow debt-fuelled balance sheet inflation. The Basel Committee is now seeking to introduce leverage ratios internationally. To be effective, it is important that leverage rules bite. They need to be robust to the seductive, but ultimately siren, voices claiming this time is different. That suggests they should operate as a regulatory rule(Pillar I), rather than being left to supervisory discretion (Pillar II)."

Finally to conclude this post, relating to Bank reform, Andrew Haldane in his excellent paper says the following:

"Events of the past two years have tested even the deep pockets of many states. In so doing, they have added momentum to the century-long pendulum swing. Reversing direction will not be easy. It is likely to require a financial sector reform effort every bit as radical as followed the Great Depression. It is an open question whether reform efforts to date, while slowing the swing, can bring about that change of direction."

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