Sunday 18 September 2011

A proposal for the ongoing European debt crisis involving debt compression.

How do you make four triangles with 6 matches? Most people instinctively think in 2 dimensions when the solution involves changing your thought process and switching to 3 dimensions.

The European sovereign debt crisis is of two levels:
-Current outstanding debt which is unsustainable given weaker growth for some peripheral countries, which will be impacted even more by austerity measures.
-Long term dynamics of debt levels and solvency issues.

The contagion we have seen to Italy and to some extent Spain recently, is directly linked to the amount, at least for Italy, to the considerable size of the existing Italian outstanding government debt stock.

The objective of debt compression is to simplify the outstanding exposures, reducing therefore credit risk, which is currently plaguing the European Financial system.
While I see it as alleviating funding issues in the near term for both sovereign countries and to their respective domestic financial institutions, it has to be part of a bigger plan involving Euro bonds.
The long term solution is a proper central treasury for Europe as proposed by some, including George Soros.

As a reminder:
European debt map:

European countries cross border exposure:

The process of European debt compression would consist in certain number of market participants voluntarily giving information to a 'compression institution' about their sovereign exposures.

About trade compression already existing and provided by vendors in the Credit Default Swaps space:
"Trade compression is the reduction of the notional amount of trades outstanding in the market, with particular focus towards the credit default swap market. Methodologies include index netting, tear-ups, and trade composting. The specific details of these methodologies are beyond the scope of this definition. However, in general, the process involves aggregating a large number of trades with similar factors such as risk or cash flow into fewer trades with less capital exposure.

Trade compression is a fairly new strategy with few applicable platforms prior to the credit default market crash. Since then the strategy has gained momentum with several competitors vying for the market leader position. Two of these companies, Markit and Creditex, seem to have taken the lead as they were selected by the International Swaps and Derivatives Association (ISDA) to create a platform to support trade compression. In August 2008, the joint effort was able to reduce the notional amount of compressible trades involving 14 dealers by approximately 56%.

Overall, trade compression is a promising strategy that is still in its infancy and with technology and regulation that are still in development."

In December 2010, I mentioned debt compression as a part of the solution for the current stock of debt and the interconnections between countries and financial institutions in the post "Europe - The end of the Halcyon day"

In May 2011, Anthony J. Evans, Associate Proffessor of Economics at ESCP Europe realised a study entitled - "The great EU debt write off". The study is available on - "The great EU debt write off". Thanks for ZeroHedge for pointing out this very interesting study.

It is the continuation of what I suggested back in December 2010, ESCP this time is doing a very interesting simulation on the exercise of debt cancellation.
In December 2010 I wrote:
"A way of reducing the burden of debt for peripheral countries, would be to create a European Compensation house and to do some debt compression. They would need to allow creditors to swap the debt of peripheral countries into more solid Euro-bonds issued at the ECB level, provided their is a haircut on the existing peripheral debt. Unfortunately the game of kicking the can down the road is still well alive with French and German politicians. At some point restructuring of the debt for some peripheral countries will have to happen."

The main findings of their simulation is as follows:

"• The EU countries in the study can reduce their total debt by 64% through cross cancellation of interlinked debt;
• Six countries – Ireland, Italy, Spain, Britain, France and Germany – can write off more than 50% of their outstanding debt;
• Three countries - Ireland, Italy, and Germany – can reduce their obligations such that they owe more than €1bn to only 2 other countries.

In addition the simulation revealed that:
• Around 50% of Portugal’s debt is owed to Spain;
• Ireland and Italy can write off all of their debt to other PIIGS countries, and Ireland can
reduce its debt from almost 130% of GDP to under 20% of GDP6;
• Greece can reduce their debt by 20%, with 60% owed to France and 30% to Germany;
• Britain has the highest absolute amount of debt before and after the write off (owed mostly to
Spain and Germany) but can reduce their debt to GDP ratio by 34 percentage points ;
• France can virtually eliminate its debt (by 99.76%) – reducing it to just 0.06% of GDP"

and the results are summarised in the table below:
Source ESCP May 2011 study.

The solution for European sovereign debt issues starts with debt compression as well as the implementation of Euro Bonds via a European central treasury.

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