Macro and Markets update - Peripheral debt - Rally Monkey!

Friday saw some massive tightening in the two years segment of Periperal government bonds:

Nope, not a typo, thanks to the European "n" plan to tackle the issues with Greek Sovereign debt in particular, and peripheral debt in general, 2 year Greek bonds rallied strongly by 614 bps when I took this snapshot. At some point they even rallied 800 bps! Portugal 2 year notes as well tightened by 184 bps and Irish two year bonds by 419 bps on the day.

On the 10 year segment for European Government bonds, the action was more muted:

Greek 10 year bonds tightened by 175 bps, Portuguese bonds by 72 bps and Irish 10 year bonds by 44 bps.

On the Sovereign CDS space, the action was more radical on the 5 year segment, the most liquid part of the market:
5YR CHG U/F
GREECE 1440-1650 -250 bps tighter      upfront market quote 39/42
SPAIN 305/315 +2 bps wider
IRELAND 850-900 -40 bps tighter                   
PORTUGAL 880-940 -10 bps tighter                   
(source, one dealer run).
The all time high for Greece was 2,568 bps on the 18th of July.

Credit Indices as well were tighter accross the board:

From its recent high of 309 bps, SOVx index has now tightened to 260 on the year point which is not surprising given the tightening move we have seen for some of its members (Greece, Portugal, Ireland).

According to Fitch, Greece, faces a "Restricted Default" following the meeting held on the 21st of July which comprise a new plan of 159 billion euro. It requires private bondholders to assume part of the cost. The proposed plan implies a 20% net present value loss for banks and holders of Greek Government debt.
The new plan is made of 109 billion euros from the Euro-zone and the IMF, and 50 billion euros coming from financial institutions, with bond exchanges and buy backs, which is expected to reduce the debt burden for Greece. The EFSF 440 billion euro fund will be able to buy debt accross the peripheral countries and aid troubled banks with credit-lines.

So, will we have a credit event, triggering pay-off for Greek Sovereign CDS protection holders?
The International Swaps and Derivatives Association said participation of private bondholders in the Greek rescue plan "should not trigger credit-default swaps" because it is "expressly voluntary" according to David Geen, ISDA's general counsel in London.

More on the new European plan:
Greece will receive loans from EFSF at rates close to swap rates but not below the EFSF funding costs (expected to be around 3.5% - 3.7%) for 15 years or longer. Coupon will therefore be lower on bonds, and the maturities extended. This is indeed more positive given that the average interest rate on all debts will be lowered, which will imply Greece to run a smaller primary surplus to stabilise its debt. Overall its alleviates the debt pressure on the Greek economy, but doesn't fully resolve the solvency risk.
In relation to the EFSF size, markets are already questioning the fact it has not been increased to keep the fund in a position to rescue Spain if needed.
The big unknown in the new plan lies in the private participation rate which is assumed to be as high as 90%. Nothing, so far has been explained on how this participation rate will be achieved.

It is another successful "kicking the can dow the road" solution. It doesn't fully address necessary debt relief in the near future, but tries to avoid at all cost a triggering of sovereign cds payments by involving the private sector in a "voluntary" way with the support of ISDA (so much for buying CDS for an accident which is happening, but is not "really" happening since the private sector is willing to participate...). Conclusion, when you don't like the rules relating to credit events, just change the rules...

Moral of the story: "If you can't win the game, change the rules".





 

Europe - The end of the Halcyon days

"Hi, I'm a _______ (add country) and I'm addicted to credit."

Greece, Ireland, now Portugal:
Banco Comercial Portugues SA (SUB) 5 Year CDS:
1472 bps +194 bps on the 6th of December +15%
Banco Espirito Santo SA (SUB) 5 Year CDS:
1467 bps +137 bps wider on the 6th of December +10.36%

These were the levels we had on the 22nd of November as published in the post Dominos in Europe:

From the 22nd of November until the 6th of December, Banco Comercial Portugues SA (SUB) 5 Year CDS has moved from 974 bps to 1472 bps, a mighty 51% increase. Banco Espirito Santo SA (SUB) 5 Year CDS, has moved from 974 bps as well to 1467, similar widening of 51% of the spread.

Any similarity with what has happened with Irish Banks Sub CDS 5 Year, which jumped above 1000 bps in September, would be of course be purely fortuitous...

Italian Financials SUB Cds are widening as seen on the 8th of December:

By accepting too early to guarantee its banking system, Ireland sealed its fate and part of its Sovereignty to Europe and the IMF. Private debt from the dodgy Irish banks have been in fact transferred to the Irish taxpayers. The Black Hole in the Irish banking system is too strong to resolve the outstanding issues as I pointed out back in November (The Irish Black Hole).
According to Dr Constantin Gurdgiev in his last post, the bailout package won't be enough to save both the Irish budget and the Irish banks. Something will have to give:
Economics 6/12/10: IMF stress tests for Irish banks
"It appears that the IMF was either not given the full realistic picture of the Irish banks balance sheets, or it is seriously underestimating the demand for future losses cover in the banks."

"Either way, the numbers continue to suggest that the €67 billion package of loans will not be enough to provide simultaneously a cover for Exchequer deficits and the funds required to underwrite losses and capital requirements of the banks. Somehow, the Irish Exchequer will have to make up for this shortfall."

Either bondholders of Irish banks debt agree take a haircut on both the sub and senior debt, or the Irish Goverment will have to cut more spending, which means more austerity for the Irish people.

On the 9th of December Fitch downgraded Ireland to BBB+ from A+, which automatically means a downgrade for Irish banks as well.

The Dominos keeps falling in Europe and France will also have to face the music at some point.
"France 'next' in Euro debt
firing line" by Hysni Kaso, 6th of December.

"The country's deficit is much, much higher than anyone realises. My view is that the markets are not prepared to finance it any more unless there is serious, structural reform. No one, not even France, can hide anymore."

These were the comments made by Xavier Rolet, CEO of the LSE. Mr Rolet is right, Germany has made great stride in implementing structural reforms which are today paying off (GDP growth, lower unemployment) whereas France has postponed structural reforms for too long. Time is running out.
France is a difficult country to reform. We have recently witnessed the difficulty, with the strikes and demonstrations relating to the increase in the retirement age from 60 to 62 then 67, when, it had already been set at 67 in many European countries.

France, like many other European countries has kicked the can down the road for to long, and now is running out of road. Structural reforms are needed, but given the looming presidential elections coming in 2012, don't expect any radical reforms in France anytime soon.
The solution for Europe is binary, it is either further integration or disintegration.

Peripheral Europe which is now the politically correct term for PIIGS, represents 17% of Pan-European GDP. Core European banks have 900 Billions USD in peripheral Europe. The ECB now owns or repo 350 Billions Euros of peripheral bonds. A nice transfer from the private hands to the public hands.

Although peripheral Europe is still sinking, macro fundamentals are very good for the likes of Sweden, Germany and Norway, to name a few.

The German economy expanded 3.90 percent in the third quarter of 2010:

The Swedish economy expanded 6.9 percent in the third quarter of 2010.

The major difficulties of the ongoing crisis is due to the characteristic of this recession being a balance sheet recession. In the post "Honey I shrunk the balance sheet", I indicated that in a balance sheet recession, and due to the amount of excess, the deleveraging process is a slow and painful and the road to repair households balance sheet is indeed a very long one. In previous recoveries, the GDP growth following a recession had been much more pronounced. Due to the nature of this particular nasty recession linked to the housing bubble, the recovery is at a much smaller pace as we can see in GDP growth figures in many countries.
What is making the crisis as well more acute in Spain, Portugal and Ireland is the high private sector leverage to GDP compared to other countries: Above 150% for Portugal, around 220% for Spain and close to 300% for Ireland.

The Euro can survive provided there is stronger integration and a tougher approaches to structural issues. France and Germany led the European project from the start. Germany seems to be left on its own to drive the project forward, given the lack of progress of reforms so far in France.

Jean-Claude Juncker and Giulio Tremonti's proposal was an interesting one.
So far both Germany and France are refusing the idea of issuing Euro-bonds.
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.

Owed to Germany:

Countries Cross-border bank exposure:

A run up to the second leg down...and no this time it is not different.

Back in December I highlighted that the theme for 2010 will be sovereign risk and I was also indicating the headwinds facing Greece in particular and the PIIGS in general. Yet the rally runs unabated in the equity market and credit spreads are tightening still, although major structural issues have barely been addressed.

In a previous post as well I encouraged readers of this blog to track the CRB index as I was expecting commodities to surge higher as the "recovery" (which should be rebranded inflation) is gathering pace.



Gold is trading at record level again and oil is also trading much higher. The surge of Oil will have some consequences on the GDP growth. It will start to be a drag before becoming a threat.

At the same time VIX has dropped significantly.



At these levels, VIX is getting my attention and a long dated ATM call option is looking more and more attractive as I expect a volatility spike in the very near future, this summer most likely.

And by the way 42 banks have failed in the US this year so far according to the latest count on the FDIC list of failed banks:

http://www.fdic.gov/bank/individual/failed/banklist.html

What are the structural issues that needs to be fixed and what are the current threats:

-"Too big to fail" is not acceptable for banks.
Hedge funds can fail and it happens (this what capitalism is all about) and apart from LTCM it hasn't been disruptive to the markets. Banks are not hedge funds and should not be allowed to act like ones using deposit money.

Glass-Steagall act should either be re-enacted or a reduction in leverage should be enforced. The taxpayers and goverments cannot afford bailing out the financial system anymore and in many parts of the world, it is seriously crippled. In Ireland for instance, the situation for Anglo Irish Bank isn't great to say the least and they need additional injection of capital directly from the government to shore up their core capital and tier one ratio which has been seriously impaired by the hits they have taken on their loans. The level of their NPL (Non Performing Loans = really bad property loans...)is staggering: 11 billions of Euros, of which 4.2 Billions of Euros have already been provided. AIB’s equity core tier 1 at the end of 2009 was 5 per cent, excluding the 3.5 billion euros of preference share investment done by the Irish government previously!

Ireland’s “bad bank” — the National Asset Management Agency (NAMA) is initially removing 16 billion euros of bad loans from three of the five Irish participating banks to purge their balance sheet.
An estimated 80 billions Euros of bad loans will eventually be transferred by September
The Irish taxpayers will be picking up the tab for the next 7 to 10 years it will take to clean up the mess...

-OTC products in general and CDS in particular: they should be cleared on exchanges -period. It would reduce counterparty risk as well as adding liquidity and transparency.

-Senator's Chris Dodd proposed bills at the US Congress for the FED are purely and simply dangerous and seriously threatening the already impaired independance of the FED.

http://www.bloomberg.com/apps/news?pid=20601087&sid=ar1GEW82NxDU

-Greece, the tip of the Iceberg.
1999 rating of Greece before joining the Euro: BBB+
9th of April 2010: Greece rating according to Fitch is now BBB-
The end of the game is approaching fast, similar to Lehman's situtation prior to its demise, Greece is experiencing massive capital flight from its banks, 10 billions euros have already been pulled out of Greek banks. Unsecured consumer borrowings for Greek banks has increased from 10% in 2003 to more than 20% today as a percentage of household disposable income (this figure is 23% in the US). Although Greek banks, have better tier one ratios than their Irish counterparts, the capital flight they are experiencing is fast and furious and doesn't bode well for their funding needs. Always remember that the banking industry is a leveraged play intensively correlated to the economy it is operating in and given the GDP contraction Greece has experienced and the state of the public finances, their fate is linked. Before Fitch's downgrade on Greece, National Bank, EFG Eurobank and Alpha Bank's ratings where BBB neg according to Fitch. You can expect Greek banks to be downgraded as well.
It is truly a Greek tragedy.



-United Kingdom upcoming elections: Conservatives need a clear majority, markets would react negatively to a hung parliament which could slow down much needed spending cuts and hurt even more the GBP. Soros is now talking about devaluation being an option for the UK government recently at a conference organised in Cambridge. It could be effective in reducing the debt burden, boosting exports in the short term but inflationary in the long term which would mean rates hikes down the line.

The importance of being earnest, about the Eurozone in general and the Euro in particular

The Unknown
As we know,
There are known knowns.
There are things we know we know.
We also know
There are known unknowns.
That is to say
We know there are some things
We do not know.
But there are also unknown unknowns,
The ones we don't know
We don't know.

—Donald Rumsfeld, Feb. 12, 2002, Department of Defense news briefing

Another change in perception this week, to follow up on my article about the Dubai mirage. This time, Greece in particular and the Eurozone in general!

On Tuesday, Fitch Ratings Inc. cut Greece's rating to BBB+ with a negative outlook and it unnerved the markets.

Markets once again have a short memory. BBB+ was the rating for Greece before the introduction of the Euro in 1999.

http://www.fitchratings.com/shared/sovereign_ratings_history.pdf

Greece managed to fiddle with its stats to get in the Eurozone and benefited from the cheap funding available to all members of the coveted Euro currency. We all know what happened to Spain, cheap funding generated a massive real estate bubble and when it went tumbling down Spain's employment rates went through the roof (Spain unemployment level will rise to 22% in 2010 and some Spanish regional banks are still sitting on hefty losses). Eastern European citizens also played a dangerous game, borrowing in Euros or CHF. All these "cheap" loans went badly wrong when Eastern European currencies had to be devalued as the GDP in these countries dropped like a stone.

As any form of peg, the Euro, although a safe haven for many, has now become some countries worse nightmare. As Greece cheated it's way it, Greece is now facing great troubles as it cannot cheat its way out by massively devaluing its currency and reduce therefore the debt to GDP percentage which currently stands at 110%.

Greece 5 year CDS (232.19 Bps on the 5 year point, source CMA DataVision) is now trading above Turkey 5 year CDS and the spread of Greek debt versus 10 years German Government bonds (Bund) is trading at level not seen since 1999...

I remember a conversation I had with a trader back in 2005, about the spread between 10 years German Bund and 10 years Italian BTP. At some point the spread between both was around 22 bps. This was abnormally tight and at the time I thought it was a fantastic bet to put on and a very simple one: betting that the spread would go back to where it was before the introduction of the Euro, above 120 bps. It did happen. Now the spread has come back to the 60bps level. I don't think that in the near future it will stay there.

The virtues of joining a single currency doesn't coincide with the vices of some European governments, who issued more debt and ran larger and larger budget deficits. It is a game you cannot play forever unless you can devalue and make your own citizens poorer in the process, which used to be a regular tool used by Italy before joining the Euro.

When I hear Mrs Christine Lagarde saying the following: 'I don't think Greece could go bankrupt,' on RMC radio. I have to disagree.

David Einhorn, who is President of Greenlight Capital, was cited in a recent letter published by John Mauldin' in the excellent "Outside the box" on the 26th of October
Here is an excellent quote relating to Mrs Lagarde foolish statement: "To slightly modify Alexis de Tocqueville: Events can move from the impossible to the inevitable without ever stopping at the probable."

Even France is increasingly at risk. The last time France had a balanced budget was in 1980. Since then, the government has been spending more than it has been collecting and the service of the external debt (payments of the interest only), is not even covered by the receipts coming from the income tax.

As per a Reuter article published today:

http://in.reuters.com/article/rbssFinancialServicesAndRealEstateNews/idINGEE5B80FO20091209

She also said that French debt was popular in financial markets but France would continue to take care to ensure that there was not threat to its credibility.

"By comparison to our partners we are very well rated," Lagarde said. "So France's signature is good. The market likes our paper and we are extremely determined to be very careful to the way we issue."

Asked about the potential size of a new loan that President Nicolas Sarkozy is planning to fund investment projects, Lagarde said: "It must be a figure which does not raise questions about the quality of France's debt signature."
It is once again all about maintaining at all cost perception that everything is fine.

Well, things are not fine.

Because of the euro, governments cannot cheat at the moment by devaluing their currency. France had three devaluations in 1983 as a reminder.

Italy used to regularly devalue the Lira before the introduction of the Euro.

Could Greece or Italy leave the Euro?

For those who would like to evaluate the probability of this event, please find enclosed the link to two very good articles:

One written by Nouriel Roubini on the subject in 2005.

http://www.rgemonitor.com/roubini-monitor/92824/what_happens_if_italy_dumps_emu_and_the_euro_devaluation_default_and_lira-lization_of_euro_debts

The other I recommend reading is the excellent article written by Macro Research House Gavekal on the subject written as well in 2005.

http://gavekal.com/dforum/attach.aspx/51/divorceitallianstyle.pdf

For those who would like to track sovereign risk in the CDS markets, please use the following useful link:

http://cmavision.com/market-data/#riskiest

The CDS market is a good indicator of the perception of risk for both corporate risk as well as sovereign risk.

It is also a very good indicator of possible movements in the equity markets. The equity market took many months to react to the widening of the CDS markets which started in August 2007, following the blow out of the two Bear Stearns Structured Credit Funds, which marked the beginning of the subprime crisis.

We have moved from a financial crisis to an economic crisis and now a sovereign crisis.

To conclude:

Yes, countries can go bankrupt and can go from being very rich to very serious distress. Markets have short memory, and so do Finance ministers...and particularly French ones as well.

Maybe Mrs Lagarde should study the history of Argentina which increased in prosperity and prominence between 1880 and 1929, and emerged as one of the 10 richest countries in the world at the time before completely crumbling down.

In our next episode we will revisit my central theme about perception and facts about the current economic situation.

I will leave you with a final quote from the movie The Matrix from 1999, year of the Euro as an appetizer for my following post

Morpheus: This is your last chance. After this, there is no turning back. You take the blue pill - the story ends, you wake up in your bed and believe whatever you want to believe. You take the red pill - you stay in Wonderland and I show you how deep the rabbit-hole goes.