Monday 30 July 2012

Paella Options

Once again July and August instead of being months of rest and sunbathing are becoming months of uncertainty and stress. Last year it was the Greek PSI. It seems so long ago but on the 21st of July 2011 the first PSI deal was stuck to save Greece at the expense of private bondholders. This year we have Spain. Sooner rather than later Europe would have to come to terms with the Spanish yields.

Spain bond pain?

We first had a hint that bondholders of Spanish bank debt may suffer losses. This is a significant change of position for the ECB. Draghi’s predecessor Mr Trichet vehemently opposed banks inflicting losses on the holders of their bonds (See Ireland). Now, it does not seem to be such a bad idea.  Forcing senior bond holders to accept losses would ease some of the money needs of the Spanish banks. It would also be according to the principle of private sector burden sharing that Germany insisted for Greece too.

Of course there is also the issue of the Tier1 equity instruments. There are about 67billion Euro worth of subordinated or hybrid capital bonds issued by Spanish banks. You know the ones. The Tier 1 perpetual with a step up call in. Those that were sold by investment banks back in the boom years as the best investment since Dutch tulips. Many are also structured with 10Y minus 2Y constant maturity swaps (10Y-2Y CMS).

Who owns these beauties? Well many have been sold to retail investors or private banking clients as they had huge profit margins. So, taking a haircut on these might not hurt European banks much.
Is this a precondition for recapitalizing the Spanish banks? We do not know. We can only suspect that this is one of the ideas. In an indirect way this is already happening. The buy-back of these bonds by the issuing banks at knock down prices has identical effect on the balance sheet of these banks. Greek banks did the same by buying back some of their hybrids.

Paella options

The market rejoiced at the recent comment by Draghi regarding action that needs to be taken. Let me repeat his words “These premia have to do, as I said, with default, with liquidity, but they also have to do more and more with convertibility, with the risk of convertibility. Now to the extent that these premia do not have to do with factors inherent to my counterparty - they come into our mandate. They come within our remit”. By “convertibility”, Draghi means, you guess it, exiting the Euro and reintroducing national currency. I guess the word “exit” is prohibited from the ECB vocabulary so an acceptable alternative had to be used to confuse us. So, if a country defaults, or wishes to exit the Euro, it becomes a monetary policy issue and thus ECB can act under its remit. In the same way they baptised the Greek SMP holdings a monetary policy instrument. We now have the basis of the excuse of introducing a massive buying program.

Speculation is rife that the ECB may restart the SMP with Spanish bonds on the menu. This is just one of the paella options that are available to Europe.
Let’s look at them:
  • ECB reincarnates the SMP. This can be done immediately as only a decision by the governing council of the ECB is needed. The aim would be to buy Spanish government bonds with a view to cap rates so that Spain can access the primary market at less penal rates. The ECB can do so if it receives adequate assurances that they would be economic structural reforms. The advantage of the ECB is that it can obtain these assurances verbally or in stealth. In other words Spain does not need to sign something like an MOU.  The problem with this approach is that it effectively subordinates every other bondholder as we saw in the case of the Greek PSI when the ECB refused to take losses. Perhaps the recent talk of OSI was aimed at reducing these fears by signalling that this policy is changing. i.e. The ECB is willing to take losses.
  • EFSF buys Spanish bonds. Again ever since the EFSF was given this additional mandate the option has not being used. The main issue with this option is the conditionality that would be placed upon the Spanish government as a necessary prerequisite.
  • ESM buys bonds and also becomes a bank. Putting aside the fact that the ESM is not in existence as yet, the idea is for it to become a bank. In doing so it would have access to the Repo operations of the ECB and thus almost unlimited firepower. This idea was most recently proposed amongst others by Novotny, the Austrian member of the ECB. Here again lies the same subordination fear but that aside one wonders why  go to such a convoluted solution when you can allow the local Spanish banks (say) to buy all the Spanish debt and repo it with the ECB.

So, in one way or another the solutions touted all involve official sector buying government bonds. The only difference is how the paella would be served. With conditions, with preconditions with postconditions or just in total panic.

End Game. 30Y 2% coupon

You may ask what is the end game with all this “official” buying of bonds. Are they trying to buy time so that they can force some political or fiscal union? The key word here is “force”. Political unions are supposed to happen out of free will not by force majeure. Pushing a union of unwilling states is a recipe for a disaster not a solution.
On the other hand there is a way out if you restructure the government bonds of Spain and Italy and any other state by invoking the principles used in Greece. Namely, L'etat c'est moi. This is the principle of all sovereign restructurings and Greece did not escape it. Very briefly, all the Spanish government bonds (and Italian) which are under local law become 30Y 2% coupon bonds. In doing so, they wipe out the entire deficit, they solve the funding needs and allow the banks who hold the bonds not to take losses as they place these bonds in the investment portfolio. It would be a NPV restructuring similar to the one proposed for Greece in 2011. In Greece it was a futile proposition but in Spain and Italy might just work.