Monday 31 October 2011

Leveraging the EFSF

Although there are no definite details of how and when the EFSF would be leveraged there are some hints that allow us to make some initial points (EFSF website, EU statement). In a strange quirk of fate, the EU is now seriously contemplating using almost exactly identical financial gimmicks and structures that it accused of bringing the world economy to the brink of extinction. i.e. SPV’s, CDS’s, CDO’s, leveraging toxic mortgages and credit slicing. Instead of mortgages, we now have peripheral debt and instead of CDS we have EFSF certificates, and EFSF controlled SPV’s.

EFSF Pool of money
The initial pool of money allocated to the EFSF was 440bln. However, as more countries are raised to the pig status this has come down. Current estimates are around 250-290bln. The uncertainty comes from the fact that the EFSF would be called to recapitalise Banks if the respective Bank and country fails to raise it.
EFSF leverage
According to the not so clear EU communiqué the EFSF would be allowed to leverage the remaining amount of cash 4 to 5 times and this is how the 1trl figure is achieved. This leverage is going to be achieved using two different options:

Friday 28 October 2011

The Thrill and Joys of Free Riding

Despite the EU statement’s vagueness on Greece, this new communiqué reiterates is the idea of the voluntary character of the PSI exchange and that the ECB will be exempt from participating.
While politicians muddled through the response to the Greek Crisis over the last 2 years, the ECB was forced over to engage in unorthodox monetary operations in order to firefight the European debt crisis. Part of it involved the activation of the Securities Market Program whereby the ECB purchased outright Government bonds of Greece, Ireland and Portugal and more recently Italy and Spain.
Although the ECB is no longer buying Greek Bonds in the secondary market, it is estimated that it still currently owns around 45billion worth of Greek bonds. Most market participants believe that the great majority (around 75%) is concentrated in the near maturities, namely 2012-2014. These bonds however, are not marked to market by the ECB but instead they are marked at the purchase price and amortized to Par. If the ECB participates in the current PSI proposal, the remarking of these bonds to their true value would result in a huge loss on their position. We guess-estimate that the average purchase price of its Greek bond holdings was around 78%.  Assuming they are marked at the purchase price, the losses would exceed €12bn and would be larger than the ECB €10.8bn of equity, forcing the ECB to raise capital from its shareholders (National Central Banks). However, as they are marked at Purchase price plus amortization to Par, the losses would be even greater if the ECB is forced to take a 50% cut on their position (18-20billion). Hence, the insistence of the ECB in exempting herself from any Greek restructuring. According to press reports the ECB tried to offload their holdings to the EFSF back in March but the European leaders refused the request. Apparently, Jean Claude was not pleased and henceforth hardened his stance towards the politicians who got him into this mess.

Greek Banks never had a choice. Bloomberg article

“Greek banks never had choice on whether to buy Greek bonds, and they’re now being punished,” said Andreas Koutras an analyst at InTouch Capital Markets Ltd., a fixed-income adviser in London. “It is possible equity valuations will go to zero.”

Full Bloomberg article

Thursday 27 October 2011

Preliminary thoughts on the EU statement on Greece

Finally the European political leaders seem to have reached an agreement on how to deal with the debt of Greece and the one brewing in Italy, Spain and France.

Although the statement issued by Europe is at places vague, the main points that can be discerned with regards to Greece are as follows:
  • The haircut would be 50% and it would voluntary. The fact that they still insist on a voluntary agreement is significant and important. The CDS may or may not trigger, but this is the least of our concerns. This is purely an ISDA decision that would predominantly affect the CDS market. The main point is that any voluntary exchange would place Greece under Selective Default and not under default thus avoiding the nasty side effects of bankrupting the Greek banks and pushing the country into a limbo state needing drip-feeding for months. 
  • The statement excludes ECB holding. 
  • The programme would contribute 30bln towards the PSI. The statement refers to “a voluntary bond exchange with a nominal discount of 50% on notional Greek debt held by private investors”. We take this to mean a reduction on the face value of the bonds, but we reserve full judgement until we have more information or clarification from the EU. 
  • It further stipulates that the objective is to reduce the debt to GDP by 2020 to 120%. There is a clear reference to “a Greek” monitoring and implementation. This is to allay fears of loss of sovereignty. Given however, the hitherto inability and inadequacy of the Greek government to enforce and implement much of what has been agreed this may be altered on the ground. There would be yet again a new Memorandum of Understanding.
With regards to the 50% haircut and whether it is on the Notional amount or the NPV we have:
NPV haircut.
The statement refers to the “notional held by private investors” and this may mean the amount rather than the face value. For this reason we examine the NPV case.
A haircut of 50% on the Net Present Value could be achieved if for example you reduce the average coupon on the PSI proposed options by 2% and lower the guarantee to 50% from 100%. In this case the 30bln that the statement refers to as a contribution to the PSI is roughly what is needed for the stock of Greek bonds. In other words, if all 177bln of outstanding Greek stock (excluding the ECB) is exchanged into a 30Y bond with only 50% AAA guarantee, Greece would need to purchase close to 29billion worth of a zero coupon (depending on where they mark the 30Y rate).
Accounting wise though the reduction in the debt to GDP from the matching of the Asset (zero coupon) and the liability (30Y bond) would only be around 56billion. Thus day one after the exchange Greece would owe around 136% and given time to 2020 this could fall to 120%. The problem however, is that Greece would also need to start servicing this debt, day one. At an average of 2.5% coupon this would mean 5billion on interest only a year. Greece unfortunately still runs a primary deficit of around 2.5billion and it would be very difficult to meet this without further external assistance or grace period.
Notional reduction
A 50% reduction on the face value of all outstanding stock would reduce the debt by 88.5 (50% of the 222 of stock-45 of ECB)billion would reduce the debt to GDP to around 124%, day one. As we have no details of how the new bonds would look like or what form the principal guarantee (if any) it is hard to evaluate it.
Combination (Face reduction, 15% cash, NPV loss)
A combination approach is the other possibility. Namely, a reduction in the face value of the bonds with a simultaneous NPV write down on the new bonds and possibly a cash payment of 15%. This was leaked a couple of days ago as an alternative. Again, the 15% cash payment or 26billion on the 177 billion (222-45) of outstanding Greek stock in Private hands ties nicely with the 30bllion that the statement says has been earmarked for the PSI. In this case a 50% face reduction (minus 88.5billion on debt) taken with the cash payment (plus 26billion) would take the debt to GDP to around 135%.
There is no mention in the statement under which jurisdiction the new Greek debt would be offered. We expect that since bondholders would suffer a substantial haircut now, they would demand future protection under English law. If that is the case, then under the scenarios examined above 100% of the outstanding Greek debt whether in the form of bonds or bilateral loans would be under English law. This would significantly reduce the ability of Greece to exercise any control over it and it would make harder any future default or restructuring for Greece.
Conclusion-Greek banks
The solution given to the Greek debt crisis does not seem to be comprehensive as it lacks important details on the sustainability of the Greek debt after the voluntary exchange. Greece would still need to have large primary surpluses day one in order to service the new debt. Also there ambiguity on the state of the Greek banks after the exchange. A 50% cut would leave them needing recapitalization. Is this going to happen through common equity and hence nationalization or through preferred? The common equity approach would overnight not only change the ownership but it would effectively place them under EU control (through the control of Greek finances). Thus the dynamics and the incentives are altered.

Monday 24 October 2011

Η συμφωνία της 21ης Ιουλίου

Λίγες μέρες μετά την συμφωνία της 21ης Ιουλίου έγραφα
Άρθρο στην Ημερησία 30 Ιουλίου 2011

Ομολογώ πως δεν συμμερίζομαι την ευφορία διαφόρων Ευρωπαίων αλλά και Ελλήνων πολιτικών και αρθρογράφων σχετικά με το τι επετεύχθη στις 21 Ιουλίου. Οι αμφιβολίες μου στηρίζονται στην χρηματοοικονομική αριθμητική του νέου πακέτου, στη δυναμική του χρέους που είναι εκρηκτική και λέει ακριβώς τα αντίθετα, αλλά και στο τελικό ισοζύγιο, δηλαδή τι κερδίζουμε και τι χάνουμε σε βάθος χρόνου.

Sunday 23 October 2011

Τι θα αποφασίσουν για εμάς χωρίς εμάς. Άρθρο στην Ημερησία. 22 Οκτ 2011

Καντε κλικ για το αρθρο στην Ημερησια

Για μια ακόμα φορά στην ιστορία της Ελλάδος το μέλλον της θα κριθεί σε κάποια Ευρωπαϊκή πόλη, σχεδόν ερήμην της. Δυστυχώς  η Ελληνική πολιτική ηγεσία όπως και οι ηγεσίες κοινωνικών φορέων είναι κατώτερες των περιστάσεων. Οι πρώτοι μάχονται για την δόση του μήνα και την πολιτική τους επιβίωση ή ματαιοδοξία και οι δεύτεροι  για το παρελθόν. Λίγοι έχουν χρονικό ορίζοντα άνω του μηνός, λιγότεροι  μάχονται για το μέλλον και για την θέση της Ελλάδος στην Ευρώπη.
Ας εξετάσουμε λοιπόν τα πιθανά σενάρια και τις βραχυπρόθεσμες όσο και τις μακροπρόθεσμες επιπτώσεις τους. Τα θέματα που έχουν τεθεί είναι, η αναθεώρηση της συμφωνίας της 21ης Ιουλίου. Η ανακεφαλαιοποίηση των Ευρωπαϊκών τραπεζών και η αντιμετώπιση της κρίσης χρέους στην Ευρώπη.

Δεν είναι πλέον μυστικό ότι η Ελλάδα είναι ουσιαστικά χρεοκοπημένη. Είναι γνωστό ότι η συμφωνία της 21ης Ιουλίου έγινε περισσότερο με γνώμονα την επιβίωση και το συμφέρον των Ευρωπαϊκών τραπεζών παρά της Ελλάδος. Τώρα η αγορά απαιτεί μία ολοκληρωμένη λύση για τον γόρδιο δεσμό που λέγεται Ελληνικό χρέος.  Δεν περνά ούτε μέρα χωρίς κάποιον χρησμό σχετικά με το ύψος της απομείωσης (κουρέματος) του χρέους που απαιτείται (21%,35%, 50%, 100% κ.λ.π.). Ας ανακεφαλαιώσουμε λοιπόν την συμφωνία και ας εξετάσουμε τι είναι εφικτό αντί να αναπαράγουμε άκριτα αριθμούς.

Η βασική παραδοχή της συμφωνίας ήταν η με κάθε τρόπο αποφυγή ενός πιστωτικού γεγονότος, σώνοντας έτσι της Ευρωπαϊκές τράπεζες (και την ΕΚΤ) από την βίαιη εγγραφή ζημιών. Παράλληλα υπάρχει ελάφρυνση στην άμεση διαχείριση της ρευστότητας αφού υπάρχει περίοδος χάριτος 10 ετών για τα δάνεια της Τροϊκας και  ανταλλαγή ομολόγων με άλλα 30ετούς λήξεως. Το IIF (Dalara) παρουσίασε τέσσερις επιλογές για ανταλλαγή στους ομολογιούχους. Οι τρεις πρώτες είναι 30τούς λήξεως με το κεφάλαιο εγγυημένο ενώ η τρίτη είναι 15τούς λήξεως με μερική εγγύηση κεφαλαίου. Αν αποτιμήσουμε τα καινούργια αυτά ομόλογα με επιτόκιο 9% τότε λαμβάνουμε ως σημερινή αξία 79%. Από εδώ βγαίνει και το περίφημο κούρεμα 21%. Γιατί όμως 9% και όχι υψηλότερο; Το 9% ήταν αυθαίρετο αλλά εκεί υπέθεσε το IIF ότι θα διαπραγματεύονται τα ομόλογα μετά την ανταλλαγή. Δεν θα μπορούσε να είναι διψήφιος αριθμός γιατί πρώτον δεν φαίνεται καλά και δεύτερον θυμίζει αναδυόμενη (ή τριτοκοσμική) και όχι Ευρωπαϊκή χώρα.
Πως λοιπόν μέσα σε αυτό το πλαίσιο θα μπορούσαμε να έχουμε μία μεγαλύτερη απομείωση αποφεύγοντας πάντα το πιστωτικό γεγονός;
Αυτό μπορεί να γίνει με ένα συνδυασμό αλλαγών 
  •    Μειώνοντας το μεσοσταθμικό κουπόνι των καινούργιων ομολόγων κατά 1% επιτυγχάνουμε απομείωση 31%
  • Αντί για πλήρη εγγύηση κεφαλαίου δώσουμε μερική (80%) τότε φτάνουμε στο 36%.
  •    Η αποτίμηση των ομολόγων με 10% και όχι 9% μας παέι στο 40%.
  • Θα μπορούσαμε να επιμηκύνουμε την λήξη στα 35 ή 40 χρόνια αλλά ίσως να μην είναι αποδεχτό από πολλούς ομολογιούχους που έχουν περιορισμούς στην διακράτηση μακροχρόνιων ομολόγων.
Με απλά λόγια μία απομείωση της τάξεως το 36% έως 40% ενδέχεται να γίνει εθελοντικά αποδεκτή. Μεγαλύτερη όμως από αυτό το επίπεδο απομείωση θα θέση σε κίνδυνο την εθελοντική συμμετοχή.

Υπάρχουν όμως και άλλα σημεία της συμφωνίας που θα μπορούσαν να βελτιωθούν. Για παράδειγμα
  • Διάθεση περισσοτέρων χρημάτων για επαναγορά ομολόγων. 
  • Εφαρμογή της ανταλλαγής σε όλα τα ομόλογα μέχρι το 2040. 
  • Να βρεθεί λύση ώστε να ενταχθούν και τα ομόλογα που διακρατεί η ΕΚΤ (45δις)
Όμως ακόμα και μετα από μία επιτυχημένη ανταλλαγή η Ελλάδα θα χρειάζεται περί τα 6δις (αρχική συμφωνία) για να εξυπηρετήσει τους τόκους των νέων ομολόγων. Αυτό μεταφράζεται σε 3% πρωτογενές πλεόνασμα κάτι που είναι ανέφικτο με τις παρούσες  κοινωνικοοικονομικές συνθήκες. Μία βοήθεια στον τομέα αυτο θα ήταν ευπρόσδεκτη αν φυσικά η Ελλάδα τηρήσει το λόγο της.

Το εφιαλτικό σενάριο του πιστωτικού γεγονότος είναι η άλλη οδός. 
  • Οι τράπεζες θα πρέπει να εγγράψουν τις ζημίες άμεσα. Οι λογιστικές αλχημείες δεν επιτρέπονται.
  • Η ΕΚΤ θα ζημιωθεί και θα χρειαστεί αύξηση μετοχικού κεφαλαίου. Τα Ελληνικά ομόλογα δεν θα αποτελούν πλέον αποδεκτές εμπράγματες εγγυήσεις και οι τράπεζες θα πρέπει να τα αντικαταστήσουν για να πάρουν ρευστότητα. 
  •  Οι Ελληνικές τράπεζες θα πρέπει να βρουν άλλες πηγές ρευστότητας για να μην κλείσουν. Μια λύση είναι η πλήρης ενεργοποίηση του μηχανισμού Επειγούσης Αρωγής Ρευστότητος (ΕΑΡ- Emergency Liquidity Assistance). Ακόμα και σε αυτήν την περίπτωση θα χρειαστούν μεγάλες ποσότητες φυσικού (χάρτινου) χρήματος για να ικανοποιηθούν οι αναλήψεις. Το ΕΑΡ όμως το εγγυάται το Ελληνικό κράτος και όχι η ΕΚΤ και ίσως να αμφισβητηθεί. 
  •  Αυτή την στιγμή η πλειονότητα των Ελληνικών ομολόγων είναι κάτω από Ελληνικό δίκαιο που δεν προβλέπει  Ρήτρες Συλλογικής Δράσης (CAC). Ένας διακανονισμός μπορεί να πάρει 6 μήνες. Όλο αυτόν τον καιρό θα χρειάζεται το κράτος να πληρώνει μισθούς και συντάξεις και να βρει χρήματα για εισαγωγές αγαθών. 
  •  Υπάρχει μεγάλος κίνδυνος επέκτασης της κρίσης και σε άλλες χώρες όπως Ιρλανδία, επεκτείνοντας τις ζημίες στις τράπεζες. Η ΕΕ πρέπει να έχει άμεσο σχέδιο επανακεφαλοποίησης των τραπεζών τις. 
  •  Αν η Ευρώπη αποφασίσει να ακολουθήσει τον δρόμο του πιστωτικού γεγονότος, μπορεί η Ελλάδα να χειραφετηθεί και να αποφασίσει να πάρει πρωτοβουλίες για το χρέος της. Για παράδειγμα, με απλή νομοθετική ρύθμιση να μετατρέψει όλα τα Ελληνικά ομόλογα σε μηδενικού κουπονιού και να τα κάνει 40ετή. Αφού η Ελλάδα δεν αρνείται την αποπληρωμή αλλά απλώς την μεταθέτει δεν τίθεται θέμα παράνομης κατάσχεσης περιουσίας.
  • Τα περίφημα συμβόλαια πιστωτικής ασφάλειας θα πρέπει να πληρωθούν. Αν και η συνολική καθαρή θέση είναι μικρή δεν γνωρίζουμε που θα εμφανιστούν ζημίες.

Το εφιαλτικό σενάριο λοιπόν είναι ακόμα ανεφάρμοστο.  Οι Ευρωπαίοι πολιτικοί δεν έχουν δώσει πειστικές απαντήσεις και λύσεις στα παραπάνω ζητήματα.

Το τι θα αποφασισθεί για την Ελλάδα θα έχει πολύ μεγαλύτερη σημασία και βάρος από οποιαδήποτε εκλογική αναμέτρηση από οποιοδήποτε κόμμα ή πολιτική ιδεολογία. Αν για παράδειγμα η ανταλλαγή προχωρήσει τότε το μεγάλο μέρος του Ελληνικού χρέους θα περάσει σε Αγγλικό δίκαιο από Ελληνικό. Αυτό θα έχει σοβαρότατες επιπτώσεις στην Ελλάδα για τα επόμενα 30 χρόνια. Αποτελεί σοβαρή απώλεια εθνικής κυριαρχίας και θα πρέπει η Ελληνική πλευρά να επιδιώξει μετατροπή του ή σε Ευρωπαϊκό όταν και εφόσον αυτό γίνει ή σε Ελληνικό αν εκπληρωθούν συγκεκριμένες προϋποθέσεις. Η αλλαγή αυτή θα έχει ως συνέπεια την μετατροπή του χρέους σε «εξωτερικό» χρέος. Αυτό, ευτυχώς, σημαίνει ότι η έξοδος από το Ευρώ γίνεται δυσκολότερη αλλά επίσης και ο οποιοσδήποτε διακανονισμός εάν η Ελλάδα δηλώσει αδυναμία πληρωμής.

Friday 21 October 2011

Comments made on Reuters TV

 Click on the link below to follow the comments made on Reuters TV regarding the proposed EFSF leverage and the Greek haircut.

Andreas Koutras Reuters 20th October 2011

Thursday 20 October 2011

EU Council. A look at the options

“We all know what to do but we don’t know how to get re- elected once we have done it.” JC Juncker.

Another Eurogroup- another opportunity for rumours scaremongering and good volatility. Merkozy
initially said that by the 23rd of October a comprehensive solution would be presented that includes Greece and the rest of Europe. Later the Germans dampened the optimism and suggested a more sober approach. Lets see then what is on the table and what solutions the market participants are
  1. Bazooka option for Europe
  2. The agreement signed on the 21st July with Greece. PSI, etc.
  3. Recapitalization of European Banks
  4. EFSF leverage
  5. Faster implementation of ESM
  6. Eurobonds or measures towards fiscal Union.
The ECB Bazooka Option
The original idea of the Bazooka option was for the ECB to start buying bonds of the European periphery once they hit a certain yield (say 5%). There are many reasons why the ECB refused to go down such a road and here at ITC we have written on it before (see Attachment). Currently, this option is out of favour both by bankers and many influential politicians (mostly German). Needless to say that there are numerous proposals, which in essence all come down one way or another into the ECB printing money or taking the risk on its balance sheet. Some, are structured so that the legal hurdles are overcome (Maastricht treaty) others are more cunning in disguising the ultimate risk taker in a complicated structure.
We therefore do not see a high probability of this option being exercised.

Greece and Restructuring the Restructuring

It is no longer a secret that Greece is insolvent whichever way you cut its debt. The truth is that the agreement of the 21st of July addressed more the concerns of the European banks rather than the solvency and sustainability of the Greek debt. Now the market is trying to restructure this agreement by demanding a full solution for the Greek Gordian knot. Hardly a day passes without someone proclaiming a figure for the haircut (21%, 35%, 50%, 60%, 100% have been mentioned).
Lets recap the deal currently on the table and see what is feasible rather than talk a number out of our head.

The deal was based on the assumptions of avoiding a credit event (proper default), saving the European banks (including the ECB) from writing big losses and easing the cash-flow burden for Greece for few years. The hidden assumption was that given all these, Greece would be able to grow out of recession and ultimately be able to sustain the debt payments.

The IIF presented four bond exchange options to the bondholders. Three involved a 30Y bond with capital guaranteed by a AAA security and one 15Y with partial capital guarantee at maturity. If one discounted these new bonds with a 9% yield then a price of 79% came out. Why 9%? Why not 10% or more, after all, the Greek yield curve is far above the 9% figure. The 9% is arbitrary but this is where the IIF thought the Greek bonds would be trading after the exchange. It couldn’t possibly be in double figure (more than 10%) as it looks ugly in the eye and very emerging market, not at all European.
How can we alter this 21% haircut without triggering a credit event. i.e. without a proper default.
Well, it can be done by a combination of things:
  • Altering the coupon. By reducing the average coupon by 1% we can go to 31% (in option 1)
  • If we reduce the capital guarantee to 80% instead of 100% to all options we gain another 5%.
  • Extending the maturity to 40Y could possibly bring some more, depending on the coupon.
  • One could assume 10% yield (say) instead of 9% yield. That would add another 3% of haircut.
In other words, without triggering too much objection from the bond holders we could have
voluntary haircut of around 36%. Anything more than that would risk the participation in the PSI,
which currently stands close to 90% (according to press reports).
Any talk of 50% or more then carries the big risk of a coercive offer, namely a default that
Europe is trying to avoid all this time.

There are however, other aspects of the deal struck on the 21st of July that can be improved. For
  • They can allocate more money in buying back some of the bonds now trading close to 50% (or less).
  • They could extend the eligible bonds to 2030. Currently, only bonds maturing up to and including 2020 are eligible.
  • They may also find a way to include the ECB holdings (around 45bil), which are currently immune from the restructuring.
  • A more detailed Marshall plan could be structured
Even after the PSI exchange, Greece would be liable to pay for the interest in the new bonds. According to our calculations this is around 6bil (assuming original PSI deal), which presupposes a 3% primary surplus for Greece. As this is hard to achieve in the current recessionary environment then further bailout funds or grace period may be negotiated given that Greece comes clean in their commitments.
The nightmare scenario for Europe is the proper credit event. Let me explain why I call it a
  • Banks including the ECB would have to write down their losses immediately. No longer the option to have them in the banking book marked to fiction. Some banks have taken that road already but many have not.
  • ECB would not only write losses on their 45bil portfolio but would no longer accept Greek bonds as collateral. They could alter that internal rule but it is highly unlikely, as it would damage the reputation of the ECB even further.
  • European banks (non Greek) would have to replace this with other acceptable collateral. Given the recent funding stress, it would only add to the problem.
  • Greek banks would need to find alternative sources of funding or go bust causing further social unrest in Greece. One possibility is for the Bank of Greece to use the full ELA tool with the approval of the ECB. However, even in this case, the run on deposits may stress the physical currency reserves (need to issue paper money to satisfy withdrawals). Accessing the ELA that is a liability of the state (in default in this case) may cause some philosophical concern.
  •  As there are no Collective Action Clauses (CAC’s) in the bonds under Greek law, it may take 6months or more to reach an agreement that satisfies the creditors. All this time Greece would need to finance pensions and salaries. 
  • The risk of other countries, in particular Ireland asking for a proper haircut is great.Peripheral debt would suffer. This would probably force more losses on the European banks who hold Peripheral debt. EU must have a recapitalisation plan in place and not expect the market to come up with the equity.
  • If Europe decides a Credit event, then the Greeks might feel emancipated to deal with their debt themselves, rather than leaving it to Europeans. For example, they could pass a law transforming all GGB’s into 40Y zero coupons. Bondholders would then need to go to Greek courts to argue their case. This is not something that they would want to do. As Greece does not deny payment but only moves the repayment date it is not an appropriation of funds.
  • CDS contracts would have to be paid out. Although the net volume is small we do not know were the losses would hit adding to the unpredictability factor.
Thus unless the European leaders have concrete answers to the above risks, a credit event seems highly improbable. In conclusion, we believe that the deal struck on the 21st July would be altered but not as some suggest drastically.

Recapitalization of European Banks
There are various estimates on how much capital the European banks are short. The summer EBA stress tests suggested 3.5bil. The IMF calculated that 200bil are needed, whereas others have placed the figure in between. Nationalising Banks is actually more expensive than saving the country so it is not an option that one can seriously consider, unless of course, you bite all senior bondholders (on top of the subordinate ones) before the nationalisation. The options that seem to be considered are a version of the American TARP. The original thought was for the respective countries to foot the bill (Germany suggested) but this looks hard from the perspective of the less well of countries that want Germany to take the bill. Another suggestion was to use the EFSF funds. However, Germany opposes the cash increase of the available EFSF, which now stands at 440bil. They instead seem to be accepting a more “efficient” use of this money.

EFSF Leverage

Various forms have been suggested in order to increase the “efficiency” of the 440bil that are currently available to the EFSF (actually less, around 250billion, as money are already committed to Ireland and Portugal and possibly Greece). The idea of transforming the EFSF into a bank and using the ECB funding was dropped very fast. The current flavour involves the usage of the EFSF as almost a monoline insurance. Under this insurance scheme, the EFSF would insure the first 20% of losses given default of the new bonds issued in the Euro area. This, proponents say could increase the effectiveness of the EFSF to 1.25trilliion (250bil times 5). Although details of this proposal are not known with accuracy or certainty there are some concerns:
  • One of the fundamental principles of insurance is diversification of risk. You simply do not insure all the flats in the same building against fire risk. In the case of Europe, Italy and Spain represent a huge chunk of EU debt (more than 2.5trillion).
  • The EFSF insurance is like a father selling protection against death for his own his family including himself. There is very high correlation as 130billion out of the 440billion in the EFSF come from Italy and Spain (Greece, Portugal and Ireland account for 30billion). This effectively means that Germany and France would foot again the bill. This may cause further downgrades from the rating agencies.
  • The PSI idea was to share the burden with the private sector. The current insurance scheme moves this back to the official sector.
Article 125
(ex Article 103 TEC)
1.The Union shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law,
or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.
  • For the past 2 years, the EU is trying hard to avoid default and credit event. They did not allow Irish banks to default neither Greece to haircut their debt back in may 2010. Now they would be insuring bonds against default that they vowed to prevent?
  • This 20% insurance would be given to all regardless their solvency position? That is certainly not a prudent insurance policy from the point of view of the insurer
  • Markets may take the opposite view and start their pricing with a 20% portion as a
  • AAA and the rest much lower. This would force the bonds of unsuspecting countries much lower than they are trading now
  • Under which credit events, would the 20% be triggered? Lets assume that “Failure to pay” is acceptable, would restructuring be an event that would trigger the insurance? Given that Greece is restructuring “voluntarily” would it be insured?
  • Some say that this insurance policy may contravene article 125 of the TFEU (see box)
At the moment we have no details of how this insurance can be implemented, however, my guess is that it is not something that can be implemented efficiently and fast enough to address the current crisis.

ESM brought forward

Another idea that is being put forward is to bring forward the implementation of the ESM. The ESM would certainly have more money to deal with the current crisis (lending of 500billion) but it also means testing for solvency all the countries at an earlier stage. In other words before the austerity plans had any time to work properly. It may then cause more volatility than ever before. Eurobonds and Fiscal Union.
Given the reluctance of policy makers to leak anything on Eurobonds and Fiscal Union we should expect very little progress on that front. However, back in august the EU charged the president Mr Van Rompuy to come up with suggestions. We have not heard much since then and in his speech at the LSE he refused to release any details. It seems however, that Germany would come up with some sort of sanctions and measure against fiscal profligacy and much closer monitoring of budgets than ever before. This direction is potentially the only viable long-term solution to Europe’s problems. However, it depends how it is implemented. If for example is just an imposition of a Franco/German fiscal will, then it would cause far more problems than it would solve.

A PDF of this article can be found here

Sunday 16 October 2011

Interview on MEGA channel

For those who wish to see me discussing the haircut options on MEGA channel click the link below (in Greek)

Monday 10 October 2011

Dexia and Pripheral Crisis. Stop blaming the Periphery. Dexia is NOT Greece

Barely three months after Dexia passed with flying colours the now infamous EBA tests with 11% equity buffer compared to the 10% that was required, Dexia (Belgian part) is being nationalised. The year 2008 may seem such a long time ago, but France, Belgium and Luxembourg bailed Dexia out then with 6.4bln.

I have read with some amusement many articles attributing this latest Bank crisis to the portfolio of Greek bonds that European banks hold and to the inadequacy of the EBA tests to account for default in the periphery of Europe.

It is true that Dexia holds GGB’s in their portfolio but this is not the root of the problem. After all back in 2008 when Dexia was saved for the first time, there was not a whiff of Greece going bust. Dexia’s balance sheet in 2010 was 560bln- however the interesting thing is their Financial instruments portfolio and their Level II and Level III assets. For example, in 2010, they had assets of 83bln in Levels 1,2 and 3 and almost half of these were in Level III (unobservable inputs, basically marked to fiction). Similarly on their Liabilities have 63bln of derivatives booked as Level II (value derived from a model with observable inputs).

Structured Products Hedging

How did all these derivatives arise in Dexia’s balance sheet? Well, Dexia has many entities but maybe the interesting one is the Municipal Agency. For many years now, Dexia was in the market for structured swaps as a liability hedge to French and other European Municipalities for their loans. This is how it worked: 
  •   Municipality borrowed money from Bank 
  •   Municipality hedged the interest rate expense (usually linked to Euribor+Spread) by entering into a swap with Dexia.
  • In the swap, Dexia paid to the Municipality the Euribor+Spread and in return received a Structured Coupon.

The catch is in the Structured Coupon. Most of the strategies employed to reduce the cost of funding for the Municipality were simple. Euribor rates for most of the last decade  hovered around 2-3%. Hence, the selling pitch involved trying to hedge any increase in the Euribor rates and finance this by selling options on rates coming down. This they did, and in many cases they did with large leverage. As the crisis unfolded, the unthinkable happened- rates went down to almost zero triggering this options on a massive scale. Some of these can actually cause losses much bigger than the notional of the loan they are suppose to hedge (i.e. Loan 100mln, hedging loss 200mln).

Most municipalities do not mark to market these swaps and do not give collateral to Dexia. On the other hand Dexia needs to provide collateral and mark to market with the Investment Banks that have the back-to-back hedging. This asymmetry of collateral and hedging causes many untold losses. It also speaks volume for the hidden debt losses of Municipalities across Europe. We got glimpses of this practice last year in Italy with the City of Milan litigating against major investment banks.
Although it is easy to blame the European Periphery debt crisis and attribute the losses to their Greek bond holdings the truth is that many European Banks have far deeper structural problems in their portfolios than most admit. Exactly this is the crisis that European politicians need to tackle. After all experience has proved that it is cheaper to save countries rather than banks.

Friday 7 October 2011

ECB Monetary Tools and the Bazooka Option

One of the most cited possible solutions to the current European Debt crisis is the so-called Bazooka Option. Proponents of this exit strategy want the ECB to use its unlimited monetary firepower to place a ceiling on the yields of Italy, Spain etc. by becoming the buyer of last resort (at 5% yield is the suggestion). Various estimates of the size of the bazooka have been given and the general consensus is that a minimum of 2 trillion Euro should be enough to calm the markets. In fact, the ECB through the Securities Market Program (SMP, Item 7.1 in Balance sheet) engaged in this outright buying of periphery bonds when the Greek crisis entered a critical phase last year. The ECB re-opened the SMP the last couple of months to support Italy and Spain. Currently the size of the SMP is around €160.5 bn. So why not go all the way as the Bazooka fans advocate and use the unlimited firepower? Opponents of this option usually cite:
  •  Although the letter of the law says the ECB is not allowed to buy government debt directly (see box) from the issuers, it so far has avoided the problem by buying secondary market bonds. This is a violation of the spirit rather than the letter of the law. 
  •   Moral Hazard. Politicians no longer need to worry about balancing budgets since any financing need will simply be absorbed by the ECB. 
  •    Once the ECB starts buying Bonds at 5% yield, it becomes incredibly difficult to stop since yields would most likely widen on all peripheral debt to achieve this ECB price. It would cause losses even in markets that have no problems as yet. 
  •    ECB would become susceptible to political pressure as the threat of haircuts on the debt by governments becomes a significant risk to their balance sheet (ECB has infinite buying power by printing new euros but limited capital of some €10bn to absorb any losses from their balance sheet purchases, ECB officially could then be considered a bad bank)
    However, another reason, which is rarely mentioned, is the issue of monetary policy and the transmission mechanism i.e. 
    Article 21
    Operations with public entities
    21.1. In accordance with Article 123 of the Treaty on the Functioning of the European Union, overdrafts or any other type of credit facility with the ECB or with the national central banks in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments. 

    Like many central bank in the world, the ECB controls market rates by determining the price at which liquidity is provided to the financial institutions. In Europe this is achieved via the use of Open Market Operations (OMOs, items A5.1, A5.2 in ECB Balance sheet) whereby the central bank lends euros to financial institutions against them posting suitable collateral. These operations are known as Repurchase Operations (Repos) and have tenure of 1 Week, 1 Month, 3 Month or even longer if deemed necessary by the Central Bank.  To control interest rates, the ECB maintains three separate facilities. The Deposit Rate as the lower bound (0.75%), the Marginal Lending rate (Upper bound, 2.25%), and the Repurchase agreement (middle of the range, 1.50%.
    In simple terms, the ECB’s aim in the Eurosystem is to manage the price of money (Interest Rate) by controlling the amount of liquidity supplied. i.e. the amount that helps banks to fulfil their reserve requirements. The standing facilities set a corridor of interest rates and if the supply is balanced relative to t he banking community’s requirements, then short-term interest rates should be close to the middle of this corridor. Reserve requirements also help to reduce volatility in short-term interest rates by giving commercial banks a buffer for unexpected liquidity flows on their accounts.
    The fact that the Eurosystem is short liquidity is thus used by the ECB to manage the short-term interest rates through their OMO’s. Before the crisis, the ECB would calculate on a weekly basis how much liquidity the Eurosystem needs and it would provide it using the Repo operations. With the introduction of full allotments, financial institutions could, if desired, borrow more than needed as a precautionary measure against market disruptions.

The calculation involves, the Autonomous factor on both the Asset and Liability side of the ECB’s balance sheet. In the graph above, the green line is the total liquidity shortage in the system, including the regulatory requirement (Item L2.1. Balance Sheet Data from ECB Website). It excludes the SMP program and its sterilization plus the Covered Bonds Program (unsterilized). Currently the total shortage in the system would correspond to approximately € 450 bn. If we now introduce the Covered Bond purchase program and the SMP (including sterilization), we find the funds needed to balance the system have dropped to around €400 bn. Finally, the Red line corresponds to the amount of liquidity needed by the system if the weekly sterilization of the SMP program was unsuccessful. In this instance, we clearly see that the drop in liquidity to balance the system has now reached around €250 bn.  (The blue spike in 2008 is due to the ECB reporting a Fine Tuning Operation line 2.3 of the liability side of the balance sheet instead of the normal 2.4 entry.)

Regulatory Reserve.
The Regulatory Reserve Requirement is calculated per financial institution as 2% of the short term liabilities. Banks need to have an average deposit with the ECB equal or greater to this amount every maintenance period (4-5weeks). It is item A2.1 in the ECB’s balance sheet

Firing the Bazooka may negate the OMO tools 

SMP and Covered bonds purchases help banking stability but destabilises Open Market Operations. 
Here lies the essence of the problem. The recent announcement of the reopening of the covered Bond purchase program by some €40bn coupled with a possible significant increase in purchases by the ECB in the SMP program (another € 200bn) may result in the ECB now transferring liquidity controls to the banking sector. Open Market Operations are no longer needed by the banks to satisfy their reserve requirements since instead of participating in the SMP sterilization program, they can use their extra cash to satisfy their reserve requirements. In this scenario the ECB is no longer a creditor bank and loses the firepower of the REPO and its main policy transmission mechanism. In other words, it cannot enforce its monetary policy decisions through its OMO (Open Market Operations).  The banks now determine how the excess cash in the system will be used either to park it in the deposit facility on a daily basis or lend the money for 1 week via the SMP sterilization program (if they find the ECB rate attractive enough for their needs) 

IMPORTANT NOTE: Currently the ECB is sterilising the SMP program by withdrawing the cash liquidity injected through the SMP via a weekly deposit (Item L2.3 in ECB balance sheet). However, Eurosystem banks are NOT obliged to give this money to the ECB. Although the ECB sets an upper limit ( 1.5% and same as repo rate) the amount offered by the banks and the rate at which they offer is beyond the control of the central bank.  Although in the present market conditions where excess liquidity is around €200bn, sterilization is easily achieved, if excess liquidity decreases to €20  or €30bn then sterilization may not be a smooth operation. A significant increase in the SMP purchase program may therefore permanently damage the ECB’s ability to remove excess liquidity from the system even if full allotments were no longer applicable in the OMOs. EONIA fixings would therefore no longer return to fixing 6 to 8bp above the repo rate  (normal conditions) but instead would drift between the deposit rate and the repo rate depending on the banks desire to participate in the sterilization operations.

The total size of the SMP matters, as it is a permanent injection of liquidity and not a REPO, as such it would stay in the system until bonds naturally mature. During this time, the ECB would no longer have full control of rates via the OMO’s but be forced to steer rates by changing the spread between the deposit rate and the repo rate (apart from begging for banks to participate in the sterilization program). In the future, in order to avoid inflationary pressures then the ECB may attempt to sterilise the excess liquidity by increasing the rate at which they sterilize the SMP program without changing the repo rate but this simply can be seen as begging with a sweetener attached. The ECB would simply become like the FED which no longer has any control in market rates as long as all the excess liquidity created by QE is still in the system. In reality, the ECB’s SMP program above €450bn is the same as QE although they may not be willing to admit it at that time

Since the need for liquidity by the banking sector is dependant on the regulatory reserves they need to post at the central bank, some may say, one possible solution would be to increase the Regulatory reserves from 2% to 10% (say) thus requiring banks to deposit close to 1.1 trillion with the ECB. This would of course force Eurosystem banks to deposit the excess liquidity back with the central bank. The problem would this change is that it represents a significant change of paradigm since Regulatory Reserves have stopped being used as a monetary tool for many years now. More importantly the reserve requirement limit is an important determinant of the money multiplier effect in the economy, a significant increase in it’s value would therefore likely result in banks being forced to significantly reduce the size of their balance sheet and therefore have a huge knock on effect on the real economy.

In conclusion, increasing the size of the SMP plus covered Bond purchase program above the threshold of € 450bn poses serious problems in the implementation of the monetary policy of the ECB, which after all is one of its primary objectives. Maybe, this is the real reason why the ECB is reluctant in pursuing this bazooka option. Incidentally, many exit strategies that have been proposed, directly on indirectly suffer from this defect (Increasing permanently the ECB’s balance sheet).

Central banks can steer short-term interest rates because they are the monopolistic suppliers of liquidity and are therefore able to lay down the terms for supplying it’
José Manuel González-Páramo, Member of the Executive 

Wednesday 5 October 2011

Restructuring the Restructuring

On the 21st of July European leaders agreed on a second bailout for Greece totalling 109bln. This was on top of the original 110bln agreed between Greece and the famous Troika (EU+IMF+ECB) to be given in instalments assuming Greece complied with the Troika’s demands. Right from the start we expressed reservations as to the ability of the 2nd bailout to deal effectively with the sustainability of the Greek debt. It became increasingly obvious that the 2nd bailout was produced with the health of the banking sector as a driving force and not the reduction of the Greek debt. So it was a matter of time before reality took over.
The news are full of reports, analysts, economists and politicians advocating a much higher haircut of 50% or a “technical revision” of the 2nd bailout. In fact most of the market is concentrating on one aspect of the bailout and that is the PSI (Private Sector Involvement) haircut.
Here we argue that a revision of 2nd bailout need not only involve changing the PSI haircut to 50% but some of the other elements of the bailout.
Main points of the 2nd bailout:
·            34bln of new money.
·            20bln to buy back Greek bonds in the secondary market.
·            20bln to recapitalise the Greek banks.
·            Marshall plan for Greece through NSRF (National Strategic Reference Framework, Cohesion Plan).
·            PSI. Rollover of bonds maturing up to 2020. Implied yield of 9% means effective haircut is 21%.
PSI. A 50% haircut? Is it doable without a full proper Default?

Tuesday 4 October 2011

Greek Default Probabilities

In the past few weeks a flurry of articles have hit the popular press regarding the probability of default of Greece. Headlines like, “Markets predict Greek Default probability 99.99%” or “CDS markets predict 100% probability of default for Greece” inspired fear to the hearts of investors and to Greek depositors who rushed to take their money out of Greece. Most of these stories have originated from the financial press[1] and from traders who used a well known mathematical formula that computes the probability of default given the bond Price.
One cannot argue the correctness of this number or the mathematical involved which have been checked by many practitioners and academics alike (including me). There is however, great ambiguity and controversy at applying this mathematical formula and interpreting this number as the market’s prediction for the probability of default for the Hellenic Republic. The reason is simple. Many of the underlying assumptions, which unfortunately are almost never mentioned, are violated in this case.

Market Liquidity and Efficiency

Figure 1. Monthly traded volume of GGB's

The credit spread of any bond whether corporate or sovereign is comprised of the following components:

a)    Risk of Default.
b)   Optionality if any.
c)   Liquidity Premium
d)   Other, like Convexity, Repo specialness, etc.

In the case of almost all Greek bonds the credit spread is simply (a) and (c). I.e. Risk of Default plus Liquidity Premium.
So how much is the Liquidity risk or premium embedded in the spread. Do we know? Can we somehow estimate its value? Most academic studies have shown that it is significant but unfortunately no satisfactory model exist (to the best of my knowledge) that can separately price it.
So, how liquid are the Greek bonds and the Greek Bond market. Greece has about 350 billion of debt. In the form of tradable bonds around 280billion as the bailout package have so far transformed 60billion into bilateral loans and there are also around 10billion in short term Tbills. How many of these bonds are traded on a monthly basis now and how many a year ago. The graph below (Figure 1) is revealing. From a high of around 45billion in March 2010 (when the debt crisis erupted) we are down to 1.7billion in March 2011 (Data are from the major providers, HDAT, MTS, Brokertec, BGC, ICAP). This is an absolute staggering reduction in liquidity to the once vibrant Greek bond market. Why did it happen? Why are these bonds not traded? Why do investors shy from them even at extremely low prices and why are scared holders don’t sell them?