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.

Tuesday 3 July 2012

EU Summit. Nice Marketing

Now that the dust is settling from the European Council circus a summary of what has been achieved is in order. Many analysts and market observers hailed the result as a “paradigm shift” a “game changing” decision or that it was the first time that an EU Council did something good for Europe. Others rejoiced at the thought that Germany’s Chancellor Merkel ostensibly backed down or as they claim, defeated. The markets went up on the news and everyone was happy.
I must say that I do not share the same exhilarating feelings. And the reason is reality versus marketing. There is no doubt that from a marketing point of view the summit was a huge success. Germany simply had to look as if they are retreating and Italy’s Monti absolutely had to appear to be standing up. Equally, Spain’s Rajoy needed a political win to gain back some credibility. Monti on the other hand was preparing to fire 100,000 public sector employees and standing up to Merkel was the perfect excuse.
Germany realised that they can play hard on the implementation and conditionality level which is more important. The new regulator and the conditionality on the banks and the states is where the game is going to be played.

On the main decisions taken by the Council we have:
·         No seniority on ESM loans
·         Setting up a pan-european bank regulator. A banking union.
·         Direct recapitalization of banks by the ESM after regulator is being set up
·         ESM could buy government debt
Let’s look each main decision in turn.