Monthly Archives: January 2011

EU, IMF, ECB In Talks About New Greek Rescue Pacage

According to several European media, the EU, IMF and the ECB have reached a basic agreement that a debt restructuring for Greece is inevitable, and that they’re currently discussing the details in a new financial rescue package for the practically insolvent Mediterranean nation. The options on the table is said to be a 35% haircut on Greek bonds, swapping the existing 3-year bonds into 30-years and an increase of the total emergency package with 25% – another 50 billion euro.

“Europe is testing the limits of reactive incremental strategy … The laws of economics, like the laws of physics, do not respect political constraints.”

Larry Summers

According to British newspaper Financial Times, the talks with Greece on the EU to get a loan of 50 billion. euros from the European Financial Stability Fund (ETCHS) to buy back debt at around 75% of the nominal value and to prolong the loan repayment of 110 billion.

Now, that’s a really beautiful arrangement: borrowing more money from the EU to pay back (or restructure) loans at 65 – 75 percent of their original value.

The article in the Greek newspaper To Vima, Monday, contains many details on the new “Brady Plan” for Greece.

The paper says that the EU, IMF and the ECB have reached basic agreement that a debt restructuring for Greece is inevitable, with the following concrete options being discussed.

  • A haircut of 35%. Technically, this will be an exchange of existing bonds with bonds of 65% of their value.
  • A bond swap to 30-year bonds with low interest rates.
  • A new loan package of 25% of the previous volume.

To Vima also recalls the “Brady Plan,” under which the US organized a similar debt swap for Latin American debt, with the help of a FED guarantee.

The paper also quotes Greek sources as confirming that they no longer expect the rebound of growth to happen immediately.

According to British newspaper Financial Times, the talks with Greece on the EU to get another loan of 50 billion euros from the European Financial Stability Fund (ETCHS) to buy back debt at around 75% of the nominal value, in addition to prolong the loan repayment of 110 billion euro up to 30 years and reduce its interest rate.

The relevant post, signed the newspaper’s correspondent in Athens, relies on sources with knowledge of the discussions.

According to Reuters, a similar deal is discussed for Ireland.

The Greek newspaper writes that the German central bank governor, Axel Weber, support the idea, and believe that the displacement of debt repayment over a long time in conjunction, with the gradual reduction of debt of Member States under Constitution provision, would give the governments of Greece and Ireland had time to make their debt sustainable.

The funding mechanism to support Greece originally provided a three-year grace period for each installment of the loan and repayment period of two years, that payment of the total 110 billion euros by 2018.

In November Eurogroup decided to grant four-year grace period for each tranche of the loan and a seven-year repayment period, that repayment of 110 billion euros by 2024.

If finally adopted, the repayment of 110 billion will be completed in 2043.

Regarding the lending rate, this would not change significantly as 30 years in the lending rate of developed countries ranges between 3.5% – 5%.

By today’s standards that Greece borrowed from the support mechanism with a floating interest rate of around 4%, which if converted into constant is 5.5%. Ireland borrow at a fixed rate of 5.8%.

If extension of time to repay loans in 30 years, the most likely scenario would be to establish the interest rate at 1.5% higher than the German equivalent – at  4.8% to 5%.

According to the schedule of debt maturities by the central government, bonds of 21 billion expires in the period 2034 to 2057.

Even if  Greece manages to drastically reduce lending and record constantly primary surpluses by 2024, the debt will still be unsustainable.

According to the news reports. the EU, IMF, ECB and Greece are expected to reach an agreement by Friday.

The financial markets may have offered a recent respite to highly indebted euro zone members, but they will still be forced into early sovereign restructuring, leading economists at the World Economic Forum in Davos said on Friday.

Their warnings come as political leaders and central bankers pledged cast-iron support for the euro but stopped short of spelling out the reforms that will be necessary to stabilize the single currency.

Speaking on Thursday, Carmen Reinhart of Maryland University who has examined centuries of sovereign debt crises, said: “It is very difficult for me to look at the [euro zone] debt numbers and say a restructuring is going to be avoided.”

Her comments were echoed by Larry Summers, until recently chief economic adviser to President Barack Obama. Commenting on the step-by-step nature of the euro zone response to its sovereign debt crisis, he told the Financial Times: “Europe is testing the limits of reactive incremental strategy … The laws of economics, like the laws of physics, do not respect political constraints.”

Okay- let’s check out the sovereign CDS market…here.

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Please, Don’t Mention “Contagion”!

Mention the word “contagion” to people in the credit markets and most of them will immediately think of the euro zone debt crisis, Greece, Ireland, and start swapping CDS’ like crazy!  This, of course, would be perfectly natural given that the fate of peripheral sovereigns is the ones that’s shapes spread direction these days. But that cognitive association may be about to change, according to Markit Credit Research.

“Investors sit up and take notice of events in North Africa. Over the last two weeks we have seen the “Jasmine Revolution” unfold in Tunisia, leading to the overthrow of a dictatorship and ongoing unrest. Investors have been asking is this contained or is it contagious? If it’s the latter then who’s next?”

Gavan Nolan

“The last few days have shown that the contagion scenario is more likely than it seemed last week and a frontrunner has emerged for the next country in line. Egypt has seen its fourth consecutive day of protests today, with anti-government demonstrators taking their cue from their Tunisian neighbors and demanding that President Mubarak, Egypt’s autocratic president, step down. The authorities have responded by cutting internet access and using force to break up the protests,” analyst Gavan Nolan writes in his weekly summary.

Credit investors have taken note, and the sovereign’s spreads have widened 17 bp’s Friday, to 405 bp’s ,and nearly 100 over the last week.

Egypt has always been one the riskier names in the region due to its considerable debt burden, high inflation and current account deficit; its spreads hit 800bp in October 2008 post-Lehman crisis.

It is also one of the more liquid credits, having a Markit Liquidity Score of 1 (the highest available). Morocco, a less liquid name (Markit Liquidity Score of 3), has also widened this week.

But now the markets are looking for answers for the “who’s next?” question beyond North Africa. Spreads have widened in Lebanon, Jordan and rich Gulf states such as Saudi Arabia, Qatar and Bahrain.  Even Israel – a liquid name – has seen its cost of protection rise sharply today. One might ask why spreads should widen in a country that is the only democracy in the region. But Egypt is Israel’s closest Arab partner, and the fall of Mubarak could leave it isolated if the dictator is succeeded by a less-friendly regime. Investors are starting to price in this risk,” Nolan points out.

In fact, one could take the view that the markets have been under-pricing political risk in emerging markets.

Investors have been focused, rightly, on the improving economic fundamentals of many countries in the less developed world. But politics matters, particularly in sovereigns with unstable, undemocratic systems.

“We remarked last week that the Markit iTraxx SovX CEEMEA was back above the Markit iTraxx SovX Western Europe index, a trend that has continued this week. This is a result of peripheral euro zone sovereigns rallying more than anything else. But the CEEMEA has widened in recent days as investors use the index to reflect their uncertainty on emerging markets. This is despite there being only three Middle Eastern names among the underlying constituents (Turkey, Qatar, Abu Dhabi). The chart above shows that the skew has widened on the CEEMEA, indicative of the widening in the index compared to the relative stability of the constituents. It is likely that the markets will start to differentiate between the countries in focus and price accordingly.”

But much will depend on how the Egypt story develops and whether the contagion effect swamps attempts at more discerning analysis.

Politicians will also have a role to play in determining spread direction in the developed world.

“Most of the key policy makers are in Davos, and it seems the informal talks of the forum have pushed opinion towards a more radical response to the sovereign debt crisis. The option of using the EFSF to buyback Greek government bonds is now “on the table”, according to EU officials. The credit markets have been nonplussed by the news thus far; they want concrete measures (unlikely before EU council meeting on March 24).” Nolan writes.

Aside from sovereigns, investors will be keeping an eye on developments in the banking sector. Spain has announced plans to boost the capital of its cajas, and the markets reacted positively to news of a restructuring at La Caixa, the biggest caja.

There was some confusion in the market over whether it would result in a succession event, though the consensus so far is that it isn’t.

“Earnings will continued to be closely watch, with bullish investors hoping that the broadly positive trend extends into next week,” credit analyst Gavan Nolan concludes.

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Europe In Debt (Part 2): Poisonous PIIGS With Toxic Lipstick

This is the second article in the in-depth analysis of the European economy by Satyajit Das at EVRO Intelligence. In this post Mr. Das takes  a closer look at the so-called PIIGS – a useful geographical clarification provided by European politicians and central bankers. However, besides Greece, no other nation accept this rather condescending classification. I suppose most of you is familiar with the term “putting lipstick on a pig”. Using this metaphor we can conclude that EU’s efforts to prevent these countries from financial default is like putting toxic lipstick on poisonous and contagious pigs – It just makes things worse.

“While Germany currently has opposed any expansion, it remains an option. Perversely, increasing the funding available to support troubled countries may signal that problems were imminent, with a resulting loss of confidence necessitating a bailout.”

Satyajit Das

European politicians and central bankers have provided useful geographical clarifications. Prior to succumbing to the inevitable, the Ireland told everyone that they were not Greece. Portugal is now telling everyone that it is not Greece or Ireland. Spain insists that it is not Greece, Ireland or Portugal. Italy says it is not in the “PIGS”. Belgium insists it was no “B” in “PIGS” or “PIIGS”.

EU pressure on Ireland to accept external “help” was to safeguard financial stability in the Euro area, as much as rescue Ireland. However, contagion is proving difficult to prevent.

Russian writer Leo Tolstoy wrote that: “All happy families resemble one another, every unhappy family is unhappy in its own way.”

The same applies to beleaguered European countries.

Communicable Diseases

Greece had a bloated public sector and an uncompetitive economy sustained by low Euro interest rates. Ireland suffered from excessive dependence on the financial sector, poor lending, a property bubble and an increasingly generous welfare state. Portugal has slow growth, anemic productivity, large budget deficits and poor domestic savings. Spain has low productivity, high unemployment, an inflexible labor market and a banking system with large exposures to property and European sovereigns. Italy has low growth, poor productivity and a close association with the other peripheral European economies.

Italy has recently started to rein in its budget deficit. The Italian banking system is relatively healthy but exposed to European sovereign debt. Belgium is really two ethnic groups that share a king and high levels of debt (about Euro 470 billion, 100% of GDP).

“Portugal, Ireland, Greece and Belgium are also small, narrowly based economies which increases investor’s risks. The countries have in common, very high and potentially unsustainable debt levels. They also have in common a reliance on foreign investors to purchase their debt.”

Contagion is transmitted through different channels.

The rising cost of borrowing increasingly makes high levels of debt unsustainable because of the cost of meeting interest payments. Eventually, countries lose access to commercial funding sources, which is what happened to Greece and Ireland. By the end of 2010, the cost of funds for the relevant countries had risen, in some cases to punitive levels. Greek debt is trading around 12%. Ireland trades at around 9.50%. Portugal trades around 6.60%. Spanish debt now trades at 5.50-6.00%, while Italy is trading close to 5.00%.

Rising rates result in unrealized losses on investor holdings of the debt. If EU/ IMF support is not available and the debt is restructured or defaults when it falls due, then this loss is realized.

This affects the profitability and potentially the solvency of investors or banks depending on the quantum of exposure or size of the losses.

“In total, banks have lent over $2.2 trillion to the PIGS. French and German banks have lent around $510 billion and $410 billion respectively. British banks have lent $324 billion to Ireland and Spain.”

The problem is compounded by complex cross funding arrangements. Spain, which may need financial support, has $98.3 billion exposure to Portugal as well as a $17.7 billion exposure to Ireland.

The risk of losses is not only on sovereign debt, but also increasingly on normal mortgages and loans affected by the deep recessions in these economies.

In December 2010, British bank Lloyds increased debt impairment charges to £4.3 billion for the year, almost 30% higher than expected, warning of a sharp rise in charges relating to its Irish loan portfolio.

Lloyds took a write down of £1.5 billion on Irish loans in the first half of the year and signaled similar losses in the second half. The announcement fomented concerns about RBS, which has the highest exposure to Ireland among British banks.

The final channel of transmission is less obvious.

Where stronger countries move to support the weaker countries, financing the bailouts affects their own credit quality and ability to raise funds. As concerns about the peripheral countries increased, interest rates for Germany and France, which would have to bear the burden of supporting others, rose.

“Europe increasingly resembles a group of mountaineers roped together. As the members fall one by one, the survival of the stronger ones is increasingly threatened.”

European leaders see markets as the cause of the problems. George Papandreou, Greece’s Prime Minister, spoke of “psychological terror” that traders were inflicting.

EU Commissioner Michel Barnier complained that traders were “making money on the back of the unhappiness of the people”.

Others variously blamed “wolf-pack markets”, hedge funds and credit ratings agencies.

But unsustainable levels of debt remain the heart of the problem.

Unpalatable Dishes

The EU and IMF are hoping that the bailouts of Greece and Ireland will restore market confidence.

In combination with stronger growth, greater fiscal discipline and domestic structural reforms, they hope that the fear of default or restructuring will recede. Eventually, the troubled countries will regain access to markets. The emergency facilities and support mechanisms will be gradually unwound.

While not impossible, the chances of this script playing out are minimal.

“A more likely scenario is that the support measures do not work and increasingly Portugal and Spain, initially, find themselves under siege.”

As market access closes, they too will need bailouts straining existing arrangements, necessitating new measures.

If Portugal (debt around Euro 180 billion) was to require assistance, then it will reduce the available funds in the existing EU’s bail-out mechanism. Spain (with debt of over Euro 950 billion) is simply too big to bail out using the present facilities.

Under such a scenario, available options include greater economic integration of the EU, expansion of existing arrangements or a decision to allow indebted countries to fail.

Greater economic integration would entail adoption of a common fiscal policy, encompassing strict controls on fiscal policy including tax and spending.

It could also include the issue of Euro zone bonds (“E-Bonds“) to finance member countries. Championed by Jean-Claude Juncker, Luxembourg’s Prime Minister and chairman of the Euro Zone finance ministers’ meetings, the E-Bond would lower borrowing costs for peripheral economies and facilitate access to markets.

Fiscal union would prevent default of over-indebted borrowers without necessarily addressing the fundamental problems of individual economies. The likelihood of greater fiscal union in the near term is limited, as it is unlikely that nations will surrender the required economic powers and autonomy.

The E-Bond proposal, for up to 50% of a State’s funding requirement, is unworkable given large differences in credit quality and interest rates between Euro Zone members of around 10%.

The E-Bond credit support structure would resurrect the ill-fated EFSF on a larger scale.

In any case, Germany takes the view that national governments should bear responsibility for their own decisions. Germany also opposes E-Bonds, as they would increase its borrowing costs. France’s early enthusiasm for E-Bonds seems to have diminished.

“The cost of full fiscal union is prohibitive, entailing between Euro 340 billion and Euro 800 billion, depending on the degree of fiscal imbalances.”

Much of this cost would have to be borne by Germany and other richer economies.

If Portugal and Spain experience problems, then in absence of a full fiscal union, the only available actions are further EU support or default.

There have been proposals to expand the EFSF/ ESM as needed.

While Germany currently has opposed any expansion, it remains an option. Perversely, increasing the funding available to support troubled countries may signal that problems were imminent, with a resulting loss of confidence necessitating a bailout.

The ECB can increase support for the relevant countries, in the form of purchases of bonds or financing Euro Zone banks to purchase them.

Interestingly, the ECB will increase its capital base, from Euro 5.76 billion to Euro 10.76 billion by end 2012, the first such increase in its 12-year history. The increase in capital allows greater support from the ECB, whilst providing reserves against potential losses.

In an extreme scenario, the ECB could simply print money, following the US Fed’s lead, to support its members, known technically as “unsterilized purchases”.

Such action may not be permissible under its existing rules, requiring amendments to EU treaties. It would severely damage the ECB’s already tenuous credibility and be resisted by Germany and other conservative EU countries.

“Extend and pretend” measures would allow orderly default or debt restructuring by some countries over time. It minimizes losses, controlling the timing and form of restructuring.

It would also minimize disruption to financial markets and solvency issues for investors and banks with large exposures.

“If the EU does not agree to fiscal union or continuing support, then pressure on Portugal, Spain, Italy and Belgium may reach a tipping point, making default or restructuring the likely end game.”

Satyajit Das

Presumably, existing programs, such as those for Greece and Ireland, would be suspended. Governments would announce debt moratoriums, defaulting on at least some debts and forcing write downs. This would be followed by a domino effect of defaulting countries within Europe.

The richer nations would still have to pay, but for the recapitalization of their banks rather than foreign countries.

By Satyajit Das

(Satyajit Das is a former derivative trader, and the author of the book; “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.”)

Read also: Europe In Debt (Part 1): Creating a Monster

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