Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Tuesday, 31 January 2012

EU Fiscal Compact - An economic straitjacket


The fiscal pact has been signed and the markets and pundits cheer. Hurrah!
British Eurosceptics thankfully stopped David Cameron from compounding Gordon Brown's Lisbon treaty disaster. And Czech Republic had the good sense to stay away from this economic straitjacket. This is a treaty which has been signed in haste and will be repented at leisure.

So what is this treaty, what does it achieve and is it indeed positive?

Briefly, according to the Eurozone leadership, this treaty will prevent another debt crisis. Excellent. My house is burning down in front of my eyes so what I must do is call up a guy to install smoke alarms and paint the walls with fire retardant. But let us take these claims seriously because if Draghi starts spraying with his hose then the fire will be put out immediately (water damage is a separate issue).

The treaty enshrines the Maastricht criteria into the national constitutions of the signatories. The main points being:
1. Structural budget deficits cannot exceed 0.5% of GDP.
2. Automatic correction mechanism for countries whose deficits exceed 0.5% significantly (Maastricht limit on deficits was 3%)
3. These countries will have to submit their national budgets to the European Commission (EC) for approval (No, no viceroy will be appointed to administer the hitherto sovereign nation). And they will have to get within the limit within a prescribed time period.
4. If the debt-GDP ratio goes above 60% (Maastricht ceiling), it would have to be reduced by 0.5% per annum.
5. In case of non-compliance to EC's directives to get their house in order, the European Court of Justice has the power to to make countries comply and impose fines upto 0.1% of GDP.

The treaty will enter into force on 1st January 2013.

The treaty imposes very strict and onerous conditions on the signatories. It substantially removes fiscal sovereignity. As monetary sovereignity has already been ceded to the ECB, it means that EU nations have effectively lost control of economic policy to some mandarin in Brussels.

Proponents may argue that the five points above may look draconian but will be implemented wisely and pragmatically (Wise and pragmatic - the two qualities consistently hidden from the public in the handling of this crisis). The automatic correction mechanism is only triggered for significant observed deviations from 0.5%. Therefore a country can easily run a expansionary fiscal policy to combat recession in the short term. This is a sophist argument. First, if the loophole is this large then the treaty will be cast aside like the Maastricht criteria by the politicians. One only needs to look at Gordon Brown's constant shifting of the goalposts to justify all his budget deficits to understand this. If it has teeth then capping deficits at 0.5% of GDP is arbitrary and excessively restrictive. In a recession, the automatic stabilisers (unemployment benefits, etc) combined with a fall in tax revenue will ensure that the deficit crosses this figure unless the government embarks on an austerity drive. Thus the treaty ensures that when the private sector is cutting jobs, the government most likely will as well.

The cap on debt-GDP at 60% is an act of bolting the barn door after the horse has bolted. Reduction to this level is going to be counter-productive at this stage. In conjunction with the cap on deficits, what this means is that signatory states will have to run budget surpluses for the foreseeable future. Once again the austerity led growth argument is being assumed as a truism in spite of evidence to the contrary.

The other problem being glossed over is the loss of national sovereignity. At the moment, with the market's gun on their head, politicians and the public are happy to cede powers to the EU/EC/ECJ. However what happens if a future recession is confined to a few EU states? Will they tolerate a job-killing austerity drive dictated by the EU? (Actually this is purely hypothetical since with current policies there is no future to speak of)

Therefore there is little to cheer from this fiscal treaty. The markets seem to realise it as EURUSD is back down, DAX has fallen back and Bund futures are back up towards close. The treaty is a non-event from a trading point of view. And it leaves the investment thesis for Europe unchanged.

Monday, 30 January 2012

EZSE – A tragedy in several acts


Disclaimer
This is a work of real fiction. With more than six billion people alive on the planet and a similar number having lived before, any resemblance to persons living or dead is probable but unintentional and coincidental.

Background to the play
A family-run conglomerate, EZSE is in deep financial trouble. The recession has led to a decline in revenues across business lines and debt service is becoming increasingly onerous.

Cast of characters
Angela – The wealthy family matriarch with an austere demeanour. Heads the Engineering and Heavy Industry division, the most profitable in the conglomerate.
Nick – Angela’s brother-in-law and self-appointed enforcer of her authority over other family members. His once profitable nuclear power division is now a mere shadow if its former self.
Mario – University professor brought into the boardroom recently by Angela to head the third largest division of the conglomerate. Replaced his brother Silvio who was forced out due mismanagement.
Papa – A distant cousin brought into the board recently. Runs the low margin and loss making olive oil business. His division has been censured for accounting fraud.
Joy – Head of the residential construction division which has been hit hard by the recent property bust.
Pedro – Head of the textile and footwear division finding it increasingly difficult to compete with the Chinese.
Kenny – Head of a traditional offshoring specialist which recently made an ill advised foray into the construction sector leading to a near-shuttering of the unit.
Mark – Head of the transport and trade division, one of the few profitable divisions within the conglomerate.
Katy – Head of the profitable forestry division.
Werner – Close confidant of Angela. Heads the Automation and Machinery division.
David – Independent member to the board. Heads the Financial Services division. It was the most profitable division until his brother Gordon’s gamble on subprime housing went awry. Hates the board and his wife wants him to spin-off his division from the conglomerate.
Albert – Company Secretary. Has a split personality
JCJ – Company Treasurer and private banker
Siprus, Eston, Mata, Sakia, Senia – Children of the family being groomed for senior management
D Mario – Chief Trustee of the family Trust


Act n Scene 1
The management board of the family conglomerate is in an emergency board meeting. Angela, the family matriarch, is seated at the head of the table surrounded by the board.

Angela (in a severe tone): Preposterous!
Papa (pleading): Angela this is only a temporary measure. My division needs another cash infusion before it can return to profitability.
Werner: If it ever returns to profitability.

Mark and Katy smile.

Papa (turning to Werner): I do wish that you’d read the report prepared by that clever consultant Christine from the Intellectually Moribund Factory. My division is turning around. All it needs is a little more cash to tide it over the short-term.
Angela: You’ve been saying that since the last two years. It’s been a very long short-term.
Katy: I refuse to give another cent unless I get some collateral in exchange.
Werner: Same here.
Nick (trying to be conciliatory): Come on, what kind of behaviour is this? We shouldn’t grudge a few Euros between family. Remember our principle of ‘All for one and one for all’. Either we help each other or the conglomerate breaks up. And we can’t let that happen.
Angela (in an indignant tone): Don’t talk about grudging a few Euros. My division has bankrolled this conglomerate for years without complaining. But there is a limit. I went against my advisors and let you merge that olive oil business into the conglomerate. And now see what the result is.
JCJ (coming to Nick’s rescue): At that time it did seem like a good buy.
Mark (murmurs to David): Definitely a good bye now.

Both snigger.
Nick casts an irritated glance at them.

Mark: Well, those numbers did look too good to be true
Papa: Oh no, not that accounting fraud allegation again. It was perfectly within the law. A lot of firms did it, even Mario’s division…
Mario (quickly interrupting): That was probably under Silvio. My new management team, which I should point out is composed of only PhDs in business administration, would never countenance such a thing
Angela (a little too hurriedly): Mario’s division is not the problem
Nick: Yes, yes. Let’s come back to issue at hand. How will we structure the next inter-group cash loan to Papa’s division?
David: I don’t think my division can spare any money. With the recession and my brother Gordon’s financial mismanagement earlier, we very stretched ourselves.
Nick: Quelle surprise
David: There is no need to be sarcastic in French
Joy: Why don’t we use our Emergency Financing for Short-term Fund? That was its purpose wasn’t it? To provide cheap funding to our divisions in need.
Kenny, Pedro: Yes, that is a good suggestion
Katy: The only problem is that we (looks at Mark, Werner and Angela) keep putting the money in and Papa, Kenny and Pedro keep taking it out. And now Mario and Joy say that they may want to take some money from it as well if their divisions don’t see a turnaround in profitability. It’s becoming more a charity than a business.
David: I quite agree
Nick (with barely concealed rage): Listen, you only merged your financial firm with our conglomerate so that you could get captive in-house clients. You’re not part of the family. You never liked us and you’ve made it quite clear that you’re not contributing to the fund. So why don’t you shut up.

David opens his mouth to reply, thinks better of it and grumpily reclines back into his chair.

Nick (continuing to speak now to the board): I agree that we need to use our EFS Fund. We should also bring forward our Enhanced Strategy Masterplan which is supposed to prevent all such problems in future.
Mark: Angela, we’re all agreed in principle that providing such help was the purpose of the EFS Fund but Katy has a valid point about this transfer becoming permanent.
Werner: Yes, there seems to be no improvement despite all the money we’ve given.
Katy (to Papa): We give you the money and you just use it to pay debt without doing anything to restore the business to profitability.
Papa: You can’t turn around a business overnight. Look at our plans. By 2020 we’re going to be in the same great shape as we were in 2009. The Intellectually Moribund Factory has given its stamp of approval to the plans. And as you know, they are the experts on business turnarounds.
Angela: Katy is right. I have turned a blind eye to your accounting practices. But I can’t ignore the fact that you continue to have massive cost over-runs; have failed to achieve even one efficiency target that was set over the last two years; still pay outsized bonuses to your employees and are way behind in disposing off non-core assets on your balance sheet to raise money.
Papa: But we are making progress, there have been some real achievements…
Angela (cutting him off): All you’ve achieved is paying back your bank creditors with money borrowed from other family businesses. Not only that, because some people (gives a withering glance to Nick who pretends to be taking notes) persuaded the family trust to buy a lot of tracker stock in your division, the family’s fortunes are even more intertwined with your division. We can’t shutter your business or hive it off.  
Papa: Please, just this last time
Nick: Angela, I’m talking to the banks to roll-over some of the loans they have made to the olive oil business so that the entire amount doesn’t come from the family this time.
Mark: Have the banks agreed?
Nick: Not yet but they soon will. I’ve made them an offer they cannot refuse (smiles).
Angela: Ok, if that is the case then we can use the EFS Fund to contribute the remainder. We have no alternative in any case.

Papa slumps back on this seat in relief. Kenny and Pedro high-five each other. Joy and Mario look relieved.

Angela: However this is the last time. And to ensure that efficiency targets are met and costs quickly brought under control, I am going to send in one of my teams to oversee top management. Papa, you and your top management will report to them.

Jaws drop in unison across the table. Papa springs up from his chair. Nick looks aghast. David drops his head into his hands.

Curtain. 
Act n+1 Scene 1 soon to follow.

Thursday, 26 January 2012

Another look at ECB's capacity to take haircuts


A debate has arisen regarding loss absorption capacity after Lagarde's call (See yesterday's post: Eurozone Snap Comment 25-Jan-12). The argument being made is that the relevant balance sheet to look at for loss absorption capacity is the Eurosystem balance sheet and not the ECB balance sheet. For the Eurosystem, general reserves are huge (~70bn) and dwarf the Greek bond holding through SMP.

Prima facie it appears to be a valid argument but to reach the correct conclusion, some facts need to be established.

The first is to understand how losses will be allocated. From Article 33.2 from the Statute of the ESCB:
"In the event of a loss incurred by the ECB, the shortfall may be offset against the general reserve fund of the ECB and, if necessary, following a decision by the Governing Council, against the monetary income of the relevant financial year in proportion and up to the amounts allocated to the national central banks in accordance with Article 32.5."

Therefore the general reserve fund of the ECB absorbs any loss first. This is capped at 100% of the capital based on Article 33.1:
"The net profit of the ECB shall be transferred in the following order:
(a) an amount to be determined by the Governing Council, which may not exceed 20 % of the net profit, shall be transferred to the general reserve fund subject to a limit equal to 100 % of the capital;
(b) the remaining net profit shall be distributed to the shareholders of the ECB in proportion to their paid-up shares."

Losses over and above this are then offset against the monetary income for the year (yield on assets funded by currency in circulation and bank deposits minus interest paid on the deposits).

If this does not prove sufficient then it becomes important to ascertain how the additional losses will be absorbed to determine whether one has to look at the Eurosystem balance sheet as a whole or purely the ECB's balance sheet.

Again going back to the Statute, Article 32.4 states that:
"The Governing Council may decide that national central banks shall be indemnified against costs incurred in connection with the issue of banknotes or in exceptional circumstances for specific losses arising from monetary policy operations undertaken for the ESCB. Indemnification shall be in a form deemed appropriate in the judgment of the Governing Council; these amounts may be offset against the national central banks' monetary income."

As far as I can check, no such indemnification has been provided. Although FT Alphaville seems to think that ECB bears the credit risk of SMP holdings.

Therefore if NCBs are next in line to take losses then there are 70bn of Eurosystem reserves to run through. This comfortably allows for haircuts on both Greek and Portuguese debt before losses flow through to ECB's paid-in capital.

However, if FT Alphaville is correct then it is the ECB balance sheet which has to be considered in isolation (as per yesterday's post).

The other interesting issue which comes to the fore when considering the Eurosystem as a whole is implicit and unchallenged assumption that no country or bloc leaves the Eurozone. This is the only way that reserves can be used and losses apportioned according to the paid-in capital of the ECB. However, if a country/bloc does leave then it leads to a loss distribution based on the actual distribution of SMP holdings and whether the leaving country/bloc has a TARGET surplus or deficit. It means that the ultimate credit risk rests with the countries which have TARGET surpluses.

Whichever way one looks, the buck as usual stops with the Bundesbank.

Wednesday, 25 January 2012

Eurozone Snap Comment - 25-Jan-12


The trophy for sheer brilliance in decision making with nary a thought for the consequences goes to...Christine Lagarde for her stupendous decision to ask the ECB to take haircuts. Critics are raving that this is even better than Hank Paulson's performance in pulling the plug on Lehman.

To understand better, let's start with a few calculations. ECB holds 40bn worth of Greek bonds. Assuming it bought them at an average of 80c to the , its capital at risk is 32bn. Paid-up capital of the ECB is 6.36bn (to be increased to 10.76bn by the end of 2012). Risk provision reserve was 5.18bn at the end of 2010 (2011 accounts are yet to be published). Given that general reserves have a ceiling of 100% of ECB's capital this can go upto 6.36bn. Therefore the theoretical maximum amount of principal haircut that the ECB can take is 20 + 12.72/4 *100 = 51.8%. So it can theoretically survive the 50% principal haircut that private bondholders are being asked to take.

So what happens in the event the ECB takes a haircut and survives to tell the tale?
1. Depending on the size of the haircut, ECB will have to call upon national central banks to contribute more capital. NCBs will then have to ask their governments if the cash call reduces their capital ratios beyond an acceptable point. The governments will then have to finance the central banks through their budgets. Governments would increase deficits unless spending is cut commensurately. This would increase debt and worsen debt-GDP ratios. See the problem? In addition, official bickering and comments at various points in the chain will destroy whatever confidence is left.

2. Is the Greek haircut going to set a precedent? Then what happens to the 20bn of Portuguese debt? And 219bn of total SMP holdings? The governing council will realise that further intervention through the SMP is almost guaranteed to lead to losses. SMP stops and that takes out the buyer of last resort. Secondary yields will explode unless political interference forces continuation of the SMP. But this would destroy central bank independence and lead to a collapse of the EUR.

Poor Eurozone.
Cannon to the right of them,
Cannon to the left of them,
Cannon in front of them...

Meanwhile across the Atlantic, Ben Bernanke and his posse (except Lacker) have stared deep into the future and declared that they should continue pushing at a string until 2014. Their unblemished record of forecasting means that the dollar is a sell. Oh wait...are we talking about the same guy who said that the subprime problem is contained? The Fed has provided a great opportunity to re-enter € shorts. Even if the Fed is right and rates have to stay low for longer, is it better to hold a currency which is slowly being debauched or one which may cease to exist at any point? 

Ideas on Tax Policy


Benjamin Franklin missed the discussion about taxes as one of the certitudes in life. Tax policy has always been a battleground of ideologies. Now the battle is heating up again especially in recession engulfed western economies. Taxation has become the focus of debt burdened states seeking to placate voters by attempting to arrest rising income and wealth inequality. And if public coffers can be replenished along the way, so much the better.

Taxation has evolved from being a protection payment to ensure that the king's men would not take away one's land, burn one's house and rape one's family. It is now more than a means to fund the sovereign. Tax policy has become a tool for social engineering. Want to promote a certain industry? Provide tax breaks. Want to discourage habits the majority deems inappropriate? Tax them to extinction. So on and so forth. The result is a tax code which runs into hundreds and thousands of pages and provides highly remunerative employment to those with the right law degree. But it utterly fails to achieve its objectives. Regression to a 'simpler' world with taxation being purely a means to fund a small government is not advisable nor is it possible. Instead what is required is removal of counterproductive minutiae and loopholes. These have been put in place by interest groups or by meddling politicians bent on societal over-engineering. What is needed now is a rational and holistic appraisal of tax policy to achieve clearly defined broad societal objectives. 

In a modern society, the primary aim of taxation still remains funding the machinery of the state. This means the entire modern welfare state. However, tax policy is independent of the remit of the welfare state.  Thus the only difference between a minimal state and a state which provides generous benefits should be the level of taxation not the composition. The secondary aim is fairness which is distinct from equality. It is this aim which leads to controversies and attempts at social engineering. Fairness can be loosely defined as "To each an income according to his ability and from each a tax according to his advantages." What this means is that ability, diligence, creativity and entrepreneurship should not be penalised but alongside this, relative advantages purely due to wealth should be minimised.

The primary aim of funding the state needs to be considered when comparing direct versus indirect taxation. Direct taxes like excise, VAT and customs are easy to levy and collect. The ratio of net tax revenue (tax revenue minus cost of collection) to cost of collection is high. Therefore funding can be substantially achieved with minimal effort. It is here that critics point out the emphasis on indirect taxes runs contrary to the secondary aim of fairness. This is due to the regressive nature of indirect taxes. The argument runs as follows: A 10% VAT on a product costing $10 pushes the sale price to $11. This $1 of tax paid is 1% of income for someone earning $100 but only 0.01% for someone earning $10,000. Thus the poor bear a disproportionate burden relative to their income. The conventional response is to ameliorate the regressive nature by taxing necessities lower than luxuries. However this opens the door for loopholes and creative taxation through multiple tax bands and classifications. For example, food and beverages are a necessity but does that mean Kopi Luwak coffee should be taxed at the lowest rate? As long as indirect taxes are reasonably low there is usually no need to try and over-engineer for fairness. Consumer behaviour and pricing automatically minimise the regressive aspect. Necessities like food and drink are cheap relative to income (in western societies) and there is a limit to an individual’s consumption. So the tax paid as a percentage of income is still very low (1% in the case above). Also reducing the tax is not going to make any appreciable difference to people's incomes. Extending the example above, a reduction in VAT to 5% (which is a 50% tax cut) leads to a difference of only 0.5% of income for the person earning $100. However, it makes a huge difference to the total tax revenue derived by the state. If 60m units were sold every month then a 10% tax nets the state $60m per month. Cutting the tax to 5% cuts the tax revenue by $30m blowing a hole in the government budget while making a negligible impact on disposable incomes. (Tangential comment: This was Gordon Brown’s folly when he cut the VAT rate)

The secondary aim of fairness assumes importance in formulating policy for direct taxation. This is where policy has become mired in controversy and language of class warfare. The latest being the outrage on Republican presidential hopeful Mitt Romney's effective tax rate of 13.9% in 2010.

The first step in formulating policy is to classify factor incomes of rent (land), wages (labour), interest (capital) and profit (enterprise) into those which come about due to labour and those which accrue due to capital. Wages are due to the former while rent and interest due to the latter and profit is a combination of both.

The second step is distinguishing how income accrues to labour and capital. Income earned from labour is intrinsic to the labourer. The ability to work is not transferable. Also the labourer has to work to earn thus placing a physical and mental limit to the amount of productive work which can be done. In contrast, income from capital is extrinsic to the owner of capital and without limit. Capital is transferable across generations and people. It is true that effort is expended in managing capital, i.e. investments, but effort only increases linearly for an exponential increase in capital managed. Moreover, capital has a force multiplier effect. The owner of capital can hire an owner of labour and thereby expand the limit of effort which can be expended. This ensures that the theoretical limit to effort in managing capital is never realised as capital tends to infinity before the limit is reached.

This difference between an intrinsic, limited income from labour and an extrinsic, unlimited income from capital is critical. However, this by itself does not imply that income from capital should be taxed higher than income from labour. In a modern capitalist society where creation and accumulation of capital is a proxy for growth, a punitive tax on income from capital is undesirable. Society broadly agrees that entrepreneurs should be encouraged and rewarded for their success. This means allowing owners of capital to keep most of their return from investing in risky ventures.

The third and final step is to consider "fairness" and distinguish between income arising from the diligence of the taxpayer versus that which comes about irrespective of his diligence. Wages and profit are in the former category whereas rent and interest are in the latter. Whether wage or profit itself is fair given the perceived ability and diligence of the factor earning it is irrelevant from the point of view of devising tax policy. Also owners of capital will claim that their rent and interest income is derived from investment ability and hence should have similar tax treatment. This is a specious argument. True, investment ability does determine the magnitude of the income but this ignores the force multiplier effect of capital. The owner of capital can hire the ability while corralling most of the income.

Keeping in mind the points above, a basic framework for direct taxation can be constructed. Wages and profits should be taxed lower as they are intrinsic and limited and in the case of profit desirable from a societal point of view. Rent and interest should be taxed higher as they are extrinsic, unlimited and are due to an effort to preserve capital rather than create it. The reader may make two main criticisms at this stage, first, profit is clearly not limited and second, are not creditors also necessary for enterprise?

The rejoinder to the first is that profit is limited insofar as entrepreneurship is limited. It is intrinsic to the entrepreneur whose creative effort has a limit. But then what about an owner of capital who invests in established enterprises through the secondary (stock) market?  He displays no more creativity and effort than a rentier? This is a valid point which has to be taken care of through progressive tax rates. As for the second point, creditors are indeed necessary for enterprise but growth itself is more dependent on ability, creativity and diligence of the entrepreneur. And debt is already structured to be a safer investment than equity. Therefore the interest the creditor receives is a fair return for financing enterprise at minimal risk and effort.

Fairness again has to be the guide in approaching the contentious issue of whether tax should be charged at a flat rate or a graduated, i.e. progressive rate. It must be reiterated that fairness does not imply equality. A doctor with several years of training is entitled to earn multiples of a high-school dropout. But to maintain a welfare state which ensures a certain minimum standard of living for all its citizens, the burden has to fall more on those with higher incomes. This is not an excuse for a rapacious tax regime with tax rates approaching 50% or higher. What is required is a reasonable top level of tax, say not more than 35% or so. Alongside there should be a universal application of progressive tax rates across all incomes (wages, profit, rent, interest). The latter is not only justified but necessary based on the nature of income accruing to labour and capital.

Putting it all together a broadly defined tax policy can be exposited.
  1. Indirect taxes should account for a majority of state funding requirements.
  2. Direct taxes should be levied on all factor incomes and at a progressive rate.
  3. Wages and profits should have the same progressive tax rates with the highest tax rate at a sufficiently high level so that very few, if any, wage earners and only a small proportion of profit earners pay the top rate.
  4. Rent and interest tax rates should be at a slightly higher level.
  5. Any social engineering projects which the political leaders of the day wish to take up should be separate from the tax policy.
The advantages of such a tax system are that it is simple to understand, promotes broadly agreed societal objectives, minimises distortion of incentives and is reasonably fair. Moreover, by separating social engineering projects, it allows a more objective evaluation of the project aiding democratic verdict on government policies.

Monday, 23 January 2012

The endless pointless argument over Greek debt swap


The wise men of the IIF have drawn a line in the sand about their willingness to accept losses on Greek debt. However, the argument on quantum of haircut and coupon is as relevant as figuring out how many angels can dance on a head of a pin. EU and IMF officials may delude themselves into thinking that PSI (Private Sector Initiative) can lead to debt sustainability but beyond a fear of EU’s iron hand, PSI participants are there to salvage something, anything out of their worthless holdings.

The other fantastical aspect in all these PSI shenanigans is the fact that the chief negotiator (IIF private-creditor investor committee) holds only about €47bn of the €140bn (approx.) worth of debt in private foreign hands and €350bn in total debt.

The fact that Greece would be unable to pay back most of its debt to private creditors was fairly clear by the middle of last year when PSI was first mooted. Since then the proposed haircut has gone from 21% to 70% without making an iota of a difference to future debt sustainability. Losses to private creditors are going to be almost 100% given their de-facto subordination to official creditors like ECB, EU, IMF and other Euro/non-Euro central banks. These losses will be spread over one or multiple restructurings as argued below.

Greek bondholding
Creditor
Approximate holding (in EUR)
ECB
45bn
EU/IMF
65bn
National Central Banks
10bn
Greek Central Bank
10bn
Domestic banks
50bn
Other domestic investors
30bn
Foreign banks
50bn
Other investors
90bn

Even if IIF does come round to an agreement with Greece which is unanimously accepted by its members (it doesn’t appear to be at this time), it only solves the problem for 127bn worth of debt (47 + 80 from domestic holders who will do as told a they are de-facto state holdings now). Assuming further that the remaining 90bn also agree (again doesn’t look likely) then let’s look at how the maths stacks up after all these benign assumptions.

A 70% haircut on notional outstanding (i.e. principal is cut from 100 to 30) achieves a reduction of 152bn. Note that this is higher than the reduction achieved by a 70% NPV haircut as currently envisaged. (Quick bond maths – A 70% reduction in NPV only reduces principal by 57% - 61% for a 4% - 4.5% coupon and 37% for a 2.5% coupon assuming a 9% discount rate)

This takes Greece’s debt to 198bn (90% of GDP). Great success!

Not that fast unfortunately because this would actually be a decapitation rather than a haircut for Greek banks as they take losses of 35bn on top of their current capital shortfall of 30bn. Adding this capital requirement to the debt would take debt back to 198 + 65 = 263bn, i.e 119.5% of GDP.

Now add the projected deficit of 5.4% in 2012 (and recall that from the time Greece has been in intensive care, it has never achieved the deficit target), the debt becomes 275bn, i.e. 125% of GDP.

Fortunately the economy will grow under austerity. Oh. A projected GDP shrinkage of 3% in 2012 (after 4.5% in 2011) leads to the final debt-GDP ratio of 129% at the end of the year.

At the end of 2012 official creditors would hold 210bn out of the 275bn total unless there are private creditors who would invest fresh money to finance the deficit or banks. (If there are such people and are reading this, I have a huge stack of Enron share certificates which offer great value). The next PSI or AEA (Another Euphemistic Acronym) will surely zero the remaining 65bn before touching the 210bn.

So why are the wise men wasting time arguing? There are two reasons:
  1. Coupons determine how quickly money gets repaid before the inevitable default. Therefore the incentive is to make the coupon as high as possible and hope that EU/IMF keep throwing other people’s money at the problem for as long as possible.
  2. Higher coupon bonds are an easier sale in a low interest rate world. With restructuring II likely to follow, banks need to unload restructured bonds to the greater f…”financial expert”. And an investment offering 4.5% coupon (2% higher than German government bonds) on “sovereign” debt is better in this respect.
Whether the talks succeed or fail, the result is going to be the same.

Thursday, 19 January 2012

Eurozone Snap Comment - 19-Jan-12


The farce continues as IMF wishes to raise its war chest to 1 trillion dollars by tapping some of the poorest countries in the world. I half expected to see something on the lines of this when they announced the sum. Lagarde's wish is a little late for Christmas gone by and too early for the next one. Also Santa may not be too happy with European leaders' behaviour in general.
FT makes it quite clear that this proposal is dead on arrival.
"People familiar with discussions on the IMF’s 24-member executive board, representing the fund’s shareholder countries, said the US was the most sceptical about the request. While some big emerging markets such as Brazil and India were more supportive, they emphasised Europe should take the lead in financing its own rescues. The UK took a moderate position, with the eurozone countries the most enthusiastic."

Today's French and Spanish auctions went well as expected. As I've pointed out earlier, it is more to do with the domestic base and ECB's lending freely against unsound collateral than confidence. Spain's confidence in its own ability to issue debt in future is shown by repeating their act of selling more bonds than the auction target (EUR6.61bn vs EUR4.5bn this time). Good tactic - make hay while the sun shines and the market ignores that crumbling housing market.

Spanish banking sector bad loan ratios are now at a 17-year high at 7.51%. And they show no signs of coming down (the October reading was 7.42%). However Spanish banks have been reducing their coverage ratios since the crisis began (because obviously every quarter "the worst is behind us"). And they seem to have been very liberal in marking their real estate assets. The comparison (graph below) between the Spanish house price index and the Irish shows the extent of collapse yet to come (of course this may be avoided as the Chinese are going to start buying beachfront property in Spain any time now). Only a matter of time before some kid in a banks research department calls out that the emperor is naked.



So this is another liquidity enhanced short squeeze. Fade as usual.

Tuesday, 17 January 2012

S&P500 - One for the patternistas


Is this the start of another beautiful rally? The chart certainly looks similar to the start of the last bull run.
Fundamentally the US economy is resilient and one of the most balanced (mix of agriculture, manufacturing and services) amongst developed nations. Consumer debt overhang and the housing market will slowly sort itself out. Capitalist systems with flexible labour and product markets have a history of sorting themselves out without help from Ben Bernanke and the "We gotta do some serious policy intervention or this sucker is going down" crowd. Apart from ill thought policy intervention the other major risk is politics. The 1% on the left masquerades as the 99% and the 1% on the right is unintelligible.

European downgrades and investment strategy


As usual the rating downgrades were priced in and after the initial knee-jerk reaction, the inevitable post downgrade rally happened. More proof of rating agency uselessness if any more proof was indeed required.

Even though downgrades and their short-term effects are a sideshow, in a world of benchmarked investors who "outsource" their credit research to the rating agencies (and hence buy AAA sub-prime CDOs) ratings do matter.

The first is because bond inclusion in portfolios and indices is governed by ratings. Rating downgrades lead to forced selling of bonds irrespective of value offered at that point in time. The second is because ratings define collateral eligibility in the repo market. A downgrade can cause collateral to stop being accepted causing a cash crunch for the owner of the downgraded bonds. This again may lead to forced selling or at the very least make the bonds a less attractive investment.

This theory is validated by the price action in Portuguese bonds. After S&P's downgrade, Portugal was relegated to the third division, i.e sub-investment grade by all three rating agencies. This means that Portuguese bonds would be kicked out of investment grade indices which led to forced selling by the benchmarked crowd. Although why anyone would still be long Portuguese bonds irrespective of whether they are in an index or not is a puzzle worthy of a PhD thesis.

France and Austria's prospects depend on Moody's mood. Therefore for the time being the market is holding in. In any case, a downgrade will have a more muted effect by only impacting collateral eligibility. 

One needs to look past this sideshow to the main issue impacting the market. Policy action has caused a trifurcation of the bond market. The top tier is German, Dutch and Finnish bonds. These have ceased to be investments and are being hoarded as cash equivalents. Hence the negative yields on German 6-month bills where investors are effectively paying for the privilege of "investing" their money safely. The second tier is French, Austrian and Belgian bonds. The possibility of default is remote (unless Belgium splits up) and the yields higher than the rate at which limitless funds can be borrowed from the ECB. Carry traders cannot help but be drawn towards this Scylla of low default probability and the Charybdis of yield. The third tier consists of iPIGS. This is where default is almost inevitable in some shape and form (calling it "voluntary" doesn't change the fact that bondholders lose money). Of course Spain can still avoid it by following the Swedish model to restructure its banking system. But the sheer quality of political leadership in Europe makes this unlikely. The only significant source of demand for third tier bonds is from investors who are already holding so much of this toxic debt that they cannot get out. Italian and Greek banks are in this boat and their fate is now determined by their sovereign. Therefore they have no choice but to buy more and attempt to keep the sovereign afloat. It helps that ECB generosity earns them a sizable interest spread. Like the passengers remaining on the Titanic after the lifeboats had left, they are trying to enjoy the band. 

This trifurcation has sharpened over time and is likely to remain. As before, there may be migration from one tier to another. Carry traders considered Italy and Spain to be in the second tier until Scylla and Charbydis ground them to pieces. Belgium may slip down, Spain and Ireland may move up and Greece is likely to soon form a tier all by itself. Trading and investment strategy primarily depends on the tier of the sovereign as given below:

Tier
Bond position
CDS position
1
Avoid unless required for use as collateral
Sell CDS. Default risk is low and headline driven mark-to-market risk is low. Sweden, Denmark, Norway, US and UK also come in this category and have the advantage of currency independence
2
Buy and shift credit risk to ECB for the duration of the bond in return for income stream. This income stream should be swapped out of Euros
Short-term trades based on trading level with a bias towards long protection positions
3
Avoid. Too expensive to short. Too dangerous to be long
Buy Italy, Spain CDS. They are still not pricing in the scale of the problem (despite Monti’s panicked pleas)

Sunday, 15 January 2012

Ode to the Danish EU Presidency


To borrow and borrow more--that is the answer:
Whether 'tis nobler in the mind to suffer
The cuts and downgrades of outrageous raters
Or to take arms against a sea of speculators
And by opposing ban them. To default, to restructure
No more; and by restructure to say we end
The headache, and the thousand yield shocks
That debt is heir to. 'Tis a solution
Devoutly to be wished. To default, to restructure
To restructure; perchance voluntarily: ay, there's the rub,
For in that voluntary restructuring what negotiations may come
When we have pissed off this market completely,
Must give us pause. There's no confidence
That makes calamity of so large a debt.
For who would care for our promises to pay back in time,
Th' borrower's wrong, the strong woman's austerity
The pangs of despised solidarity, the summit's delay,
The incompetence of office, and the spurns
That downgraded credit of th' untrustworthy takes,
When ECB itself might its quietus make
With unsterlilised printing? Why would investors bear,
To grunt and sweat under a weary market,
But that the dread of something after default on debt,
The uncharted territory, from whose bourn
No sovereign recovers, taxes the political will,
And makes us rather ignore those ills we have
Than try solutions that we know of?
Thus immediate need to be elected does make cowards of us all,
And thus the native hue of dissolution
Is whitewashed o'er with the pale cast of sound-bite,
And enterprising union of great potential
With this regard its constituents turn away angry
And further lose the investor's confidence.

(Apologies to Shakespeare)

Thursday, 12 January 2012

Eurozone Snap Comment - 12-Jan-12

After a month-long hiatus from the markets and London winter, I returned full of hopium imbibed during my sojourn in India. But the new year cheer dissipated quickly. Even clips of Merkel-Sarkozy solving the crisis didn't help. (http://www.youtube.com/watch?v=GO4GGizw-fI
While the inability of European politicians to grasp the bull by the horns is not surprising, it makes for boring markets with high correlations and tiresome volatility. The market is still turning on a headline while underlying fundamentals continue to deteriorate.
Today's big news was the "great success" of Italian and Spanish debt auctions. Italy sold EUR12bn worth of short-dated debt (1-year and 136-day bills) at (hold your breath) less than half the yield compared to the Dec-12 auction! The reigning football world champions also saw the goal open and scored brilliantly by doubling the 3-year bond issue size to EUR10bn. This "success" is more ECB largesse rather than investor confidence. The 3-year LTRO against expanded "collateral" (the quotation marks are important to note) extends the Greek T-bill game to other sovereigns and assets. And wanton disregard of Bagehot's rule of lending freely against sound collateral means that the ECB is now the toxic dump of all European credit risk. It is no surprise that President Draghi is adamantly opposed to the precedent of a haircut on ECB Greek holdings. 
Another observation on this "success" is based on this gem from January 2010 (it helps to have memory in a memoryless market): "...officials breathed a collective sigh of relief on Monday evening (25 January) after the country's first bond issuance this year attracted considerable investor interest, a sign that market concerns over the country's public finances have, at least for the moment, partially subsided". Investors had placed EUR25bn of orders for 8bn of debt. Any guesses as to which country is being talked about? Here is the original article from which the excerpt is taken: http://euobserver.com/19/29338.