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

Wednesday, 29 February 2012

Eurozone Snap Comment - 29-Feb-12


The extra day of the leap year was fully exploited by ECB to further engage in monetary debauchery. First a gargantuan sum of 530bn was loaned out to 800 banks in exchange for collateral which the banks themselves wouldn't lend against. Then the SMP was activated to buy Portuguese bonds. It is the latter which is of interest since the former has been commented upon ad nauseum.

After two weeks the SMP was reactivated presumably to counter the slump in PGBs (Portuguese Government Bonds). The interesting part is that they bought 10 year bonds as opposed to shorter maturity (2-4 years) that they have been buying. This does not augur well for Portuguese debt holders. In any case, the precedent set by Greece means that ECB is a senior creditor. Therefore any additional bond buying increases the losses that ordinary bondholders must suffer in the event of a restructuring (voluntary or not). Moreover, buying long-dated (10 year) bonds strongly indicates that a Portuguese haircut is imminent despite claims of Greece being a special case. Again going back to the Greek precedent, ECB knows that it will have to fork over any profit from bond buying in case of restructuring. In other words, debt equivalent to the difference between par and market price is written off. Therefore it makes eminent sense to buy bonds which are trading at the lowest price adjusted for duration risk. Looking at PGB cash prices across the curve, ECB's behaviour starts making sense.
Bond
Price (approx.)
Debt relief
PGB Jun-14
80
20
PGB Feb-16
72
28
PGB Apr-21
51
49
PGB Oct-23
51
49


Does this mean that Greece is not a "special case" but just the "first case"?


Associated reading:
The current Portuguese debt waterfall is here and my argument on why Portugal is likely to follow Greece was made here.

Tuesday, 28 February 2012

In defence of the German point of view


The G-20 has told Europe that it is on its own. And the poor Germans find themselves in the unenviable position of being made the scapegoat. European solidarity and panicked governments demand that the rich nation of Germany lend some money to poorer cousins down south. This is the equivalent of an industrious rich man being accosted on the street and forced to hand over his money to poor people while bystanders nod in approval and relief at a “fair” and “charitable” distribution of someone else’s wealth.

Real life is mirroring the much emailed joke on the fable of the ant and the grasshopper. In the twisted joke, the grasshopper screams, cries and gathers a band of followers to justify sharing the ant’s food hoard during winter after spending the summer singing and dancing. A look at the graph below shows which nations were singing and dancing and which ones were hoarding away food for the harsh winter. From 2003 to 2008, German workers were taking real wage cuts while the rest were celebrating their economies having reached a permanently high plateau.
(Source: ECB)

During the same time, the German government improved its finances by cutting the deficit to almost zero in 2008. The salubrious economic environment certainly helped as can be seen by the reduction in Euro-area deficits. However, German outperformance was the result of prudent macroeconomic policy. Fiscal policy pursued was closer to true Keynesianism; save during expansions to spend in recessions. In stark contrast, the only other nations to record a surplus were Ireland and Spain where housing manias deceptively flattered government revenue and engendered complacency.

(Source: Eurostat)

If thrifty and prudent behaviour were the only cause of German antipathy to bailouts then there might be grounds for criticism. After all it would be very hard hearted of the ant to not help at all and instead deliver an ‘I told you so’ lecture to the grasshopper. However, in this case economic righteousness is mixed with moral indignation.

A look at Transparency International’s Corruption Perceptions Index makes it clear why the Germans are baulking at signing blank cheques despite Timothy “Bailout” Geithner’s pleas. Germany ranks 14th in the world and 4th in the Euro-area (after Finland, Netherlands and Luxembourg). In comparison, the peripheral economies rank much lower (none in the top 10-percentile) with Greece and Italy being notable laggards (table below).
  
Country
World Rank (Out of 182)
Euro-area rank (Out of 17)
Portugal
32
10
Italy
69
16
Ireland
19
6
Greece
80
17
Spain
31
9
Belgium
19
6
France
25
7

German anger is engendered from a mix of moral and economic righteousness. The moral issue of corruption and tax evasion is superimposed on the economic issue of entitlements in these structurally rigid economies. Adding to this resentment is the fact that Germany has bankrolled the gravy train for a long time. EU budget figures for 2010 illustrate this point aptly.

Not only did the grasshopper not gather any food itself, but against the ant’s advice it also frittered away what the ant gave it. Now in peak winter it wants the ant to unconditionally share some of the remaining food while only half-heartedly promising to reform its frivolous ways. If this is not just cause for anger then one does not know what is.

However, outrage and anger have no part in policy formulation. The insistence on austerity is born from anger and is completely counterproductive. Help must be given in a manner which avoids both extremes of high-handedness and unconditionality. Unfortunately the current approach manages the amazing feat of being high-handed and unconditional at the same time. Intrusive monitoring and usurpation of sovereign powers is high-handed and likely to engender a reaction against the union in member states. Indeed, such a reaction is well under way in Greece. Simultaneously, providing money on the basis of random economic predictions and opening the central bank vault wide open makes transfers unconditional. It not only fails to solve the problem but increases the severity of the next outbreak because of moral hazard and reduced pressure to reform. This increasing severity can be seen in the exponential increase in estimated bailout funds required since the onset of the sovereign debt crisis – from €20bn to solve the Greek problem in 2010 to €1trn not being enough now.

The solution is to restructuredebt aggressively in all problem economies, pursue structural reform andprovide money to help the transition. This is better than the current practice of massaged figures which generate impressively precise estimates (120.5% debt-GDP for instance) from exceedingly imprecise guesses of an economy’s path eight years in the future. Then proclamations are made about these estimates being achievable and sustainable which not just stretch but create a wormhole in the fabric of credulity. This is finally followed by throwing more good money at a hopeless situation under the fig leaf of conditionality which everyone knows will never be met in practice.

The justifiably angry ant is in a position of considerable power. It can either use this power wisely to save and reform the grasshopper to earn its gratitude. Or it can slam the door on the grasshopper’s face and set it the impossible task of searching for food in the harsh winter.

Thursday, 23 February 2012

Eurozone Bank Deposit Trends

There is no giant sucking sound as deposits are pulled from peripheral nations and sent to the core. Wonder when corralito will be announced in Greece and the rest? Images below speak louder than words (Rebased with Jan-09 deposits as 100%).















Source data: IMF, Bloomberg

Jargon translation:
GGB - Greece
PGB - Portugal
ITALY - Italy
SPGB - Spain
IRELND - Ireland
DBR - Germany
NETHER - The Netherlands
RAGB - Austria
FINL - Finland
FRTR - France

Wednesday, 22 February 2012

A new species is born


Like Dr. Frankenstein, European officials are trying to breathe life into the curious amalgam that is the Eurozone. While everyone is fixated by the body of Greece and the apparatuses protruding from it, another species has quietly been born in Dr. Euro’s financial engineering laboratory. This is the SPC or Euro Sovereign Protection Certificates. European officialdom's nemesis of the evil CDS (Credit Default Swap).

SPCs (pronounced species), like CDS, offer protection to investors against sovereign restructuring/default but unlike CDS they shun the dark side (as defined in the European Treaty against Evil Speculation, Section 6, subsection F, point vi). These certificates will be issued by a special purpose entity owned by EFSF called the European Sovereign Bond Protection Facility (ESBPF). They can be issued along with sovereign bonds at the request of a sovereign that has entered into a Master Financial Assistance Framework Agreement (FFA) with the EFSF. The aim is to reduce borrowing costs for the sovereign by providing a partial guarantee to investors against default (illustrated below).



The price and trading behaviour of SPC will diverge from CDS due to the following significant differences between them:
  1. SPC is Euro-denominated and settlement currency is Euro (EUR) as opposed to Sovereign CDS which is usually traded in US dollars (USD) and settlement currency is any G7 currency, Euros or Swiss Francs.
  2. ESBPF is the sole underwriter of SPCs whereas there are multiple underwriters for CDS (usually banks).
  3. SPC claims can be settled by ESBPF through payment of either cash or EFSF bonds. In contrast, CDS is always settled through payment of cash.
  4. Payment is capped at 20% - 30% of bond par value unlike CDS which pays the difference between par and recovery.
  5. SPC requires insurable interest unlike CDS, i.e. the holder of the SPC has to hold sovereign bonds to claim in the event of default.
  6. In case of credit event (repudiation/moratorium, failure to pay or restructuring), SPC may be triggered if 25% of the holders ask for it. However CDS can only be triggered if the ISDA Credit Derivatives Determinations Committee rule that a credit event has occurred.
Euro-denomination and ESBPF being the sole counterparty introduce correlation risk into SPCs. As default probabilities for Eurozone sovereign/s increase, EUR would tend to weaken. Additionally counterparty (i.e. ESBPF) default probability would increase as well since it is backed by EFSF which itself is backed by Eurozone sovereigns. Therefore the protection afforded by SPCs would fall in value. Another way to think of this is the parallel to AIG’s Financial Products Division. The protection (ironically through CDS) it sold would have been worthless to the holders had it not been guaranteed and paid by the US Treasury.

Moreover, the ability of ESBPF to pay SPC holders in EFSF bonds makes a complete mockery of any claim that SPC provides protection against default. For a large peripheral sovereign such as Italy or Spain whose credit deterioration would significantly impact EFSF and hence ESBPF, SPCs are going to fall in value along with sovereign bonds. Hence SPCs are unlikely to protect bondholders even from mark-to-market losses on their bond holding.  

It is difficult to quantify the correlation risk implicit in SPCs. However, the discount due to currency-sovereign credit correlation risk can be discerned from observing EUR-USD CDS quanto prices. For example, Italy CDS denominated in USD is trading at 395bps (3.95%), which is 85bps (0.85%) wider than EUR denominated CDS. The market is implying that EUR CDS is only worth 78.5% of USD CDS. Adding counterparty-sovereign correlation will decrease the value further. This is unobservable since quite understandably there is no market in counterparty-sovereign correlated CDS.

Additionally SPC fails to act as a hedge as expected losses in event of default rise above its cap. It behaves as a fixed-recovery CDS. Using the standard model assumption of 40% expected recovery in event of default, SPC would be worth only 33% - 50% of Euro-denominated CDS for a 20%- 30% cap. And for one percent decline in expected recovery, the ratio of SPC’s value to CDS will fall 1.6% approximately. Therefore, ignoring counterparty-sovereign correlation and knowing that most sovereign defaults in history have led to haircuts in excess of 30%, the theoretical maximum value of SPCs is going to be 26% - 39% of USD denominated CDS. In reality due to counterparty-sovereign correlation and ability to pay in EFSF bonds, the value is going to be appreciably lower.

This value is not impacted by the requirement of insurable interest. Since the number of SPCs created are going to depend upon notional amount of bonds issued, the chances of a squeeze in the event of default are minimal.

The comparison of SPC value to CDS is complicated by the unusual triggering mechanism. First it provides enormous power to the Determination Agent (HSBC Bank Plc) to prepare grounds for triggering by concluding that “terms applicable to a "Standard Western European Sovereign" Transaction Type and/or market practices applicable to credit derivative transactions referencing the Reference Sovereign have been amended, changed, modified or replaced”. Second after such a determination, it enables 25% of the holders to trigger SPCs. The logic of vesting all power in one institution (which incidentally is not a member of the ISDA CDDC due to the low volume of CDS traded by it) is questionable and introduces unquantifiable non-market risk. This risk is magnified if HSBC is going to trade SPCs on its own account.

The ease of triggering SPCs might be a sweetener to entice investors to migrate from CDS to SPCs. But it might be more insidious; a Trojan horse through which European officials destroy the CDS market. The ease of triggering is worrying especially in light of the statement mentioning change in terms or market practices. If buying CDS is made legally difficult through removing loopholes in the current legislation then SPCs become the only alternative. By law CDDC may not be able to rule on a credit event, thus leaving CDS buyers holding worthless contracts. Although the CDS contract does provide protection from sovereigns changing domestic law to prevent a trigger but the UK being a signatory to the Lisbon Treaty means that Europeans can force a change in English law to void CDS contracts.

It would be interesting to watch how this CDS nemesis develops. The stigma of issuing SPCs along with investor scepticism may mean that it is yet another stillborn new species from Dr. Euro’s financial engineering laboratory. However, the odds are that the environment deteriorates so rapidly that this species becomes extinct before it can propagate.

Addenda:
1. Do read FT Alphaville's excellent (as usual) take on this: http://ftalphaville.ft.com/blog/2012/02/22/890241/an-efsf-credit-derivative-is-born/
2. For those who believe that nothing beats going to the original documents:
    2.1 http://www.esbpf.eu/attachments/esbpf-presentation.pdf
    2.2 http://www.esbpf.eu/attachments/esbpf-base-prospectus.pdf

Monday, 20 February 2012

Sovereign CDO: Portuguese Debt

Differing treatment of creditors to Greece sets a precedent despite repeated attempts to portray it as a "special case". This means Eurozone peripheral sovereign debt is no longer pari-passu. The tranching and differing seniorities have been made explicit. The slide below shows who's at risk in Portuguese debt. Depending on the targeted debt/GDP ratio in case of a "voluntary" restructuring, bondholders can expect a 36%-63% haircut on notional (this reduces by 3% in case ECB donates its SMP profits on PGB to charity as it has done in Greece).



Friday, 17 February 2012

EZSE - A tragedy in several acts returns


Financial playwrights despaired as the sub-prime drama came to an end. Ben Bernanke and his horsemen of the monetary apocalypse snuffed out the flames gripping the financial system by throwing wads of paper over them. No more exciting market swings, no more tense weekends waiting for colossal policy errors, no more suspense about who was next. It was time to write a book on the crisis and move on.
But they despaired too early. Europe as always was ready to lend a helping hand to sustain an ancient art form such as drama. As we head into another nail-biting weekend, the drama is back – bigger, grander, better.
Without further ado, Llama Productions presents Act n+1 of ‘EZSE – A tragedy in several acts’.


Cast of characters (introduced in this Act)
Antony – The real power centre and Papa’s rival for the CEO post. Confident of staging a boardroom coup to become CEO
George – Mercurial member of the top management committee
Evan – Current CFO of the olive oil business
Moira – Omnipresent secretary at meetings
Wolf – CFO of Angela’s business (Engineering and Heavy Industry division)
Francois – CFO of Nick’s business (Nuclear Power division)
Jan – CFO of Mark’s business (Transport and Trade division)
Julie – CFO of Katy’s business (Forestry division)

Act n+1 Scene 1
After the emergency board meeting, Papa is sent back to his business HQ to persuade the management and workers to agree to the harsh terms outlined by Angela in return for saving the olive oil business. The scene opens with him in a heated discussion with other members of the firm’s management committee.

Papa: Listen, if we don’t agree to these demands then it is all over. We can’t repay our debts and the business will be shut down.
Antony: These demands are impossible.
Evan: We have no choice.
George: It is only a matter of choosing our preferred method of collapse.
Papa: Now…
Antony (interrupting): We can’t cut the workers’ wages any further. They will either resign or refuse to work. And without workers there is no production. That means no revenue. No revenue, no loan repayment.
George: In the end we still default but in the meantime we inflict massive pain on the workers. The same people who have been loyal to us their entire life. (raising his voice) What sort of nonsensical plan is this?
Papa: Now George, a lot of people with degrees in microeconomics have said that we need to have swingeing cost cuts to re-instill confidence in our suppliers, customers and lenders and give our business a second change. And this buys us time.

Phone rings. Moira picks it up and takes a message.

Moira: Sorry to interrupt, but the plant manager just called. The workers seem to have heard about the proposed cuts to their salary and benefits. They’re picketing at the gate.

Papa: Oh god.
Evan: We have to undertake these cuts. The board of the conglomerate will not give us the money otherwise. And without the money we’re finished.
George: They will give us the money.
Evan: Why? I know that Angela is tired of doling out cash to us.
George: Because if we go, the conglomerate goes.
Antony (chucking): Yes.
George: As John Paul Getty said, if you owe the bank a hundred dollars and can’t pay then you have a problem. But if you owe the bank a hundred million and can’t pay, the bank has a problem. If we go down not only will they lose what they've given us earlier but the lenders will probably also pull the plug on Pedro’s business. And then hasta la vista conglomerate.
Papa: That is crazy talk. We are not engaging in such brinkmanship. It’ll permanently damage our standing with the rest of the conglomerate.
Antony: So what do you want to do? Punish our workers and then default anyway?
Papa (weakly): We won’t default.
Antony: A degree in microeconomics is great. Common sense is better. The workers are already picketing. They won’t stand for another round of cuts. Especially as harsh as these. Motivation is already low and is affecting productivity and therefore we keep missing revenue and profit targets despite the cuts already made.
Evan: Once the workers understand that the option is between unemployment and low wages, they’ll return to their posts. And believe me, if the cuts are not made Angela is not going to transfer the money. Even if you’re right, it is better to be paid for a few months more before the inevitable hits.
Antony (after some thought): I see your point.
George (looking at Antony): What? I will not stand for this. The workers will never forgive us.

Phone rings. Moira again picks it up and takes a message.

Moira: Sorry to interrupt again but the workers are turning violent. They’ve started throwing petrol bombs into the factory compound. The police have been called.

Papa: Oh god.
George (sarcastically): Bravo! They know their management is selling them out.

Phone rings again. Moira picks it up.

Moira: JCJ on line 1. Asking how we’re getting on.
Evan: Put him on speakerphone. 

Moira puts JCJ on speakerphone.

Evan: Hi JCJ, we’re quite close to an agreement. Are you ready to transfer the funds?
JCJ: Before I transfer the funds I need a signed agreement by the entire management committee that the cuts will be made.
Evan: All our signatures? Is that necessary?

Phone rings. Moira picks it up.

Moira (to Papa): Sorry to interrupt, it’s Charles the banker on the line. He is getting a bit jittery.
Papa: Tell him everything is proceeding smoothly. I’ll call him back in some time.

Moira relays the message and has a brief conversation and again addresses Papa.

Moira: He’s seen the striking workers on live news. He’s not convinced that things are going smoothly. I told him that it is all under control and you’ll call shortly to confirm.
Papa: Live news! There should be a law...Thanks Moira.
JCJ: Yes we’re seeing it on live TV as well. That’s why we think it is a good idea if all of you collectively sign up for the cuts. We don’t want some boardroom reshuffle to lead to you reneging on our agreement.
Evan: We’re not going to renege on the agreement. Isn’t that right Antony?
Antony: Of course not. But these are harsh cuts and on principle I do believe that any future CEO should have a free hand. Of course he must try and honour all prior commitments but if that is impossible due to the circumstances prevailing at that time then it may be worth revisiting the commitment.
JCJ: I don’t like equivocation…
George to Antony (whisper): Rich coming from a banker
JCJ: The conglomerate’s finance committee is meeting in half-an-hour. We need you to send us the signed agreement in order for us to consider approving the money transfer.
Papa: No problem. You’ll have it. Goodbye.
JCJ: Goodbye.
George (emphatically): Goodbye. (starts walking out)
Evan: Where are you going? We’re not finished and you need to sign.
George: I will never sign. I resign from the management committee. (Walks out and bangs the door behind him)
Papa: Antony, are you going to sign?
Antony: Yes, we should take the money now and then see.
Evan: Good decision. Moira, can you send the agreement to JCJ ASAP. Also call up Charles and tell him to proceed with the debt rollover.

Scene 2
The conglomerate’s finance committee’s meeting is in progress chaired by JCJ. In the background a large screen TV shows news of rioting workers in the olive oil factory.

JCJ: I’ve just received the assurances from Papa and his team that they will impose the cost cuts. So I assume that we should wire the funds to them?
Wolf: I’m not so sure. The olive oil business is a hopeless case. And reading the text of what they’ve signed, Antony seems to be equivocating.
Francois: Oh come on, they’ve agreed to what we asked. Let’s now keep our end of the promise and disburse the money.
Jan: The numbers don’t add up. They seem to be missing 325 million in cuts.
Julie: You're right. We absolutely can’t disburse the funds until they show how they’re going to fill that gap of 325 million. And Antony promises to honour the agreement no matter what.
CFO 1: We musn’t delay. Charles can’t rollover their debt until we pay and they don’t have funds to make the next debt repayment.
CFO 2: I agree. They’ve agreed to our conditions. We must disburse the funds. It’ll be catastrophic otherwise.
Wolf: This threat of ‘Give us more funds or catastrophe beckons’ has gone on long enough. We seem to be shovelling money into a bottomless pit.
Jan: I agree. It’s time to divest the olive oil business. The conglomerate will be stronger for it.
Francois (horrified): You cannot be serious!
Julie: We are trapped in a sunk cost fallacy. The money we’ve given is gone. We can at least try to save what we have.
CFO 1 (panicked): But, but...what’ll happen to us? Charles’ banks will pull our credit lines if they think that the conglomerate is happy to divest loss making businesses.
Wolf: You needn’t worry. You are making good progress on your cost cutting program unlike Papa and co. so we’ll support you.

Phone rings. Moira picks it up.

Moira: Sorry to interrupt but Charles is on the line asking if you’ve sent the money and should he then start the debt rollover?
Wolf: No, tell him that the money isn’t going to be sent today.
Moira (relays the message): He’s asking what decision has been made?
Wolf: We’ve decided to decide the transfer at the next meeting subject to our conditions been met.
Moira: The usual decision then? I'll let him know. 

Moira relays the message and ends the call.

Curtain.

Wednesday, 15 February 2012

Spanish Banking System's True Real Estate Exposure


I was sent an interesting presentation made by the Spanish Ministry of Economy and Competitiveness.

The first thing that caught my eye was their proposed solution for the financial sector. The gist was “Don’t worry, we know the problem and we have the solution.” However rather than feeling reassured and calling my broker to buy Spanish bonds on margin, I sold some more Euros.

The first point itself raises an alarm. It is the definition of the problem facing banks. After a huge house price boom and a half-hearted bust (The Economist’s house price indicator graph is very informative – in Q3 2011, Spanish house prices were still ~140% of Q1 2003 compared to flat in US and 90% in Ireland) the Ministry defines the problem as being only loans to developers. This is disingenuous given that total real estate exposure of the Spanish banking system is roughly €1trn (€383bn to developers and approximately €600bn in residential real estate). 

This blinkered view seems to be the official line. Even Banco De Espana (Spanish Central Bank) dismisses residential real estate lending to households as not posing a problem to banks. The ostensible reasons being a historically low default rate and a low average loan to value of 62%. The former reminds me of the ‘never an annual house price decline’ assumption in US house pricing models. The latter however, is a stronger data point to refute. Let us analyse if it can indeed support the hypothesis that Spanish officials are making.

An eventual house price decline similar to Ireland or US will cause the loan to market value (LTMV) to soar to 100%. Even though Spanish borrowers can’t walk away like negative equity borrowers in the US, inability to pay mortgage installments leads to foreclosures irrespective of the total amount of loan, LTV or LTMV. With unemployment at 22.83%, the stress on borrowers and inability to pay is rising. This is seen in the low (for now) but rising bad loan data. Moreover, an LTMV of 100% means that for every foreclosed home the bank just about recoups its principal if lucky (usually the bank makes a loss given foreclosure costs). Therefore the only way in which residential real estate lending can be ignored is if the Spanish housing market is expected to turn around in the near future due to fresh demand. Unfortunately this is a little too optimistic. On the supply side, the boom has left a glut of properties which would take years to clear. And on the demand side, marginal demand is likely to be low given the high percentage of home ownership in Spain (¬80%). In addition, youth unemployment at ~50% implies that contribution to domestic marginal demand from first-time buyers is probably non existent. Foreign demand might provide some solace but it is unlikely to be significant enough to make a dent in the existing unsold inventory (IMF July 2011 report estimated that it will take four years to clear).

Therefore the Spanish banking sector has to be assessed on the basis of a ~€1trn exposure to real estate not €383bn. Of course, residential real estate loans should outperform loans to developers but it doesn't mean that losses will be contained. It is understandable that Spanish officials try and paint a positive picture to jittery markets but hopefully they don't actually believe what they're spinning.

Monday, 13 February 2012

Hopium flows eternal in the market


As the 'risk-on' rally continues unabated, the market has declared bear season open. To avoid being shot, even perma-bears like Roubini have put on horns to appear bullish. Unfortunately like the innumerable rallies that have come and gone since Mervyn’s NICE (Non-Inflationary Consistently Expansionary) decade turned NASTY (Non Aspirational Socially Tumultuous Years) this one is also not going to end well.

There are three main reasons for the current surge. The first is the ECB’s LTRO, which is likened to Fed’s QE, and is supposed to have taken default risk off the table for banks. The second is the false understanding that Greece doesn’t matter. And the third is the hope that the contagion will not spread to Portugal and others. The intelligent investor must examine these reasons put forth to judge whether to participate or fade the rally.

By widening the collateral criteria and opening the vault to anyone and everyone, ECB has reduced funding pressures on banks. However, unlike QE where the Fed bought assets (MBS and Treasuries) from banks and took the risk on its own balance sheet, LTRO only leads to partial financing of the asset (due to haircuts charged). The risk stays on the bank’s balance sheet. This is a critical difference. Banks are unlikely to loosen lending criteria when they have to set aside reserves for future asset impairment. Combined with higher capital requirements, this leads to a credit crunch. Dud assets on bank balance sheets were one factor contributing to Japan’s lost decade.

The other pernicious effect of breaking Bagehot’s rule (lend freely to solvent banks against sound collateral) is that the risk ultimately resides with ECB and the Eurosystem. If a bank goes bust, ECB seizes its collateral in lieu of the loans provided. But if the collateral is worthless then ECB takes a loss. The eagerness with which banks have lapped up LTRO funds and have stated intentions to increase their sovereign holding is a huge negative rather than a positive. There must be a huge neon sign flashing ‘Moral hazard’ in Frankfurt. It is certainly flashing inside the Bundesbank given their reluctance to widen collateral criteria. LTRO has only bought time at the huge cost of correlating default probabilities. The Eurozone’s strength is rapidly converging to the strength of its weakest member, i.e. Greece.

The crux of the argument that Greece doesn’t matter is that the EU will do everything to prevent a disorderly default. Also, in any case everyone has accepted that Greek bondholders are going to take a hit. Therefore current market prices already discount the inevitable restructuring. This reminds me of the sanguinity prevailing on the week before Lehman declared (or was forced to) bankruptcy. CDS only surpassed the previous high (made in March 2008 at the time of Bear Stearns’ demise) on Wednesday and closed around 700bps (7%) on Friday. An implied default probability of only 33%. (For the layman – higher CDS spread implies higher default probability and hence higher risk of default). The political risk of a disorderly default is rising judging by the rhetoric from Germany and the EU and intensification of Greek riots. The hopium shooters dismiss this by stating that this is nothing new and has always been the case. This is similar to the expectation that the authorities would arrange a Bear Stearns type solution for Lehman.

The other problem with this argument is the apparent inability to grasp the implications of a Greek default by both policymakers and market participants. The former seem to be repeating Hank Paulson’s mistake of not properly planning for an assumed small-sized default which would also teach everyone about moral hazard. The latter are in a hopium haze.

In case of default what happens to Greek collateral held by the ECB? Is there an orderly default plan with a bank recapitalisation plan? Or like Draghi said, that to have a Plan B is to admit defeat. Without an orderly default, the inevitable disorderly default of Greece would leave the ECB with around €200bn of Greek collateral pledged by Greek banks. It isn’t going to be worth much. Greece is unlikely to be in the Eurozone in such a scenario. So what happens to the TARGET liabilities of the Greek central bank? (i.e. the amount that the Greek central bank has borrowed from other Euro area central banks). Mr. Draghi, just because one hasn't admitted defeat doesn't mean that one will not be defeated.

The hope that after Greece, the contagion isn’t going to spread is an extraordinary one. It is based mostly on some encouraging words from Schaeuble last week. However, after having seen the endless money requirement in Greece, the EU is unlikely to embark on a similar pointless bailout of Portugal. Therefore the contagion will not spread only if Portugal regains the market’s confidence. But that is not possible. As I’ve talked in my earlier note, they are headed for a restructuring as well.

With EU/IMF to decide on the €130bn package on the 15th of February and Antonio Samaras (the likely next elected PM of Greece) making noises about renegotiating the austerity measures post election, the current ‘risk-on’ rally is in serious danger of being overtaken by events. A momentum chasing hopium shooter would do well to heed Harold Macmillan's words about what blows governments off course  “Events, dear boy, events”.

Thursday, 9 February 2012

Greek political drama masks tragedy

Like rockstars making a fashionably late appearance on stage, Papademos and co. finally agreed to €3.3bn in budget cuts. Now we await the main act of Eurozone finance ministers. They are apparently working late into the night to structure a bail-out package to return Greece to a sustainable footing by 2020. Gratuitous piece of advice to them - go home and sleep. It is a pointless exercise. A look at these two graphs makes it abundantly clear.


Exhibit A: Greek unemployment is rising exponentially 




Exhibit B: Industry has all but shut down
(NB: The horizontal red line is zero growth)


Given this dire macroeconomic situation, austerity is not only wrong but also cruel. It takes away any chance of growth, impoverishes the citizens and does nothing to make the debt burden sustainable. At this stage, there is no alternative but to restructure debt to such an extent that even official creditors take a hit. Eurozone leaders have only themselves to blame for letting the situation get so out of hand. 

Wednesday, 8 February 2012

Philosophical musings on banker bashing


"It is not from the benevolence of the butcher, the brewer or the baker, that we expect our dinner, but from their regard to their own interest." - Adam Smith

Adam Smith's simple observation is very difficult to understand given human tendency to ascribe morals to every action. We are indoctrinated from an early age. For example, sharing is "good", shouting is "bad". These moral undertones, although helpful in preserving the social fabric, ensure that any economic discussion generates more heat than light. To understand how difficult it is to grasp and apply Smith's principle, consider the object of almost universal opprobrium, the village moneylender. He also acts from regard to his own interest but is reviled whereas the butcher, brewer and baker are considered to be upstanding members of village society performing useful "social" service. But doesn't the moneylender charge an usurious (an adjective which aptly demonstrates the point about actions being bestowed with moral connotations) rate of interest to the poor (another adjective with moral connotations) farmer? This question presumes moral failure even before an answer is made.

Morals ascribed to an activity are transient. What was unacceptable a hundred years ago is commonplace now and vice versa. However, the poor moneylender has been vilified throughout history. In our current modern society he has transformed into the reviled banker. The "good" butcher, brewer and baker have become the the industrial sector. This is apparent from the nostalgic romanticism of politicians as they wax eloquent about "making stuff" rather than "moving money" as a way to generate "fair" economic growth. These moral judgements conveniently forget the image of Victorian industry, from whose excesses rose Marxism. Quite ironic in light of Charles Dickens' 200th birthday celebrations. Forgotten too is the nostalgia and hankering for a simpler agrarian life which accompanied the rise of industrialisation.

The intrusion of morality into the economic sphere is partly explained by the human tendency to latch on to the certain past and believe it to be better than the uncertain present. This is especially acute in times of crisis. Witness the nostalgia of people living in tumultuous ex-communist countries about erstwhile hated communist regimes. However, it does not explain the enduring hate towards the moneylender or his modern equivalent, the banker.

This hate and the implied assertion of moral failure is due to three main characteristics of money which make a dealer in money (moneylender/banker) unique. The first is its infinite life. The second is its status as medium of exchange. The third, which proceeds from the first two, is the fact that it acts as a store of value. (Standard economics defines money only in terms of the second and third characteristic as infinite life greatly complicates academics).

These characteristics are more easily understood through considering a simple village economy where there is only one person for each job, i.e. one baker, one butcher, one farmer and so on. In this economy, money is the only commodity which can be stored to last forever. The produce of the farmer, butcher, baker decay after a short period of time. In contrast, gold bars last forever. In addition, as a medium of exchange, money confers on everyone the ability to exchange their produce, whether labour or goods, for money. Thus the moneylender can easily be repaid by all for his moneylending services. In contrast, everyone else has to convert their produce to money and then use that to pay for goods and services they consume. Therefore, the moneylender is in a position to accumulate his produce while the others are not. They can only store their surplus produce by converting it to money (with the exception of labour which cannot be stored). And they will store this surplus as money due to its durability and status as medium of exchange. This leads to money becoming a store of value. Assuming there is no inflation, the farmer knows how much wheat to set aside and sell for gold now to buy seeds for the next planting season.

To see how these three characteristics favour the moneylender, one has to look at the accumulation of money in the economy. Assuming a fixed quantity of money circulating in the economy, any producers which generate a surplus over their consumption will be matched by those who generate a deficit. Those producers who generate surpluses will store them as money. Unless they lend this money, and become moneylenders themselves, their accumulation of money will be solely dependent on their surplus produce from one time period to the next. Those who generate a deficit will borrow from the moneylender and repay him a larger sum of money (interest) from their surplus in future. To simplify greatly, assume that over time surpluses and deficits largely cancel out at the individual level. The result is a net accumulation of money by the moneylender due to charging of interest.

For a more modern capitalist economy, the assumption of surpluses and deficits cancelling out can be dropped. This leads to a situation where there is a rise of the wealthy at one end and indentured labourers at the other. Further assume that the wealthy lend their surplus money to the moneylender who then lends them out at a higher rate to those who need it. Voila, the village moneylender has become the modern banker. Even now, a part of the future produce of borrowers is taken by the bankers. As long as there are borrowers (and there always are) the banker accumulates money.

This net accumulation which comes about with little physical exertion leads to moralising about the "evil" of charging interest. If borrowed money is repaid in future then why should there be a charge? Why doesn't the moneylender perform physical labour to earn his daily bread like everyone else in the village? This line of thought not only ignores repayment risk but also assumes that the moneylender is not providing a service. What if the baker borrows money and then leaves the village or dies or his bakery burns down making him unable to repay the moneylender? Also the butcher, brewer or baker don't give their produce free of charge. Then why should the moneylender do such a thing?

Even if the argument is accepted that interest is a charge for risk and for services rendered, the rate of interest becomes a moral bone of contention. However, interest rate is simply a function of the characteristics of money and the market in money in the village. The price of money, i.e. the interest rate, is limited by the number of suppliers (moneylenders) and what people are willing to pay rather than make alternative arrangements (eg. a farmer may promise wheat in future for bread now rather than borrow money to pay for it if the moneylender's rate of interest is too high). As there is a monopolistic supplier in the village the rate will be as high as the market can bear. Similarly, the farmer is also free to increase wheat prices. But the price limit for the farmer is much lower since there are no alternatives to food consumption (therefore increasing the price too much will lead to social breakdown as villagers seize the wheat forcibly). The moneylender may be bypassed, the farmer cannot be.

Thus the unique characteristics of money lead to a moral veil being cast on an economic activity. The moneylender or the banker is serving his own interest similar to other people. Therefore, singling this one profession out for moral outrage and sanction is uncalled for.

This does not mean that banks and bankers can be absolved of all blame for the recent and present crises. However, rather than vilifying bankers and snatching their bonuses and honours, thought must be given to reforming the incentive system for the entire economy. We confront a systemic problem which is yet to be tackled. Short-termism led politicians to buy votes through supercharging economic growth by ensuring freely available cheap credit. A bid to keep up with the Joneses led to dishonest behaviour. Ayn Randian dogma ensured speculative excesses continued and regulators looked the other way. Finally it all culminated in large private gains and commensurate public losses. Scapegoating is not the solution for this. And if we are being so morally judgemental, let he who has not sinned cast the first stone.

Monday, 6 February 2012

Et tu Portugal


“Never believe anything until it is officially denied.” – Rt. Hon. James Hacker[1]

“Feb. 6 (Bloomberg) -- Portugal “expressly” denies that it’s sounding out advisers on options to restructure its debt, the Finance Ministry said in an e-mailed statement today. “Such information is completely groundless,” the Finance Ministry said.”

Hacker has been proved right time and again during this crisis. Now as Greek talks flounder, the market’s attention has turned to Portugal. Just as Portugal was forced to follow Greece into the arms of the IMF in 2011, it is now being forced into a restructuring[2]. Once the debt spiral begins, denials and counterarguments follow a familiar pattern as illustrated below.



To determine whether the end is near or not, one needs to analyse the facts. Market prices of bonds have lost all significance as an indicator due to an illiquid and dysfunctional market. On fundamentals, optimists cite Portugal’s progress against IMF targets as proof that it is not going to follow Greece. Not only is it implementing the IMF/EU programme successfully but it also has a much lower debt/GDP. Moreover, it has a majority elected government under Coelho which is committed to reform. This is in sharp contrast to the political gridlock in Greece or even the unelected cabinet in Italy.

On surface, these are credible arguments. However, as with all distressed assets, the difference between investor's dream and disaster is decided by the detail. The much touted success on achieving deficit targets in 2011 was due to a one-off €6bn transfer from bank pension schemes to the social security system[3]. Without it the deficit would have been around 10% of GDP (not far off from the 2011 Greek deficit forecast of 9.1 – 9.4%). The IMF mandated deficit target for 2012 is an overly ambitious 4.5%. This implies a 5.5% reduction in deficit even as the IMF forecasts a 3% economic contraction with “risks skewed to the downside”. These strongly echo the impossibly optimistic Greek targets which reality kept revising. Greece missed its IMF deficit target by 1% in 2010 and about 2% in 2011. IMF expected the Greek economy to contract by 4% in 2010[4] and 3% in 2011[5]. Instead it contracted by 4.5% and 6% respectively. Usually deficit reduction is easiest in the first year as grossly inefficient and wasteful spending can be cut immediately. In addition, one-off transactions can flatter the figures. However, as Greece has demonstrated, continuing structural improvement through battling vested interests is much more difficult. And if it has to be done in a debt-deflationary environment where growth is falling off a cliff, then it is impossible. Portugal has achieved the easy part but now it is facing the impossible with regard to deficit cutting.

The second point that the optimists make is that Portugal’s debt/GDP ratio is much lower than Greece. At 105% of GDP it is even lower than Italy’s. However, it is still a gigantic 70% higher than the 35% which Reinhart & Rogoff define as a sustainable level[6] (and is 45% higher than the Maastricht criterion). This ratio is increasing as deficits increase the numerator and economic contraction decreases the denominator.

The final argument in defence of Portuguese debt sustainability is based upon political stability. A recently elected majority government which is committed to reform is expected to reverse the worsening debt dynamic. This misses two important factors.

The first is the structure of the Portuguese economy. It is closer to developing countries than to developed ones. The main industries are low value added ones such as textiles, footwear, wood, paper manufacturing. Competition from China and other low labour cost economies is intense. This resulted in the decade long stagnation of the Portuguese economy even before the crisis. In addition, demand from Portugal’s main export partner, Spain, has been impacted by the real estate crash there. But what really bodes ill for the future is the relative lack of highly educated workforce as shown in the graphs below.
  
Figure 1: Proportion of population aged 30-34 having atertiary educational attainment
Source: Eurostat

Figure 2: Distribution of population aged 25-64 by highestlevel of education, 2010

Lack of skilled workforce and an economy being structurally outcompeted due to globalisation preclude an Irish style turnaround in growth.

The second important factor is the Euro. Currency depreciation to restore competitiveness is impossible. Therefore the entire brunt has to be borne by the population through real wage reduction. Even if Coelho can survive the wave of unpopularity that this invariably produces, the economy’s structural problem will eventually ground him. 

Thus no amount of leadership or popular mandate can turn the Portuguese economy around in time. It is only a question of how much time can EU/ECB/IMF buy. Here the parallels with Greece break down. Being the first mover, Greece enjoyed EU and creditor patience through the last two years of protracted negotiations. Now that patience has run out. Unless the Greek credit event is as appallingly mishandled as Lehman, Portugal (and others) are likely to rapidly follow the Greek precedent. 


[1] Those unfamiliar with the great man should watch: http://www.amazon.co.uk/Complete-Yes-Minister-Collectors-Boxset/dp/B0002XOZRO
[2] This blog’s policy is to avoid euphemisms to maintain clarity. A restructuring by the following names is still a restructuring and stinks just as much: “voluntary rollover”; “debt sustainability exercise”, “Private sector initiative”
[3] They literally robbed the bank
[4] May 2010 estimate which substantially revised the EC estimate of -0.3% growth made in late 2009
[5] December 2010 estimate
[6] The exact definition of the limit is based on external debt/GNP but approximating to debt/GDP will not change the thesis much

Friday, 3 February 2012

Follow the money - Buy Indian stocks?


NIFTY (50 large cap Indian company index) has broken the downward trendline and is trading above 200dma. Technical traders should be all over it.
The fundamental backdrop has been supportive as well. It has been helped by better than expected economic data and RBI's dovishness (and more importantly its CRR cut). The current vertical take-off seems to be largely due to FIIs piling back in. Until 1st Feb, they had invested $2.6bn into the equity market including a mammoth $422m on the 1st of February. The table below puts this number in perspective:

Date
Jan Inflow ($m)
Annual ($m)
2000
56
1,469
2001
854
2,741
2002
74
738
2003
223
6,702
2004
535
8,627
2005
286
10,901
2006
753
8,338
2007
-65
18,518
2008
-4,368
-12,918
2009
-869
17,639
2010
-230
29,321
2011
-1,387
-512
2012
2,183



FT's Lex has sounded a note of caution. And short-term indicators point to the market being overbought. However, Indian market performance is highly correlated (and there is some causality as well due to reflexivity) to inflows of foreign money. Any shift in investor portfolios from developed markets towards EM/BRICs will lead to a sustained bull run. Even if the shift is a percent or two, given the relatively puny size compared to developed markets, the effect will be outsized.

Best way to play this is through ETFs. Bloomberg lists 5 pages of them.