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

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”.

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