If you have been keeping up with the news over the weekend you probably know by now that the latest Italian bond auction went pretty poorly. Due to this I suspect next week we will be seeing a barrage of news articles discussing the fallout from this and the reasons behind it. Given that many of the people who read MacroBusiness aren’t in the financial industry I thought it would be valuable to give a bit of background to what we could be seeing before the new week begins.
For those of you who haven’t already done so I recommend you read my piece from Friday on the EFSF for a background on exactly what it is and some of the issues it is likely to face. Basically the EFSF is becoming a CDO instrument, collateralised against loans to struggling nations and insured, in part , by the European AAA rated core. The final insurance mechanism that will be provided is still up in the air but either way the issues stand. On the surface the EFSF sounds like a grand plan but as I explained in that post it is actually a huge gamble and may in fact turn into a giant dangerous flop.
As I have stated over the last 2 weeks the most important component of the 3 point plan was the write-down of Greek debt. At this stage it would appear that Greek bondholders agreed on a 50% write down with €30bn in “sweeteners” to accept the deal. There will also be another €106bn loan for Greece which combined with the write-downs is supposed to achieve 120% debt-to-GDP ratio by 2020 and also convince the markets that it will never need another bailout. Obviously I have my doubts even on those figures, but if you read the finer details the numbers actually aren’t that good.
It is unknown exactly who the bondholders are and exactly how many will finally take up the deal, but it is most likely that many of them are in the Greek financial sector which means they will need more bailouts after the write-down. Next there is the ECB and the IMF who hold about €130b but will not be part of the deal and let’s not forget that the new €106bn loan will actually need to be serviced. So my rough guess is that the 50% number is much more likely to equate to something like 25% when the dust finally settles. It already doesn’t sound too good, but it gets worse.
In order to get this write-down the Eurocrats had to negotiate with the banking lobby to come up with a deal that was deemed to be “voluntary” as not to trigger a credit event and therefore force counterparties ( mostly European banks ) to pay-out insurance on the bonds that had just been defaulted on. I’ll provide you with the definition for the word voluntary from Wikipedia.
Voluntary may refer to:
▪ A word meaning done, given, or acting of one’s own free will.
Obviously the term “free will” conjures up all sort of philosophical arguments, but I think that any rational human, even a child, is able to make a balanced judgement as to what is and what is not a decision based on their own free will. I am sure lawyers have spent hours, possibly even months , arguing this point but I am sure if you asked a child of even 4 years old whether a decision was one of their own they could easily tell you.
However, it turns out that the definition of “voluntary” was extremely important to this deal as you will notice from he following Wall street journal article.
The landmark accord forged by Europe to reduce Greece’s sovereign debt burden was “absolutely a voluntary deal,” the leader of a group representing Greece’s private creditors told CNBC in an interview.
Charles Dallara, the head of the Institute of International Finance, insisted marathon negotiations with France and Germany were productive and nonthreatening. Dallara also said he anticipates the final deal won’t trigger what some analysts have feared: a technical default that could trigger a credit event or a financial meltdown.
“We are confident that it will be very, very highly subscribed when the deal is done,” Dallara said to CNBC commentator Larry Kudlow. “So I’m very confident that this is voluntary deal, and it will lead to a very successful debt exchange.”
Under the deal, the details of which still have to be hammered out, Greece will see a nominal 50% cut in the face value of its bonds held by private investors. Governments have said a deal should be concluded by year-end.
So here is a question. If you lent someone $100 and then they approached you and said “I can’t afford to give your $100 back, I will give you $50 or nothing it is up to you”, would you consider that deal voluntary ? I know I wouldn’t and the definition I provided above seems pretty clear to me that no one ever should. However in this particular case the sovereign nations of Europe seem to have convinced the banking sector to pretend that it is and at this point the body that gets to make the final decision on this , the ISDA, seems to agree. As an aside I would recommend you watch this recent interview posted on naked capitalism to get some more details about whether ISDA’s decision is actually legally binding in this case.
So the headline is that this deal was good for Europe because they have managed to get the bondholders to accept a deal without a “credit event” that would trigger payments in the opaque credit markets where no one is really sure who owes what to who or just how much money is involved. However this decision has some potential horrific flow-on effects. Let me explain further.
As a purchaser of a someone else’s debt you have to weigh up the expected return against the risk that the issuer will default before you get your money back (principal + interest). In making these decision bond markets set the interest rate payable on debt issuances. One way to mitigate the risk of default for purchasers is to also purchase insurance in the form of a credit default swap or CDS. The normal expectations of a CDS purchaser are that in the event that the bond issuer defaults then they will receive whatever value is specified in their CDS contract from the insurance issuer. The fact that CDS are available, and trusted, means that the rate of interest on debt instruments is lower than it would otherwise be in an environment where no insurance was available. This particular point is where the events of the last week start to create problems.
There is now a perception that any CDS contract on European debt has the potential to be negotiated away by sovereign nations. This has the potential to render CDS against European sovereign debt issuance, including that of the EFSF, useless. This potentially means that purchasers of debt instruments issued and/or backed by European sovereigns will demand higher returns in order to mitigate the additional risk caused by the lack of trusted insurance. Did we just see the first of that for Italy ?
If this turns out to be the case then you suddenly come to the conclusion that by asking the banks to take a “voluntary” write-downs on Greek debt the Euro-crats have created an environment of higher funding costs for the rest of Europe. That is, they have just created an environment that is the exact opposite of what they set out to achieve with the EFSF; lower funding costs for indebted nations.
Bloomberg has more on this point.
The European Union’s ability to write down 50 percent of banks’ Greek bond holdings without triggering $3.7 billion in debt insurance contracts threatens to undermine confidence in credit-default swaps as a hedge and force up borrowing costs.
As part of today’s accord aimed at resolving the euro region’s sovereign debt crisis, politicians and central bankers said they “invite Greece, private investors and all parties concerned to develop a voluntary bond exchange” into new securities.
If the International Swaps & Derivatives Association agrees the exchange isn’t compulsory, credit-default swaps tied to the nation’s debt shouldn’t pay out.
“It will raise some very serious question marks over the value of CDS contracts,” said Harpreet Parhar, a strategist at Credit Agricole SA in London. “For euro sovereigns in particular, the CDS market is likely to remain wary.”
Talk about unintended consequences !!
I have to admit I was surprised when the members of the EU summit managed to cobble together a plan in the dying hours of Wednesday night. The fact that they managed this was a display of true leadership. I was expecting some sort of last minute road-block to halt the whole thing and I think I said as much. I, for one, am suffering from ‘European crisis exhaustion’ and was therefore very willing to give any plan the benefit of the doubt if the Europeans could manage to overcome their political differences and put one together, even with my prior knowledge of many previous failed attempts. I would really like this crisis to be over but at every turn Europe never seems to do enough to halt flow of contagion. I really do hope I am not being too bearish on this latest plan and Europe does manage to find a way to sort through to some sustainable future. But the issues I have highlighted above are real and I suspect the Italian bond auction results mean that the markets already realise it.
Next week I hope to talk about the third part of the plan which is the bank re-capitalisation. The aim is to get European banks holding 9% tier 1 capital against their risk weighed assets by June next year. There is still limited details on this particular component so it is hard to make an assessment, but I am already wondering exactly where this additional €100bn in capital is going to appear from. I am also wondering, even if they can raise it, whether it is enough given that some agencies, including the IMF, have previously estimated that far larger values are required…. but that is all next week’s problem.
Enjoy what is left of your weekend.