EFSF ideas

When in 2008 the world almost came to an end, most politicians were very quick in apportioning blame on the bad practices of banks, the lack of regulation and the greediness of the investment bankers. They pointed out that the practice of moving assets to SIVs and SPV’s off balance-sheet in order to hide the leverage was detrimental to the world’s financial health. These SIV’s had the following characteristics:

1)    Had little capital compared to the assets they were holding

2)    They financed the assets by issuing paper (mainly short term)

3)    Because of the collateral, they were given AAA status by the rating agencies

4)    Had liquidity provision lines back to the mother company (which was eventually called, causing the credit crunch)

So when the price and quality of the assets (mainly mortgages) went down, investors stopped buying the SIV’s bonds. The result was a huge shortfall of funding. As they were not banks but offshore entities (so called “Grey or Shadow banking”) they did not have access to the unlimited provision of ECB or FED money. Feeling desperate they went back and activated the liquidity provisions they had with the mother company. This in turn caused the credit crunch and the global crisis.

Now move fast forward to 2011 and look at the proposal for saving Europe.

1)    Establish a European SPV (or transform EFSF) with 50billion (say) of capital

2)    Give it the status of a banking institution

3)    Leverage it 20 times or more to 1 trillion by issuing bonds into the market

4)    Use the proceeds to buy Peripheral debt and/or bad bank assets.

We do not know whether the plan involves short term or long-term bonds. The difference between this new SPV and the previous one is that it would no longer be a “Shadow banking”, as it would have access to the unlimited funding of the ECB. This is the mother of all leveraged SIV’s. It actually transfers the financial technology that was responsible for the credit crunch to the sovereigns and to the real banking system. If the quality of the bonds this SPV owns, goes down, there would be no problem in funding them forever, assuming the accommodative ECB stance is forever. The whole scheme is a stealth way of printing money without the ECB violating article 21 (grey area). I don’t understand why we have to complicate these things. We do not need SPV’s, just ask the local banks (Italian, Greek, Irish etc) to buy more new Government debt and then repo it with the ECB. Even better, ask the local NCB to increase the ELA (Emergency Liquidity) to 1trillion. In fact this is the real onshore “Shadow Banking”. The ELA has the ability to finance any kind of toxic asset by “Ponzi-ing” it with the state. The Irish are doing it for a year now. Why not extend the practice across all Europe?

Alternative ELA Proposal

Let the Greek banks give tax-loans to the Greek retail customers. In other words, loans for the Greeks to pay their government’s Taliban tax raids. The lender bank can turn around and give these loans to the Bank of Greece’s ELA and get the funding. Doing so the Greece collects all the taxes and appears perfect in Troika’s eyes. The fact that the ELA is a liability of the Greek state is a minor detail that can conveniently be overlooked for some time. 

These new proposals are just a covert way of introducing more leverage to the already overleveraged banks and governments by placing smokescreens and printers. It is just another sleight of hand to distort reality and buy some time.

Greek Bond Prices and Default Probabilities

In the past few weeks a flurry of articles have hit the popular press regarding the probability of default of Greece. Headlines like, “Markets predict Greek Default probability 99.99%” or “CDS markets predict 100% probability of default for Greece” inspired fear to the hearts of investors and to Greek depositors who rushed to take their money out of Greece. Most of these stories have originated from the financial press[1] and from traders who used a well known mathematical formula that computes the probability of default given the bond Price.

One cannot argue the correctness of this number or the mathematical involved which have been checked by many practitioners and academics alike (including me). There is however, great ambiguity and controversy at applying this mathematical formula and interpreting this number as the market’s prediction for the probability of default for the Hellenic Republic. The reason is simple. Many of the underlying assumptions, which unfortunately are almost never mentioned, are violated in this case.

Market Liquidity and Efficiency

 

Figure 1. Monthly traded volume of GGB's

The credit spread of any bond whether corporate or sovereign is comprised of the following components:

a)    Risk of Default.

b)   Optionality if any.

c)   Liquidity Premium

d)   Other, like Convexity, Repo specialness, etc.

In the case of almost all Greek bonds the credit spread is simply (a) and (c). I.e. Risk of Default plus Liquidity Premium.

So how much is the Liquidity risk or premium embedded in the spread. Do we know? Can we somehow estimate its value? Most academic studies have shown that it is significant but unfortunately no satisfactory model exist (to the best of my knowledge) that can separately price it.

So, how liquid are the Greek bonds and the Greek Bond market. Greece has about 350 billion of debt. In the form of tradable bonds around 280billion as the bailout package have so far transformed 60billion into bilateral loans and there are also around 10billion in short term Tbills. How many of these bonds are traded on a monthly basis now and how many a year ago. The graph below (Figure 1) is revealing. From a high of around 45billion in March 2010 (when the debt crisis erupted) we are down to 1.7billion in March 2011 (Data are from the major providers, HDAT, MTS, Brokertec, BGC, ICAP). This is an absolute staggering reduction in liquidity to the once vibrant Greek bond market. Why did it happen? Why are these bonds not traded? Why do investors shy from them even at extremely low prices and why are scared holders don’t sell them?

New risk Emerge. Leviathan. Turkey Israel Cyprus

·            Papandreou cancels trip to NY

·            Conference today at 17:00 (London time). New measures to be announced

·            Coupon Payment delay unlikely.

·            Elections?

·            Leviathan

Papandreou cancels UN trip

The Greek saga continuous and it is better than watching Joan Collins in Dynasty. In a theatrical and dramatic gesture the Greek PM swapped, UN cocktail parties, Bloomingdale sales and a meeting with Turkish PM Mr Erdogan for Mr Venizelos. The official reason given is that Mr Venizelos encountered a hostile reception (putting it in polite terms) by his European colleagues who did not believe that his latest Taliban Tax raid on housing was going to work. The European leaders were also possibly annoyed by the support of the Americans and especially by Mr Geithner who urged the Europeans to stop bickering about the debt and get on with the job of dealing with it. Judging from the recent, last hour debt ceiling deal in the US, which brought the US within days of defaulting most Europeans would be sceptical of his wisdom.

New Measures

Greek government target is to:

·            Comply with the 2011 budget as dictated by Troika

·            Achieve primary surplus in the 1H of 2012

Both targets are ambitious. In order to be within the 2011 budget, as time is running out, further tax raids may be on the cards.

Merkezy, PSI, Taliban Taxes, Conditions for Default. 15 Sep 2011

·         Merkezy statement on Greece

·         PSI

·         New taxes in Greece

·         Default cui bono

·         Conditions for expecting default

Anyone expecting some big announcements after yesterday’s Sarkozy, Merkel and Papandreou videoconferencing, does not comprehend how the EU works and functions. The principles of opaqueness and secrecy are adhered religiously. Why, was it only Merkel and Sarkozy versus all European leaders? After all, this is a European problem. Is this a new EU body that I missed? In any case, what was really said and decided we will find out in the next few months. Afterwards, they stated the obvious i.e. that Greece would remain in the Eurozone and that Greece would stick by the medium term plan. Most importantly of all, they reiterated the resolve to proceed with the PSI.

It is obvious that some kind of political deal was struck but we would not risk speculating. One however, could infer that the threat of disrupting the instalments the past few days was directed at Mr Papandreou and not at the markets. There are no significant bonds maturing till December 2011, so any delay in the instalments would have meant bringing down the Papandreou administration by October end, without risking default. So, by saving his job for now, it is natural that the Germans got something in return.

One should expect some major announcements from Greece in the next few days possibly even today that aim to convey the message.

Europe implicitely asks Greek PM to go.

·            Greece announces one more tax raid to plug the hole in the budget as the estimated deficit jumps to 9.5% from the 7.6% forecasted for 2011.

·            Greek PM credibility at its lowest

·            European leaders barking at Greece

·            Scenarios going forward

It should by now be very clear that every time we are approaching an installment, Greece would start kicking and the European leaders/lenders would start shouting verbal abuse. In addition, there would be the customary rumors regarding Greece exiting the Euro, declaring default over the weekend and the seven plagues visiting Greece together with the Troika inspectors.

I am surprised, by the inability of the market to comprehend that the European Union is just a babel of views and that it should not pay attention to what they say but what they can or cannot do. With that in mind, can we seriously estimate the cost of Greece proceeding with a disorderly default and possibly exit from the common currency? I think not, at least not in the near future. It is not a question of morality or whether it is right or wrong to punish the non-compliant Greeks. Morality exists only in humans and not in states and right or wrong never enters a political calculation. It is rather the monetary consequences to the European Financial institutions, the ECB and the Global economy.  Then we have the social consequences in Greece and across Europe. The philosophical ideal of a united Europe would suffer a blow and the notion that we have a German led coalition of northern countries against the south would gain credibility. In short, other countries not having similar problems might think of leaving the Union or not entering at all. After all, this is supposed to be a Union of willing partners and not vassalage. 

I therefore find the market’s reaction slightly over the top and that the most likely outcome to the current mess is a compromise and more time-buying.

Greek PM has become part of the Problem.

Watching the PM’s speech in Thessalonica was a painful ordeal. The market was expecting some mood changing announcements and instead they got the usual Greek rhetoric. The PM seems to have forgotten that the speech’s audience was the European politicians and the markets and not the Greek public. He reiterated the usual “we shall fight on the beaches” and “we will do whatever it takes” slogans coupled with the customary attack on the conservative opposition.

Greece May Default as Finns Demand Aid Collateral: Euro Credit 2011-08-25

By John Glover
Aug. 25 (Bloomberg) -- Finland’s demands for collateral on loans to Greece may trigger a default on 18 billion euros ($26
billion) of bonds sold by Europe’s most-indebted country.
The securities, which represent less than 7 percent of Greece’s 286 billion euros of bonds, are governed by English, not Greek, law, and include conditions that insist on equal treatment for all investors. Giving collateral to Finland as a condition for aid may breach the requirement that fresh debt doesn’t win repayment priority over existing notes.
“I am pretty sure the Greek government didn’t even know this, their incompetence is legendary,” said Andreas Koutras, an analyst at InTouch Capital Markets Ltd., a London-based fixed-income adviser. “One should be very careful when giving securities or other collateral, like the Greek government is with the Finns.”

Greece decides to wake up. Is it too late?

In a cabinet meeting full of the usual Greek drama, the finance minister and deputy Prime Minister Mr Venizelos announced the capitulation of the Greek government to the Troika’s demands (salary review, privatisations, closing of state enterprises, opening of closed professions etc) . For the past 2 year the government of Mr Papandreou is playing the game of chicken with the EU creditor-partners. i.e. committing to changes outside and implementing nothing (or at least watering down reforms) inside.

This policy was successful initially in scaring/tricking the EU politicians and the markets but it now seems to have reached the sell by date and the EU now clearly demands action and deeds and not just the usually empty promises. In fact, the EU politicians are more scared that Italy may follow on the path taught by the Greeks rather than Greece itself. It is no secret that Greece is being used as a laboratory monkey, to test economic policies, European public opinion and political careers (Merkel, DSK, Lagarde, Regling and many more).

Greek Update. PSI, IMF, Finland

·            PSI conclusion on the 9^th Sep.

·            IMF leaves Greece to come back in 10 days.

·            Issue of collateral and security given to Finland

PSI

According to the schedule the PSI should be completed by the Friday the 9^th of Sep. The IIF and the Greek government has set a target of 90% of participation for the bond maturing up to and including July 2020 (81 bonds in total). Bond holders are invited to chose “voluntary” between 4 options ranging from 15Y to 30Y with some having capital guaranteed at maturity.

The problem is that this 90% participation seems to be hard to achieve and currently news reports suggest that so they have collected near to 50-70% with only 4 days remaining for the rest. The low participation is easily explained as a strategy to maximize profits. If a bondholder sees that the 90% has been reached there is no incentive for him to participate but to hold out and get paid Par. Thus everyone is waiting to see what the others are doing in order to make up his mind. In the end there are 3 scenarios:

·            The 90% is achieved and the rollover proceeds according to plan. Then we expect the Greek bonds maturing in the next few months to rally possibly near par. This is because what is left would be paid in full.

·            Less than 90% is achieved say 65-90%.  The Ministry of Finance communiqué was carefully drafted to allow Greece to proceed even if less than 90% is collected. Thus we believe that if a reasonable participation for bonds maturing in the next 2-3 years is achieved then Greece would proceed with the rollover exchange. They would then try to get the rest later possibly by extending the bond maturities to 2025. In this case some close maturities would rally.

·            Less than 65% and the Greeks decide not to proceed with the exchange and thus effectively threaten with a coercive restructuring or with a renegotiation of the agreement of the 21^st July. This would most probably trigger another European Bond crisis with exploding periphery yields and banking crisis. 

We believe that the most likely scenario is the second one. i.e. The full 90% is not achieved but nevertheless the Greek government goes ahead.