First Act of Greek Default Proceedings Drawing to a Close

Global stock markets are up about 10% since the beginning of the year, volatility has collapsed, US economic data continue to defy even the mild slowdown proponents and the ECB seems to have backstopped the European banking system. 

Yes, my dear reader. This is how quickly you move away from the apocalyptic abyss and back to normal. My base case is that we are close to excess complacency in equity markets and a sell off is overdue, but it is exactly also under these circumstances (where smart money start to hedge) that the market may deliver one final run up to get everyone and the postman in before hosing everyone. 

In the short term, one of the only remaining stumbling block in the form of the ongoing default proceedings in Greece seem to be no match for the ongoing positive animal spirit of the equity market. Only a week ago, we got news that talks in Greece had stalled, but most recently we have been reassured that talks are back on track. 

The main niggle on the first occasion appeared to be what kind of interest rate that investors would get on their new bonds and thus, ultimately, the loss of face value currently said to be 50% but also, by some, claimed to be as high 62.5%. Another issue would be whether Greece would pass legislation that forces investors to participate in the debt swap if a majority of investors agree to the PSI terms. This was specifically being discussed in the context of a particular group of investors holding both CDS contracts and the underlying bond and who would maximize their payout on the former by forcing through a hard default. 

None of the terms seems have changed massively in the past week, but time is running out with March the 20th set as the final deadline as this is when Greece would otherwise have to make a payment of 4.5 billion-euro ($18.7 billion) on maturing debt. The general consensus is that if no agreement is reached, this date would mark the hard default. The reason for the optimism is then that we are very close to full surrender in the form of a 90% participation rate of creditors and, we are told, it is only a matter of time before the final 10% agrees. 

The details reported so far are as follows;

Quote Bloomberg (21 Jan 2012)

The parties are near an initial agreement under which old bonds would be swapped for new 30-year securities carrying a coupon that would begin at 3.1 percent, reach 3.9 percent and go as high as 4.75 percent, Athens-based newspaper Proto Thema reported on its website yesterday, without saying where it got the information.

The desired macroeconomic outcome of all this is obviously well advertised. In 2020, Greece is supposed to have a government debt to GDP ratio of 120% and presumingly some form of growth that would allow this level of debt to stay stationary or perhaps even decline over time. 

Let me be clear absolutely clear here. Within any conceivably realistic macroeconomic model, there is no way that Greece can reach a stable debt level with moderate growth under these conditions. Under the interest rate scenario noted above (let us with a average interest rate of 3.8% on the new debt) the nominal interest rate would still be substantially higher than the growth rate of the economy. The only way, the nominal debt level could then be kept stationary is by forcing the fiscal balance into surplus. However, the problem is that this affects the denominator in the debt/GDP calculation by sucking out demand (growth) from an economy already structurally impaired (within a currency union and all that).

The implications are obvious I think . The promises of stability that the PSI currently holds (even if it comes with considerable pledges of IMF money) are bound to disappoint. 

First act of several to come

First of all, let us be clear. Despite, politicians' mortal fright to use the D-word and the media's acceptance of this fact on the basis that CDS contracts are not activated under the PSI, this is a stone wall default [1]. Anyone, who bothered to take merely a scant look at the history of sovereign defaults will see that the current Greek situation fits well within the framework. Indeed, the proposition that this is not a default because CDS contracts are not activated is ludicrous since in the vast majority of sovereign defaults, the debtor country begins negotiations with creditors well before the actual default is forced upon it. The fact that insurance contracts bought to protect a creditor involved in such negotiations have now been rendered useless says more about the nature of the our modern financial system than it does about the definition of a sovereign default. 

Hence, we come to the real nature of this game. 

The deal which now seems to be close to completed by no means closes proceedings. It is very likely in my opinion that private creditors who are currently the only ones being forced to take a haircut due to seniority of the IMF and the ECB will face a near 100% loss on their holdings. The argument is simple. Given the amount of debt held by the ECB and the IMF and the fact that these two institutions are senior debt holders the debt held by private creditors becomes juinor debt and thus the tranche which takes the first (and in my opinion likely complete) loss in the event of a default. 

Of course, once we reach this point the issue of CDS contracts will rear its head yet again since if a 50-60% haircut can be considered voluntary anything beyond this becomes very difficult to characterize as such. Any rating agency would find it difficult not to classify further losses as a default and thus begins the fun in earnest. And then comes the ECB and IMF's share. It will be politically dynamite if the ECB had to print on the liability side to cover losses on the asset side on Greek sovereign debt [2] or if the IMF had to ask its contributors for extra cash to cover for losses on loans made out to Greece or any other economy. Obviously, much will be done to prevent this, but just look at the numbers of Greece's economy and you will see that it is not that outlandish, especially if Greece opts to stay in the euro zone. Finally, Greece only represents the starter here. Any deal agreed  in Greece will be ardently watched in Ireland and Portugal who will feel they are entitled to the same deal with their private creditors. 

Most tragedies have several acts, twists and turns. Investors should expect no less from the one currently being played out in the European sovereign debt markets. 

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[1] - I know that the legal smarty pants will wade in now noting that default is only used when a payment is missed, but fact of the matter is that sovereign debt restructurings and defaults throughout time have always been a long process. Claiming that the Greek situation is different because it is allegedly voluntary and CDS contracts not activated is pathetic in my view, nothing less really. 

[2] - In practice the ECB could do nothing and see its balance sheet shrink with the amount lost on the asset side (i.e. reduce lending to the banking system (delevering) with the amount lost on the bonds). However, in the event of a large loss beyond provisions (if any) it is likely that the ECB would "need" to credit reserves with the amount lost on Greek bonds (hence printing money) it would do this by increasing open market operations (the LTRO essentially) on the asset side. I mention the liability side first though since the mechanism would essentially be deleveraging. Whenever a bank takes heavy losses on loans it usually responds by raising capital AND reducing lending. Since the ECB can't really issue debt in the same way as commercial banks, it would need to either reduce lending OR if that is not possible issue liabilities to match the loss of which it is, as a central bank, free to do at its lesure. 

Old News

Unlike Mr. Market who seem to be in full risk-on mode at the moment I am a bit handicapped on account of an awfully slow internet connection which is why posting is unusually slim at the moment. Another part of the market which seems to be a bit handicapped is the usual suspects in the form of the European periphery which seems to be ever so slowly creeping its way back to the front line of the discourse after having stirred in the background.  Perhaps this is a sign of the the market attention-deficit-disorder which follows naturally from the inability of anyone to keep track of all discourses at the same time [1], a point which Team Macro Man described recently quite elegantly;

It’s a right old mess out there at the moment. There are so many broad macro themes all colliding at the moment it looks like a slow motion replay of a motorway pile up. Deflation meets printing presses, meets commodities, meets politics, meets intervention, meets civil unrest, meets desperation, meets Voldemort.

Perhaps, this was also why the FT’s Ralph Atkins felt that he had to remind us of something we already knew this morning but which is still at the crux of the economic issues in the Eurozone. Basically, the ECB would like to think that everything is fast returning to normal and that, by consequence, monetary conditions should follow suit. Apart from the obvious in the form of a gradual increase in the main refinancing rate (currently at 1%) this would also mean a gradual withdrawal of liquidity support to the European banking system and a dismantling of the possibility to post collateral to obtain liquidity.

Mais, plus ca change in Frankfurt as the same problem which has been nagging the past 2-3 years is still, well, nagging;

Overall lending by the ECB has fallen to about €600bn ($780bn) compared with peaks of up to €900bn. But the amounts have stabilised at high levels in those countries worst hit by this year’s crisis over public finances. Greek, Spain, Portugal and Ireland account for 61 per cent of the total, despite comprising only 18 per cent of eurozone gross domestic product.

And this is indeed a royal mess since obviously not all banks in the Eurozone are equally distressed but just as the single interest rate policy creates macroeconomic distortions so will an overall liquidity scheme create the same kinds of distortions on a market level. One would think they would have learned by now. The problem though is no laughing matter. Jacques Cailloux, European economist at the Royal Bank of Scotland makes a key point when he notes that while the ECB clearly knows which banks that are using the funding facilities because they really need and which who use it for arbitrage (borrowing at 1% from the ECB and invest in the widening periphery yields to the Bunds) it is very difficult to do anything about the latter as annoying and frustrating it might be for the ECB to be a part of. Of course, you start to make differentiated access to auctions either by positive or negative discrimination but the end result would almost surely be the downfall of a number of European banks since the market would interpret this, and rightly so, as a sign that these banks would not be able to survive as independent private entities.

Meanwhile, in market land and while the SP500 tests new highs at around 1130ish the water is starting to boil under the Irish cooker just as you might have thought that Ireland was one of the better of the bunch. Yields on 10 year Irish bonds rose to an all time high today nudging above 400 bps as worries mounted that the government would not be able to meet its otherwise fine and lauded austerity plan on account of a darkening economic outlook not to mention the odd bank bailout (this time being Anglo Irish’ turn). The problem is essentially that at some point you simply run out of line and as such, finance minister’s Brian Lenihan’s assurances over the weekend that Ireland would not only have no problem finding bid for its 1.5 billion euro bond offering today and that the market would get a final tally on the recapitalisation of Anglo Irish, the screw has so far kept turning.

On Anglo Irish, WSJ’s Market Beat raised a further concern today;

In the coming days, Ireland’s central bank will also provide more clarity on the biggest bug bothering investors: The total cost to the government of winding down troubled lender Anglo Irish Bank Corp.
Investors will be watching not just the final tally, but also details on what could happen to holders of the bank’s senior bonds and roughly 2.5 billion euros worth of riskier “subordinated” bonds.

This is a point also recently made by John Dizzard in the FT and it goes to heart of the uncertainty surrounding Anglo Irish and indeed the whole bailout mechanism since where it is all well and good that stockholders get buggered bondholders have, for now, in most cases been spared. The cost so far of bailing out the bank has been staggering for Ireland. To date the government has injected a full 23 billion Euros and Standard & Poor estimated back in August that this figure might rise to 35 billion Euros over time. Even at 25 billion Euros Dizzard points to the dizzying fact that this already constitutes 5600 euros for every man, woman and child in Ireland.

While all this trundles on the yields of the periphery continue to widen and apart from Ireland, Portugal has also found its spot in the market cross hair.

The real question to answer then is if and when Ireland (and Portugal) capitulates and goes to the trough of the European Stability Fund (charging 5% for a loan) and/or the IMF. According to Goldman Sachs' Erik Nielsen, anything beyond 5% (i.e. as a lingering yield on Irish bond offerings) would mean that they are cooked and this, remarkably and scarily, is even in the context of a country that is actually fully funded until mid 2011. However, with the underlying assumptions on the economic outlook almost certainly too positive and the butcher’s bill on Anglo Irish more likely to rise than fall this particular fact might mean very little. But this I reckon is already old news by now.

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[1] I intend to present a solution for this at some point so stay tuned!

Full Disclosure: Some readers at Seeking Alpha have requested that I disclose what I am "buying and selling" and while this of course requires that I am actually buying and selling anything in the market I do run a small time retail portfolio. Now, before you sharpen your pens too much please note that the money committed so far probably amounts to half the Salomon Brother bond desk's budget on Guacamole on Mexiday, (in 1985 prices!) but still. Here are my positions as of today; 

Long Amedisys (AMED) (in profit)

Long Seagate Technology (STX) (in profit)

Long Grains (ETF) (in profit)

Long Natural Gas (ETF) (in loss, almost flat though)

Long Ultrashort S&P500Proshares (most recent trade as a put option on the market basically, oh and of course in loss!)

As a parasite on the financial system I trade through CFDs through IGMarkets which, as far as I can see, is neither better or worse as broker for your average small time retail punter.

Liquidity Giveth, Liquidity Taketh - The IMF on International Capital Flows

To be an economist these days is a rare privilege and especially; it is a privilege to be a blogging economist since there is just so much good material to write about at the moment. On the one hand, there is the unfolding unravelling of Goldman Sachs (loads of material out there already, but just read Felix and you will be fine) and on the other there is the increasingly ominous signs that the Eurozone as we know it is about to become a thing of the past [1].

I hope that I will get to deal with these specific topics at a later time, but for now I would like to point,  in the most obscure of all directions, to chapter 4 [2]of the IMF's part released Global Financial Stability Report which deals with the transmission of global monetary supply to international capital flows and global asset prices as well as inflation (hat tip: Tracy Alloway at FT Alphaville). Essentially the IMF report takes up the baton of some fundamental issues of global capital markets and issues which I have discussed on numerous occasions. The issue can be summarize through the two following questions;

1 - Can increasing nominal interest rates to quell domestic inflationary pressures be counterproductive and actually lead to overheating?

2 - What is the global effect of near ZIRP policies in a number of big developed economies and what will the effect be if this persists? 

My own answer to the questions above is yes to the first with the qualifying remark that this implies a relative loss over the domestic monetary transmission mechanism both from the point of view of receiving (high interest rate) as well as sending (low interest rate) economies. And as for the second question I tend to see it as an externality to the global economy and crucially so, an externality which adds considerable volatility to global asset prices [3] since implied risk aversion in the market will determine whether the open taps by the G4 are used (or not) to build carry trade positions [4].

In their recent analysis on global capital flows (see link above), the IMF produces quantitative results and a well tailored methodology to boot to support these claims:

The global liquidity cycle started in 2003 and accelerated from the second half of 2007 when country authorities began to undertake unprecedented liquidity-easing measures to mitigate the effects of the crisis (Figure 4.1). While helping stabilize the financial system and support the return to growth, current easy global liquidity conditions and the accompanying surge in capital flows pose policy challenges to a number of countries where the crisis did not originate, with the primary challenge being an upside risk of inflation expectations in goods and asset markets. Such “liquidity-receiving” countries have had to ease domestic monetary conditions in response to both the slowdown in global demand and the acceleration in global liquidity, adding further pressure to asset prices. The policy challenge posed by easy monetary conditions is greater in economies—primarily emerging markets—that, in addition to strong growth prospects, have fixed or managed exchange rate regimes.1 The associated surges in capital inflows also raise early concerns about vulnerabilities to sudden stops once the global liquidity is unwound, with implications for financial stability.

Thus, what the IMF coins as liquidity receives are those economies subject to carry trade inflows (e.g. Brazil, Australia, New Zealand, South Africa etc) and liquidity senders on the other are developed economies with low interest rates. Recently, these were confined to Switzerland and Japan, but in the context of the financial crisis the UK, Europe (to some extent), and the US have also move short term interest rates to the floor and flooded their banking systems with cheap money for the wholesale market. This has even led some to dub it as the mother of all carry trades.

Now, I am tinkering at the moment with a model of international capital flows and global liquidity transmission which exactly seeks to incorporate this effect. In this sense, I think IMF's results are very welcome. I am of course including demographics which I see as the missing link here since while I suspect the US (and the UK) may ultimately succeed in creating inflation which would force them to pull back liquidity provision others will not. Japan is the famous example here, but as the world ages there will be more and more.

In the jargon of the IMF; old age makes economies structurally prone to being a liquidity sender [5] and as the world ages we will have relatively more liquidity senders than receivers. This poses an externality to the global system and also adds to volatility of asset returns and growth over time.

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[1] - Please note that I am in no way favor of this as I am personally a big believer in the European project but Germany has neither the capacity nor willingness to keep paying for others regardless of the fact that Germany's economy is also, itself, an integral part of the problem.

[2] - See a web cast of the conclusions here

[3] - Which, by the way, is why I see great risks from the policy advice that central banks should target asset prices since there is a hidden volatility multiplier in the works here from tinkering too much with short term nominal interest rates.

[4] - I have even made my own humble contribution to a growing body of literature on this.

[5] - C.f. My master's thesis I think this can be explained through intertemporal preference, but I am open to other interpretations.