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A Macro View Of The Week Ahead.

  • Written by Syndicated Publisher 60 Comments60 Comments Comments
    October 31, 2011

    It’s only fitting that on Halloween we discuss a rather scary proposition. On Wednesday evening European leaders announced a “plan” details will come “later” to expand the aid to those in need.

    In lieu of physical capital which doesn’t seem to exist somehow these magicians will take nothing and turn it into something. Through the power of magic they will turn approximately 200 billion euros into 1 trillion.

    So before you book tickets to Europe to experience this new found utopia perhaps it’s worth a look “under the hood” at some potential problems. In fact each potential problem actually builds upon one another creating a much more immediate risk. Did leaders in trying to solve one problem actually fast forward the pace of many more?

    Debtors Have The Power

    Imagine walking into your bank, telling the customer service agent that you can’t pay your loan but if they will cut it in half you should be fine. After the laughter subsides you are quickly asked to leave. In essence that is what Greece did. The debtor turned to the creditor and said you need to reduce our debt. You need to work with us.

    The fear of Greece defaulting is a path the EU simply does not want to embark upon. European leaders made this very clear. They would rather forgive some debt on their terms versus facing a complete loss where they have no control. Ireland, Portugal, Spain and Italy paid close attention.

    Size Of The EFSF

    The EU was desperate to use the word trillion in their plan even if it is purely a function of leverage. Take roughly 200 billion Euros left in the EFSF fund, apply five fold leverage based on a 20% first loss guarantee and you get to where they “needed to be.” But if Greece debt had a default rate of 50% shouldn’t the leverage actually be two, not five?

    In other words isn’t the fund really worth 400 billion Euros? A much smaller number that will do little if anything. Greece used up half of that on their own.

    Moral Hazard

    A phrase from 2008 is back. If I give my child $100 am I not “obligated” to give it to the other children? If the EU gives Greece 50% debt forgiveness why should they not do the same for Ireland and Portugal. What if Spain and Italy need help why should they not be treated similarly? I mean they are all part of the same union. It’s only “fair.”

    Initially perhaps these countries will say Greece was a different circumstance and EU leaders are not allowing us to receive such favorable treatment. How long does that really last though when there are riots and protests in your streets demanding this wipe out of debt.

    If a leader can either ask for billions in austerity from taxpayers or billions in debt forgiveness from bondholders what do you think is the easier path to follow?Why should an Irish taxpayer who contributed to the EFSF not be allowed to benefit as a Greek taxpayer does?

    Bond Arbitrage

    Italian and Spanish debt trades on the secondary market. With Greek debt suffering a 50% loss and no ability to hedge via CDS (credit default swaps) the prices of sovereign debt will trade well below par. Let’s assume Italian debt now trades for 70 cents on the dollar (for every $1 in par you only pay $.70). This new EFSF insured Italian debt will trade initially at par with a low coupon.

    So in essence the new debt is really trading at 80 cents on the dollar because the fist 20 cents is guaranteed. Sounds good but why not buy on the secondary market at 70 cents? It’s the same underlying risk in terms of the Italian government.

    So if buyers are gravitating to the cheaper, uninsured bonds won’t that force this new EFSF insured debt to either offer insurance above the 20% first loss, in this example 30%? They certainly won’t increase the coupon because the purpose of this plan is to reduce, not increase the debt service the Italian government must face.

    As stated above, the 20% or five fold leverage is comical at best and well under realistic levels.

    Rating Risk

    In September 2008 as the funding stress grew within the financial sector rating agencies began to “price in this risk” by downgrading various institutions. AIG for example faced with a downgrade found themselves in an immediate need to raise capital in an environment where they were shut out of the capital markets. The only way of preventing bankruptcy was for the government to inject capital. On September 12 AIG announced that in two weeks they would announce a reorganization plan to calm investors. Five days later they were bailed out by the Federal government.

    Banks across the EU were told to raise over 100 billion Euro by June 2012. Many have argued that number is far below estimates. Already shut out of the capital markets these banks are selling assets to raise cash. All it takes now is a rating agency to downgrade them. AIG thought they had weeks. In reality they had days.

    This may very well force the governments to assist them as the US assisted AIG. The problem here is France is at most risk of a downgrade themselves which would then put all of the pressure upon Germany to expand the EFSF.

    Bottom Line

    This fund does nothing. It has no capital so rather than buying debt it simply buys time. No sooner was the plan announced and Sarkozy and team were in China pleading for capital. Will China be the white knight? China already said their investment is contingent upon participation of others. Brazil already said they are not interested. Japan said they would contribute but they too are limited. How much can the IMF truly contribute?

    The only source of real capital needed (which is really debt) is from taxpayers. Private investors are simply not willing to take on the risk. The only way to convince taxpayers is through a crisis. An event where the free world is once again portrayed to be at risk.

    So in my view this plan did nothing but accelerate the timetable. Already there are rumblings from Ireland and Portugal. Moral hazard is alive and well and something the EU must now face as well. Now that is a truly scary proposition.

    Images: Flickr (licence attribution)

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