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The Greek Solution: Debt Swaps and Back Dated Deals?

  • Written by Syndicated Publisher No Comments Comments
    March 13, 2012

    The mainstream media is still focusing its attention on leaves while ignoring the danger posed to the entire forest. A quick scan of the big headlines for the day…

    ECB Sees Slower Growth, Flags Success of Money Flood - Slower EU growth directly following a devastating EU recession is a very, very bad thing. Combine this with the fact that the ECB felt the need to flood its banking system with a trillion euros of cheap liquidity collateralized by quasi-used toilet paper should make clear that they are terrified of what comes down the pike. Is or is not the writing on the wall?

    Roubini: Private Sector’s Greece Deal Is ‘Sweet’ - Yeah, well, 50% is a 100% percent more than nothing – which is exactly what some bondholders may get as they hold out until this time next year. See LGD 100+: What’s the Possibility of Certain European Banks Having a Loss Given Default Approaching 100%?

    Witching Hour: Will Enough Investors Take Greek Deal? - Does it really matter? The deal doesn’t seem to be enough to put Greece on the path to sustainable economic recovery since by our calculations Greece will be forced to come back to the table within two to four years, reference The Ugly Truth About The Greek Situation That’s Too Difficult Broadcast Through Mainstream Media. As a matter of fact, what seems to be missed is the greater economic fallout of all of this free money engineering…  Watch As Near Free Money To Banks Fails To Prevent Nuclear Winter For European CRE. This gets even worse. If PSI doesn’t go through and CAC is implemented then you have a credit event and CDS market does its job thereby banging those American banks that wrote the CDS. If the CAC is not implemented then the CDS didn’t do its job and the premium that was absorbed by CDS will then be applied directly to sovereign debt meaning heavy debt service. The only way out of this is debt destruction, a true default.

    Furthermore, there’s the common sense consequence of what the ECB has done that apparently wasn’t too commonly perceived amongst those decision makers at the ECB, as reported byZeroHedge last night:

    In what could prove to be the most critical unintended consequence of the ECB’s LTRO program, we note that as of last Friday the ECB has started to make very sizable margin calls on its credit-extensions to counterparties. While the hope was for any and every piece of lowly collateral to be lodged with the ECB in return for freshly printed money to spend on local government debt, perhaps the expectation of a truly virtuous circle of liquidity lifting all boats forever is crashing on the shores of reality. This ‘Deposits Related to Margin Calls’ line item on the ECB’s balance sheet will likely now become the most-watched ‘indicator’ of stress as we note the dramatic acceleration from an average well under EUR200 million to well over EUR17 billion since the LTRO began. The rapid deterioration in collateral asset quality is extremely worrisome (GGBs? European financial sub debt? Papandreou’s Kebab Shop unsecured 2nd lien notes?) as it forces the banks who took the collateralized loans to come up with more ‘precious’ cash or assets (unwind existing profitable trades such as sovereign carry, delever further by selling assets, or subordinate more of the capital structure via pledging more assets – to cover these collateral shortfalls) or pay-down the loan in part. This could very quickly become a self-fulfilling vicious circle – especially given the leverage in both the ECB and the already-insolvent banks that took LTRO loans that now back the main Italian, Spanish, and Portuguese sovereign bond markets.

    This huge increase in margin calls can only further exacerbate the stigma attached to LTRO-facing banks - and as we noted this morning (somewhat presciently) both the LTRO-Stigma-trade, that we created, and the potential for MtM losses on the carry-trades that LTRO ‘cash’ was put to work in could indeed start a vicious circle in European financials, just as everyone thought it was safe to dip a toe back in the risk pool.

    Hmmmm… Let’s take a more critical look at the potential consequences by reviewing page 9 of the subscriber forensic report for BNP Paribas (click here to subscribe).

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    Heavy ECB margin calls on institutions that have abused the ambiguity cover provided by Topic 820 can foresee some significant pain in the near future. Having to sell something for reality’s price that you carried on your books at fantasy’s price has never proved to be a profitable endeavor.

    Subscribers should now review pages 10, 11, and 12 of said document – which will really get your britches in a tear.

    It really doesn’t look to positive, but that’s bullish, right!!!!

    Can such a thing really happen? Here’s another interesting story from ZeroHedge on the carry trade gone bad…

    We know how AIG and MF ended, as of yet we don’t know how LTRO will end.

    AIG was the ultimate carry trade. They sold massive amounts of CDS for a very small spread. They had no funding cost, no collateral requirements(initially), and no mark to market risk for their own P&L.  The year before AIG blew up, management was spending all sorts of money buying back their “undervalued” shares. Actually they probably bought back a lot of shares in early 2008.  What could go wrong with the trade?  The only thing that could go bad was a downgrade to AIG at the same time as the assets they wrote CDS on went down, because then and only then would they have to post collateral.  Their CDS had massive negative mark to markets long before they were on the verge of collapse. It was the fact that a downgrade to their ratings could enable their CDS counterparties to call for collateral.  It was the threat of collateral calls that ended it for AIG.

    LTRO has variation margin.

    What happened at MF?  Massive positions in short dated bonds to earn the “carry”. All was fine until the size concerned people. They had trouble financing the position. The position was so large the market pushed against them. With so much leverage they couldn’t meet the margin calls and selling the bonds would wipe them out.

    LTRO has variation margin and the banks have disproportionately large positions in the debt of their country.

    Lots of “carry” trades have worked out well, but when they don’t, the result is pretty ugly. Many argue that LTCM was also just a giant “carry” trade that unwound when vol and mark to market blew through their ability to post collateral.

    In closing, I urge all subscribers to play with the BNP bank run model once again. Remember my admonitions from last summer?

    Saturday, 23 July 2011 The Anatomy Of A European Bank Run: Look At The Banking Situation BEFORE The Run Occurs!: I detail how I see modern bank runs unfolding

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    Cheap dollar funding is not going to help BNP anymore than it helped Lehman. I have prepared several models to illustrate such, and are designed to go hand in hand with both our illustrative trading supplements and our forensic research on BNP – namely:

    The first model (all are cast in Excel 2010 format [.xlsx]), File Icon BNP Exposures – Free Public Download Version, is available to the public free of charge and is designed to spark the discussion of Whether Another Banking Crisis Is Inevitable? Here are some screen shots.

    The Impairment Scenarios: a very important concept that practically the entire European banking systm has somehow forgotten to address.

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    Trading and HTM inventory at Level 1,2,3 or fantastical fanstasy?

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    For those not familiar with the banking book vs trading book markdown game, I urge you to review this keynote presentation given in Amsterdam which predicted this very scenario, and reference the blog post and research of the same – and then revisit this free model and reapply your assumptions:

    The next nugget of knowledge is the File Icon BNP Exposures – Retail Subscriber Download Version. It enables users to simulate an anecdotal bank run – for retail subscribers only of course. In addition to those above, it sports…

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    For those professional investors and institutions, namely hedge funds, asset managers, regulators, high net worth individuals with ties to BNP and family offices, heres to you. This is not a toy, but a tool that can truly communicate why you feel BNP may, or may not be a candidate for a bank run – contingent upon your inputs: File Icon BNP Exposures – Professional Subscriber Download Version. Additional screenshots above and beyond that included above…

    Income statement implications of a true bank run…

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    Images: Flickr (licence/attribution)

    About The Author

    Reggie Middleton is an entrepreneurial investor who guides a small team of independent analysts to uncover truths, seldom if, ever published in the mainstream media or Wall Street analysts reports. Since the inception of his BoomBustBlog, he has established an outstanding track record

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