On Greek CDS

Under the efficient market theory the following trade should not be possible, yet you can put it on right now:

• Buy 5-year Greek Government bonds (rated BB+) to yield 11.2% and,
• Buy a 5-year CDS on the same Greek Government bonds at 620 bp (6.2% per year) from, say, Deutsche Bank (rated A+).

The net result is you make 500 bp (5%) net profit per year (11.2% - 6.2%) for up to five years and, at the same time, lower your credit risk very substantially, since Deutche Bank is rated six whole notches higher than the sovereign risk of Greece.   If Greece defaults you just deliver the bonds to Deutsche, get 100 cents on the euro and walk away.

Execution of the actual trade may result in somewhat different numbers since bid-offer spreads are very wide right now, but the arbitrage window is, nonetheless, enormous.

What gives?

Note: German Government 5-year bonds (schatz) yield 2% and those issued by Deutsche yield 3%.

Petunias In The Park

“In many local communities, fountains are not switched on and flowers are not planted in the public parks because of a lack of money,” said  Andreas Blätte, a political science professor at the University of Duisburg-Essen in the state of North Rhine-Westphalia, explaining why so many Germans oppose lending money to Greece.

Hold the presses.  Germans can't afford petunias in the park and, thus, are willing to chuck European solidarity and integration into the compost heap of history.

 Revealed At Last:  The Missing Link To European Monetary Integration

Helloooooo?  Wake up Germany, this is the most important test ever of the euro as a major global reserve currency and, therefore, the EU's prospects for becoming  a real player in the balance of power game.

Unless, of course, the vision is to shrink the eurozone to an uber-alles core of Germany, Holland and Austria by ejecting the "weak" South and other such untermenschen from the club.  If this is the plan and your euro becomes so strong vs. their drachmas, lire or pesetas... who's going to buy your products?  Surely not the Chinese, so we'll see then what productivity is all about, eh?

Figure it out: Alles cannot be in ordnung all the time within a Union of so many different  and disparate members.  The skills necessary for the Union's leaders are flexibility, diplomacy, a willingness to cut deals in back rooms and (gulp) a certain amount of charm.  Come to think of it, maybe you should leave the job to the Italians.

Is A Greek Default Inevitable?

No, it isn't.  But it may very well be desirable for all concerned, up to a point.

There are two extreme possibilities in resolving the Greek debt crisis:

• Plan A:  Massive default with near zero recovery for creditors and exit from the eurozone. 
• Plan C:  Massive Greek fiscal adjustment with murderous wage, pension and public service cuts, plus tax hikes.

Plan A puts the entire workout cost on the shoulders of  lenders.  Most of them are foreign banks that have posted their holdings as collateral with the ECB, and various public pension funds.  This makes Case A politically and strategically untenable, as lenders would then try to seize Greek financial and physical assets  wherever and whenever they find them,  freeze trade and generally bring unbearable pressure to bear.  ECB's balance sheet would take a huge blow and the euro could fall apart.

Plan C places the entire burden on the Greek economy.  This may seem fair at first.  After all,  it was Greeks who borrowed with abandon and squandered the money on overpriced houses, Olympic Games and a hugely bloated public sector.  Not to mention a thoroughly corrupt cleptocratic political system that is constantly in bed with a private sector that no longer produces much of anything at globally competitive prices.  

And yet.. it was foreign lenders who made all this possible, even though they knew - or should definitely have known - what was going on in Greece.  For example, it was foreign banks that kept buying Greek bonds at a ridiculously tiny spread of 30 bp (0.30%) over German bunds for years because they could post them as "cheap" collateral at the ECB.  What happened to their fiduciary responsibility?  It went out the window - the same window that allowed for the manufacture of poisonous AAA synthetic CDOs from CCC subprime mortgages.  It is ludicrous that such irresponsible practices should be rewarded post facto and their practitioners be made whole.

Therefore, I call for implementing Plan B, a solution obviously in-between A and C.

• Plan B: Share the blame and the cost, but not necessarily 50-50.  

My proposal (though obviously not my opening gambit at the inevitable bargaining table) would be to pay creditors a net present value of  65-70 cents on the euro through a combination of maturity extentions, lower coupons and outright principal reductions.  At the same time, I would demand the Greek government to implement at long last serious tax, pensions and public sector reforms in order to immediately (i.e. 2011) produce primary budget surpluses.

As part of the bargain I would also like to see all EU or eurozone countries exercise their right of eminent domain over their sovereign bond credit default swap contracts (CDS).  To wit, I would require all such contracts agreed under EU laws, or between parties domiciled in the EU, or their subsidiaries wherever domiciled, to be settled in case of default or other credit event, only by tendering the relevant bonds.  This would include all present and future CDS contracts.

In other words, all should share in the pain because all share the blame of creating and sustaining the debt bubble.
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Greek Debt Watch: 5-year CDS currently at 850 bp;   implies CPD of 72% if recovery is assumed at 65%

The Lineup

I don't know why, but the following picture from Reuters strikes me as hilarious.  It must be the fact that these guys are all being sworn to tell the truth. Uh-huh..

 From The Goldman Sachs Congressional Testimony

Oh, and notice the IDENTICAL 6-inch thick binders in front of each.  Words fail me, but what need have we of words when pictures speak so eloquently. 

PS Think the guy on the right is a Trekkie?

The End Of Debtopia

April 26, Monday morning update: Greek 5-year CDS reaches 700 pts. (see chart below).  Assuming a 67% recovery, this works out to a cumulative probability of default (CPD) of 67%.  At 80% recovery, CPD rises to 82%.  These are daunting odds, indeed, and mean that Greece will not likely avoid some sort of "credit event".

Two-year Greek government bonds are quoted 86-87 to yield 12.4%, meaning that the bond market is already pricing in a significant part of such an eventuality. 

 

Chart: CMA

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Greece is turning into history's first failed debtopia, an economy that thoroughly eviscerated its production and earned income foundations to replace them with consumer spending on cheap imported goods and asset inflation, both fuelled by massive foreign debt.  Naturally, GDP growth kept zipping ahead for a while, but so what? To arbitrarily extend the ketchup economics of Larry Summers, Greeks shut down all of their tomato-processing factories,  borrowed a ton of foreign money to turn factories and farmland into expensive condos and bought cheap imported ketchup, instead.  Naturally, there were lots of  domestic jobs in home construction at first, but as soon as credit conditions turned sour it was game over.

Greeks no longer make anything that anyone else wants to buy at the price Greeks demand (see chart below), cannot earn enough money to service their debt properly and - quite obviously - cannot maintain a lifestyle that rose to unsustainable levels because of that ever-higher debt.  Furthermore, they cannot devalue their currency to increase competitiveness and inflate their way out of debt.  Their only choice is domestic deflation and even the head of IMF has pointed this out: "The only effective remedy that remains is deflation" he said a few days ago.

 Table: Eurostat 2009 Yearbook

Greek Labour Productivity Extremely Low

Of course, what Mr. Strauss-Kahn means when he says "deflation" is fresh loans in exchange for a reduction in the domestic cost of production, i.e. lowering workers' wages and benefits, plus a healthy dose of deregulation.  In other words, the standard IMF medicine administered many times with dubious results (think Argentina).

Quite apart from the obvious retort of "lower the cost of making what?", since the Greeks no longer make ketchup, I fear that the IMF's plan for Greece will prove an utter failure, at least as it is envisioned right now.  While I agree that deflation is absolutely necessary, since being a member of the eurozone Greece cannot perform a competitive currency devaluation,  I strongly disagree with the type of deflation that is needed.  To wit, I would recommend debt and asset deflation,  to bring fixed costs in line with what the economy can earn.  

For example, residential and commercial real estate prices should come down enough so that wages and business earnings may once again comfortably cover its purchase or rent.   Right now they don't,  and by a wide margin (e.g. an apartment in Athens can cost several times more than the average single-family house in the U.S.).  Similarly, the country's total debt load should be reduced - instead of increased with more loans from the EU or IMF - to a level where it can be serviced properly by the real economy.

And as an aside maybe I should point out the debtopic similarities between Greece and the United States?  Ah, but the U.S. has its own currency and can devalue at will, you may retort.  Can it, really?

Most Likely Scenario For Greek Debt Crisis

I will hazard a prediction:  The most likely resolution of the Greek debt crisis is a combination of debt restructuring (haircut plus maturity extensions) and IMF/EU funding for the next 2-3 years.

Before I get accused of becoming a prophet in my old-blog age, I hasten to clarify that this is what the market is already predicting: the 4.60% Greek Government Bond due 9/2040 is currently trading at 68-69 (YTM = 7.20%), i.e. at something less than 70 cents on the dollar.  This is a spread over the nearest equivalent German bonds of 334 basis points.  By contrast, the shorter 6.25% GGB due 2020 is trading at 89-90 (YTM=7.75%), a spread of 467 bp over Bunds. Notes coming due in two to seven years are trading at even wider spreads - see the chart below.

 Front-end Of Greek Government Bonds Trading At Much Bigger Spreads Over Germany

I expect, therefore, a voluntary debt swap i.e. swapping bonds coming due over then next 5-10 years for longer maturities, maybe with a self-amortization feature, along with the IMF/EU funding package.  The voluntary feature will likely be there to avoid triggering a credit event under CDS terms, but if structured properly most everyone would want or have to participate - a.k.a. a shotgun marriage.

For example..

Concurrently, the Greek government could enact more revenue-enhancement measures (that's what new taxes  are called, in beffuddle-the-masses speak), probably a real estate ownership tax.  Such a tax could easily raise 5 billion euro/year (current debt service runs at 12-13 billion/yr) and, crucially in a country where tax avoidance is the national sport, would be nearly impossible to avoid.

Take that tax money, segragate it into a special account administered by a Paris Club-type of group, earmark it for the sole benefit of those accepting the debt swap with first-lien bonds  and voila..

The key element in such a deal will be to structure it in such a way as to minimize immediate stress in the balance sheets of major Greek debt holders, i.e. foreign and domestic banks, plus pension funds.  Given the generously stretchy accounting rules for banks holding sovereign debt, it shouldn't be too difficult.

P.S.  I looked at the numbers before I came up with the "..most likely" part of the post's title.  Playing around with the Cumulative Probability of Default (CPD) formula, we can evaluate various scenaria of recovery rates (i.e. how much the "haircut" will be in a potential debt restructuring).  If we assume a generous 80% recovery (20% haircut) current CDS prices of 500 bp indicate a CPD around 60%.  And, in fact, most Greek government bonds already trade around 70-85 cents on the dollar, depending on maturity and coupon.

I don't think Greece will bother to go through a painful debt restructuring process unless it can significantly reduce its debt load, say at least down to 80% of GDP from a projected 120% at the end of 2010.  This implies a haircut of approx. 33% (recovery of 67%).  Plugging in these numbers to the CPD formula (r=67%, CDS=500) we get a 5-year cumulative probability of default of 55%.


UPDATE: Five year CDS now trading around 650 bp, implying a CPD of 62% at 67% recovery.

Oldie But Goldie

Well, well... Turns out that Goldie wasn't "doing God's work" after all. The SEC has just charged the world's biggest investment bank with defrauding investors in a sub-prime mortgage synthetic CDO (i.e. a virtual bond made up of credit default swaps). 

I will spare you repetition of details - readers of this blog  being a well-informed crowd - and just share a Wall Street joke of old, applicable to this situation.

A broker invites his customer - the manager of a large pension fund - to a dinner meeting of Wall Street big shots.  They arrive together at the fancy restaurant promptly at 7.30 pm and, as they make their way towards the private dining room in the rear, the broker confides to his customer - sotto voce, of course - that amongst those attending the function tonight will be a wold-class sucker, a schmuck whose perennially misguided investment decisions provide untold millions in  profits for all the rest.

As the customer makes the rounds during the pre-dinner cocktail hour he stares at the attendees, trying to identify the "mark": "That's Lloyd, certainly no sucker.. and that's Ken, certainly no fool.. and there's Bill, a really sharp guy".  

After a while, the customer gives up shaking his head. "Oh well, I guess he never made it to this dinner", he says as he heads to the bar for one more drink.

P.S.  Given that structured finance hanky-banky has certainly occurred at many other financial institutions, it is very interesting that for its first serious action after the meltdown SEC is going after Golman, Wall Street's most emblematic firm.  It could be a sign of seriousness, or it could just be political smoke.  We will just have to wait..

Suspension Of Debtbelief

I have been a close observer of the Greek Debt Crisis for quite some time now.  What strikes me most is the absurdity of calling for additional debt as a solution.  It's not enough that Greece already has a government debt rapidly approaching 120% of GDP and cannot realistically fund itself through the markets, its government, the EU and the IMF are proposing that it takes on even more debt, albeit at lower-than-market interest rates, as a way out of its already untenable situation.

Let's go back a few years to the height of the debt bubble when Greece - already over-indebted  at 100% of GDP - could sell 10-year government bonds at a mere 25 basis points (0.25%) over Germany (the spread is now 400 bp).  I maintain that this required a suspension of disbelief equivalent to observing Harry Potter ride a broomstick over the skies of Hogwarts on the silver screen and accepting it as fact, i.e. total immersion into fiction-as-reality.  Park your brains at the popcorn stand, sit back at the comfy chair, sip the kool-aid and enjoy while the movie lasts.

What, me worry?  was the attitute. New Age Credit was flowing freely, whilst risk was supposedly being taken care of by newfangled instruments devised by the apprentice financial engineer-magicians.

Well, guess what folks? The movie's over. Suspension of disbelief is over. What's going on right now, best exemplified by the preparation of Greece to tap the IMF and EU for even more debt,  it's like those folks who stubbornly refuse to leave their seats staring forlonly as the credits roll over the black screen, hoping to eke just a smidgeon more of happy times.

We all need a radical reality check, to understand that our kool-aid was heavily spiked with debt acid.  That for a while we lived in a make-believe world where we acquired goods and services with a mere scrawl at the bottom of promisory notes that someone else - obviously dropping even heavier acid - accepted as prima facie "assets".

In other words, we need to suspend our "debtbelief", that debt is a panacea for all economic ills from stagnant earned income to a minuscule savings rate and the emasculation of the western manufacturing and technological base.


 

Crossroad Signs

We are, as usual, at a financial crossroads and the signs to guide us to the proper route are, also as usual, smeared with graffiti and conflicting directions.  But in this instance the crossroads are significantly more important than at other times;  it's a bit like equality amongst Orwellian animals.  Decisions made in times of Great Recessions carry much more impact for the future than any other time.

Roadsign To Future Success

But, at least, we have a pretty good picture of the possible futures we may face:

• (a) High(er) inflation, caused by the massive amounts of "new" money created by western central banks and governments in the course of The Great Bailout or,
• (b) Deflation, caused by the default of these western nations crushed by their massive sovereign debt obligations versus their earned income or,
• (c) None of the above, see further below.

In the current context most analysts and academics are already choosing (a) high(er) inflation, though they routinely mask their arguments in terms of "growth", "recovery", "higher real interest rates", etc.  They expect this to be the least painful eventuality, probably because of their familiarity with high inflation during the 1970's and '80s.  Another reason, particularly for Americans, is their institutional fear of the Great Depression with its wrenching bank runs, dust bowls and fulminating political unrest. (They didn't call them grapes of wrath for nothing, and it should be remembered that in the 1930's the monied classes considered FDR a communist.)

As partial - but powerful - proof that the cognosenti are preparing for Future (a), PIMCO  (the world's largest fixed-income money management firm based in California, assets under management $1 trillion) is planning to offer actively-managed equity funds for its clients, since bonds severely underperform equities in times of rising inflation.

By contrast, almost no one is seriously predicting a real bout of Great Deflation - no one, that is, but members of the inevitably regular doomsayer brigade for whom the clock is permanently stuck at 5 minutes to catastrophe du jour.  But some of them may have something valuable, indeed, to contribute to our views on possible monetary and fiscal futures;  I should't even call them doomsayers.  Prophets of inflection points, perhaps?

I am referring to peak oil theorists and analysts.  First, please note the absence of capitals in "peak oil";  it is meant to separate sober fact from the panting and hyperventilation common just a couple of years ago, when crude oil had reached $150/bbl.  Add climate change to the mix, stir well and let settle.  Do you see a possible monetary future emerging - or, at least, a desirable future?

• (c) A plateau-eing in outstanding amounts of money/debt, zero to slightly negative overall credit expansion, very low interest rates and the gradual removal of finance from center stage in the economy.

Under such a scenario, central banks and policy makers are going to dust off a long-neglected monetary policy tool, i.e. targeting money supply. 

I claim that the EU/IMF $61 billion standby bailout arrangement for Greece can and should be interpreted in terms of money supply conservation, i.e. it is meant to prevent the rapid evaporation of fiat money/debt into thin air via default.  At the same time, because of global sober credit evaluation and very low risk appetite it is impossible to create trillions in incremental high-powered money/debt.  Leverage has become a four-letter word and I believe it will remain so for decades.

Now, is the road-sign any clearer? Umm..

The Great Debt Bailout

This blog was created in late 2006 in order to "vent" my frustration over the huge debt bubble and what I  perceived to be the risks it posed to the global economy.  In summary, I claimed that the economy had become hooked on debt to create additional GDP growth - or "growth" in quotation marks - and that the finance "tail" was wagging the real economy "dog".  

Soon thereafter, the bubble burst - first in the U.S. and then everywhere else. What followed was the worst economic crisis since the Great Depression.  And we are still in the midst of it, albeit in ever-mutating form, so today's post is meant as a tour d'horizon, a quick summary of how I see things shaping up today.

I believe all that has happened so far is The Great Debt Bailout.  Governments and central banks have issued trillions in new government-backed debt, some to replace private debt gone bad (bailouts for billionaires) and some to finance massive budget deficits (pennies for penniless).  It is a policy mishmash produced by the combination of  (a) Bernankean revulsion to monetary deflation and (b) Keynesian aversion to economic recession.  

This veritable flood of new and replacement public money averted the occurrence of an immediate, catastrophic Great Deflation, but at the cost of sharply higher sovereign risk.  Debt was not allowed to be destroyed through default or voluntary cancellation but, instead, was transferred onto the shoulders of the public at large. The gross amount of credit risk, therefore, has remained essentially the same as at the height of the credit bubble, ameliorated somewhat by the fact that government debt usually carries lower interest rates and can thus be serviced more easily. But relative to the shrinking economy, total debt has gone higher still. 

Look at the chart below: Total credit market debt in the U.S. has hardly budged in the last two years after its previous rapid rise  (blue bars), but because the economy slumped debt to GDP kept rising (red line).

The same debt-fever condition is inflicting just about every western economy, from Japan to the U.K.

And this is why the Greek debt crisis is so important right now, despite the country's relatively  small economy (its GDP ranks it 27th in the world and amounts to just 3% of total EU output).  It is the first significant sovereign debt crisis, occurring as it does in a country that mostly adopted the free-markets, debt/asset /finance sector bubble model to boost its economy.  Yes, there are important details unique to Greece, such as a bloated public sector, graft and a rather inefficient economy, but the big picture is not unlike that of the U.S. or the U.K.  To wit, Greece is suffering from a South European variant of the Anglo Disease.


We are, therefore, about to witness the first significant sovereign bailout (see this, too) in what is shaping as the next domino to fall during this Great Recession.  What will come next I have no clue, but I should point out that many - if not all - western nations are in similar straits, i.e. their total debt is simply too large to be serviced properly by earned income.  And as the masthead of this blog says: "A sustainable economy is not possible with unsustainable debt".  Or, to put it another way, you can't cure a debt bubble by blowing more debt into it..