“Eurogeddon” averted or just more can-kicking?

March 9th, 2012

Nick Hays

Dhaka, Bangladesh

Today - on The Long and the Short:

* Largest sovereign default in history confirmed: "Uncharted territory"

* “Eurogeddon” averted? Or just more can-kicking?

* The law of unintended consequences

* “No way out”

Tuesday’s sharp sell-off in equities, driven by a combination of ‘fear-factors’ which I wrote about here, reversed on Wednesday and Thursday, with the S&P 500 up 1.6% during those two trading sessions, recovering all of Tuesday’s losses in the process. 

In the same time frame the VIX ‘fear index’ has taken a solid beating, giving up all its Tuesday gains and suggesting that I may have been too soon in identifying a possible breakout. (I will be writing more about the VIX and S&P 500 in my next post.)

News flow out of Europe has been the dominant driver behind the price movements during the last couple of days, with fears of a disorderly default in Greece receding as negotiations for the PSI (Private Sector Involvement) reach a  conclusion. The PSI involves holders of E206bn in Greek government debt agreeing to trade in their existing bonds for newly issued ones of lower value. This write-down, or “hair cut”, equates to a loss of over 70% in Net Present Value terms for the bond holders.

Today it was confirmed that investors holding 83% of holders of Greek government debt have accepted the proposed bond swap. This beats the 75% below which the deal would have failed, triggering a disorderly default and likely financial chaos across the Eurozone.

The largest ever sovereign debt default, and the first for a Western European country in 50 years, this is huge news and analyst commentary on the deal is pouring in. The short-term market reaction is likely to be one of mild relief. However the longer-term picture remains far from certain and I expect it will not be long before doubts begin to resurface – to be sure, this has been the cycle for at least the past 12 months.

What comes next is very much up for debate as, in the words of Berenberg Bank’s Chief Economist, “We are in uncharted territory”.

Eurogeddon averted? Or just more can-kicking?

The aim of the debt deal is to reduce Greece’s sovereign debt burden from more than 165% of GDP to a more manageable level. Best-case scenarios project this deal will set Greece on track to reduce its debt levels to 120.5% of GDP, just above the maximum threshold of 120% considered sustainable by the IMF.

Longer term, however, considerable risk remains that this deal is little more than the latest in a series of can-kicking exercises, simply buying more time before the next crisis inevitably rears its ugly head. In fact the IMF itself sees Greece’s debt to GDP ratio on an “ever-increasing trajectory” and much doubt remains as to whether the debt burden can be reduced in the long-term. In fact, the new bonds are already trading at steep discounts to face value, indicating that the market still does not expect Greece to be able to pay back in full. 

The severe austerity measures ongoing in Greece are a painful but necessary step towards debt reduction for the country; but most economists agree that these measures must be accompanied by much-needed market reforms to improve its trade competitiveness. Deprived of the option to de-value its currency (aside from the ‘nuclear’ Euro-exit option) Greek competitiveness will have to be restored through a combination of a painful reduction in wages (making Greek exports more attractive) and removing the market-unfriendly policies and red-tape which currently throttle the private sector.

The scale of the reform required and the difficulty to implement it should not be underestimated. In this respect, Greece is like a patient requiring double heart bypass surgery, a lung and kidney transplant and chemotherapy all at once. Carrying out the necessary treatment to get Greece back on its feet undoubtedly means a lot more pain ahead for the country and its people: expect to see more urban violence, tyre-burning and pitched battles with riot police in the months ahead.

Street thuggery aside, the upcoming elections in May will provide a more constructive outlet for the Greek electorate to voice its frustration - and perhaps to vote in a new government on the back of promises to 'ease the pain'. This could mean scaling back on austerity measures, further debt default, a Eurozone exit or all three.

The road ahead for Greece will not be free of challenges, that much is clear, and the market’s relief resulting from the debt resolution will probably not last long. In fact I believe the deal itself sets a dangerous precedent and may result in a number of unintended consequences.

Unintended Consequences

Risk 1: Greek debt deal may encourage other sovereigns to follow the same path.

If Greece can reduce its debt burden by imposing a 'voluntary' default on its creditors, what is to say other nations won't also look to this approach? The other PIIGS nations - Portugal, Italy, Ireland and Spain - may well calculate default to be a more politically acceptable route to debt reduction than the programme of grinding austerity measures to which they have currently subscribed.

Anticipating this, credit markets would demand higher yields to compensate for the additional risk of default. Higher yields make the governments’ debt harder to service, with more and more output being consumed by interest payments. Hence their fiscal position becomes less sustainable and this in turn makes default all the more likely - a downwards spiral ensues.

Risk 2: Greek deal undermines the value of CDSs (Credit Default Swaps)

CDSs are essentially insurance premiums which investors and speculators can purchase to profit from a default on the debt obligations of a corporation or a government. One key difference between a CDS and an ordinary insurance premium is that you don’t have to own the underlying asset in order to buy the CDS – an analogy would be insuring a house against fire damage when you don’t actually own the house.

CDSs are economically useful because they enable bond investors to hedge their exposure, with the aim of reducing their overall risk. This ability to hedge their position and reduce risk makes investors more willing to invest in the bonds in the first place – all else equal, this increases demand, raising the bond prices and reducing the yield (yields go down as bond prices go up). The corollary of this is obvious: undercut the value of sovereign CDS and you raise the yields on government debt. When this happens, governments find it more expensive to raise capital or to roll-over maturing debt.

This is exactly the risk facing us today. Let me explain.

For all the talk of this being a "voluntary" write-down, the reality is that the private sector has been strong-armed into the deal, and was left with little choice but to take it. The message from the Greek Finance Ministry essentially boiled down to, "it's this or nothing": in other words, either everyone takes the "voluntary" PSI deal now or we proceed with an outright default and you get nothing.

The short-term consequences of an outright disorderly default would have been nothing short of catastrophic, certainly dwarfing any hedging gains from CDS payouts. Hence it should probably come as no surprise that today’s debt deal demonstrates the fact that Greek bondholders (on aggregate) have calculated that a 70% "voluntary" haircut and no CDS pay-out is preferable to a 100%  disorderly cut with a CDS payout.

But to call this "voluntary" is stretching the definition. The decision facing bondholders was like a man being given a choice between being hit by a car or by a freight train. Pausing for just a moment, the man responds, “Neither option sounds good to me, but on balance I'll take my chances and go with the first one...”

Essentially bondholders have not been given a choice at all. And what is more, in the process of accepting the "voluntary" default, bondholders may have surrendered their rights to any CDS payouts.

Whether to pay out on CDSs or not is the subject of discussion at an ISDA meeting (International Swaps and Derivatives Association) this afternoon. The committee (made up entirely of investment banks  and asset managers) requires a super majority (12 out of 15) to make a ruling. However regardless of the outcome of that meeting, the mere existence of doubt as to whether CDS payouts should or should not  be made in itself trashes the value of that instrument as a future hedge. To re-use the analogy, why waste your money insuring your house against fire when you expect the insurance firm will wriggle out of its obligation?

By undermining the value of default insurance (and all else remaining equal) bond yields will rise as traders price in the higher risk associated with holding a position which cannot be directly hedged. This has the potential to lead us to the same downwards spiral which I highlighted in Risk 1.

The long and the short of it?

Any relief rally associated with the Greek deal will be short-lived as questions of the country’s fiscal position resurface and investors begin to get to grips with the longer-term implications of today’s events.

Odds-on bet: we have not seen the last of easy monetary policy from central banks worldwide and we are likely to see a lot more of this in future. Governments and investors alike have become addicted to liquidity courtesy of the Fed, ECB, BoE and BoJ and, like an addiction, each time a bigger ‘hit’ is needed to have the same effect. As the Wall Street Journal wrote on 27^th February:

“All of the available signals point to the likelihood that the Fed will have to turn to more vigorous creation of new money (inflation) at some point—or face the possibility of rising market rates on government securities that sharply raise the Treasury's borrowing costs and devalue the Fed's enormous balance sheet.

No way out. No way out.”

EDIT:
Related Bloomberg article:
 “The rules have been changed here,” Gross, co-chief investment officer at Pimco, said in a radio interview on “Bloomberg Surveillance” with Tom Keen and Ken Prewitt. “The sanctity of their contracts is certainly lessened. Bondholders have that to look forward to going into the future.”