UnRisk 7

Why The French Greek Bank Debt Exchange Proposal Won’t Work

The proposal to extend the maturity of Greek bonds emanating from the Élysée Palace reflects French strengths first identified by Napoleon III: “We do not make reforms in France; we make revolution.” Structured to meet a German requirement that private creditors contribute to the Greek bailout, the proposal falls short of what is actually required.

Under the sketchy proposal, for every Euro 100 of maturing bonds, banks will subscribe to new 30 year securities, but only equal to Euro 70 (70%) effectively repaying themselves. for maturing debt that Greece cannot otherwise repay or refinance. Of the Euro 70, the banks will keep Euro 50 (50%) and invest the other Euro 20 (20%) in 30 year high quality zero coupon bonds (via a special purpose vehicle) to secure repayment of the new bonds. The new 30 year Greek debt will carry an interest rate of 5.5% per annum with a bonus element linked to Greek growth of up to an additional 2.5% per annum, making the maximum interest rate 8 % per annum.

Of the Euro 340 billion in outstanding Greek bonds, banks hold 27%, institutional and retail investors hold 43% and the International Monetary Fund (“IMF”) and the European Central Bank (“ECB”) hold 30%. It is not clear whether non-bank investors are willing to participate in the arrangements. The ECB has previously resisted any debt restructuring, including maturity extension.

The French plan assumes holders of bonds would agree to roll over 50% of their holdings to provide Greece net funding of Euro 30 billion. But under the French banking federation’s own figures, this would if impossible unless all the Euro 60.5 billion (excluding central bank holdings) maturing by mid-2014 is rolled over. This is also inconsistent with the proposal’s assumption of investor acceptance of 80%.

The plan assumes that the “voluntary” exchange will not be treated as a “selective or restrictive” default by rating agencies or trigger credit insurance contracts on Greece. Fitch Ratings and S&P have indicated that the French plan will “very likely” be deemed a default, albetit for an unspecified “temporary” period, as it constitutes a distressed debt restructuring.

The Euro 20 invested in high quality collateral will need to earn around 4.26% per annum to accrete in value to Euro 70 to cover the principal of the new 30 year bonds. German 30-year bunds currently yield around 3.75% per annum, less than the required rate. Other AAA rated bonds, such as the European Financial Stability Fund (“EFSF”) bonds, might be used to provide the extra return. Given that the EFSF is backed by guarantees from countries with questionable long-term credit quality and who may need a future bailout, the security afforded by such a guarantee is unproven.

Greece must find Euro 50 for every Euro 100 debt exchanged under the proposal. Given it has no access to commercial funding, this would have to come from the EU, IMF, EFSF or ECB.

Greece’s cost would be between 7.7% and 11.20% per annum, as it only receives Euro 50 of the Euro 70 face value of the new bonds. Assuming the remaining funding is at 6%, then Greece’s blended rate for every Euro 100 of finance would 6.85-8.60% per annum, well above that considered sustainable by markets and economists.

Most importantly, the overall level of debt, considered unsustainable, of Greece would remain unchanged.

The exchange scheme seems designed primarily to allow banks to avoid recognising losses on holdings of Greek bond. But even if the principal of the 30-year bonds is considered “risk free”, the interest remains dependent on Greece’s ability to pay. Valued at a rate of 12 % per annum for 30 year Greek risk (a not unreasonable estimate), this would mean that the new bonds are only worth around 64% of face value, equivalent to a mark-to-market loss of around 36%. It is not clear if the authorities will require this loss to be recognised.

The French proposal has lost momentum in recent days as its flaws have become obvious.

One alternative under consideration, an exchange of maturing bonds for new 5 year (French proposal) or 7 year (German) bonds is even worse as it defers the problem for an even shorter period of time.

A more logical solution would be that suggested reluctantly by the Institute of International Finance. Under this proposal, Greece would repurchase some its outstanding debt at current market prices, well below the face value of the bonds. This would reduce Greece’s debt level. It would also result in the bank’s sustaining losses.

According to the Bank for International Settlements, French banks have exposures to Greece, including of around Euros 50-60 billion. German banks have exposures of around Euro 30-35 billion. These banks might result require new capital to absorb the writedowns. If necessary, then the French and German governments would need to provide this capital. In effect, rather than lending to Greece, it would have to use the funds to recapitalise its own institutions. This would, in the final analysis, be more sensible than continuing with the farce that Greece is solvent and the bank’s holding of Greek debt are worth the face value of the securities. It would be the first logical step in addressing the problem of over indebted European nations.

History records that in August 2001, the IMF oversaw a debt exchange for Argentina in an unsuccessful, last ditch effort to avoid default. Indecisive and confused action by European authorities seems doomed to ensure that this restructuring, if it eventuates, will be followed by others and an eventual messy, disorderly and expensive default.

The French proposal perpetuates the lack of acknowledgment that Greece has a “solvency” rather than a “liquidity” problem. Like the EFSF whose structure has been criticised as nothing more than a collateralised debt obligation (“CDO”), it uses financial engineering techniques to defer or disguise losses in an unending game of “extend and pretend”.

© 2011 Satyajit Das

Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (FT Press, forthcoming August 2011).

How It May End in Europe

Since December 2010, at each EU meeting, the German view, set out by Chancellor Angela Merkel, has with some minor exceptions prevailed.

The EU has rejected any attempt to increase the scope and amount of the existing bailout facilities, instead agreeing clumsily to resort its originally intended capacity of the bailout fund to Euro 440 billion.

Even then the capital structure remains confusing and fragile. The Euro Zone members will either provide guarantees or cash over time to secure the fund.

The E-Bond proposal was quietly shelved. The EU agreed to formalise the European Stability Mechanism (ESM)through a short amendment to the Lisbon Treaty. The new facility will remain be inter-governmental with any Euro Zone member having a national right of veto. The facility was highly conditional, capable of being triggered only as a last resort. For example, given Portugal's reluctance to agree to certain austerity measures, it is unclear whether they would gain access to the facility.

A key element of the arrangements was the requirement for "collective action clauses", effectively forcing lenders to bear losses. The provision, which must be included in all European government bonds after June 2013, would require the payment period to be extended in case of a crisis. If the solvency problems persisted, then further extension of maturity, reductions in interest rates and a write-off in the principal would occur.

In addition, once the ESM facility kicks in, commercial lenders will be subordinated to the ESM, in a form of Debtor in Possession financiang.

The stronger members of the EU, led by Germany, may have decided to limit future liability in bailouts. As membership of the Euro prevents large devaluation of the currency, economic adjustment will require reduction of the budget deficit and deflation. As Greece and Ireland demonstrate, more rigorous deficit cutting may not return the countries to solvency. The EU proposals implicitly recognise that over-indebted countries cannot sustain current debt levels. The reduction of the debt burden will have to come through restructuring or default, with creditors taking losses.

Unless confidence returns rapidly or the EU changes its position, it seems restructuring or defaults by several peripheral European sovereigns may be unavoidable. Investor concerns that the Greek and Irish did not solve the fundamental problems may be confirmed. The safety nets are now seen as unlikely to be large enough to rescue larger countries, like Spain and Italy, if they require support. Investors will need to take losses.

Portugal is likely to have increasing difficulty raising funds at acceptable rates. Spain has managed to issue debt successfully, giving investors confidence - temporarily - that the problems are manageable. However, there is upwards pressure on the interest rate payable. Portugal's 10-year bonds are at levels above what investors demanded from Greece and Ireland shortly before both countries finally capitulated and accepted bailout packages. These issues will do little to alleviate longer-term pressure.

Large volumes of maturing debt mean that the test is likely to come sooner than later. The heavily indebted European sovereign states face $2.85 trillion of maturing debt in the period to 2013. Portugal, Italy, Ireland, Greece and Spain have bond maturities of $502 billion in 2011.

European problems now threaten global recovery. China, which contributed around 80% of total global growth in 2010, has expressed growing concern about the problems in Europe. Trade between China and the EU, its largest export market, totals around $470 billion annually, contributing a trade surplus of Euro 122 billion for China in the first nine months of 2010. Any slowdown in Europe would affect Chinese growth.

A continuation of the European debt problems, especially restructuring or default of sovereign debt, would also severely disrupt financial markets.

Events since the announcement of the bailout package in early 2010 have been reminiscent of 2008. Then, the optimism following bailouts of Bear Stearns and other troubled American banks produced premature. The promise of China to purchase Portuguese and Spanish bonds is similar to the ill-fated investments of Asian and Middle-Eastern sovereign wealth funds in US and European banks.

Eventually with each successive rescue and the reemergence of problems, the capacity and will for further support diminished. The EU rescue of Greece and Ireland are also reminiscent of US attempts to rescue its banking system, with more and more money being thrown at the problem. The strategy was defective, preventing the creative destruction required to restore the system to health. The actions may have doomed the economy into a protracted period of low growth, laying the foundations for future problems.

© 2011 Satyajit Das All Rights Reserved. Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (Forthcoming in September 2011) and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)

Contagious European Debt Virus

Prior to succumbing to the inevitable, the Ireland told everyone that they were not Greece. Portugal is now telling everyone that it is not Greece or Ireland. Spain insists that it is not Greece, Ireland or Portugal. Italy says Irelan is the 'I' in the “PIGS”, arguing that "PIIGS" is incorrectly spelled . Belgium insists there is no “B” in “PIGS” or “PIIGS”.

EU pressure on Ireland to accept external “help” was to safeguard financial stability in the Euro area, as much as rescue Ireland. Mor recently, some members of the EU have suggested the Portugal too seek a bailout for the European cause. However, contagion is proving difficult to prevent.

The rising cost of borrowing increasingly makes high levels of debt unsustainable because of the cost of meeting interest payments. Eventually, countries lose access to commercial funding sources, which is what happened to Greece and Ireland. Portugal and Spain are now facing similar pressures as their borrowing costs also rise.

Where stronger countries move to support the weaker countries, financing the bailouts affects their own credit quality and ability to raise funds. Recent agreement on restoring the European Financial Stability Facility's lending capacity to Euro 500 billion (around its originally announced level rather than the Euro 250 billion that it was capable of lending becuase of structural flaws) will require the EU members to increase their guarantees. The impact of this will be greatest on the stronger AAA rated members, led by Germany.

Europe increasingly resembles a group of mountaineers roped together. As the members fall one by one, the survival of the stronger ones is increasingly threatened.

The EU and IMF are hoping that the bailouts of Greece and Ireland will restore market confidence which combined with stronger growth, greater fiscal discipline and domestic structural reforms will reduce the fear of default or restructuring. The chances of this script playing out are minimal.

The support measures are unlikely to work. Increasingly Portugal and Spain, initially, are under siege. As market access becomes constrained and then closes, they too will need bailouts straining existing arrangements, necessitating new measures. A bailout of Portugal is conceivable, one for Spain is not under existing arrangements.

Under such a scenario, available options include greater economic integration of the EU, expansion of existing arrangements or allowing indebted countries to fail.

Greater economic integration would entail adoption of a common fiscal policy, encompassing strict controls on fiscal policy including tax and spending. It could also include the issue of Euro zone bonds (“E-Bonds”) to finance member countries, lowering borrowing costs for peripheral economies and facilitate access to markets.

The likelihood of greater fiscal union in the near term is limited, as it is unlikely that nations will surrender the required economic powers and autonomy. The E-Bond proposal, for up to 50% of a State’s funding requirement, is unworkable given differences in credit quality and interest rates between Euro zone members of around 10%. The E-Bond idea was stillborn when German and then France failed to lend the idea its support.

The cost of full fiscal union is prohibitive, entailing between Euro 340 billion and Euro 800 billion, depending on the degree of fiscal imbalances.

The recently announced "grand compact" maintains elements of integration in the guise of a vague "competition policy". It seems that Club Med will have to adopt a teutonic approach to its finances, a cultural as well as fiscal challenge.

If the debt problems continue, then in absence of an unlikely full fiscal union, the only available actions are further EU support or default.

While Germany currently opposes any expansion of the bailout facilities, it remains an option. The ECB will it is planned increase support for the relevant countries, in the form of purchases of bonds (in the primary though not the secondary market) or financing Eurozone banks that purchase them.

For the moment, the EU, that is the stronger members led by Germany and France, appeared committed to preserving the cumbersome status quo. They are praying for growth and inflation to bail out the peripheral economies out of their excessive indebtedness. The primary objective is to defer the day of reckoning for as long as possible, at least until past the current term of the president/ prime minister/ government/ central banker [delete ad necessary].It is more hope than reality.

The actions are designed for the moment to protect the lenders to the relevant countries - banks as well as bon investors. The defaults would affect the balance sheets of banks, potentially forcing governments, especially in Germany, France and UK to inject capital and liquidity into their banks to ensure solvency. The richer nations would still have to pay, but for the recapitalisation of their banks rather than foreign countries.

© 2011 Satyajit Das All Rights Reserved.

Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (Forthcoming in September 2011) and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)

The European Bailout Revisited

The return of European sovereign debt problems in late 2010, culminating in the bailout of Ireland highlighted the deep seated and perhaps intractable problems of some over indebted European nations.

The Irish bailout facility totalled Euro 85 billion, made up of Euro 35 billion for the banking system (Euro 10 billion for immediate recapitalisation and Euro 25 billion to be provided on a contingency basis) and Euro 50 billion to cover the financing of the State. The average interest rate would be of the order of 5.8% per annum, varying according to the timing of the drawdown and market conditions.

After a brief rally, familiar concerns re-appeared. Estimates suggested that the Irish banks alone required around Euro 16 billion in capital and a further Euro 38 billion in financing. This totalled Euro 54 billion, a large chunk of the Euro 85 billion package. Given that Ireland required Euro 70 billion to meet maturing debt until 2013, the size of the bailout facility was arguably inadequate. As in the case of Greece, the bailout package dealt only with short term liquidity, failing to address Ireland’s longer term solvency.

The arrival of an IMF/ EU team to prescribe a “cure” did not inject confidence in an imminent recovery. Ireland had been self administering the same medicine for some time, with indifferent results.

The Irish economy has not recovered from recession, with GDP only registering growth in one quarter since 2007. Overall, the economy had shrunk by nearly 20% from its peak. Gross National Product (“GNP”), which is a better indicator of living standards, has fallen for nine successive quarters. The official unemployment rate is around 14%, though the level of real un and under employment is greater. House prices are 36% below their 2006 level. Consumer spending has fallen sharply, the result of lower income and increased savings levels of around 12% of income (an increase from 3.9% two years ago).

Cuts in government spending and higher taxes have mired the economy in the recession. Falls in tax revenue necessitate increasingly deeper cuts in spending to try to stabilise public finances. In 2010, the budget deficit was forecast at 12% of GDP, even after spending cuts and tax rises worth Euro 14.5 billion

The problems of banking sector are increasing due to the poor economic conditions. The problems, hitherto largely confined to commercial property, are now spreading to the broader economy. Unemployment and lower incomes mean that householders are unable to meet payment obligations on mortgages and other loans. Weak economic conditions have affected businesses, increasing default levels.

After the bailout, the Irish government announced further cuts in the budget deficit of Euro 15 billion, with Euro 6 billion in 2011. The package included Euro 10 billion of spending cuts in social welfare, health care, education and the public sector. There were Euro 5 billion of tax increases, including increases in value added tax (VAT), income taxes and property taxes. Controversially, the low 12.5% corporate tax rate, crucial to maintaining Ireland’s competitive position, remained unchanged, despite complaints and pressure from the EU.

The ability to meet the required targets is uncertain. Forecasts are predicated on “aspirational” growth of 2-3% Moody’s Investor Services, the rating agency, cut Ireland’s debt rating by five notches Baa1, two notches above junk, with a negative outlook.

The experience of Greece under the IMF/ EU plan is instructive. While there has been some progress, Greece is struggling to meet its budget targets due to a shortfall in tax revenues, forcing ever more aggressive spending cuts exacerbating Greece’s deep recession. Planned asset sales, if they eventuate, and structural reforms are unlikely to stabilise public finances.

Faced with the unpalatable choice of withholding funding due to non-compliance with the plan or allowing default, the EU/ IMF will continue to disburse funds propping up the economy. In the case of Greece, the interest rate has bene lowered by 1.00% pa and the maturity of the bailout package has been extended to 7 1/2 years from the original. All this tacitly acknowledged that the debt cannot be repaid.

In the absence of strong economic growth, inflation and a massive devaluation, the peripheral economies, such as Ireland and Greece, may be unable to shrink themselves to solvency.

Given the toxic conjunction of high cost of funding, low growth and high starting level of debt, it is near impossible for these countries to contain the spiral to a restructuring of their debt or default.

When asked for directions, the old joke is that some wise guy pipes up: “If you want to go there, then I wouldn’t start from here.” The same could be said of rescuing overburdened European countries.

© 2011 Satyajit Das All Rights Reserved.

Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (Forthcoming in September 2011) and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)

Traders - Choose Your Weapon, I Mean, Currency!

During the European debt crisis, in a matter of days, the dollar strengthened by around 10%. The weakness of the Euro and resultant appreciation of the Renminbi by over 14% reduced Chinese exporter’s earnings and competitiveness. Some of the moves reversed equally quickly when markets stabilised. Volatility of currency exchange rates has increased markedly in recent months.

To paraphrase Oscar Wilde, the US dollar has no enemies, but is intensely disliked by its friends, especially key investors like the Chinese. The Euro is now the “Drachmark” (a derisory combination of the former Greek Drachma and German Deutschemark). Investors assumed that the Euro would be a new Deutschemark, supported by German commitment to fiscal and monetary rectitude avoiding Gallic and Mediterranean extravagance. Instead, investors have been left holding a currency underpinned by unexpected German extravagance and Gallic and Mediterranean rectitude.

Despite sclerotic growth, public debt approaching 200% of GDP and a budget where borrowing is greater than tax revenues, the Japanese Yen has risen to its highest level against the dollar in 15 years. China is even switching some of its currency reserves into Japanese government bonds with returns only apparent under powerful electron microscopes.

Fears about the value of any currency have seen a resurgent interest in gold. Traders are now reading their John Milton: “Time will run back and fetch the age of gold.”

Amongst currencies, it is simply a race to the bottom. On 27 September 2010, the Brazilian Finance Minister Guido Mantega stated the obvious speaking of an “international currency war” as governments around the globe compete to lower their exchange rates to boost competitiveness. In the words of English philosopher Thomas Hobbes it is “war of every man against every man”.

Arcane currency shenanigans point to deeper, unresolved economic issues that policymakers are unwilling or unable to confront but whose resolution is crucial to a sustainable recovery and growth. The odd thing is that the problem is not new, having been there all along.

Since the end of the de facto gold standard and Bretton Woods, currencies increasingly have become weapons of choice in trade and economic wars. In the German and Japanese model of economic development, an undervalued currency is a key mechanism for maintaining competitive costs and high levels of exports to drive growth. Successive generations of emergent countries, most notably China, copied the model.

Despite tensions, the model worked well in a world of strong economic growth and increasing trade. It was a question of dividing growing wealth. The model is more problematic in a world of low growth.

Currently, the world may be entering a period of lower growth. Consumer spending, funded in developed countries by debt, has slowed. Given significant over capacity in many industries, business investment is weak. Under increased pressure from money market vigilantes, governments are cutting spending and raising taxes, embracing the “new austerity”.

As growth slows, maintenance of competitiveness requires businesses to manage costs brutally. Cheaper currency values assist in remaining competitive, avoiding the need to overtly cut costs by reducing wages or cutting benefits, explicitly lowering living standards. During the global financial crisis, the repeated manouevering of China, Japan and Germany to maintain the low value of the Renminbi, Yen and Euro against the dollar was designed to maintain export volumes to cushion the worst effects of the recession.

To a large extent, it reflects the underlying structure of economies heavily geared to exports. Angela Merkel has repeatedly stated that she sees no change to the export driven German economic model in the near term. For Japan, falling living standards combined with an aging, falling population means increasing dependence on exports. For China, increasing wages pressures and domestic inflation means that rising production costs must be offset by other means, including an undervalued currency.

The problem of shifting models is great. In 1985, the Plaza Accord forced Japan to effectively revalue the Yen, setting off a rise from Yen 230 per dollar to Yen 85 per dollar. The rise in the Yen reduced Japanese export competitiveness and led to a recession. To stimulate the economy, the Bank of Japan and Government pumped large amounts of money into the economy. Rather than assisting recovery, the money set off a commercial real estate and stock market boom that collapsed spectacularly at the end of 1989 plunging Japan into the “ushinawareta junen” - the Lost Decade.

Aware of the Japanese experience and at risk of repeating the experience, China has fervently resisted revaluing its currency, despite pressure from the US. Recently, Chinese leaders have spoken about the economic and social catastrophe that would result from a major reminbi revaluation.

Chinese Premier Wen Jiabao told an European business conference that: “If we increase the yuan by 20 percent-40 percent as some people are calling for, many of our factories will shut down and society will be in turmoil. If China’s economy goes down, it’s not good for the world economy.” In order to forestall, European calls, led by French President Sarkozy, for a revaluation of the Renminbi, Wen cunningly voiced support for Chinese purchases of Greek debt. Wen urged Europe not to “join the choir to press China to allow more yuan appreciation.”

The unstable currency order creates distortions, frequently preventing action to deal with economic problems. It leads to countries pursuing odd and sometimes contradictory policies.

For example, financial triage, cutting the unsustainable and unlikely to survive countries out of the Euro, would restore their competitiveness through devaluation. But Germany is unlikely to allow weaker countries to leave the common currency precisely to avoid a sharp increase in the value of the Euro, making its exports less competitive. Contrary to popular view, the Germany has much to lose from changes in or abandonment of the Euro.

Recent German economic performance has benefited from the effects of a stronger Yen relative to the Euro making its exports more competitive. German corporate profitability has recovered strongly to pre-crisis levels. More recently, Japan has intervened in currency markets to prevent the Yen testings its 1995 high of Yen 79.75 against the dollar.

Interest rate policies pursued, in part, to manage currencies also perpetuate economic dislocations. Paralleling the events after the Asian monetary crisis in 1997/1998, the flight to dollars during periods of European instability pushes down interest rates on U.S. government debt.

The possible reintroduction of quantitative easing (it used to called “printing money” in a less politically correct world) refelcts, in part, attempts by policymakers to influence currency values. Paradoxically, lower interest rates reduce pressure for required deleveraging and deficit reduction by lowering the cost of servicing debt.

Major reserve currencies, like the dollar, Euro and Yen, provide some ability to offset changes in value by invoicing trade in their own currencies. Unfortunately, for minor currencies, the fact that trade continues to be denominated in the major currencies creates difficulties where a one day move in foreign exchange markets can wipe out the entire profit margin. The higher volatility means that the cost of hedging the risk of such currency moves is large, reducing profitability.

The currency crisis highlights the “beggar thy neighbour” policies pursued by many economies. China, Japan and Germany have consistently pursued policies that emphasise high domestic savings, low domestic consumption and an undervalued currency to drive its export driven economies. These global imbalances contributed significantly to the current financial problems.

A global economic order where a few countries save and lend to finance their exports while other countries act as consumers of last resort is unsustainable. A system where each country seeks to maximise its own competitive position and financial security at the expense of trading partners is not viable.

An emerging toxic combination of inflexible global currency arrangements, a destructive cycle of currency devaluations, trade restrictions and the need of governments to rein in spending to balance budgets is reminiscent of the 1930s. They threaten a period of prolonged global economic stagnation.

The globalization of complex financial relationships, much lauded before the crisis, is now proving a liability in resolving the crisis. Optimists must rely on Israeli politician Abba Eban's observation that "History teaches us that men and nations behave wisely once they have exhausted all other alternatives."

© 2010 Satyajit Das All Rights reserved.

Satyajit Das is the author of the Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2010)

European Confidence Tricks

As European sovereign debt concerns return, increasingly attention may focus on the European Financial Stability Fund ("EFSF"), a key component of Europe’s financial contingency plan.

In order to finance member countries as needed, the EFSF will need to issue debt. The major rating agencies have awarded the fund the highest possible credit rating AAA. The EFSF structure echoes the ill-fated Collateralised Debt Obligations ("CDOs") and Structured Investment Vehicles ("SIV").

The Euro 440 billion ($520 billion) rescue package establishes a special purpose vehicle ("SPV"), backed by individual guarantees provided by all member countries. Significantly, the guarantees are not joint and several, reflecting the political necessity, especially for Germany, of avoiding joint liability. The risk that an individual guarantor fails to supply its share of funds is covered by a surplus "cushion", requiring countries to guarantee an extra 20% beyond their shares.

The arrangement is similar to the over-collateralisation used in CDO’s to protect investors in higher quality AAA rated senior securities. Investors in subordinated securities, ranking below the senior investors, absorb the first losses up to a specified point (the attachment point). Losses are considered statistically unlikely to reach this attachment point, allowing the senior securities to be rated AAA.

If 16.7% of guarantors (20% divided by 120%) are unable to fund the EFSF, lenders to the structure will be exposed to losses. The adequacy of the cushion is questionable. If one peripheral Euro-zone members has a problem then others will have similar problems. If one country requires financing, guarantors of the EFSF will face demands at the exact time that they themselves will be financially vulnerable.

The size of the EFSF may be more limited than envisaged. Where an Eurozone member draws on the facility, the amount of funds lent by EFSF is adjusted by deduction for a 50 basis point service fee and a percentage equal to the EFSF’s on-lending margin. This fungible general cash reserve ("the Reserve") supports all EFSF debt. An additional reserve specific to each loan made by EFSF ("the Buffer") will be created.

The requirement for the Reserve and Buffer significantly reduces the funds available from the EFSF. After adjusting for the guarantee overcollateralization and the exclusion of Greece from EFSF's program, the EFSF can raise up to Euro 350 billion (20% lower than the announced amount). After adjustment for the fact that borrowing governments cannot guarantee EFSF bonds and deduction of the Reserve and Buffer the potential available EFSF lending is further reduced. Assuming a Reserve of say 13.5% and a Buffer of 10%, this would reduce the amount available to around Euro 270 billion (39% lower than the announced amount).

Assuming an equivalent reduction in the IMF component of the package, the total amount available is around Euro 460 billion. This compares to the forecast budget financing need of Greece, Ireland, Portugal and Spain of over Euro 500 billion in the period 2009 to 2013.

In order to attain the coveted AAA rating, the EFSF structure has been "tweaked" subtly. For example, Moody’s states that "the Buffer is to be sized so that the remaining portion of the debt issue that is not fully backed by cash will be fully covered by contributions from Aaa-rated member states." This confirms that the EFSF’s rating relies heavily on the support of the guarantees of AAA countries, meaning that significant reliance is being placed on Germany, France and the Netherlands. If a larger Euro-zone member encountered financial problems, then the rating and viability of the EFSF might be in jeopardy.

At this stage, the EFSF has indicated that they don’t plan to issue any debt, as they do not anticipate the facility being used. The facility also has a very short maturity, three years till 2013. S&P inferred that the "EFSF has been designed to bolster investor confidence and thus contain financing costs for Eurozone member states." However, if as pressures mount and market access becomes problematic for some Eurozone members, then the EFSF and its structure will be tested.

Ironically, the actual structure of credit enhancement encourages troubled countries to access the facility early to ensure availability. If market conditions deteriorate, market access becomes limited and countries draw on the EFSF facility (eliminating them from the guaranty pool), then increased financial pressure will be exerted on the AAA rated Eurozone countries. The need to maintain adequate coverage to preserve the EFSF’s AAA rating on existing debt will mean that the Buffer will increase and the capacity of the EFSF to lend may become impaired. Moody’s rating analysis indicates that in the event that a large number of countries simultaneously lose market access and draw on the facility, the current lending capacity of the EFSF would likely be overwhelmed. Moody’s believes that it would be unlikely that the EFSF would start issuing under those circumstances.

Government and policy makers increasingly are playing elaborate financial games to try to stave of financial instability and create conditions for economic recovery. The EFSF’s structure raises significant doubts about its capacity to support financially challenged Euro-zone members. Investors are placing significant faith in a mechanism that may be little more than a "confidence trick". As H. L. Mencken observed: "Faith may be defined briefly as an illogical belief in the occurrence of the improbable".

© 2010 Satyajit Das

Satyajit Das is the author of "Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives- Revised Edition" (2010)

Botox Economics – Part 2

From late 2008 onwards, Governments have spent aggressively, going into or increasing deficits, to increase demand within the economy to offset weak private sector consumption and investment.

Financing these initiatives presents significant challenges. In the five quarters ending 30 September, 2009, U.S. Treasury borrowing increased by $2.8 trillion, a rise of around three times from the level of previous years. The U.K. and European countries increased public debt by similar or higher amounts (in percentage terms).

In 2009, investors readily bought large new issues of government debt, despite relatively low interest rates. Rating agencies maintained sovereign debt ratings, especially for major countries despite deteriorating public finances.

Central bank purchases under ‘quantitative easing’(“QE”) (read printing money) programs helped the market absorb the volume of new issuance. According to estimates by Morgan Stanley, Fed purchases of assets, QE programs and other liquidity support programs reduced private sector net purchases of new Treasury issues to $200 billion in 2009. In 2010, in the absence of continued Fed support, private buyers will have to absorb $2,000 billion.

If buyers of sovereign debt puul back, Ireland, Greece and Spain provide an insight into the actions necessary. In order to restore fiscal stability, the Irish government introduced a special 7% pension levy and implemented the toughest budget in the country’s history. Public sector salaries were cut between 5-15%. Unemployment and welfare benefits were also cut. More recently Greece and Spain proposed a program of similar budgetary austerity.

Focus in the short run will be on the ‘PIGS’ (Portugal, Ireland, Greece, Spain) but in the longer term it will shift to major economies with high levels of government debt - the 'FIBS' (France, Italy, Britain, States). At least, Japan has its very large pool of domestic savings.

The need to maintain the confidence of rating agencies and investors as well as access to markets may ultimately force the required disciplines. As James Carville famously observed: “I want to come back as the bond market. You can intimidate everybody.” Politicians everywhere will learn the reality in Thatcher’s terms: “You can’t buck the markets.”

The need to reduce the overall level of debt in certain economies has not been fully addressed. Public debt has been substituted for private debt. As his friend Dink tell author Joe Bageant in Deer Hunting with Jesus: Despatches from America’s Class War: “Sounds like a piss-poor solution to me, cause they’re just throwing money we ain’t got at the big dogs who already got plenty. But hell what do I know?”

The last few decades have seen an economic experiment where increasing levels of debt have been used to promote high growth. This policy had the unintended consequence of increasing risk in the global economy, which was not fully understood by the individual entities taking this risk or regulators and governments. This experiment is now coming to an end.

The real risk is of long-term economic stagnation. A period of low growth, high unemployment or underemployment and over capacity is possible while individuals, firms and governments repair balance sheets.

Governments and central banks continue to inject liberal amounts of botox to cover up problems, at least, while supplies exist. In absence of any definite solutions, policymakers are deferring dealing with the problems, rolling them forward. In the words of David Bowers of Absolute Strategy Research: “It’s the last game of pass the parcel. When the tech bubble burst, balance sheet problems were passed to the household sector [through mortgages]. This time they are being passed to the public sector [through governments’ assumption of banks’ debts]. There’s nobody left to pass it to in the future.”

The summary of 2009 and the outlook for 2010 may be the logo on a black T-shirt worn by Lisbeth Salander, the heroine of Steig Larsson’s Girl with the Dragon Tatoo: “Armageddon was yesterday - Today we have a serious problem.”

© 2010 Satyajit Das All Rights reserved.

Satyajit Das is author of the just released Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2010, FT-Prentice Hall).

Botox Economics – Part 1

Botox is commonly used to improve a person’s appearance by removing facial lines and other signs of aging. The effect is temporary and can have significant side effects. The world is currently taking the “botox” cure. A flood of money from central banks and governments -- "financial botox" -- has temporarily covered up unresolved and deep-seated problems.The surface is glossy and smooth, the interior decayed and rotten

The 2009 ‘recovery’ was based on low or zero interest rate policies (“ZIRP”) of major central banks. Massive government intervention also helped arrest the rate of decline of late 2008/ early 2009. Without government support, it is highly probable that most economies would have been in serious recession. Just as China practised capitalism with Chinese characteristics, developed economies discovered socialism with Western characteristics.

Capital injections, central bank purchases of “toxic” assets and explicit government support for deposits and debt issues helped stabilise the financial system. Changes in accounting rules deferred write-downs of potentially bad assets. Despite these actions, the global financial system remains fragile.

Further losses are likely from consumer loans, including mortgages. In the U.S. mortgage market, one-in-ten householders are at least one payment behind up from one-in-14 a year ago. If foreclosures (now around 5%) are included, then one-in-seven mortgagors are in some form of housing distress.

Recent stability in U.S. house prices may be misleading reflecting the effect of government incentives (the $8,000 first time homebuyer tax credit) and low mortgage rates driven in part by the Fed’s MBS purchases. The value of 20-30 % of properties is less than the loan outstanding. Home sales remain modest with around 25-30% of sales of existing homes being foreclosures. Housing inventories also remain high in historic terms. With more adjustable rate mortgages resetting in 2010 and 2011, the risk of further losses on mortgages cannot be discounted unless economic conditions improve.

Rising vacancy rates, falling rentals and declining values of commercial real estate (“CRE”), primarily office and retail properties, are apparent globally. In London, Nomura, the Japanese investment bank, secured a 20-year lease of a new office development on the River Thames - the 12-storey Watermark Place – for £40 per square foot. This was over 40% lower than the rents of nearly £70 per square foot demanded prior to the GFC. Nomura will also not pay any rent until 2015. Mark Lethbridge, partner at Drivers Jonas who advised Nomura, told the Financial Times: “… I’m unlikely to see [the terms] again in my career.”

Banks are likely to remain capital constrained in the near future reducing availability of credit. Commercial and consumer loan volumes have declined reflecting a lack of supply but also a lack of demand as companies and individuals reduce leverage.

The real economy remains fragile. Government actions, such as fiscal stimulus and special industry support schemes (cash for clunkers; investment incentives, trade credit subsidies), have boosted demand and industrial activity in the short term. The problem remains as government incentives encourage current consumption and investment but ultimately “steal” from future demand.

Employment, a key indicator given the importance of consumption in developed economies, continues to decline albeit at a slower pace. In the U.S., unemployment reached 10%.

In many countries enforced reduction in working hours and taking paid or unpaid leave reduced the rise in unemployment levels significantly. Working hours and personal income have fallen.

Changes in the structure of the labour force also distort the real picture. If workers working part time involuntarily and looking for full time employment are included, the U.S. underemployment figure is in the 16-18% range. Long term and youth employment also remains high.

European economies, especially countries such as Spain, are also experiencing significant unemployment. In some economies, unemployment is a new “export” as guest workers are shipped back to their country of origin or remittances home fell sharply.

In developed countries where an increasing part of the population is nearing retirement age, wealth effects affect consumption behaviours. Low interest rates and reduced dividend levels limit income and expenditure.

In 2009, global trade stablised after precipitous earlier falls. According to the CPB Netherlands Bureau for Economic Policy Analysis, as of September 2009 world trade was 8.0% above the low of May 2009 but 14% below its peak of April 2008. Trade protectionism threatens recovery in global trade.

Major risks in the financial and real economy remain and may disrupt the hoped for resumption of business as usual.

© 2010 Satyajit Das All Rights reserved.

Satyajit Das is author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2010, FT-Prentice Hall).

2009 Prospects – Trench Warfare

There was palpable relief as at the end of 2008 the “financial” crisis moved into the “real” economy. Commentators could move to the relatively familiar language of “recessions” and “depressions”. The arcane minutiae of securitised debt, derivatives and toxic three letter acronyms (ABS; CDO; MBS; SIV; CDS etc) could be left behind. Familiarity, no matter how terrible, is comforting.

Markets are hoping for stability and the shoots of recovery in 2009. There are reasons for caution.

Banks continue to be in the intensive care unit and on life support. Further losses, more bank failures, a bleak earnings outlook and difficulties in raising equity and funding will mean the need for continued state largesse. Some financial institutions are clinging to state led “no bank left behind” equity programs for survival. The creeping nationalisation of many banking systems is probable.

Financial system balance sheets will continue to contract reducing the availability of funding and increasing the costs of funds. “Loan” and “debt” are now four letter words.

Substantial losses in investment portfolios of insurance companies, pension funds, asset managers and endowments will emerge. A combination of investor redemptions and unavailability of leverage will result in gradual liquidation of a significant portion of the hedge fund industry.

The sharp decrease in debt levels is driving reduction in growth pushing most major economies into recessions or near recessions.

The financial headlines scream “de-leveraging” at every turn. Companies are cutting production, reducing staff and costs, suspending investment plans, raising equity and trying to sell assets to reduce debt. Consumer spending is falling sharply as individuals increase saving and reduce debt. Falling investment earnings and lower interest rates also adversely affect the income of savers reducing consumption. Increasing unemployment (as companies retrench) and lower investment (as global demand collapses) mean the chance for a quick recovery is receding.

Emerging markets have not “decoupled”. China and India have slowed sharply. Russia, Brazil and the Gulf are also facing a slowdown as commodity prices fall sharply in the face of slower global growth. Global trade is also slowing.

The de-leveraging may claim further casualties. Over 71% of debt outstanding as at 2008 was rated non-investment grade. This compares with less than 30% as at 1980 and less than 50% as at 1990.

Companies that have taken on debt to finance acquisitions will face challenges in refinancing debt. Many private equity transactions, undertaken on aggressive terms, may be unable to service its debt commitments and will need to be restructured or will default.

The markets are placing considerable reliance on the ability of governments to arrest the decline and restore the global economy’s health.

The central banks have flooded money markets with liquidity. The money unsurprisingly is not flowing through into the economy. Banks are stockpiling the cash or using it to purchase government bonds. The money is needed by banks to finance around $5-10 trillion of assets that are returning to bank balance sheets from the off-balance “shadow banking” system. Banks also need to refinance substantial amounts of maturing debt and meet contractual payments to corporations who are drawing down credit facilities.

Banks are reluctant to lend as the real economy slows with rising unemployment and lower corporate earnings. Banks also lack the risk capital to make loans.

Central banks, in some countries, have moved to re-capitalise the banks and have guaranteed bank borrowings. This provides the banks with expensive capital and funding. It is difficult to see that these steps will be sufficient to arrest a sharp decline in the balance sheets and credit creation capacities of banks.

Governments are resorting to lower interest rates and massive spending initiative to stimulate growth. In 2008, aware of the massive de-leveraging of the financial system, credit markets bought government bonds anticipating slower growth and lower interest rates. Equity market, at least initially, viewed lower rates as supporting growth and to corporate earnings. By late 2008, equity markets saw low rates as symptomatic of low growth prospects and declining corporate earnings. Equity market did not react positively to the announcement from the US Federal Reserve that it will adopt a zero interest rate policy. Equities remained weak even as interest rates continued to decline.

The experience of Japan is salutary. Zero interest rates and repeated doses of fiscal medicine have not restored the health of the Japanese economy that remains mired in a form of suspended animation. The rest of world is struggling to avoid turning ‘Japanese’.

The health of the financial system and the extent of the slowdown in the real economy remain key concerns.

There is renewed concern about emerging markets, especially in Central and Eastern Europe (“CEE”), Latin America and Asia. The fundamentals of the CEE economies are not dissimilar to the position of the Asian economies in the period immediately before the 1997/ 1998 crisis. European banks have large exposures to emerging markets in CEE, Latin America and Asia. Problems in these economies and the failure of IMF intervention will affect them adversely. “It’s deja-vu all over again” as Yogi Berra might say.

The financial sector bailouts (carmakers are apparently now banks!) and government spending have converted a private sector problem into a public sector financing problem. High levels of public debt in and poor fiscal positions of some countries mean that the spending may be difficult to finance. The continued heavy reliance on savers in Asia, Europe and the Middle East is increasingly problematic given emerging problems in these countries that may limit the funds available. At a minimum the increased issuance of public debt risks crowding out other borrowers.

The problem is most acute for the U.S. In late 2008, Akio Mikuni, president of Japanese credit ratings agency Mikuni & Co., suggested that Japan should write-off its holdings of Treasuries because he believed that the U.S. government would struggle to finance increasing debt levels let alone repay the borrowings. He suggested that debt forgiveness was the only way out of the problem.

These pressures have manifested themselves in the currency markets. The last weeks of 2008 saw astonishing volatility in the Euro/US$ rate which moved between US$1.3356 to US$1.4719 (10.2%) in less than one week.

The risk of deflation (falling prices) is creating another massive asset price bubble in government bonds. Investors concerned about recession and deflation have purchased long maturity bonds driving long-term interest rates to unprecedented levels. A rate less than 3.00% pa for 30 year US government debt appears inadequate compensation for the risk entailed.

The coming year may see new phases in the financial crisis as the world continues to aggressively reduce debt. This will result in a sharp reduction to sustainable growth rates. $4 to $5 of debt is required to create $1 of growth. Approximately half the recorded growth in US over recent years was driven by debt primarily from mortgage equity withdrawals. As the level of debt in the global economy decreases, attainable growth levels also decline.

In effect, the world used debt to accelerate its consumption. Spending that would have taken place normally over a period of many years was squeezed into a relatively short period because of the availability of cheap financing. Business over invested misreading the demand and assuming that the exaggerated growth would continue indefinitely creating significant over-capacity in many sectors.

A lower growth future has political and social implications. China and India are deeply concerned about failing to provide jobs for the millions coming into the workforce each year.

As in Genesis, the “years of plenty” have ended. The improvident wasted the bounty of the years of prosperity and now find themselves in want in the “years of dearth”.

2008 was the year of “shock and awe”. 2009 may well prove to be a year of grim and brutal trench warfare as the world adjusts to a new economic order and reduced expectations.

© 2009 Satyajit Das

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

2008 - Look back in Horror!

Shell-shocked investors are coming to terms with the financial carnage of 2008 that saw their portfolios decline substantially in value. The value of investments fell to such depths that investors needed specialised diving equipment just to find what anything was worth.

Only “boring” investors who presciently owned government bonds or “lucky” shorts who had short sold everything else registered positive returns.

Equities (both developed and emerging market), residential and commercial property, credit investments and commodities all fell sharply in value. Defensive assets (traditional widows and orphans stocks and high quality corporate bonds) fell. Alternative assets (private equity and hedge funds) that were meant to perform differently to other asset classes and diversify investment portfolios also fell.

Volatility reached astonishing levels. Correlation between asset classes hovered close to one as all prices moved in unison mimicking gold medal winning synchronized divers. An investment in a Zambian copper mine behaved almost identically to a bond issued by a high quality corporation in Scandinavia.

What the “geeks bearing Greeks” and their quantitative investment models, risk analysis and trading strategies made of all this is unknown.

Fundamentals of value were largely irrelevant as the ‘great de-leveraging’ (surely the financial word of 2008) dominated. In recent years, cheap and abundant money (mainly borrowed) drove up the value of other assets. As the debt in the financial system was reduced, money became scarce and expensive triggering a sharp fall in asset prices. Anybody who had borrowed to purchase financial assets had to stump up margins or were forced to sell to reduce debt.

A shortage of buyers and lack of available liquidity meant that generally selling risky assets was nigh impossible. The marginal seller, usually distressed, and the cash rich buyer, increasingly scarce, set market prices. Central banks and governments, depending on the plan du jour to save the world, were “buyers of last resort”.

The process is far from complete. Many hedge funds took refuge behind “gates” – the new buzzword for suspending redemptions - putting off liquidating positions. The hope was that markets would miraculously improve in the New Year (I think it was 2009 that they were referring to but am not sure!).

Investment logic undeniably changed. Any business model based on availability of cheap and abundant debt, such as private equity or hedge funds, is now questionable. Anybody with major amounts of debt to refinance in the immediate future or any other financial cash calls (such as margin calls on credit downgrades) is carefully scrutinized.

In recent years, the value of real and financial assets were driven by a combination of higher earnings from the “great moderation” (strong economic growth and low interest rates) and an expansion of price earning multiples.

During this period, earnings also became “financialised”. Companies relied on financial engineering to boost earnings. Industrial companies boosted profits by financing purchases of their products, acquiring, merging and de-merging, borrowing to share buybacks, or trading in financial instruments. Financial sector profits rose to around 30-40% of total corporate profitability.

Prices reflected high termination or resale values; that is a ‘greater fool’ with even greater leverage would come along and buy whatever the investor had bought at an even higher price. This reflected the “leveraged” bid (from private equity, hedge funds and share buybacks) and financial engineering. All this now is a distant and fond memory that is unlikely to return until collective memory fades and scar tissue heals.

Investors are now focused on cash flows (income or dividends) from the investment. Capital gains have joined the list of endangered species. Prices must equate to the cash flows discounted back at capitalisation rates factoring in much higher costs of capital. Valuation fundamentals, that Benjamin Graham would have recognised, are once again fashionable.

Some of this is already in the price. Nobody knows whether assumed earnings sufficiently factor in the low growth environment ahead or whether the higher costs of capital have been incorporated.

A change in investment patterns favouring debt over equity is likely. Current credit margins are pricing in very high levels of default on high quality debt. Abundance of cheap debt drove down debt margins boosting equity returns. As credit margins increase there is a transfer of value from equity to debt. Potential equity raisings and asset sales as companies de-leverage also increase the risk of dilution of equity returns.

The form of investment may also change. Investors want to get as close to the cash flows as possible and avoid complex investment structures. Leveraged investment vehicles are out of fashion. Absolute rather than relative returns will be sought.

Management of the “liability” side of funds, specifically redemption risk, is increasingly important. Investors will be wary of the risk of value erosion in pooled investment structures (such as mutual funds and unit trusts). In 2008, unrelated redemption pressures drove down values of pooled investment and absorbed scarce liquidity. Closed end funds and self liquidating structures may become the new new thing.

Fund manager’s fees will be under pressure. A fee of 1% plus management expenses of 1% for a fund where the returns are negative will not pass muster. The hedge fund standard 2% and 20% of performance will only be acceptable for exceptional managers with a long history of high and stable returns (like Mr. Bernard Madoff) or where the performance fee is paid on realised returns.

We are, of course, in a “new paradigm”. Investors will need to adjust their expectations. The new investment mantras may well be:

1. Flat is the new up. 2. Debt is the new equity. 3. Dividends are the only return. 4. If you’re looking for the bottom of the market there’s a special offer - buy one you get the next one free.

The best investment story of 2008 relates to a banker who had a modest shareholding in his employer – a storied investment bank. Upon being transferred to London, he sold the stock to finance a Range Rover. As business in London turned down, the banker was transferred to Dubai.

When selling his Range Rover, he suffered a loss of around 50% of the price he paid barely six month ago. The interesting thing was that the proceeds from the sale of the car (despite the 50% loss) would have allowed the banker to purchase five times the number of shares he sold to finance the car. 2008 is perhaps the only year on record in which a distressed price for a Range Rover outperformed equities.

In Iceland, where there is an oversupply of Range Rovers as the economic good time ended, the cars are now known as “Game Overs”. For investors 2008 was also a case of game over.

Look back in horror!

© 2009 Satyajit Das

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

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