The Countdown to Sovereign Debt Write-Offs Has Started

by: Peter Tchir
Don’t be fooled by the IMF’s announcement that Greece will get a new round of money. This bailout will give the parties a couple of months to seriously negotiate what haircuts and debt extensions investors need to take in Greece, Ireland and Portugal. Virtually all of the comments made by the involved parties support the view that we are now in a phase where people are negotiating how much they will write off and what else they will do. Almost none of the comments indicate that anyone is really trying to put together a plan that is going kick the can down the road for a long time. I am fading this rally as only the most optimistic investor can believe that this problem won’t lead to real default/restructuring with haircuts in the next couple of months.

Why Do Banks Waive Covenants?

It looks like Greece has failed to meet the criteria the IMF had set out to provide more money, yet the IMF seems intent on releasing the next tranche. Banks typically waive covenants and release more money only when they truly believe that the borrower will turn around, or when they extract enough value from the borrower that they feel safe making the new loan, or when they aren’t prepared to deal forcing the borrower into default.

Does anyone really believe that Greece is going to get turned around? I don’t. In fact, I am highly confident that Greece will still not meet the criteria the IMF has set out when it is time for the next tranche. That will be the deadline for the default/restructuring. The IMF can waive the covenants this time because they will shortly get to review the progress again and can fail them at that time.

Could the IMF, which allegedly has some collateral for the loans it is making, be receiving even more collateral on this latest tranche? Could they have perfected their security interests making their own loans extremely safe? That is a real possibility. If this next tranche only includes IMF money, or lending that is collateralized very specifically, it would be another clear sign that the game has changed and the lenders are protecting their new loans at the expense of existing bondholders.

Are the IMF, the EU, the ECB, or any the central banks, prepared to deal with a default or real restructuring right now? The answer clearly seems to be no, but it is also clear that over the past month, the EU, in particular, has realized restructuring, possibly with losses needs to occur. Talk about the ‘Vienna Accord’ and ‘voluntary private restructuring’ has become louder. That will take time. How do you easily pressure a bank into taking a loss, particularly when they were still hopeful for a painless solution just a few weeks ago?These ‘voluntary’ decisions won’t be so voluntary, but it will take time for the governments to convince their banks en masse to reach an agreement.

Waiving the covenants and providing the next tranche of IMF money, particularly if fully secured, is completely consistent with the idea that we have entered a relatively short period of negotiations leading to real restructuring.

Germany Is Laying the Groundwork for Real Write-Offs

Germany was the first EU member to suggest private sector haircuts. It has seemed more open to private sector losses than any other government. Not only has the German Finance Minister been outspoken on his desire to include the private sector in any package, but the Bundesbank issued a statement that it is confident that the euro can withstand Greek default. That was the first time in this crisis that a statement has come out trying to prepare the markets for a potential default. As soon as a statement starts to come out stating that the banking system is strong enough to withstand a default, you know that someone is seriously considering a default. I believe that this statement, which has been largely ignored, is a tell. It is the first step in the process of trying to soften the market.

Against this, the ECB continues to lash out that restructuring/default is not an option. At least that is how it seems on the surface. A little below the surface and it seems like they are starting to take some steps to soften their stance. First, and most importantly, Draghi seems to be the main spokesman. Trichet seems to be quiet on the subject now. Many people (at least me) blame Trichet for making the situation worse through the ECB’s wanton purchase of Greek (and Irish and Portuguese) bonds in the open market. By bringing Draghi to the front line, are they starting to distance themselves from ECB policy under Trichet? Are they setting him up as a scapegoat? It is plausible to me. Looking even more closely at what Draghi says also indicates a potential softening. He says “The cost of a real default…” What does he mean by real? Is that to make it easier to wiggle out down the road and say whatever happens wasn’t a “real” default?

Germany seems to be moving further into private losses and preparing the markets for how contained those losses will be. The ECB is softening a bit and making it easier to blame its original stance on Trichet if they change their mind.

What About Contagion Risk?

There is real risk of contagion. That is another reason that the EU/IMF/ECB need to buy a few more months. When the next plan is announced, it will be comprehensive and Greece, Ireland, and Portugal will be included. I had been surprised at how quiet Ireland has been. Other than being mentioned in general terms as part of a contagion argument, relatively few new specifics were being talked about. Suddenly this week, here they are. Allied Irish sub debt had a credit event. Noonan is speaking about haircuts for senior Allied Irish bondholders. He is commenting on Greece. It is not a coincidence in my mind that he is suddenly speaking out, as he is likely involved in this next phase of negotiations. In fact, it seems that the number of finance ministers and ECB officials who are hitting the airwaves is expanding. I assume that if many people feel the need to comment, something serious is going on behind the scenes.

Contagion risk is there, but it is being addressed so Greece, Ireland and Portugal can be sorted out at once, and the banks that would be in biggest trouble can get help if they need it.

The Government Changes in Greece Point to Default

You could argue that the changes to the Greek parliament are an attempt to get approval to jam another round of austerity on its people. That could be, but I think it is more likely that Prime Minister Papandreou does not want to be labeled as the man who put Greece in default or who crushed the euro, so he is trying to escape that role, or drag others into a group to share the blame. If I was him, I would be trying to do things so that my name doesn’t go down in history as the person who broke the euro.

Banks Can’t Handle the Defaults

I really think most banks can handle the defaults. The most likely outcome, in my opinion, is that there is some amount of permanent debt reduction and any remaining debt has its maturity extended for a long time. The banks that aren’t mark to market would have to take a loss on any permanent reduction in principal, but there is no reason why they have to take a loss on any debt that they extend the maturity. So if a bank took 100 million of 2 year bonds, and exchanged them for 80 million of 10 year bonds, they would take a write off of 20 million. That seems manageable for most banks (and the governments can directly support any bank that can’t handle it).

From a stock price perspective, no one is buying the stocks of banks with big exposure to Greece, Ireland, and Portugal on the basis that they don’t have impairments in the portfolio. Given where debt is currently trading, and how much of the write off is permanent, and the trading price of new bonds, bank stocks may rally. I occasionally read articles about banks trading below book value as being cheap. I usually stop there because I believe smart investors trying to figure out the value of the banks holdings are not easily fooled by non mark to market accounting. If I am correct, the banks will have some big losses, their share prices may not react much, and the various EU countries can bailout their own banks directly if they choose to.

CDS?

CDS is a subject that will get its own write-up, but from the data available from the DTCC, concerns about CDS on sovereigns seems overblown, even if there is a credit event. Of all the subjects written about, the only that seems to get the least accurate treatment is the potential impact of CDS on the outcome. The problem is a debt problem. The bulk of all losses will result from poor lending and bond buying decisions. CDS will spread some gains and losses around, but will not in itself have a meaningful impact on the market.

Trying to compare AIG is wrong as AIG had almost nothing to do with single name CDS and had ridiculously loose collateral terms even by the 2007 standards, let alone today. Lehman, with massive amounts of debt, saw its CDS settle with little confusion, and the market dealt pretty well with the loss of Lehman as counterparty on so many CDS trades. There were more surprising losses from things as simple as repo agreements than from its role as a CDS market maker.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.