The Real Reason the 'Voluntary' Greek Haircut Is Hurting The Market

Includes: FXE
by: Peter Tchir

Suddenly, everyone is discussing how the IIF “deal” made sovereign CDS worthless and that is why we are seeing a renewed sell-off in sovereign debt. That is just plain wrong. What the Greek “deal” did was make it perfectly clear, that banks that survive on the benevolence of the ECB directly and the IMF/EFSF bailing out their positions indirectly, will do what the governments tell them to do. The separation of banking and state has been violated. That is the problem, and that means banks need to reduce positions because they are scared of what their masters will demand of them, and they cannot survive a haircut on Italian or Spanish bond holdings.

CDS – Far From Worthless

So many comments about how sovereign CDS is now “worthless” after the Grand Plan and the “voluntary” Greek haircut. Greek CDS closed at 61.5 on October 26th. The Greek 5 year bond closed that day at 38, making the “basis package” price of 99.5 (you could buy the bond at 38 and CDS at 61.5). By the close of business on the “legendary” day of October 27th, the CDS had closed at 54.5 and the bonds at 41.75. So both the bonds and CDS improved on hopes the “Grand Plan” would work. The basis package was at 96.25 because CDS outperformed. That made sense as banks in particular would want to sell their CDS since it wasn’t going to be triggered. Some would also sell their bonds (i.e., the basis package) because they wouldn’t want to deal with the negotiations – because frankly who really cared about the IIF until this “Private Sector Initiative” was announced. Other banks may have sold CDS but held onto their bonds because an NPV of 50% is higher than where they had the bonds marked.

As more concern grew about the “voluntary” nature of the “proposed NPV haircut grew, the CDS continued to squeeze tighter and was at 51.5 by the end of the next day, while the bonds stagnated and closed at 42, making the “basis package” worth only 93.5. This, it turns out, was the best it got for sovereign credit. Those same Greek bonds now trade at 29, and the CDS is back to 61.5. So the basis package is down to 90.5, but the overall situation is worse.

So to say that “CDS is worthless” you would need to argue that a price of 61.5 prior to the “Grand Plan” being announced is worth a lot more than the 61.5 that it is currently worth. Just to be truly annoying, since the CDS trades in $’s, if you convert the price into euros the value has INCREASED, since October 26th, as the euro has dropped.

It isn’t just Greek CDS that experienced this “strange” form of worthlessness. Italian CDS went from 457 prior to the “Grand Plan” to 400 by the end of the first day’s rally based on an overly optimistic assessment of the plan’s potential. It got as wide as 595, and is only back to 540, after serious ECB intervention in the bond market. So it is more than 80 bps wider since prior to the “Grand Plan.” The story is almost identical for Spain, which went from 380, down to 316, hit a high of 480 and is now lingering at 465.

If CDS aren't worthless, than why are bonds moving wider?

It is clear that CDS aren't worthless. It is also clear that banks in Europe are not independent of their regulators or politicians. Many of the European banks only survive in their current state because of the backstop provided by the ECB. Without the ECB’s lending, many European banks (in Greece and Portugal in particular) would have to be shut down. Many others would have to shrink dramatically. Without the ECB and FED, many of the “Yankee banks” would have to shut virtually all of their U.S. operations. It is not just the explicit lending that is keeping their businesses intact, but also the implicit floor that gives some brave (or foolhardy) lenders the willingness to lend to them in dollars. On a side note, it seems that more of the Yankee bank funding in the US is coming from money market funds and ETFs. The banks seem to be smart enough to cut off lending, but the average saver is unwittingly stepping in. That is very similar to Lehman, where banks pulled out, and hedge funds bought the low priced longer dated paper, and money markets and funds, bought the short end to offer “incremental” yield, for a large increase in risk.

Asides from the ECB support which is direct, the banks are relying on the IMF and EU support indirectly. Since over 50% of Greek bailout money goes to service debt held outside of Greece, the real chain of bailout money is from the EFSF/EU/IMF to Greece to EU banks. The banks have been enjoying these benefits. They are quite happy to discuss the situation while in box seats at some Barca match, hoping to get an invite to a private party with Messi organized by some investment bank. They have been busy convincing the various agencies how critical it is to the economy (and not just banks) that these bailouts occur. Most of the talk about austerity seems to be done in plush offices (the IMF offices and meeting rooms that I saw on 60 minutes yesterday seemed off the charts for an agency that lives on public money and shouldn’t have to try and impress people to get their job done).

One little part of the “Grand Plan” was for the EFSF to provide equity capital for banks. It was assumed that it would come cheaply. This was an additional source of leverage the EU had over their banks.

For the first time, banks were threatened by the very agencies and groups that have been propping them up. What could they do? Well, they sent the IIF to the summit as a show of good faith. I don’t think many banks are influenced by the IIF, but it made it look like they were trying something. I believe the banks were more shocked than the rest of us when the IIF “agreed” to a 50% haircut. This was the first time that enjoying the policies of the EU and IMF and ECB had cost them anything. Suddenly all the bailout money, direct and indirect had a cost – agreeing to participate in the bailout in a material way.

Banks are selling because they own too much sovereign debt. Many of the banks own that debt at par. They owned the debt with the conviction that it would eventually be paid back at par. Most assumed it would be paid back at par on the originally scheduled maturity date, but figured, even if the maturities were extended, they could finance the positions for almost free with the ECB and not be hurt too badly. Now they couldn’t hide behind that view. It was clear to all that they might not get paid par for the bonds they held, and even worse, the decision might be taken out of their hands.

We have started to see banks take charges on their Greek debt because of this. They could no longer hope and pretend it was money good. What is interesting is that in spite of these large write-offs of Greek debt, not a single bank has gone bankrupt! What happened to all the people in 2010 said that a Greek default and losses on Greek debt would destroy the banking system? Most banks, as I have argued all along, were actually well enough capitalized to handle a Greek default. All this time and energy and money that has been wasted in the past year to avoid a “calamitous” default was likely unnecessary since the financial system could actually have handled a Greek default. In fact, not only was it unnecessary, it was downright harmful. It took focus off of Spain and Italy who chose to fix nothing. It made Sarkozy say so many cavalier things about bailouts and French willingness to throw money away that it has impacted their spread to bunds. His statements and actions are having a real direct cost to the citizens of France.

So by playing a game with Greece, which they have ultimately lost, they let Spain and Italy slip through the cracks, and let the bailouts spread contagion rather than stop it. They also have looked so poorly advised on things like EFSF that their credibility is dropping.

It is EU/IMF/ECB Intervention in otherwise functioning markets that is making the sovereign debt crisis work

Banks don’t have that many hedges on. Where they do, it is part of a “basis package”. Well over a month ago, we were warning that the basis would shift against holders, not only because of the IIF proposals, but also because of potential direct intervention in the CDS market. We warned that the intervention in the CDS market would only shift the basis and not affect the value of bonds, because the bond markets are bigger and actually drive CDS more than the other way around. Banks will be exiting basis packages (if they are smart), but hedge funds will buy them since they cannot be “voluntarily forced” into accepting any EU plan. In the end, that is somewhat risk neutral and doesn’t explain the big sell off in sovereign debt. What explains the big sell off in sovereign debt is the realization that you may not receive par, and as a member of the IIF, you may be asked by your government to do things you otherwise wouldn’t have done, and given all their support, you would have to do it. The control the EU chose to impose on the banks is why we were selling off, and let’s be totally honest, banking stocks would not have been as high as they got in Europe without all the support from the EU, so it isn’t unfair, it just seems that way.

Making the Greek plan (if it ever gets done) a Credit Event won’t help and would probably make things worse

First, I doubt that the IIF deal will ever be completed. They were never planning on a 50% reduction in notional that Greece owed. They were planning on a 50% NPV reduction in their holdings including some shift of risk from Greece to the EFSF. The plan was always vague at best, and the IIF is a fairly powerless organization. I doubt the plan will come through, but let’s say it does.

Would making it a Credit Event help other sovereign debt? The first problem is that making it a Credit Event would violate the ISDA terms and conditions. As I have written, any entity that decides (for whatever reason) to renegotiate their bonds or loans, should not have the right to trigger a Credit Event. Both the intention of the ISDA documentation, and how it is actually drafted support that conclusion. So without a true failure to pay, trying to make this into a Credit Event when the documentation is clear that it isn’t (and shouldn’t be) would create a new set of problems. Asides from the lawsuits, it would be another example of the EU trying to break the law. It is a very bad idea to force the ISDA Credit Event Determination Committee to call something a Credit Event, when it isn’t.

There would also be some initial fear of cascading counterparty risk. I think the market would be pleasantly surprised to see the CDS settle. There will be growing concern about the health of banks that wrote a lot of CDS and that may translate into margin (collateral) calls, which could be the undoing of some weaker banks. It is what I think makes the most sense, and in the long run is best, but I don’t think it will spark an immediate rally in other sovereign debt.

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