Institutional Investors Need To Short, Or At Least Avoid, French Debt

by: Convex Strategies

Private investors, pension funds, insurance firms, hedge funds, and banks are all dealing with the same issue: a shortage of quality assets with sufficient yields. As a result, we are operating in an economy where countries like the US, which runs annual deficits over a trillion dollars and is consistently trying to debase the very currency its debts are issued in, can obtain 10-year financing at less than the annual rate of inflation.

Logic implies that a borrower running trillion dollar deficits with a stagnant economy and agenda to keep its currency weak should be paying far more than 2.5% for 30 years. In reality however, trillions of dollars in float, pension assets, and client money need to be allocated to assets that can be expected to preserve capital and pay some sort of yield.

When we look at major assets that the market believes to fit this criteria, we are left with the following:

  • US, Swiss, German, French, Canadian, Japanese, and few smaller sovereign debt instruments
  • Highly rated (A and above) corporate bonds
  • Highly rated municipal bonds
  • Money market funds
  • Hedge Funds
  • A small niche of equity offerings
  • Cash (Which has no yield)

That's essentially it. While these assets are in high relative demand even during periods of high interest rates, global debt crises have forced a lot of capital out of emerging markets and peripheral EU debt and further pushed down yields into an even narrower selection of assets.

I certainly don't question the capital flows into most corporates; tons of cash, clean balance sheets, and increased efficiencies make their collective debt (like you'd get in a bond fund such as LQD) safer than most sovereigns in my opinion, particularly the ones who can't print their own currency.

Many municipals are good bargains, and some may even have the implicit backing of the US (major cities).

The risks regarding money market funds became well-known in the aftermath of the financial crisis, and managers like Warren Buffett don't invest in them as they can't be counted on in times of true crisis.

As for sovereign nations who can print their own currency, and therefore monetize their debt, capital preservation isn't of particular worry. For example, if you invest in a newly issued 10-year US treasury, I can guarantee you will receive your principal at maturity. Of course, the dollar you invested 10 years ago won't be worth nearly as much as it was initially worth, but the US will never legitimately default on its debts. Period.

People keep wanting to find the bottom in US debt yields, but we are nowhere near it yet. The rationalization for the so-called bottom is that yields are no longer justifiable given the fact that their yields are below the rate of inflation. To that I have to ask: Don't you think investors know that? The typical private investor owns some treasuries in retirement; what better options do they have? The bank?

As for the big players (the primary dealers, pension funds, insurance float etc.), they're not necessarily holding their securities to maturity, and are allocating their flood of cash to these debt instruments in lieu of money market funds and currency. Banks, for example, can't get enough treasuries. Loan demand is weak, and low interest rates make the risk-reward profile generally unfavorable. Banks would generally rather buy a 30-year treasury yielding 2.5% than lend 30 years worth of capital to a fringy borrower in a mortgage yielding 3.75%, especially since the MBS market is drier than it once was. Throw in capital requirements and the deep liquidity that the treasury market offers, and it starts to make sense from a bank's perspective.

This dynamic will continue until 1) central bank interest rates rise meaningfully or 2) the ultimate credit worthiness of most distressed sovereigns improves and removes catastrophic risk from the system.

Now that we have some context on the current dynamics of the capital allocation flow, let's take a top-down look at France.

The Euro Experiment

At this point in the game, it's more than fair to say that the Euro has not only been a failed political experiment, but a complete disaster. The idea that a large group of nations with different cultures, vastly different economies, and different politics could operate efficiently under the same economic policy was, and continues to be truly naive.

The main issue has ultimately turned out to be the economic restrictiveness of a common currency. Without the ability to manage (alright, manipulate) their own currencies, and similarly, their interest rates, the EU periphery has been completely helpless in managing their long-term debt crisis.

Furthermore, the common currency policy harms countries whose economic realities don't align with the value of the euro. This ends up distorting the domestic credit creation process, import and export values, etc. The ultimate result has been structural imbalances all throughout the Eurozone, and record high unemployment above 11%.

French Debt: The Real Story

Before getting into the consequences of the socialist path France's voters have elected to go down, let's discuss the reality of France's fiscal situation.

Despite an official debt to GDP ratio of about 86% (which is higher than Spain's nonsensical official ratio of about 70%), the true debt to GDP ratio is 146%. This figure takes into account "contingent liabilities, promises to pay, derivatives" etc. These are very real factors that France is ultimately liable for. The market hasn't allowed Spain or Portugal to get away with their understated ratios of 70% and 105% respectively, and France is next in line.

Europe's second largest economy is on pace to run a 4.5% deficit in 2012, and expects to run a 4.% deficit in 2013, well short of the EU-targeted 3%.

Of course, this deficit is predicated on France's internal growth estimates of 1.3%. This estimate, as is perpetually the case for the rest of the Eurozone, is unrealistic and based on the strange idea that growth improves with time, i.e, the Eurozone crisis and worsening recession is just "temporary" and somehow the structural deficit issues will improve by next year.

This has been a problem for the EU since 2009; consistent, unrealistic growth estimates that are modeled on the idea that extensive liquidity measures lead to sustained growth improvements. Higher year-on-year estimates fly in the face of current economic trends showing accelerated contractions in the manufacturing sectors of China, the US, and the entire Eurozone, in conjunction with a slowdown in Brazil and India.

Moving on, S&P believes France will only achieve 0.7 growth in 2013, compared to the estimated .3 in 2012. With the French manufacturing PMI at a 38-month low at 43.4 (vs. 45.2 in June), business optimism at the lowest since March 2009, and retail sales declining rapidly, I'd argue that France will likely be in a technical recession by 2013; a far cry from the .7% growth Standard & Poor's is projecting on their models.

Here's French retail sales:

Italy, in the context of Europe's largest economies, is the clear underperformer.

These economic figures starkly contrast with France's projection of 1.3% growth in 2013.

France's Mediocre Private Sector

Without getting too political here, it should come as no surprise to those familiar with the French work ethic that an absurd 55.7% percent of France's entire GDP is derived from government spending. This makes France's GDP the sixth highest in terms of dependency on government spending. This puts them in the company of Iraq, Libya, Cuba, Ireland, and Italy. Think the US is highly dependent on government spending? It's 113th at 23.6% of total GDP.

Of course, as is the case in most of Europe, France has much higher effective tax rates than does the US, making this figure more understandable.

However, with France already running budget deficits of 4.5% at record low rates of funding, two huge worries are what happens when:

  1. Rates of interest rise meaningfully, as has happened in Spain, Italy, and Portugal
  2. Budget deficits become unmanageable and require spending cuts

Though growth models assume economic improvements over the next few years, I find no basis for this projection. EU economies are contracting at an accelerating rate and structural deficits have yet to be meaningfully addressed.

Former president Sarkozy often argued against the 35-hour workweek; no surprise that he was voted out. An NPR report from January noted the excessive amount of overtime that workers must take before 2012 is over, leading institutions like hospitals to worry about being understaffed.

At its core, the private sector is unwilling, and therefore unable to compete with today's economic demands. That dynamic, in conjunction with over half of annual economic output coming from the government, is a dangerous and unsustainable equation.

French Banks: A Ticking Time-Bomb

Next, we have French banks. The major players here are BNP Paribas (OTCQX:BNPQY), Societe Generale (OTCPK:SCGLY), and Credit Agricole (ACA.PA).

Leverage ratios for BNP Paribas are the same as Lehman Brothers' before the crisis. With $2.5 trillion in asset footings, compared to $80 billion in tangible common equity, the bank is dangerously levered at 31X. It's deposits are just 29% of total asset footings compared to figures of 50% at the largest US banks.

David Stockman points out that with combined asset footings of $6 billion, the big three French banks have assets worth almost three times the entire French GDP of $2.2 trillion, compared to 40% of assets to GDP for the big three in the US.

French banks have about $40 billion in direct exposure to Greece, and Credit Agricole is perhaps the most poorly positioned; it lost 2.4 billion euro last year as a result of its Greek subsidiary. With a mere 9 billion euro market cap and a share price of 3.57, Credit Agricole, at 66x leverage, is my candidate for the first bank in France to collapse. Raising equity is mighty difficult at 3.57 euro a share.

How about the fact that French banks own more than $400 billion in Italian sovereign and private debt? With Italy's bonds sliding, the banks are starting to really feel the pain.

It's not a matter of if, but when for the French banks. Though they claim to be delevering rapidly, their balance sheets show a far different story, and the situation in the EU may not provide enough time or liquidity to allow for such.

The leverage ratios and leading euro-crisis exposure are sending a loud and clear message: France is going to be on the hook for absolutely stunning bank recapitilizations and full-scale nationalizations.

The Obvious Conclusion: French Bond Yields Don't Accurately Reflect Risk

Here's the yield curve for France, as of August 1st, 2012:

As you can see, France trades as if there is absolutely zero risk of default.

France has somehow gotten away with 50-year financing at 3.204% - it's highway robbery.

The CDS prices also show relative complacency, with the 5-year CDS valued at 150, relative to PIIGS CDS prices, which trade on average around 500.

The market should have recognized the long-term jeopardy that France is now in thanks to its shiny new, socialist leader. The French population has spoken, and they don't want to address structural deficit issues if it means working longer or cutting back on entitlement spending. Rather, its plan is to tax the rich until the problem is solved, and continue with the same way of life.

Unable to print its own currency, France will be forced to address its deficits in the near future. The catalyst will likely be the weakness of its banks. As the euro-crisis drags on and liquidity injections have diminishing impacts, the French banking institution will begin to realize losses on its vast amount of assets, and without adequate capital or ability to raise funding via equity or even through the repo market (due to shoddy and limited collateral), the burden will fall on public finances.

France is in no better position than Spain or Italy. Its economy is contracting, its banks are massively levered, and government spending is more than half of total GDP. Contagion is a rapidly occurring phenomenon, and France is the next shoe to drop.

The Trade

Without ready access to shorting French government bonds or buying credit default swaps, I'm largely unable to currently take advantage of my thesis.

One could short the aforementioned banks on the OTC markets, but it's likely pretty difficult to find shares to borrow. Additionally, the French index fund (NYSEARCA:EWQ) could be shorted, or you could sell calls/buy puts. Lastly, retail investors could short the French ADS listings, like France Telecom (FTE), but it's not nearly direct or profitable.

If you own any financial institutions, particularly insurance companies, comb through their SEC filings to make sure they have limited exposure to French financials or sovereign debt.

For institutional investors, I like the convexity, or positively skewed risk-reward of shorting French government bonds maturing in five years or more, or buying credit defaults swaps on French debt. The downside is very limited; yields are currently falling as a result of the misguided view that French debt is a safe haven. Crises can do that. However, confidence is a fragile intangible, and erodes very quickly once people start to pick up on France's economic reality. Fair value for French debt is in my opinion much closer to values of the PIIGS debt, offering quite an opportunity for those who want to take advantage.

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

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