To Disburse Or Not To Disburse, Or, Here Comes The Drachma

Includes: EWP, FEZ, FXE
by: Colin Lokey

Recall that just two short weeks ago, the Greek debt crisis was considered as good as solved. On November 7 the Greek parliament approved -- barely -- a new austerity package worth 13.5 billion euros. Forcing the measures through was no easy task. The vote took place amid work stoppages in Athens that had left schools and banks closed and had crippled the public transportation system.

While protesters hurled firebombs and shrieked that the government and the troika were "drinking their blood", an even more surreal series of events unfolded inside parliament. At some point during lawmakers' discussion of the 500-page bill, it became apparent to the parliamentary workers present at the proceedings that the measures under consideration appeared to include salary and benefit cuts for... parliamentary workers. Essentially then, the workers were assisting in negotiations which, if successful, would be detrimental to their own financial well-being. As one might expect in such a situation, the workers promptly walked out, halting the whole process while the Prime Minister and his aids "considered their demands".

Just days after the veritable circus described above, Greek lawmakers also approved a 2013 austerity budget. Together, the two positive votes were supposed to ensure that Athens would receive the next tranche of aid from its international lenders, delayed since June and worth some 32 billion euros. Doubts about the timing of the disbursal began to surface almost immediately however, with Greek 10-year spreads swinging some 330 basis points in less than 48 hours after officials said no decision on Greek aid would likely be reached before a 5 billion euro bond (held by the ECB) came due the following Friday.

As I noted in an article published the day after the Greek austerity package vote, Greece would likely have to resort to Emergency Liquidity Assistance to raise the funds necessary to pay back the ECB. The irony: the 'assistance' part of Emergency Liquidity Assistance comes from...the ECB:

"The very same thing happened in August when Greece faced a 3.2 billion bond payment to the ECB. The solution devised by Mario Draghi and company at the time was to raise the limit regarding the amount of Greek T-Bills the Bank of Greece could accept as collateral for loans, essentially allowing the Greeks to issue worthless T-Bills in exchange for euros which would then promptly be paid back to the ECB in the form of a bond payment."

This time around however, Athens faced a problem. The emergency measure enacted by the ECB on August 2 which increased the amount of T-Bills the Bank of Greece was allowed to accept as collateral for euros expired, meaning that the limit fell back to 3 billion euros from 7 billion. This presented the following frightening scenario:

"...even if Greece managed to roll its maturing €5 billion in Bills with a new Bill issuance (which it did), it would be unable to actually obtain cash for this worthless paper, through a repo with the European Central Bank."

Here is how, theoretically, the situation described above would have played out: Athens, intent on paying back its 5 billion bond to the ECB, sells enough T-bills to Greek banks to cover the balance and the Greek banks take the Bills to the Bank of Greece to obtain euros which will then be funneled back to the Greek government to repay the bond. However, in this instance the Greek banks wouldn't be able to pledge all of the Bills for cash and the Greek government would be unable to pay its debt to the ECB because the ECB forgot to extend the emergency mechanism it had put in place in August whereby it was essentially paying itself back by loaning Athens money for worthless Bills.

As this is clearly not an option -- if you're the ECB you don't want to force a country to default on the bond it owes you by abruptly changing your crisis-time management policies -- the central bank had to devise a new way for Greece to obtain euros. From the Wall Street Journal on November 12:

"The European Central Bank has thrown Greece another lifeline by lengthening the list of eligible collateral banks are allowed to use in Emergency Liquidity Assistance...the broadening of eligible collateral more than compensates for the effect of a lower T-bill ceiling."

The gap (the difference between the money Greece needed to raise to repay the ECB and the 3 billion euro T-Bill ceiling) was filled by the posting of "other" collateral, namely "unspecified, lower-quality assets", according to the ECB's governing council. More specifically, one official said, according to the Washington Post,

"...other acceptable collateral including asset- backed securities on banks' balance sheets have increased in value enough to make up the difference."

So the implication here is that Greece's banks have asset-backed securities on their books (that by the ECB's own words are "low quality") that have increased in value by some 2 billion euros over the past several months.

Setting aside the absurdity in claiming that Greece's banks have balance sheets full of rapidly appreciating asset-backed securities, this entire enterprise is comical for two reasons. First, the ECB is now contorting it collateral rules (which, readers are reminded, the central bank has repeatedly said are what keeps its balance sheet safe) beyond recognition in order justify loaning countries money so those countries can hand it right back to the ECB. Second, the ECB apparently thinks the asset-backed securities on Greek banks' balance sheets are more credit worthy than Greek T-Bills which should set off alarm bells at all the hedge funds who just a month ago were still maintaining that Greek debt presents a 'wonderful opportunity.'

Given what is taking place here it is abundantly clear that no responsible lender would, in their right mind, extend credit to this country. It should come as no surprise then that on Tuesday, the troika failed (again) to agree on whether and when to disburse the next tranche of aid to the Greeks. From Reuters:

"After nearly 12 hours of talks through the night during which myriad options were discussed, euro zone finance ministers, the International Monetary Fund and the European Central Bank failed to reach a consensus, without which emergency aid cannot be disbursed to Athens"

The main point of contention is that the IMF wants Greece's debt-to-GDP ratio brought under 120% by 2020, something which cannot be accomplished without some manner of official sector writedown, a prospect Germany and other member nations are loath to consider. The EU prefers instead to give Greece two extra years to reach the goal, a prospect the IMF says is unacceptable.

Investors should ask themselves how long this can go on. The ECB is printing more and more euros to prop Greece up while the rest of the country's official sector creditors debate the country's future. This aid tranche was supposed to be disbursed in June. Consider now how ridiculous Antonis Samaras' promise made just two weeks ago to the Greek people seems:

"As soon as the new measures are passed and we get the critical aid tranche, liquidity will start again to feed businesses and households, uncertainty will end, sentiment will change."

As I and many others have said before, this situation is becoming more untenable by the day. In all likelihood, Greece will exit the euro within the next 12 months, the new drachma will depreciate some 60%, and the shockwaves will reverberate throughout the eurozone producing a ripple effect here in the U.S. Note as well that the idea of 'contagion' is alive and well: Moody's stripped France of its Aaa rating on Monday. The dominoes are slowing falling and investors should remain short European equities (NYSEARCA:FEZ) (NYSEARCA:EWP), periphery sovereign debt, and the euro (NYSEARCA:FXE).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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