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Playing Greek Chicken

Playing Greek Chicken

Last week was mostly not a good one for bears, especially not for me. I think I pretty well pegged Ben Bernanke in my “Go on, fight the Fed” post. But I underestimated how actively other doves on the Fed’s monetary policy committee were agitating for more aggressive easing. I also slightly overestimated how negative the early US economic data for August would be, and I was caught off guard by some unexpectedly good data for July.

I can’t say I was justified by Friday’s triple-whammy – the terrible jobs number, the Greek bailout breakdown, and the raft of subprime suits. By then, the market had already rallied so hard that it only fell back to where it was on August 24, when I wrote that it was poised for a sharp decline.

So my market call was a big flop. It happens. Nothing spoils my day more. I did warn very clearly that I was making a risky bet.

All of this has done very little to change my outlook. My assessment of US economic performance through August is a bit less negative, but I still see a clear slide towards recession and no sign of anything that could reverse that course. Bears still need to be wary of the risk that QE – or just talk of QE – could re-inflate equity prices. But I don’t see any possibility that any kind of Fed action could stop the slide into recession.

Why not? I’ll have to save that explanation for later. This week, markets will be focused on Europe.

 

A BAD TIME TO GET WIGGLY

In Greece and Italy, the natives are getting uppity. Having accepted foreign aid, they’re trying to wiggle out of the promises they made to get it – to raise taxes and cut spending.

The situation in Greece seems most urgent. The IMF and European governments announced on Friday that they had put their aid to Greece on hold until it comes up with new measures to reduce its deficit, which widely overshot its target for the first half of the year.  The Greek government is so far refusing, claiming it wouldn’t be able to get new austerity measures through parliament.

An unnamed Greek government minister told the Wall Street Journal: “An angry population will take matters into its own hands, the government will collapse and we may end up with political crisis in a near-bankrupt euro-zone country which nobody will know how to control.”

It’s another round in the already familiar game of Greek chicken. Either there will be a compromise, or Greece will default. Conventional wisdom says that both sides have every incentive to veer away from catastrophe at the last minute, as they did at the end of the game’s last round in July.

But the game of Greek chicken has a special twist. The two sides are doomed to keep on playing, round after round after round after round, until they finally get so fed up they would rather just have that big, old smash-up.

So is this the final round? I don’t know, but it could be.

It would be very difficult for Greece’s creditors to grant it leniency on deficit targets. If they did, the loans they have already agreed to give to Greece would not be enough to cover its future deficits and debt payments. Eurozone governments would eventually be faced with a choice between increasing the size of Greece’s bailout program or letting it default.

And as the European economy drifts into recession, Greece will only fall further behind its deficit targets. The rest of the Eurozone countries will be increasingly worried about their own problems, and aid to Greece will be increasingly unpopular.

It is not even a sure thing that Eurozone governments can deliver the aid they’ve already agreed. The €109 billion extension of Greece’s bailout agreed in July must be endorsed by all 17 of their national parliaments, despite strong and growing popular opposition in most countries.

The most intense political battle is in Germany, where polls show the dominant Christian Democrats are heading towards a wipe-out in federal elections due by 2013, largely because their supporters are dissatisfied with Chancellor Angela Merkel’s support for bailouts. As I wrote this, exit polls showed Merkel suffering a fresh setback in local elections in her home state. I see a “dump Merkel” backlash among fiscal conservatives in the making.

There’s another aspect of the Greek bailout extension that is likely to undermine its popularity.  In what is being deceptively touted as a “contribution” to Greece’s bailout, private holders of Greek government bonds that mature by 2020 are being offered to swap them for new bonds that come with collateral worth 24% to 32% of the principal of their old bonds. In essence, Eurozone taxpayers would be giving Greece’s private creditors an immediate payment worth 24% to 32% of what they are owed by Greece. Private bondholders get a guaranteed minimum recovery of 24% to 32%, which they can claim right now. Eurozone taxpayers increase their investment in Greece and get no guarantee of any recovery. Normally, creditors to an entity on the brink of bankruptcy compete with each other to maximize their own recovery.

With some €150 billion of eligible privately held bonds, this up-front payment of collateral by Eurozone taxpayers to Greece’s private creditors could be as high as €48 billion. It would be funded out of the €109 billion bailout that Eurozone governments are seeking to get ratified. It’s a hidden, preliminary bailout of European banks, especially of the Greek banks that are most heavily into Greek government bonds.

 

KEY DATES AND EVENTS

A key event this week comes on Wednesday, when the German Constitutional Court is due to rule on a lawsuit challenging the constitutionality of the Greek bailout and a corresponding expansion of the European bailout fund, the EFSF. The court is expected to allow the bailout. But if it doesn’t, this game of chicken is up and Greece must default.

Meanwhile the European Central Bank has started a similar game of chicken with Italy. The ECB recently started bailing out Italy by buying its government bonds on the secondary market, an indirect way of lowering the rates that Italy pays when it sells debt at auction. As the Italians started reneging on austerity promises, the ECB let secondary market prices gradually slide over the course of last week, as a kind of warning shot. The Italians acted as if they didn’t hear. So now eyes are on an ECB governing council meeting this Thursday where members could potentially decide to pause purchases of Italian bonds. More likely, Italy will signal its willingness to compromise at the last minute. This after all is only the first round of their game.

The next key date is Wednesday of next week, September 14, when negotiators for Greece’s official creditors are due back in Athens to re-start talks. If Greece sticks to its current hard line, the official creditors will put off their return to Athens, and market fears of a default will magnify.

In any case, this round of Greek chicken will drag on at least into next month. Technically, the recent dispute is only over disbursal of the next €8 billion tranche from the original Greek bailout program that was approved back in 2010. But practically speaking, the dispute holds up everything, including approval of the €109 billion bailout extension and the bond swap for private creditors. This round of Greek chicken isn’t over till all 17 Eurozone parliaments ratify.

 

WAYS TO PLAY

Even if this isn’t the final round, there will be plenty of market scare before it’s over. The last round of Greek chicken in July, which never really looked like the final, was still worth drops of more than 50 points in the S&P and 400 points in the DAX. I figure this round will at least temporarily push the S&P through 1100 and the DAX through 4800. It could do much more than that. But this round will be playing out for more than a month, so expect both ups and downs.

One fairly conservative way to play is to simply bet on a drop in the price of Italian government bonds. You can do this by shorting ITLY or ITLT, two US-listed ETFs, the latter of which is 3x leveraged. I don’t like these much because they are illiquid, hard to borrow, with wide spreads and small bid/offer sizes. I prefer BTPS, a double-short ETF listed in Milan. The spread and commission aren’t great but at least it’s liquid. As (almost) always with ETFs, don’t hold your position through periods of sideways volatility, or you’ll lose money from the volatility drag. If these start going against you, dump them, and maybe get back in later.

It’s hard to short Greece directly without access to the Athens exchange, which I don’t have. There are only two US listings with any liquidity: NBG, the National Bank of Greece, and HLTOY, Hellenic Telecom (on the pink sheets). There is also GRE, a Paris-listed ETF linked to the MSCI Greece index, which is liquid and shortable.

There are still many ways to short European banks, despite the ban by five countries. Spain’s Santander and Bilbao Vizcaya Argenta can be shorted and put through their NYSE listings (STD, BBVA).  Italy’s Intesa, and France’s BNP Paribas, Credit Agricole, and Societe Generale can be shorted through the pink sheets (ISNPY, BNPQY, CRARY, SCGLY), albeit with wide spreads and little liquidity. German, Swiss and UK banks are still shortable on their home exchanges, and several have reasonably liquid NYSE listings with options (DB, CS, UBS, RBS, LYG, BCS). For Europe-wide bank exposure I know of two shortable long ETFs, US-listed EUFN and German/Italian-listed SX7PEX, and one short ETF, Paris-listed BNKX.

Or you can short the most contagion-susceptible European markets. There are shortable US-listed ETFs for Germany, Spain, Italy and France (EWG, EWP, EWI, EWQ). But you’ll get the best liquidity and the best variety of long, short, leveraged and leveraged-short ETFs if you go to the main home exchange of the country you are trying to short. The options are too many to list here.

In the US I am holding puts on the SPY. I would not single out the banks for shorting here, as they’ve just been beaten down by the FHFA lawsuits and so are likely to recover, at least relatively, as panic subsides and settlement talks begin.

Another interesting way to essentially short the S&P is by buying VXX, an ETF linked to short-dated VIX index futures. The VIX behaves similarly to the prices of puts on the S&P: it gains from growing fear of potential future declines as well as from actual declines.

Currently VIX futures are in backwardation (second-month futures are cheaper than first-month), and since VXX’s rules require it to constantly sell first-month futures and buy second-month, it’s making daily profits. This means VXX gains proportionally more when the VIX rises, loses proportionally less when the VIX declines, and makes a little money when the VIX moves sideways. It’s kind of like a 3x leveraged short ETF that pays daily dividends instead of penalizing you with volatility drag. But of course it’s still better for active trading than for passive betting on trends. Dump it when it starts to go against you, and be long gone before VIX index futures go back to their usual condition of contango.