Friday, September 30, 2011

Remember that the endgame is a Greek default

So Germany's Bundestag voted overwhelmingly to expand their contribution to an expanded EFSF to  €440 billion and German's guarantee rises from  €123 billion to  €211 billion. While this step is constructive, it amounts to giving a terminal cancer patient a massage - the long-term results are still the same.

Be careful about getting overly excited about the subsequent rally in risky assets. Damien Reece, writing in the Telegraph, believes that the vote only kicks the can down the road to November because the problem has morphed into something much bigger than originally envisaged:
Unfortunately for the Bundestag members who voted in large numbers in favour of the greater bail-out powers for the EFSF on Thursday, the world has moved on since July 21.

If they thought it was difficult to get this far, all they've done is ratify a solution to a problem that has changed materially in the intervening period. The measures that European countries are agreeing to allow the €440bn fund to buy the debt of distressed European countries such as Greece, give financial help to banks and lend money to cash-strapped governments. To the optimists this all looked very impressive in July. But it looks all very puny now. It's a solution to a problem that no longer exists.

Back in July the eurozone crisis was a multi-billion euro problem. Now it's a multi-trillion euro problem. 
Michael Ridell at Bond Vigilantes posted 10 reasons why the EFSF is not the Holy Grail. The post is well worth reading in its entirety. For me, but the most important ones are:
(4) Legal risk. Investors in EFSF bonds have no understanding of what the money is to be used for (initially investors were told the facility was not to be used for bank bailouts but that looks likely to change). And if an EFSF guarantor reneges on its guarantee then there’s no payback (so if Slovakia pulls out, Germany just ends up guaranteeing more).

(5) Some of the initial guarantors (Spain and Italy) are themselves in trouble and probably need bailing out. If problem (3) is somehow overcome, then that means more EFSF bonds. But then you run into the problem of fungibility. Each EFSF bond has different guarantors, so the first EFSF bond was issued in January to bail out Ireland. Portugal remains to this day one of the guarantors for that particular bond, despite Portugal itself also needing to be bailed out (the two subsequent EFSF issues were to bail out Portugal, of which obviously neither Portugal nor Ireland are guarantors)...
(10) EFSF is not prefunded. Investors need to be persuaded to part with billions of euros to invest in a vehicle with an ever-expanding mandate that lends money to European governments and banks at precisely the time when the market has decided that those governments and banks are insolvent.
Why would any sane bond investor want to buy credit risk riddled EFSF paper without a hefty risk premium? Because someone told them it's AAA-rated?

Engineering the "orderly" default
I came across the headline ‘Orderly’ Greek default could be market positive a few days ago. Apparently, a number of analysts believe that the effects of a Greek default could be contained and therefore market positive.

I call this wishing for Santa Claus scenario. I suppose that if the EU governments were to mount a TARP-style rescue, by making bond holders whole in the manner of the US bailout in the post-Lehman era.

Duh! If Santa Claus came to the rescue then of course that would be market positive.

I continue to favor a Swedish-style bailout of depositors with an upper bound in costs of €800 billion. Under such a scenario, the authorities allow Greece to default. They would then tell the banks: "We know that you are insolvent but we stand ready to backstop you and inject sufficient equity to recapitalize you. If you take our option, then the shareholders will get diluted to virtually zero and bondholders will have to take haircuts. Management will get replaced. No depositor funds will get lost. This plan is not mandatory. You may find a private market solution before coming to us if you wish."

Such a solution would make the market capitalization of the banking sector in the European stock indices go to virtually zero. On the other hand, it be enormously stabilizing for capital markets as risk premiums would come down, though credit risk on European sovereign debt would probably rise.
Is that market positive enough for you?

Don't forget the endgame
You shouldn't forget what the endgame in the Euro-drama is going to be. Greece will default. It's just a question of when and how.
John Hempton sketched out two reasonably credible scenarios for Greece after a default (read it here). There is one for if she left the eurozone and one if she stayed. Neither is exactly a party. To add to the gloomy outlook, even euro area architect and former ECB chief economist Otmar Issing believes that a Greek exit from the eurozone is inevitable.
Joshua Brown took notes from a luncheon with superstar bond manager Jeffrey Grundlach. Here are some selected key quotes:
On the Euro Crisis: "I don't know what's going to happen in Europe but there is one thing I am certain about - eventually, someone is going to take a big loss. As investors, the most important thing we can do is to make sure that we aren't the parties taking that loss." He says DoubleLine's portfolios have zero European stocks, zero European bonds, zero european currencies, zero assets denominated in euro currencies - also, zero exposure to US bank stocks.
And here's the one to remember:

On Bull Markets and Bear Markets: If you study history, you'll see that "bull markets are about cooperation, bear markets are about divisiveness." Jeffrey says the Euro common currency came about in 1999 at the very peak of global cooperation, the fact that asset prices peaked around then too is not a coincidence. Right now divisiveness is everywhere and a global bear market is underway.
This is a bear market. Adjust your risk appetite accordingly.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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