Thursday, October 27, 2011

Let the 'Debt Relief' Celebrations Begin?

James G. Neuger and Stephanie Bodoni of Bloomberg report, EU Sets 50% Greek Writedown, $1.4T in Rescue Fund:

European leaders cajoled bondholders into accepting 50 percent writedowns on Greek debt and boosted their rescue fund’s capacity to 1 trillion euros ($1.4 trillion) in a crisis-fighting package intended to shield the euro area.

The 17-nation euro and stocks climbed while bond spreads narrowed after leaders emerged early today from a 10-hour summit in Brussels armed with a plan they said points the way out of the quagmire, albeit with some details still to be ironed out.

“Overall the outcome is better than we anticipated one week ago,” Laurent Bilke, global head of inflation strategy at Nomura International Plc in London, said in an interview. “There are several issues left open, but I do believe that getting a more necessary debt relief for Greece is a pretty important step.”

Last-ditch talks with bank representatives led to the debt- relief accord, in an effort to quarantine Greece and prevent speculation against Italy and France from ravaging the euro zone and wreaking global economic havoc. Greek Prime Minister George Papandreou will address the nation at 8 p.m. in Athens to outline the summit’s ramifications for the country at the eye of the two-year sovereign debt crisis.

“The world’s attention was on these talks,” German Chancellor Angela Merkel told reporters in Brussels at about 4:15 a.m. “We Europeans showed tonight that we reached the right conclusions.”

ECB Role

Measures include recapitalization of European banks, a potentially bigger role for the International Monetary Fund, a commitment from Italy to do more to reduce its debt and a signal from leaders that the European Central Bank will maintain bond purchases in the secondary market.

The euro advanced to a seven-week high against the dollar, rising above $1.40 for the first time since September. It was at $1.4007 at 11:48 a.m. in Brussels. The Stoxx Europe 600 Index surged 2.6 percent.

“It’s long on words, short on detail,” said Peter Dixon, an economist at Commerzbank AG in London. “The solution that’s been put in place now gives us enough ammunition to stave off any immediate problems but we may well run into other problems down the track.”

The summit was the 14th in the 21 months since Europe pledged solidarity with Greece, and came amid mounting global pressure for the bloc to deliver a credible anti-crisis toolkit before a Group of 20 meeting Nov. 3-4 in Cannes, France.

Banks Summoned

Europe’s leaders took the unusual step of summoning the banks’ representative, Managing Director Charles Dallara of the Institute of International Finance, into the summit to break the deadlock over how to cut Greece’s debt to 120 percent of gross domestic product by 2020 from a forecast of about 170 percent next year.

Dallara squared off with a group led by Merkel and French President Nicolas Sarkozy around midnight after issuing an e- mailed statement that “there is no agreement on any element of a deal.”

Sarkozy said the bankers were escorted in “not to negotiate, but to inform them on decisions taken by the 17 and then they themselves went on to think and work on it.” Luxembourg Prime Minister Jean-Claude Juncker said the banks’ resistance was broken by a threat “to move toward a scenario of total insolvency of Greece, which would have cost states a lot of money and which would have ruined the banks.”

Insolvency Threat

The resulting “voluntary” losses by bondholders were the key plank in a second bailout for Greece, which was awarded 110 billion euros in May 2010 at the outbreak of the crisis. The new program includes 130 billion euros of official aid, up from 109 billion euros envisioned in July.

The Washington-based IMF, meanwhile, said it is ready to disburse its 2.2 billion-euro share of the next installment of Greece’s original bailout. The release of the euro zone’s 5.8 billion-euro share was approved last week.

Greek, Spanish, Italian and French bonds all rallied today, with the spreads over benchmark German bunds narrowing. The yield on German 10-year bonds jumped eight basis points, the most in more than 11 weeks, to 2.11 percent at 10:05 a.m. London.

The yield on Greek bonds due in October 2022 fell 117 basis points to 24.15 percent, Spanish 10-year yields dropped 16 basis points to 5.32 percent and Italy’s 10-year bonds advanced for a second day, with yields falling 13 basis points to 5.81 percent.

ECB President Jean-Claude Trichet, who has warned against the spillover effects of bond writedowns on the banking system, didn’t take part in the confrontation with bankers on the debt relief. He later praised the leaders’ determination to get ahead of the crisis.

Trichet’s Call

The measures agreed “have to be fully implemented, as rapidly and effectively as possible,” Trichet, who leaves office Oct. 31, said afterwards.

Leaders tiptoed around the politically independent ECB’s broader role in keeping the euro sound, making no mention of its bond-purchase program in a 15-page statement. The Frankfurt- based central bank has bought 169.5 billion euros in bonds so far, starting with Greece, Ireland and Portugal last year, then extending the coverage to Italy and Spain in August.

While Trichet didn’t mention the controversial purchases either, his successor, Mario Draghi of Italy, indicated that the policy will continue. Speaking in Rome yesterday, Draghi said the ECB remains “determined to avoid a poor functioning of monetary and financial markets.”

Leaders backed two ways of leveraging up the 440 billion- euro rescue fund, which was designed last year to shield smaller countries such as Greece, Ireland and Portugal, and lacks the heft to protect Italy, the euro area’s third-largest economy.

Leverage Options

Under plans to be spelled out in November, the fund will be used to insure bond sales and to create a special investment vehicle that would court outside money, from public and private financial institutions and investors.

Canadian Prime Minister Stephen Harper, speaking at a conference in Perth, Australia, called the agreement “grounds for cautious optimism,” and urged European leaders to work out details of the plan and implement it.

Europe cast about for more international money to aid the rescue, with France’s Sarkozy set to call Chinese leader Hu Jintao tomorrow with the goal of tapping into the world’s largest foreign exchange reserves.

While the mechanics are a work in progress, European Union President Herman Van Rompuy said the leverage effect would multiply the power of the fund by a factor of four to five. He compared it to normal banking business that needn’t entail excessive risks.

‘Detail Further’

“It will be important to detail further the modalities of how this enhanced EFSF will operate and deliver the scale of support envisaged,” IMF Managing Director Christine Lagarde said.

Europe also struck a bank-recapitalization accord, setting a June 30, 2012, deadline for lenders to reach core capital reserves of 9 percent after writing down their sovereign-debt holdings. Banks below that target would face “constraints” on paying dividends and awarding bonuses, a statement said.

The European Banking Authority estimated banks’ capital needs at 106 billion euros, with Spanish banks requiring 26.2 billion euros and Italian banks 14.8 billion euros. It gave them until Dec. 25 to submit money-raising plans to national supervisors.

Banks that fail to raise enough capital on the markets will first tap national governments, falling back on the EFSF rescue fund only as a last resort.

So what does this deal mean for Greece and the global economy? When it comes to deals of this magnitude, the devil is in the details. Andreas Koutras sent me his preliminary thoughts on the EU statement on Greece:

Finally the European political leaders seem to have reached an agreement on how to deal with the debt of Greece and the one brewing in Italy, Spain and France.

Although the statement issued by Europe is at places vague, the main points that can be discerned with regards to Greece are as follows:
  • The haircut would be 50% and it would voluntary. The fact that they still insist on a voluntary agreement is significant and important. The CDS may or may not trigger, but this is the least of our concerns. This is purely an ISDA decision that would predominantly affect the CDS market. The main point is that any voluntary exchange would place Greece under Selective Default and not under default thus avoiding the nasty side effects of bankrupting the Greek banks and pushing the country into a limbo state needing drip-feeding for months.
  • The statement excludes ECB holding.
  • The programme would contribute 30bln towards the PSI. The statement refers to “a voluntary bond exchange with a nominal discount of 50% on notional Greek debt held by private investors”. We take this to mean a reduction on the face value of the bonds, but we reserve full judgement until we have more information or clarification from the EU.
  • It further stipulates that the objective is to reduce the debt to GDP by 2020 to 120%. There is a clear reference to “a Greek” monitoring and implementation. This is to allay fears of loss of sovereignty. Given however, the hitherto inability and inadequacy of the Greek government to enforce and implement much of what has been agreed this may be altered on the ground. There would be yet again a new Memorandum of Understanding.
With regards to the 50% haircut and whether it is on the Notional amount or the NPV we have:

NPV haircut
The statement refers to the “notional held by private investors” and this may mean the amount rather than the face value. For this reason we examine the NPV case.
A haircut of 50% on the Net Present Value could be achieved if for example you reduce the average coupon on the PSI proposed options by 2% and lower the guarantee to 50% from 100%. In this case the 30bln that the statement refers to as a contribution to the PSI is roughly what is needed for the stock of Greek bonds. In other words, if all 177bln of outstanding Greek stock (excluding the ECB) is exchanged into a 30Y bond with only 50% AAA guarantee, Greece would need to purchase close to 29billion worth of a zero coupon (depending on where they mark the 30Y rate).

Accounting wise though the reduction in the debt to GDP from the matching of the Asset (zero coupon) and the liability (30Y bond) would only be around 56billion. Thus day one after the exchange Greece would owe around 136% and given time to 2020 this could fall to 120%. The problem however, is that Greece would also need to start servicing this debt, day one. At an average of 2.5% coupon this would mean 5billion on interest only a year. Greece unfortunately still runs a primary deficit of around 2.5billion and it would be very difficult to meet this without further external assistance or grace period.

Notional reduction
A 50% reduction on the face value of all outstanding stock would reduce the debt by 88.5 (50% of the 222 of stock-45 of ECB)billion would reduce the debt to GDP to around 124%, day one. As we have no details of how the new bonds would look like or what form the principal guarantee (if any) it is hard to evaluate it.

Combination (Face reduction, 15% cash, NPV loss)
A combination approach is the other possibility. Namely, a reduction in the face value of the bonds with a simultaneous NPV write down on the new bonds and possibly a cash payment of 15%. This was leaked a couple of days ago as an alternative. Again, the 15% cash payment or 26billion on the 177 billion (222-45) of outstanding Greek stock in Private hands ties nicely with the 30bllion that the statement says has been earmarked for the PSI. In this case a 50% face reduction (minus 88.5billion on debt) taken with the cash payment (plus 26billion) would take the debt to GDP to around 135%.

Legal
There is no mention in the statement under which jurisdiction the new Greek debt would be offered. We expect that since bondholders would suffer a substantial haircut now, they would demand future protection under English law. If that is the case, then under the scenarios examined above 100% of the outstanding Greek debt whether in the form of bonds or bilateral loans would be under English law. This would significantly reduce the ability of Greece to exercise any control over it and it would make harder any future default or restructuring for Greece.

Conclusion-Greek banks
The solution given to the Greek debt crisis does not seem to be comprehensive as it lacks important details on the sustainability of the Greek debt after the voluntary exchange. Greece would still need to have large primary surpluses day one in order to service the new debt. Also there ambiguity on the state of the Greek banks after the exchange. A 50% cut would leave them needing recapitalization. Is this going to happen through common equity and hence nationalization or through preferred? The common equity approach would overnight not only change the ownership but it would effectively place them under EU control (through the control of Greek finances). Thus the dynamics and the incentives are altered.
Let me give you my preliminary thoughts on this debt deal. First, let me just say that I'm glad EU leaders told the bankers to "go fuck themselves," which is what they should have done long ago. Second, as reported in ekathimerini, a 50% haircut means that Greek debt is sustainable but banks face temporary nationalization and pensions will get hit:

A deal that imposes 50 percent losses on private sector bondholders means Greece's debt burden will be sustainable, Greek Prime Minister George Papandreou said on Thursday.

Greece will produce no more primary budget deficits from next year, but some of the country's banks may face temporary nationalisation as a result of the debt relief, he warned.

"The debt is absolutely sustainable now,» Papandreou told a news conference after a meeting of euro zone leaders, which reached agreement with private investors on a 50 percent write-down.

"Let's hope a new and better day dawns, both for Greece and for Europe... Greece can settle its accounts from the past now, once and for all».

Debt-laden Greece needed the drastic measure to avoid a sovereign bankruptcy that was threatening to engulf other weak members of the eurozone periphery such as Ireland, Portugal and Italy.

Under the 130-billion euro deal, Greece will obtain 30 billion euros upfront from other governments, as a guarantee for banks that will take part in the voluntary reduction of 100 billion euros of the debt they hold.

Papandreou said he expected the deal, which will be implemented through a bond exchange, to be wrapped up by the end of the year.

The deal cuts Greece's debt by 50 percentage points of GDP, compared with just 12 percent under a previous EU deal struck in July, Papandreou said.

If Greece pushes reforms fast enough, it may even manage to return to markets much faster than 2021, as currently predicted by the International Monetary Fund (IMF), he added.

"Enough with primary budget deficits, from next year on there won't be any, we'll be passing to primary surpluses,» Papandreou said.

The haircut is expected to impose big losses on the country's banks and state-run pension funds, which are up their necks in toxic Greek government bonds of about 100 billion euros.

The government will replenish pension funds' capital, but banks may face temporary nationalisation, Papandreou said.

"It is very likely that a large part of the banks' shares will pass into state ownership,» Papandreou said. He pledged, however, that these stakes will be sold back to private investors after the banks' restructuring.

"After restructuring we will then take it (the shares) out to the market, as other countries have done... it is a very standard procedure and nothing to be afraid of,» he said.
Of course, the deal was met with skepticism from the country's conservative opposition, stating that the haircut cannot make the Greek debt sustainable, as this would require a primary surplus and economic growth. But the deal will give Greece the breathing room required to focus on structural changes and economic growth. Interestingly, ekathimerini reports that Greece will use future revenue from the country’s ‘Helios’ solar energy project to cut debt by as much as 15 billion euros ($21 billion).

Are sunny days ahead for Greece and the global economy? I think so and remain overweight/long tech, commodities, cyclicals and energy, especially Chinese solars and underweight/short defensives (basically go long anything that got slaughtered in Q3 and underweight/short anything that rallied in Q3). I would, however, sell the news on the euro and would be very careful here as this is only a temporary reprieve; there remains a long, tough slug ahead (see interview below with Mark Dow, a hedge fund manager at Pharo Management).

The Irish are already crying foul on the Greek debt deal and surely Spain, Portugal and Italy will want to cut their own deals. In fact, that's what Berlusconi is probably thinking in that picture above. Or maybe he's thinking of more "bunga bunga" parties with women dressed as nuns performing stripteases. Whatever the case, let the 'debt relief' celebrations begin and let's move past this endless debt crisis which has wreaked havoc on global capital markets.

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