Dodgy going ons in Italy!

Very very interesting. Indeed. Something smells rather fishy here. Earlier today Italy sold €5 billion in 1 year Bills at an average yield of 6.087%, the highest since September 1997, and almost 3% higher compared to a month ago, when it prices at 3.570%. However, what really catches the eye, is the fact that just before the auction, the 1 year was trading at a huge 7.75%, almost 200 bps ABOVE the auction. Who is prepared to receive a 6.09% yield in a new auction when they can receive a juicy 7.75% in the secondary market? Unless someone (read ECB) had alternative interests in forcing the yield lower. Now that certainly would be interesting, as the ECB is prohibited by law from intervening in the primary, auction market.

Once the Euphoria wears off.....................

Some initial thoughts from last weeks European party:

• 50% proposed haircut that the headlines were full of, actually closer to 16%. Why? Greek debt approximately EUR 350b. Of which approx. EUR 150b held by Greek and European central bank, which is not subject to any restructuring. Leaving us with about EUR 200b. Greek banks and pension funds own about EUR 85b. This is contentious and debatable, but if they take a 50% haircut, they will essentially be bust. Hence, they may well be absolved too. That leaves EUR 115b that will "voluntarily" take the haircut. 50% of which, is EUR 57.5b, or 16%.
• The initial reaction was euphoria, with PIGS bonds falling drastically. But once the euphoria wore off, Spanish and Italian bonds made a quick u turn, and are back to the levels they were trading at pre-announcement, dangerously close to the 6% level where other countries have required help. Why? Because EFSF doesn’t take a default off the table. It delays the time until default, by rolling maturities, but all it really does is shift who takes the loss. And Italy and Spain are too big for ANYONE to take the loss.
• The EFSF is leveraging EUR 440b 4 or 5 times, just 3 weeks after Merkel promised the Germans that it would not be leveraged. The leverage would use the EFSF AAA credit rating to enhance new debt and set up Special Purpose Investment vehicles to obtain the leverage. I.e. more of the problems of the 2007/08 credit crises.
• How does the leverage work? EFSF is like an empty box filled with promises of money- many of them from the very people who are most likely to need to borrow that same money. So should they need to borrow the money. They won't be able to fulfill their promise, so there will be less money for them to borrow. And then they've decided to leverage these empty promises of nothing.
• Who is going to buy into the new leveraged EFSF fund? Sarkozy seemed to imply if China WANTED to contribute, then Europe would probably be open to allowing them. However, Chinese Prime Minister said "Countries must put their own houses in order". A member of the Chinese central bank went on to say "It is in China's long term and intrinsic interest to help Europe because they are our biggest trading partner, but the chief concern is how to explain this decision to the Chinese people. The last thing China wants is to throw away the country's wealth and be seen as source of dumb money". China is extremely likely to invest in the EFSF, but on terms that are favorable to China.
• This was no solution. It’s a plaster for a long term problem. Don’t forget that at the last stress test, Europe's strongest bank was Dexia ……
• Also, the fact that these private investors were forced to take a voluntary haircut to the tune of 50%, does not create a credit event. I can't imagine the big banks who hold CDS's will take that lightly.
• And further, who is going to want to buy sovereign bonds now? At least beforehand, I can buy protections in the form of CDS's. Now that CDS's have been deemed worthless, why should I buy these EFSF bonds? Who is going to buy these bonds? Someone has to, otherwise Europe will blow up. And best case scenario, is that there are buyers, but too few of them, hence an - oversupply, a low price, rising yields ...... problem sounds familiar?

Greece

One of our avid readers (hi Mum!) pointed out how we have failed to comment on the main story currently hitting all the headlines …. that of Greece. That is correct- probably the main reason is due to the fact that the news flowing out of Greece, is so fast, that I would have undoubtedly got to the end of my blogging, by which point I would have had to write a whole new posting due to an updated newsflash! Often, the latest revelation is a full 180° from the previous newsflash, and that is no doubt significantly contributing to the increasing volatility we have been privy to, with investors being whipsawed from one side to the other! Risk on, risk off, threat of contagion, restructurings, haircuts ….. isn’t life exciting! The other reason for not writing about Greece, is that I would undoubtedly have to disclose that my main ECONOMICS tutor was Greek, and what does that say about my knowledge of economics/finance?!!! Truth is, he was also my Football Manager ……. And he was a darn sight better at football than at Economics!!!

What is clear, is that Greece has run out of money, again, and needs some form of bailout/restructuring. So far, Europe, the ECB, IMF and everyone else has responded to the problem by throwing more money at Greece, allowing them to "buy time". Nobody has used the downright rude and ugly term of "insolvent", with "liquidity" being the preferred terminology. Lenders have been willing to lend more money, because the problem is one of liquidity. They have been willing to lend more money to banks and Governments. And Greece for their part, have not once admitted the need for default or restructuring, and so the banking sectors have not been forced to write down any more debt and/or need to raise more capital. A win win for everyone.

This would have bought some more time. Time is a fantastic healer. However, the issue was not one of liquidity, rather one of insolvency-debt problems are unlikely to be solved by taking on more debt. As a minimum, investors will require a credible plan for the economy to return to solvency to become willing to fund the banks and public debt of the troubled economy in question. This does not seem to be the case though, with the general Greek population revolting (in the other sense of the word), then one has to wonder where that credible solvency plan is going to come from. What is clear though, is that of those included around the negotiating table, nobody but nobody is "allowing" Greece to simply default. A solution will seemingly be found to prevent Greece from "legally" defaulting- even if it means some quick changes to EU law, account rules or ECB operation guidelines.

Whats the big deal with a Greek default? Why are they working so hard to prevent it? The Eurozone debt crises, is not especially extraordinary- it is merely another credit cycle, whereby debt extends beyong the capacity of consumers and economies. Debt then contracts as uncollectable debt gets written down, and bad debt is purged from the system. Throwing more money at Greece is merely extending and prolonging the problem?

Although a default is a default, and from a value point of view it doesn’t make any difference whether it is the debt of Greece, Portugal, Azerbaijan or the US that is written down, from an economic point of view, it certainly makes a difference. If Greece are thrown another lifeline, both Ireland and Portugal will operate under the assumption that in the future, they will also get another bailout should they need it. Markets know that, and hence speculation will continue on the "Who's next path", and cause investors to demand additional premiums, causing yields to rise. Eventually, the larger economies will be targeted too. How do I know you wont default either Spain? And that will cause even more serious problems, as who is left to bailout the larger and more important economies?

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