Third Times the Charm? A Commentary on the Most Recent European Debt Crisis 'Fix'

Early yesterday morning, word trickled out that a new "comprehensive" deal to "fix" the euro-debt crisis had been cemented. Investors in Europe and abroad were thrilled; markets rallied an average of 3%. Analysts were less enthusiastic, somehow universally agreeing to use the term "cautious-optimism" to qualify the deal. While the media and analysts are still digesting the hard data (many in the negotiations were quoted saying they had trouble understanding many of the components of the deal), a few things are certain. Greek debt holders will take a 50% haircut on the face value of their paper (much more than previously agreed upon this summer), banks will have to raise their tier-1 capital to 9% of the banks' holdings, and the EFSF will be leveraged to a total of 1.4 trillion euros to meet all previous obligations without being totally zapped.

While this is indeed great news (primarily because we now know the EU has come to their senses and will not expect Greece to fully pay all of its unrealistic debt), many details remain to be determined. One particularly interesting detail yet to be negotiated is the fate of credit-default swaps (CDSs) on the Greek bonds. The EU deal has chosen to classify the 50% haircut as a "voluntary" write-down. While these losses are, in reality, far from voluntary, the deal is trying desperately to avoid a "credit event" that would trigger pay-outs of the CDSs. However, if this massive write-down isn't a "credit event", despite the fact that it is clearly a default (albeit an "orderly" default), what the heck is? With the EU saying the nearly 4 billion euros worth of CDSs purchased on Greek bonds wont be triggered (think your fire insurance refusing to pay because only half of your house burnt down), this will, in my opinion, trigger a credit-event of a different kind. The liquidity of the CDSs market will all but disappear, at least on sovereign paper. What would make sense, at least to me (and we all know I am more of the outsider-looking-in than any kind of real expert), would be for the CDSs to pay out what is written down. That was the original intention of the CDSs in the first place, to insure against losses of any kind. In theory, the sellers of swaps should not be all that surprised that Greece is defaulting, and should have more than enough cash to cover half of the losses. The risk of default, when calculated accurately, should be reflected in the price of the CDSs. I have a hard time believing that banks (or whoever originated the CDSs, or later bought the puts) would sell a Greek bond swap at the same rate as a US swap. And they didn't. The International Swaps and Derivatives Association would be far better suited to NOT bend to the will of the EU, and declare the haircut a credit event, therefore triggering payouts. After all, the negative implications on future derivatives markets should be of much bigger concern to the association in charge of it than a puny €2 billion, since the default was only on 50% face value). For the sake of the future of swaps and derivatives (at least on sovereign debt), I hope the ISDA holds firm.

(sources: The Economist)

Moody's and Fitch Downgrade Europe, Dexia bailed out...where does it end?

This week will surly go down as one of the worst, in global economic terms, since October 2008. Fitch downgraded the credit worthiness of several European countries, including Italy, Spain, Portugal, as well as placing some countries once presumed totally solvent up for review, such as Belgium. Between this, the Moody's downgrade of 12 UK banks, Greece's struggle to meet austerity requirements for their next bail-out tranche, and the forced recapitalization of Franco-Belgian bank Dexia, it looks like the catastrophe in Europe is coming to a head. And all of this coming on the heels of a bad end to a bad quarter...what comes next?

Well, as the markets this week reflect, I think the solution is coming sooner rather than later. With ECB President Jean-Claude Trichet scheduled for retirement next month, we can only hope that the new regime will take into consideration the aforementioned crisis and deal with the real issue at hand: deflation. While Trichet has been spending much political and actual capitol on battling inflation with more than one rate hikes since January, the money flow has all but ground to a halt. If I were a betting man, I would gamble that we are going to see a real-life TARP-like bail-out of banks in Europe, as well as a few shotgun mergers just to be safe. What is to be done about Greece is a different battle, and personally I think Europe would be better without Greece in the Euro.

S&P Downgrades US Debt

To top off the worst week in recent memory, the ratings agency Standard & Poor's downgraded the long term United States debt from triple A to AA+. While most US based banks and institutions that hold these bonds have recently renegotiated self-imposed restrictions against holding lower than perfect rated debt in their vaults, the effects this downgrade will have on international institutions is has yet to be determined. But one question remains: why did S&P downgrade T-Bonds, even after the debt ceiling deal?

For weeks now, S&P has been threatening to downgrade US debt if the government did not improve its ability to meet payments. The agency said it would spare the US if the debt ceiling deal included at least $4 trillion in cuts over the next decade. According to the bipartisan Congressional Budget Office, the deal cut less that $2 trillion. Despite a $2 trillion dollar mathematical error that postponed S&P's downgrade announcement Friday, the agency stuck to its guns. Politically, this controversial move was necessary if only to show the public that the agency would make good on its threats. This is especially important when reminded of the role the ratings agencies played leading up to the financial crisis; many highly questionable mortgage backed securities were stamped triple A with little or no due diligence performed.

Despite S&P's claims that politics in Washington threaten the ability of the government to pay its bills, and the historical contextual importance of proving the agency is both comptent and willing to judge financial instruments faithfully, one question remains: what about Fitch and Moody's? How can two of the "big three" ratings agencies believe the US to be triple A worthy and not the third? Judging by their ratings of other nations' debt instruments, it is not accurate to say that S&P is consistently more critical, while the other two are consistently more generous. By and large, the only reasonable explanation I can come up with to account for the lack of consensus amongst the agencies regarding our credit worthiness is the high degree of subjectivity that comes with rating debt. The actual difference between a bond rated triple A and AA+ would be difficult to quantify. Although I cannot prove this theory, it is possible that the complex bureaucratic web that makes up an agency (and the nuanced differences between the makeups of the three agencies) permit different conclusions between them, even if their mathematical models were identical (and we must assume they are not). It will be interesting, if nothing else, to see how the international markets react to this news. All we can do is wait and see.

Debt Ceiling: Is the US Government Still Threatened by a Downgrade?

In an article on thestreet.com, Robert Holmes tells the story of Jeffrey Sica, a money manager, and his politically unpopular view that Standard and Poor, the ratings agency, should make good on its threat to downgrade US paper, despite the debt ceiling deal reached today. This move would be nothing short of necessary for the ratings agency to retain its credibility, especially after a dismal track record of rating dangerous securities triple-A during the pre-recession MBS bubble. This statement resonantes with many Americans still frustrated with the trajectory of federal spending, many noting that no individual or corporation could possibly maintain access to cheap capital with anything close to the spending/revenue ratio we are currently seeing. While S&P has not yet issued a statement regarding this latest debt deal, the markets have reflected the continuing uncertainty felt by many regarding the recent revisions of the first quarter's GDP, and well as recalculations of inflation and manufacturing outputs. Treasury rates are also up, indicating bond investors are not yet willing to embrace "mission accomplished" on the debt problems plaguing the government. Could we be witnessing the decline of modern Keynesian Economics?

EU Sets Terms of Greek Bailout, Bond Holders Take a Hit

Recently, European Union policy makers agreed on the terms for the next round of bailout money to be released to Greece. While much of the plan is formulated around minimizing the moral hazard of yet another large bailout of a sovereign nation, the terms are rather generous (interest rates on the bailout loans have been cut by a third), not to mention placing some of the fiscal responsibility upon private debt holders as well as the country itself.

By far the most debated aspect of the new plan was bond holder participation, so-called private sector involvement (PSI) in the bailout. This complex and somewhat paradoxical scheme intended to save Greece billions by restructuring much of its forthcoming bond debt actually punishes bondholders and EU taxpayers. The problem with the outstanding bond debt is the outrageous interest rates and face-value discounts Greece had to offer to induce investors to purchase the bonds. Now, not surprisingly, Greece cannot afford to pay these rates, and as each payment cycle arrives, the debt total climbs almost exponentially. The solution ---a mercifully favorable solution for Greece --- is what is referred to as debt restructuring. This means that the issuer alters the terms of the loan, or bond in this case, to be more favorable; in this case, cheaper for Greece. This, however, means the bondholders are getting the short end of the stick, about 21 percent less on average than what was stated at the time of purchase. To avoid what could become a riotous situation in the banking community, the debt restructuring program is being offered as "voluntary", as forcing the debt holders to take a hit would be nothing short of criminal. Despite being elective, the EU expects more than 90 percent of all eligible debt will be restructured in one of four offered options: three different swap plans, a rollover option, as well as some buybacks.

Now here's the rub. Except for banks that hold these bonds in their vaults, I cannot see any incentive for the individual investor to participate in these restructuring options (perhaps individuals only account for 10 percent of the outstanding debt held, and was therefore already taken into account, I am not sure). It would clearly behoove a non-institutional bond investor to take at least a small speculative position on Greek bonds when the interest rates were at all-time highs. For that investor, nothing could compel him to take a 21 percent hit unless his only other option was to not get paid at all.

Institutionally on the other hand, this is exactly what banks want to hear. €35 billion is to be used as collateral for the new bonds issued in exchange for the old, to guarantee a triple-A rating. While this does mean the interest rate is substantially lower, it also means banks in Europe are allowed to carry them on their banking books (as opposed to trading books that have more lenient debt quality requirements). For the banks, this is a welcome solution. However, for the taxpayer, this means €35 billion that could be used in other ways (and there are many in Europe today) is doomed to sit in a government vault in Athens to guarantee payout of these new bonds.

While this deal is far from ideal from every perspective, it is a leap in the right direction for a sustainable future in Greece as well as the greater European Union.

Gof6 Budget Plan: Will it Help Raise the Debt Ceiling?

For some reason, the answer appears to be, no. Surprisingly enough, the criticisms regarding the plan drafted by the "Gang of Six" and its inclusion into debt ceiling negotiations came from both sides of the aisle. House republicans have already begun to critique the plan because of inclusion of "tax hikes" in the plan. Senate Democrats have been cited saying the proposal comes too late to be included in the debt ceiling negotiations.

Despite what is being said, it does not appear that any new taxes are included in the proposal. While 26% of the dollar total of the bill comes from "revenue", as I read it, the proposed money comes from closing tax loopholes and streamlining the confusing tax codes. While this will generate up to $1 trillion in revenue over the next ten years, the technical data reveals an actual "$1.5 trillion tax cut".

While this is a leap in the direction of austerity that America desperately needs, the implementation of any plan resembling this one is likely not to be even discussed in Congress until August 3rd (assuming the debt ceiling is raised).

Breaking News: Gang of Six Proposes Budget Plan

http://online.wsj.com/article/SB10001424052702303661904576456042405686316.html?mod=e2fb