In order to assess the impact of sovereign debt restructuring on the market prices of the sovereign bonds that undergo restructuring (haircut in the principal amount or maturity extension), we retrieved price data of the Argentinean bonds that underwent restructuring in 2005. The sovereign debt restructuring in case of Argentina was a combination of maturity extension and principal haircut. Argentina defaulted on its international debt in November 2001 after a failed attempt to restructure the debt. The markets priced in the risk of a substantial haircut around this time and the bond prices plummeted sharply. We at BoomBustBlog are in the habit of taking market prices seriously, and have factored historical market reactions into our analysis in calculating prospective price action in distressed and soon to be Sovereign debt. Before moving on, it is highly recommended that readers review our haircut analysis for Greece (“With the Euro Disintegrating, You Can Calculate Your Haircuts Here”) and our more likely to occur restructuring analysis for the same (What is the Most Likely Scenario in the Greek Debt Fiasco? Restructuring Via Extension of Maturity Dates).
The restructuring of the Argentina debt in default was occurred in 2005 when the government offered new bonds in exchange of old securities. The government gave the option of either accepting A) a par bond with no haircut in the principal amount but substantially lower coupon and longer maturity or accept B) a discount bond with a haircut in principal amount to the extent of 66.3% but relatively better coupon rate and shorter maturity than in case of Par bond. If the bondholder accepted A), for each unit of bond, one unit of Par bond will be allotted. If the bondholder accepted B), for each unit of bond, 0.33 unit of Discount Bond will be allotted. The loss to the creditor, which is decline in the NPV of the cash flows, was nearly the same in both cases as the lower principal amount in Option B was offset by better coupon rate and shorter maturity. The price of the par bond in the market and the price of the discount bond multiplied by the exchange ratio (real price to the bond holder) were largely the same when they were listed in the market in 2005.
In "With the Euro Disintegrating, You Can Calculate Your Haircuts Here", I explicitly illustrated the likely loss to principal of sovereign debt investors who would be forced to take haircuts "for the cause". While we fully stand behind the calculations and the logic, chances are several sovereigns may attempt to undergo sleight of hand in order to placate investors as best they can. We suspect we will soon be hearing of significant restructuring plans in the Eurozone, starting with Greece. The piece below expands on these thoughts and offers subscribers live spreadsheets that illustrate the potential repercussions. It is recommended that these scenarios be taken into consideration in light of the info offered in the post "Introducing The BoomBustBlog Sovereign Contagion Model: Thus far, it has been right on the money for 5 months straight!" and compared to the haircut analysis as well.
Greek Restructuring Scenarios
There are several precedents of sovereign debt restructuring through maturity extension without taking an explicit haircut on the principal amount, and many analysts are predicting something of a similar order for Greece. This form of restructuring is usually followed as a preemptive step in order to avoid a country from technically defaulting on its debt obligation due to lack of funds available from the market. It primarily aims to ease the liquidity pressures by deferring the immediate funding requirements to later periods and by spreading the debt obligations over a longer period of time. It also helps in moderating the increase in interest expenditure due to refinancing if the rates are expected to remain high in the near-to medium term but decline over the long term.
As of 6:40 am, US futures are down 15 points, with the MSM blaming the nationalization of the Spanish bank CajaSur.
The Bank of Spain seized troubled CajaSur with 500 million euro ($624 million) in funding to keep it solvent. The move pushed the Euro lower and left investors concerned about the country’s fiscal health.
The nationalization comes at a time of rising concerns over Spanish credit-worthiness, despite the European Union's decision earlier this month to put together a safety net for distressed European economies.
On Sunday, Spanish Prime Minister Jose Luis Rodriquez Zapatero told a group of socialist mayors, "No one can doubt at any time that Spain is a strong country and an economic power that will meet its obligations and pay debts." CajaSur's failure is the second in Spain since the start of the global financial crisis.
The bank -- based in the southern city of Cordoba -- has 13 billion euros ($16.35 billion) in loans and holds 0.6 percent of the total assets in the Spanish financial system.
I have made our position on Spain clear through a complete forensic review of the state's finances for subscribers:
Spain public finances projections_033010. An excerpt from this subscription document (subscribers, reference page 2) shows the euphoric, yet highly unrealistic optimism upon which Spain has built its fiscal austerity projections.
Policy makers in China are likely to shift towards tightening with CPI inflation nearing 3% y/y. Inflationary pressures are induced by the sharp increase in money supply, higher food and housing prices, destructive weather patterns, and fuel and utility price liberalization. Inflation will be offset by industrial overcapacities, falling pork prices, and weaker wage growth.
China’s CPI increased by 2.8% y/y in April 2010, while producers prices increased by 6.8% y/y in April 2010. These statistics are not extremely inflationary and provides a time cushion for policy makers to implement monetary tightening measures.
The People’s Bank of China Q1 monetary report reiterated its commitment to maintain “appropriately loose” monetary conditions, but pointed out that inflationary pressures are not captured in stable CPI and PPI statistics.
Instead of fully withdrawing the current stimulus in China, the government may settle for stricter monitoring of wasteful projects and corruption due to an uncertain global macroeconomic outlook and export prospects.
The four main factors that determine y/y CPI growth in China include excess liquidity(defined as growth in M2 money supply subtracted by industrial growth), export, real estate prices, and share prices with a correlation of 0.36:0.13:0.22:0.04 to 1 unit of CPI growth.
The growing gap between M1 and M2 growth rates suggests that funds are being shifted from time deposits (interest rates capped at 2.25%) to demand accounts. This is driven by inflation expectations and will drive up inflationary pressure if the funds are spent.
Inflation rates tend to peak six months after money supply growth rates, and stronger-than-expected external demand could trigger overheating.
The high M2 growth rates are overblown because movements of households’ long-term savings moving between the stock market and deposits can affect M2’s growth rate and do not change the underlying purchasing power.
The great monetary expansion in China may contribute to asset bubbles, credit misallocation and bad loans if not controlled.
In the Eurozone gossip and news for the week past...
Roubini Warns of Greek Exodus, Chinese Slowdown: Bloomberg
- Falling Euro is necessary to compensate for high nominal wages in uncompetitive PIIGS nations
- Greece deficit/GDP going from 13% to 3% may be the textbook example of mission impossible
- Financial Contagion vs. Economic Contagion: Does the Market Underestimate the Effects of the Latter
- Greek Crisis Is Over, Region Safe”, Prodi Says – I say Liar, Liar, Pants on Fire!
- Lies, Damn Lies, and Sovereign Truths: Why the Euro is Destined to Collapse!
- With the Euro Disintegrating, You Can Calculate Your Haircuts Here
Note: For those who have been reading my work for a while and will not benefit from a backgrounder in my investment style, successes and faux pas, you can move directly to the Sovereign Debt Haircut Model Summary below.
The Asset Securitization Crisis of the US and much of the developed and emerging markets (2007-2009) apparently ended for many relatively quickly, despite being the worst economic downturn the country (and most likely the world) has seen since the Great Depression. How did the US pull out so fast, or more importantly, did the US actually pull out of it at all? Well, it was never my belief that the problem was over, simply papered over with some accounting changes and force fed massive amounts of liquidity coupled with a drive to privatize profits while socializing losses. Of course, the natural result of such actions was the gorging of the public sector on debt and bad assets. This sleight of hand was able to create a positive GDP print in many countries while rescuing sub par private companies that would have toppled under less generate corporate welfare, but more importantly, it succeeded in poisoning several governments whose finances could not handle the extra burden of unrestrained spending during economic boom times combined with the assumption of massive private sector losses during the "bust" times.
Thus the Asset Securitization Crisis has been morphed, through direct and explicit government and central banker intervention, into a Pan-European Sovereign Debt Crisis, Soon to be the Global Sovereign Debt Crisis. This particular environment have been custom-made for my proprietary investment style, see "The Great Global Macro Experiment, Revisited".
Understanding my proprietary investment style
My own, personal and discretionary investment style leverages long and short positions in any traditional or alternative asset class, in any instrument, in any market around the world with the goal of profiting from macroeconomic trends.
This is the skinny on those French and German banks that are at significant risk to PIIGS drowning, or potentially even getting significantly wet. The sell side banks have released reports on which bank is exposed to Greece, etc., but we decided to take it a few steps farther in order to create a truly actionable document that our subscribers can actually use to base concrete decisions upon. As is customary, I am releasing snippets of the proprietary research for free to the blogoshpere. This time around, I'll feature a European bank that we feel is thoroughly insolvent, yet trading at one of the highest premiums in all of Europe! As excepted from the reports referenced below:
The bank reported its exposure to sovereign debt of Greece, Italy, Ireland, Portugal and Spain at €1.3 billion, €4.7 billion, €350 million, €50 million and €1.2 billion.
Applying the loss rates under the base case, the total estimated losses on sovereign debt holdings is €1.7 billion (60.1% of tangible equity) on the total European sovereign debt exposure of nearly €24.9 billion (based on the reported sovereign debt exposure of December 2009). The existing Texas ratio of the bank is 139%, and if we include the losses on sovereign debt (unconventional, but illustrates solvency in a clearer fashion), the Texas ratio* will be 177%. The bank is trading at price to tangible book value of 1.83x. The stock is trading on a high multiple largely owing to speculation of full takeover by Deutsche bank. The float is 36% of shares outstanding as 39.5% is owned by Deutsche Post and 25% is owned by Deutsche Bank. See Deutsche Bank vs Postbank Review & Summary Analysis - Pro & Institutional and Deutsche Bank vs Postbank Review & Summary Analysis - Retail for a detailed overview and analysis of the unusual Deutsche Postbank situation.
How many of those Greek, Portuguese, Irish and Spanish bondholders have factored the near guaranteed "additional" haircut (/scalping) they will receive having to stand behind the IMF in the event of a (probably guaranteed) default or restructuring? Do you think the investors of European banks (that includes central banks) that are holding/and currently still buying a boat load of these bonds have factored this into their valuations?
The IMF, like many other international institutions, asserts that it has a "preferred creditor status", and this has been a practiced convention in the past. Thus, IMF has de facto seniority rights over private creditors despite the fact that there is no legal or treaty-based foundation to support this claim and this seniority of rights for IMF will continue under the recent EU rescue plan announced as well as it has not been noted otherwise implicitly nor explicitly. This is the reason why Sarkozy said it is a said day when the EU has to accept a bailout from the IMF (aka, the US). The EU now, and truly, contains a significant parcel of debtor nations.
To add fuel to this global macro tabloidal fire, the Euro members’ loan will be pari passu with existing sovereign debt i.e. it will not be considered senior. Although there is no written, hard evidence to support this claim, it is our view that otherwise there will be no incentive for investors to hold the debt of troubled countries like Greece, which will ultimately defeat the whole purpose of the rescue package. Moreover, there are indications that support this idea. As per Dutch Finance Minister Jan Kees de Jager, “We are not talking about a special preference for the eurogroup loans, that’s not possible because then you would have the situation that already-existing rights of creditors at the moment would be harmed.” (reference http://www.businessweek.com/news/2010-04-16/netherlands-excludes-senior-status-for-greek-aid-update1-.html). Of course, if more investors did their homework and ran the numbers, that same disincentive can be said to exist with the IMF's super senior preference given the event of a default and recoverable collateral after the IMF has fed at the trough.
IMF’s preferred creditor status coupled with the expensive Euro members’ loans which are part of the rescue package can create a public debt snowball effect that could push the troubled countries towards insolvency when the IMF debt becomes repayable in three years time. This could be seen particularly in case of Greece (subscribers, please reference Greece Public Finances Projections). Even if all the spending cuts and revenue raising are achieved as planned for Greece, its debt will peak to 149.1% of the GDP in 2013. Please keep in mind that these numbers are based on what we perceived (as does simple math) to be pie in the sky optimism. I urge all readers to reference Lies, Damn Lies, and Sovereign Truths: Why the Euro is Destined to Collapse!.
Yesterday I commented on the folly of promising big money to throw at a myriad variety of highly indebted nation without a central authority to enforce the structural change needed to actually cure the problems that created the need for the monies in the first place. See The EU Has Set Up An Oppurtunistic Entry Point for Shorts Instead of Expressly Offering a Solution to the Pan-European Sovereign Debt Crisis! and What We Know About the Pan European Bailout Thus Far. The primary flaw, by far, that I perceive in this most grand of grand bailout schemes is that it is just that - a bailout, not a solution. Methinks the market is about to call the EU on their bluff pretty much along the same lines that I espoused above. For those subscribers who follow my belief that the ECB and EU leaders are making one of the largest policy blunders of modern times, this may be an opportunity to set up a short position that makes the Lehman Brothers' debacle look like a day rally. All subscribers are welcome to download our latest Euro Bank Sovereign Debt Exposure Preview. A more verbose summary will be released for pro and institutional subscribers shortly. Reference the following articles in this early morning edition of Bloomberg:
In continuing my rant of earlier this morning, let's take a look at what we know thus far about the Great Pan-European Bailout. Before we go on, I would like to make clear how dangerous this bailout game is for those in the confines of the EMU. Suppose.... Just suppose, as with the Greek Bailout(s) announced just weeks ago, the markets call the bailers' bluff? Exactly what ammunition will be left to move forward? The ECB/EU had better hope that this rally will hold up (and recent history shows that it will probably have an ever decreasing half-life), for if it doesn't the member countries are in a world of hurt.
Unlike many pundits, I am more than willing to offer solutions in lieu of just bitching about problems. So, what is the solution? Everyone needs to come clean in regards to the true state of their economic affairs, as well as the realistic prospects of earning their way out of their respective problems using realistic numbers. In this fashion, I would never be able to pen a piece called Lies, Damn Lies, and Sovereign Truths: Why the Euro is Destined to Collapse! Once we have an honest, realistic starting point, then we move forward with very, very stringent contingencies on loan dollars and specific demands on selling off state assets using realistic valuations as estimates. As it stands now, the loans are given to counties that are knowingly attempting to mislead, and have a history of chicanery in their attempts to join the EMU. This can easily smell like a farce and the risk of failure is very high. Yes, the promise of massive liquidity will drive a big rally in risky assets, but if these risky asset prices diverge from their fundamentals, the snap back will be destructive. It is my opinion that offering money without a structural solution is a non-solution of throwing good money after bad. Remember, monetization is now on the table and in a big way. This means that the REAL value of the Euro is still looking downward...
A quick rundown of the bailout
EU policy makers have come out with a massive rescue plan worth EUR 750 billion to combat with the unprecedented crisis that threatens not only the stability but the very survival of the monetary union. The new EU stabilization mechanism which will be backed by funds of up to €750 billion, of which two thirds will be provided by euro-zone members (€500 billion) and one third by the IMF (€ 250 billion), is by far the strongest effort by EU and the ECB to avert a regional debt crisis.