Monday, 10 January 2011 10:40

The ECB Loads Up On Increasingly Devalued Portuguese Bonds, Ensuring That They Will Get Hit Hard When Portugal Defaults

About a month ago, I pulled the covers off of the speculation over whether Portugal would default or not. Most of the "experts" declared that a default was not in the cards. I strongly recommended that the so -called "experts" pull out a calculator and run the math. Not only will there be defaults, but the haircuts will look particularly nasty. See The Truth Behind Portugal’s Inevitable Default – Arithmetic Evidence Available Only Through BoomBustBlog followed by The Anatomy of a Portugal Default: A Graphical Step by Step Guide to the Beginning of the Largest String of Sovereign Defaults in Recent History (December 6th & 7th, 2010).

Today, in the mainstream news we find the ECB Throws Portugal a Temporary Lifeline. From CNBC:

The European Central Bank threw Portugal a temporary lifeline on Monday by buying up its bonds, traders said, as market and peer pressure mounted for Lisbon to seek an international bailout soon.  A senior euro zone source told Reuters on Sunday that Germany, France and other euro zone countries were pushing Portugal to seek an EU-IMF assistance programme, following Greece and Ireland, in a bid to prevent contagion spreading to much larger Spain, the fourth biggest economy in the euro area.

The interest rate premium on Portuguese sovereign debt fell on Monday after rising sharply late last week as traders said the ECB intervened to buy government bonds on the secondary market. "They're buying five-years and 10-years in Portugal, whatever people are offering really," one trader said.

Another trader said the ECB appeared to be buying Greek and Irish bonds too. EU sources say the central bank has not yet bought Spanish government debt. The euro zone source said Lisbon would need between 50 billion and 100 billion euros ($64.5-$129.1 billion) in loans, similar to Ireland, which accepted an 80 billion euro EU-IMF rescue in December after a banking crisis caused by a burst real estate bubble lumbered the state with huge liabilities.

... German Finance Minister Wolfgang Schaeuble denied that Berlin was pushing anyone to seek assistance, but he said it was defending the euro. Spanish Economy Minister Elena Salgado said Portugal did not need to apply for aid because it was meeting its commitments to reduce its budget deficit.  And the European Commission said no discussion was currently under way on assistance for Portugal or any other country.

But economists and market analysts said it was widely regarded as only a matter of time before high-deficit Portugal, with a stagnant economy that has lost competitiveness since joining the euro area, had to seek aid. "If market spreads keep rising, Portugal has little chance of escaping a bailout," said Laurence Boone, research director at Barclays Capital in Paris. Deutsche Bank economists Gilles Moec and Marco Stringa said in note that the Lisbon government would have to significantly "over-issue" debt in the first four months to avoid a sharp deterioration in its cash position while Portuguese banks will face a peak in their refinancing needs in January and February. "It would be rational for Portugal to call for external help sooner rather than later," they said. European finance ministers are due to consider a more comprehensive response to the continuing debt crisis at their next monthly meeting on Jan. 17-18.

I will be addressing this issue in significant detail for my subscribers next week, with the obligatory spillover into the public blog. We consider serial defaults to be a foregone conclusion. The harder question is to determine which direction and it will originate from and when. I will mathematically determine if the European safety net that was formed is even physically possible of containing the threat. On that topic, and back to CNBC:

The toughest item on that agenda is the strengthening of the financial backstops because of German resistance to increasing the size of the 440 billion euro European Financial Stability Facility, EU sources say. Berlin has also opposed allowing it to be used more flexibly to provide standby credit lines or to buy government bonds or fund bank recapitalization before a country hits the buffers.

Portuguese Prime Minister Jose Socrates said last Friday his country had no need of outside assistance because it was ahead of schedule in reducing its budget deficit.

Socrates, who heads a minority socialist government, is stubbornly avoiding a bailout, mindful of the traumatic history of Portugal's two International Monetary Fund rescues since its return to democracy in 1974.

The Mathematical Truth Concerning Portugal's Debt Situation

Before I start, any individual or entity that disagrees with the information below is quite welcome to dispute it. I simply ask that you com with facts and analysis and have them grounded in reality so I cannot right another "Lies, Damn Lies, and Sovereign Truths: Why the Euro is Destined to Collapse!". In other words, come with the truth, or at lease your closest simulacrum of it. In preparing Portugal’s sovereign debt restructuring model through maturity extension, we followed the same methodology as the Greece’s sovereign debt maturity extension model and we have built three scenarios in which the restructuring can be done without taking a haircut on the principal amount.

  • Restructuring by Maturity Extension – Under this scenario, we assumed that the creditors with debt maturing between 2010 and 2020 will exchange their existing debt securities with new debt securities having same coupon rate but double the maturity. Under this type of restructuring, the decline in present value of cash flows to creditors is 3.3% while the cumulated funding requirements and cumulated new debt between 2010 and 2025 are not reduced substantially. The cumulated funding requirement between 2010 and 2025 reduces to 120.0% of GDP against 135.4% of GDP if there is no restructuring. The cumulated new debt raised is reduced marginally to 70.6% of GDP from 72.2% of GDP if there is no restructuring. Debt at the end of 2025 will be 104.8% of GDP against 106.1% if there is no restructuring
  • Restructuring by Maturity Extension & Coupon Reduction – Under this scenario, we assumed that the creditors with debt maturing between 2010 and 2020 will exchange their existing debt securities with new debt securities having half the coupon rate but double the maturity. The decline in the present value of the cash flows is 18.6%. The cumulated funding requirement between 2010 and 2025 reduces to a potentially sustainable 99.5% of GDP and the cumulated new debt raised will decline to 50.1% of GDP. Debt at the end of 2025 will be 88.6% of GDP (a potentially sustainable).
  • Restructuring by Zero Coupon Rollup – Under this scenario, the debt maturing between 2010 and 2020 will be rolled up into one bundle and exchanged against a single, self-amortizing 20-year bond with coupon equal to 50% of the average coupon rate of the converted bonds. The decline in the present value of the cash flows is 17.6%. The cumulated funding requirement between 2010 and 2025 reduces to 100.1% of GDP and the cumulated new debt raised will decline to 52.8% of GDP. Debt at the end of 2025 will be 90.9% of GDP (a potentially sustainable).

We have also built in the impact of IMF/EU aid on the funding requirements and new debt raised from the market between 2010 and 2025 under all the scenarios.

A more realistic method of modeling for restructuring and haircuts

In the previously released Greece and Portugal models, we have built relatively moderate scenarios of maturity extension and coupon reduction which would be acceptable to a large proportion of creditors. However, these restructurings address the liquidity side of the problem rather than solvency issues which can be resolved only when the government debt ratios are restored to sustainable levels. The previous haircut estimation model was also based on the logic that the restructuring of debt should aim at bringing down the debt ratios and addition to debt ratios to more sustainable levels. In the earlier Greece maturity extension model, the government debt at the end of 2025 under restructuring 1, 2 and 3 is expected to stand at 154.4%, 123.7% and 147.0% of GDP which is unsustainably high.

Thus, the following additional spreadsheet scenarios have been built for more severe maturity extension and coupon reduction, or which will have the maturity extension and coupon reduction combined with the haircut on the principal amount. The following is professional level subscscription content only, but I would like to share with all readers the facts, as they play out mathematically, for Portugal. In all of the scenarios below, Portugal will need both EU/IMF funding packages (yes, in addition to the $1 trillion package fantasized for Greece), and will still have funding deficits by 2014, save one scenario. That scenario will punish bondholders severely, for they will have to stand behind the IMF in terms of seniority and liquidation (see How the US Has Perfected the Use of Economic Imperialism Through the European Union!) as well as take in excess of a 20% haircut in principal while suffering the added risk/duration/illiquidity of a substantive and very material increase in maturity. Of course, we can model this without the IMF/EU package (which I am sure will be a political nightmare after Greece), but we will be recasting the "The Great Global Macro Experiment, Revisited" in and attempt to forge a New Argentina (see A Comparison of Our Greek Bond Restructuring Analysis to that of Argentina).

Here is  graphical representation of exactly how deep one must dig Portugal out of the Doo Doo in order to achieve a sustainable fiscal situation. The following chart is a depiction of Portugal's funding requirements from the market before restructuring...

This is the same country's funding requirements after a restructuring using the same scenario "4" described above...

And this is the depiction of new debt to be raised from the market before restructuring...

And after using the scenario "4" described above... For all of you Americans who remember that government sponsored TV commercial, "This is your brain on drugs. Any Questions?"

The full spreadsheet behind all of the calculations, scenarios, bond holdings and calculations can be viewed online here by professional level subscribers. Click here to subscribe or upgrade.

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Please be sure to read up on our full Pan European Sovereign Debt Crisis analysis, which is freely available to everyone. Coming up next are a more realistic recast of Greece's restructuring scenarios (with the goal of attaining GDP/Debt ratios below 100%, as well as similar research for Spain, Italy and Ireland.

Last modified on Monday, 10 January 2011 10:40