Thursday, 09 June 2011 00:19

Over A Year After Being Dismissed As Sensationalist For Questioning the ECB's Continued Solvency After Sovereign Debt Buying Binge, Guess What!

There has been a lot of noise in both the alternative and the mainstream financial press regarding potential risk to the ECB regarding its exposure at roughly 48 to 72 cents on the dollar to sovereign debt purchases through leverage, and at par at that. This concern is quite well founded, if not just over a year or so too late. In January, I penned The ECB Loads Up On Increasingly Devalued Portuguese Bonds, Ensuring That They Will Get Hit Hard When Portugal Defaults. The title is self explanatory, but expound I shall. Before we get to the big boy media's "year too late" take, let's do a deep dive into how thoroughly we at BoomBustBlog foretold and warned of the insolvency of both European private banks and central banks, including the big Kahuna itself, the ECB! The kicker is that this risk was quite apparent well over a year ago. On April 27th, 2010 I penned the piece "How Greece Killed Its Own Banks!". It went a little something like this:

Yes, you read that correctly! Greece killed its own banks. You see, many knew as far back as January (if not last year) that Greece would have a singificant problem floating its debt. As a safeguard, they had their banks purchase a large amount of their debt offerings which gave the perception of much stronger demand than what I believe was actually in the market. So, what happens when these relatively small banks gobble up all of this debt that is summarily downgraded 15 ways from Idaho.

Well, the answer is…. Insolvency! The gorging on quickly to be devalued debt was the absolutely last thing the Greek banks needed as they were suffering from a classic run on the bank due to deposits being pulled out at a record pace. So assuming the aforementioned drain on liquidity from a bank run (mitigated in part or in full by support from the ECB), imagine what happens when a very significant portion of your bond portfolio performs as follows (please note that these numbers were drawn before the bond market route of the 27th)…

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The same hypothetical leveraged positions expressed as a percentage gain or loss…

 

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Relevant subscription material for BoomBustBlog paying members:

  1. File IconGreece Public Finances Projections
  2. File IconBanks exposed to Central and Eastern Europe
  3. File IconGreek Banking Fundamental Tear Sheet

Online Spreadsheets (professional and institutional subscribers only)

Several months later I posted several followup pieces along the same vein:

To Cut or Not to Cut, The Irish Threaten To Play Rough With Those Clippers: Threats of Haircuts Rattle the ECB! Thursday, March 31st, 2011

I also made it very clear that haircuts and restructurings were on the table for Portugal.

The last bullet point is the kicker, but before I expand upon that, let's look at what loading up on Portuguese bonds felt like back then. These Bloomberg screen shots provided by Zerohedge tell the story in an instant:

Same thing for Ireland:

And below are the three horsemen of the Eurocalypse. Ironically the bond market is offering a far higher yield for ultra short-term Portuguese than Irish.

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. SeeThe 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). We find the ECB Throws Portugal a Temporary Lifeline, but just as with Greece and Ireland, that faux lifeline will simply not be enough in the real world.

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.

... Now back to the present day...

So, More Than A Year After I Sounded the Alarm About Insolvent Central and Private European Banks, I See the Following Headlines in the Mainstream News

Look at what's been floating in the news yesterday...

Financial Times: ECB firefight leaves it exposed to Greek shock:

As eurozone politicians scramble to bring Greek public finances back under control, the question of how much the European Central Bank will lose if they fail to avert a default has taken on greater importance.

ECBIn the past year, the ECB has bought €75bn ($110bn) in government bonds from the eurozone’s weakest economies and provided unlimited liquidity to their banks against collateral of declining quality. The suspicion in eurozone capitals, especially Berlin, is that ECB opposition to a debt restructuring is so vehement because the financial consequences for the euro’s monetary guardian would be substantial.

“Hefty losses for the ECB are no longer a remote risk,” warned Open Europe, a London-based think-tank, in a report on Monday.

It estimates the ECB has €444bn in exposures to Spain, Italy, Portugal and Ireland, as well as Greece. “There is a hidden – and potentially huge – cost of the eurozone crisis to taxpayers buried in the ECB’s books.”

Here's another one - European Banks’ Capital Shortfall Means Greece Debt Default Not an Option, as excerpted:

A failure by European regulators to make banks raise enough capital to withstand a sovereign default is complicating efforts to resolve Greece’s debt crisis.

The “fragilities” of Europe’s banking industry mean a Greek default isn’t an option, European Union Economic and Monetary Affairs Commissioner Olli Rehn said in New York last week. By delaying a decision some investors consider inevitable, policy makers risk increasing the cost to European taxpayers and prolonging Greece’s economic pain.

“European officials are trying to buy time for the troubled economies to get their house in order and the banks to be strengthened,” said Guy de Blonay, who helps manage about $41 billion at Jupiter Asset Management Ltd. in London.

While estimates of the capital shortfall vary, the vulnerability of European banks to a sovereign shock isn’t disputed. Independent Credit View, a Swiss rating company that predicted Ireland’s banks would need another bailout last year, found in a study to be published tomorrow that 33 of Europe’s biggest banks would need $347 billion of additional capital by the end of 2012 to boost their tangible common equity to 10 percent, even before any sovereign default.

Here's a newsflash for all of you who are still not grounded in reality. The loss to the banks have already occurred it just hasn't been officially recognized. You see, their bond and debt holdings are already devalued. The value is gone, vamoosed, disappeared. Waiting makes things worse because the excessive austerity measures imposed upon Greece (and every round of negotiations to appease the political gods makes things that much worse) are very recessionary and the debt noose is tightened with every proposed bailout. More debt is being added (problem) when the path to recovery is less debt (solution). It's really just that simple. The longer the asset holders wait under these recessionary austerity measures smothered by increasingly excessive debt, the less said assets will be worth. Those of you who regularly read me know this song, I've been singing it in American English to the stateside banks regarding real estate assets:

  1. Reggie Middleton’s Real Estate Recap: As I Have Clearly Illustrated, It’s a Real Estate Depression!!!
  2. There’s Stinky Gas Inside Of This Mini-Housing Bubble, You Don’t Want To Be Around When It Pops!
  3. The Residential Real Estate Week in Review, or I Told You We’re In A Real Estate Depression! The MSM is Just Catching Up
  4. Reggie Middleton’s Real Estate Recap: As I Have Clearly Illustrated, It’s a Real Estate Depression!!!
  5. Dexia Sets A $5.1bn Provision For Loss On Trying To Sell The Same Residential Real Estate Assets Upon Which JP Morgan Has Slashed Provisions 83% to $1.2bn from $7.0bn

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So fail to recognize your losses if you wish, you will just have bigger losses to recognize when the European fat lady sings :

And from Professor Rogoff of "This Time Is Different: Eight Centuries of Financial Folly" fame, in the FT.com:

Yet if the euro is torn by centrifugal force, perhaps because European leaders are constitutionally incapable of making tough decisions on how to radically trim periphery debt burdens, it could take a great many decades before any other region attempts a similarly ambitious programme. The 1980s and 1990s taught us that for countries with open capital markets, fixed exchange rates are a mirage that cannot be indefinitely sustained. If the euro goes the way of the Argentine currency peg, the noughts and tens – the first decades of the 21st century – will be viewed as teaching the same lesson about more radical currency marriages. Sovereignty and currency co-habitation do not mix.

Oddly, the euro was not at the heart of the recent financial crisis. Only Spain can really be described as an epicentre country, and of course the US and the UK had far greater systemic importance. Rather, the sovereign debt crises that Europe is experiencing today are a typical aftershock of a deep financial crisis. Nevertheless, even if the euro system was not at the heart of the crisis, it needs to be able to withstand two standard deviation shocks.

From Open Europe via ZeroHedge: ECB Has €444 Billion PIIGS Exposure, A 4.25% Drop InAsset Values Would Bankrupt European Central Bank

"The ECB’s attempts to paper over the cracks in the eurozone may have temporarily softened the impact of the crisis, but have exacerbated the situation in the long-term. The ECB has dug itself into a hole and now we are seeing that there is no easy way out.”

“Huge risks have been transferred from struggling governments and banks onto the ECB’s books, with taxpayers as the ultimate guarantor. There’s a real risk that these assets will face radical write-downs in future with eurozone governments and banks teetering on the edge of bankruptcy. This amounts to a hidden – and potentially huge – bill to taxpayers to save the euro.”

“The ECB’s wobbly finances and operations to finance states have landed a serious blow to its credibility. It must now seek to become the strong, independent bank that electorates were promised when the Single Currency was forged.”

Requisite video viewing on this topic...

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Last modified on Monday, 11 July 2011 07:35