Monday, 17 May 2010 04:10

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

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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.

Basically, I attempt to profit off of the policy errors of governments and central bankers world wide. This has been a most profitable profession over the last 10 years or so, with said errors causing massive and obvious bubbles in real estate, equity and credit markets which paid those in the real estate markets handsomely. This "multi-asset bubble" culminated in what was "an easy to see coming"crash that allowed both me and my subscribers to score abnormal returns on the downside as well. Back when I tabulated my results publicly, 300% and 400% returns were common place (see Sample Research & Performance), not including the equally impressive levered returns garnered during the bubble. I was able to time the exit from the real estate market 6 months before the market peak, a combination of luck, intuition and spreadsheets. This 9 year performance was dampened in the last 3 quarters of 2009, where I took a 39% loss by misjudging the timing of the effect of central bankers' policy errors (yes, they are still making big mistakes and no, this is not a bull market but a bear market rally - I was simply off about 9 months in the anticipation of the European Sovereign Debt Crisis). I wrote about this in detail in my Year End Note to BoomBustBlog Readers and Subscribers in an attempt to both put things in perspective and self-flagellate.

Case Shiller index has been amplified by a factor of 10x for the sake of comparison to the S&P 500.

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Click any graphic to enlarge.

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Needless to say, the time to ride the bear is here again, and in a fashion that many do not appreciate for I fear the Sovereign Debt Crisis may make the Asset Securitization Crisis look like a mini-bull rally in and of itself, dwarfing the capital destroying potential of the latter in both size and scope. This brings us to the analysis below.

The PIIGS at the Center of the Global Sovereign Debt Crisis

Greece, Portugal, Ireland, Spain and Italy, collectively referred as PIIGS, are a reflection of how the developed countries, the credibility of whom have been endorsed over the years by high credit ratings and low credit spreads, are turning out to be the epicenter of sovereign risk in Europe. Huge fiscal deficit and unimaginably high levels of public debt, dragged these nations to the verge of default when the markets refused to lend money at prevailing rates against their fragile fiscal situation and structurally decaying economies. Greece, the weakest of all, has effectively defaulted on its debt obligations when it approached EU/IMF for funds (see How the US Has Perfected the Use of Economic Imperialism Through the European Union!). The support extended by the European Union was primarily to contain the contagion effect (resulting from common currency as well huge inter-country claims) which would have done greater damage and would have cost more. However, the aid extended by EU and IMF is quite insufficient as it will solve only a fraction of the liquidity problem, and even then for a short term, while the major solvency and liquidity issues over the medium-to-long term remain. Thus, the only inevitable outcome which can bring sustainability to the public finances of these countries is the restructuring of their sovereign debt.

The Sovereign Debt Restructuring

Sovereign debt restructuring can be done either by taking haircuts on the principal amounts or by extending the maturity of the debt. While the latter will result in some losses to the creditors owing to resultant reduction in Net Present Value , the losses shall be significantly lower than in case of haircuts in the principal amount. However, in the case of PIIGS, this option will solve the liquidity side of the problem rather than solvency issues. In the following model, we have estimated the haircuts on the principal amounts that might be taken to bring the sovereign debt of PIIGS to a more sustainable levels.

The restructuring of the sovereign debt of PIIGS nations, especially Greece, is likely to occur owing to, either or both, of the following reasons

Government debt ratio (Government debt as % of GDP) is at unsustainably high levels

  • Government debt levels in excess of 100% of GDP are highly unsustainable owing to the the huge re-financing risk as well as the interest rate risk. Interest expense on such a high debt level is already a huge burden on the fiscal situation; an increase in interest rates can put more pressure on the public finances of the country. Further, the country runs the risk of failure to refinance or roll-over such high level of debt in the market .
  • PIIGS have been facing tough times meeting their debt obligations (interest expense and the principal repayment) owing to increasingly expanding spreads over the perceived safe haven rate of the German bund. The liquidity crunch (pre-EU/IMF bailout announcement) that they are witnessing in the market is owing to high risk perception build due to poor public finances situation (rising primary and fiscal deficits) as well as bleak economic outlook of these countries. Subscribers should reference:
  • While the IMF/EU package will be a short term liquidity relief over the next three years, after 2013 these countries will again turn to the credit markets to finance not only the scheduled bond obligations but also repay IMF and EU loans (reference What We Know About the Pan European Bailout Thus Far). Thus, restructuring of the debt might become inevitable for PIIGS countries specially those which have debt levels in excess of 100% of GDP. Out of the PIIGS countries, Greece and Italy already have government debt in excess of 100% of GDP while Ireland and Portugal are rapidly approaching those levels. Greece in particular has unsustainably high debt ratios which are estimated to spiral from 116% of GDP to 140-145% of GDP in 2013

Increase in government debt ratio (Government debt as % of GDP)  is unsustainable

  • Increases in government debt ratios stem primarily from the "snowball effect" and the primary deficit. The snowball effect is the self-reinforcing effect of debt accumulation arising from the spread between the interest rate paid on public debt and the nominal growth rate of the national economy. If the average interest rate paid on existing public debt is higher than the nominal GDP growth rate, it will result in increase in government debt ratio (Government debt as % of GDP).
  • PIIGS are recording huge primary deficits, i.e, government expenditures (excluding interest expenditure) exceeding government revenues, which are leading to additional borrowing that then adds to the government debt levels - wash, rinse, repeat... This coupled with the snowball effect, which itself increased substantially due to negative nominal GDP growth and rising interest rates, has been contributing substantially to the increase in the government debt ratios of these countries. In the case of Greece, this effect has been extremely large owing to very high government debt, rising borrowing cost and the shrinking economy.

The BoomBustBlog Haircut Model

Below is a live spreadsheet summary, currently updated by our analysts with new developments and refinements, that calculates the expected haircuts in several of the PIIGS members, followed by a much more comprehensive sheet for our professional subscribers.

[iframe http://spreadsheets.google.com/pub?key=tcuYZUt0PPWR5dp0wmCZ99Q&single=true&gid=10&output=html&widget=true 800 600]

Professional and Institutional subscribers may access this full model (which calculates each of the PIIGS members' estimated haircuts individually) online by clicking this link. You may click here to subscribe or upgrade to the professional/institutional level.

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Last modified on Wednesday, 19 May 2010 05:54