Friday, 18 February 2011 13:39

ECB Swallows Massive Portuguese Bond Losses As It Is Clear That The Third State Will Soon Join The Bailout Brigade - Haircuts, Here We Come!!!

Here is a sequence of events that I warned thoroughly about, and is unfolding like clockwork. Witness the massive destruction of capital, despite the fact that it could have been so easily seen at least a year in advance. Let's walk through just the past couple of months. In January, I posted "The ECB Loads Up On Increasingly Devalued Portuguese Bonds, Ensuring That They Will Get Hit Hard When Portugal Defaults". To wit...

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.

So, the ECB is stuffed with these bonds, eh? So, what do you think happens? Well, as the aforementioned post clearly articulated in the title, The ECB Loads Up On Increasingly Devalued Portuguese Bonds, Ensuring That They Will Get Hit Hard When Portugal Defaults...

From Reuters yesterday:

Portuguese yields under pressure, Bunds rally

LONDON, Feb 17 (Reuters) - Five-year Portuguese yields hit a new euro-era high on Thursday as peripheral debt underperformed on concerns that Portugal will be forced to ask for financial aid, and on some disappointment over a Spanish bond auction.

German Bunds rallied on a jump in U.S. jobless data and concerns over geo-political tensions in the Middle East, helped by the two-year Schatz future breaking above a resistance level.

The five-year Portuguese bond yield PT5YT=TWEB rose to a 7.126 percent high after the Jornal de Negocios reported, without citing sources, that Germany is pressuring Portugal to request an international bailout before the European rescue package is revised in March.

Portugal seen taking bailout by April -euro zone source

* Consensus growing that Portugal will need bailout

* End of March seen as crisis point for Lisbon

European Union member states are increasingly concerned about Portugal's ability to fund itself in financial markets and believe Lisbon will have to seek a bailout by April, a euro zone source said on Thursday.

"Portugal is drowning. It's not going to be able to hold on beyond the end of March," the euro zone source said. "That's already understood to be the case in financial markets, but now it's also understood among (EU) finance ministers."

Reuters Update 1: Portugal govt urges Europe to respond to crisis

* Report of Germany putting pressure on Lisbon

* Bond spreads widen

"Any delay of an effective European response to confront this situation (debt market turbulence) damages all the countries and the euro itself," Silva Pereira told reporters after a cabinet meeting. "That is why our message is that Portugal is doing its work. Europe also needs to do its part."

Earlier on Thursday, the Jornal de Negocios daily reported without citing sources that Germany has been pressuring Portugal to request an international bailout immediately, before any changes to the European rescue package are decided at a summit in March. [ID:nLDE71G0HG]

Asked about the report, the minister said "the government has no comment in relation to this."

Portuguese bonds have been under pressure in the past few weeks on growing concerns over its public finances and that it may be forced to follow euro zone peers Greece and Ireland in requesting an international bailout. The concerns have also risen on worries Europe may not reach a deal in March on fixing the debt crisis.

Hey, that didn't take too long did it? Five weeks before the ECB aid effect evaporates, as well as the capital behind the aid? Let's walk through the EXTREMELY valuable research that I posted on on Portugal to see what happens in the case of a default - starting with the explanations given in 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):

Price of the bond that went under restructuring and was exchanged for the Discount bond during the Argentinian bond crisis...


That’s right! Ouch! Imagine this times 10! That is what we are looking forward to. Let’s jump straight into Portugal’s situation, and remember that many of these countries have deliberately mislead and misrepresented their fiscal situations for years (see Once You Catch a Few EU Countries “Stretching the Truth”, Why Should You Trust the Rest? and Lies, Damn Lies, and Sovereign Truths: Why the Euro is Destined to Collapse!).

This is the carnage that would occur if the same restructuring were to be applied to Portugal today.

Yes, it will be nasty. That 35% decline in cash flows will be levered at least 10x, for that is how much of the investors in these bonds purchased them. A 35% drop is nasty enough, 35% x 10 starts to hurt the piggy bank! As a matter of fact, no matter which way you look at it, Portugal is destined to default/restructure. Its just a matter of time, and that time will probably not extend past 2013. Here are a plethora of scenarios to choose from…

This is Portugal’s path as of today.

Even if we add in EU/IMF emergency funding, the inevitability of restructuring is not altered. As a matter of fact, the scenario gets worse because the debt is piled on.

Let it be known that there are larger sovereign states that are worse off. Ireland is a prime example. If one were to look at the cumulated funding requirement of Ireland over the next 15 years as clearly illustrated in Ireland’s Bailout Is Finalized, The Indebted Gets More Debt As A Solution But The Fine Print Is Glossed Over – Caveat Emptor! Monday, November 29th, 2010

There are other states that are not in as bad a shape but are poised to do much more damage,  and then there are a plethora of states that will get dragged down through contagion. Yet, the natural manner of pricing risk in the equity markets does not transmit these facts because of the unprecedented amount of liquidity stemming from central bankers around the world doing the Bernanke/Japanse QE thing.

Keep in mind that the German's game plan is to kick this down the road till 2013, at which point it will be unsustainable but the mechanisms will be in place to force bondholders to take haircuts in front of the tax payers...

Sounds like a plan, doesn't it? Except for the high probability that you will probably have a rate storm well before 2013. If rate volatility and/or levels spike for the more developed nations before then, all hell breaks loose. In the US, we're damn near zero now. Hey, what happens to residential and commercial real estate valuations when rates spike higher? See  The Coming Interest Rate Volatility, Sovereign Contagion, Geo-political Unrest & Double-Dip Recessions: Here’s The Answer To Valuing Global Real Estate Through This Mess.

Revisiting the Topic of Haircuts

Now, let's return to the post “The ECB Loads Up On Increasingly Devalued Portuguese Bonds, Ensuring That They Will Get Hit Hard When Portugal Defaults“. All readers should open this link in a new window, scroll down to the spreadsheet at the bottom of the post, and reference the first column with the cell labeled "Decline in present value of cash flow for creditors" under the label "Haircut in the principal amount". Now, scroll over the to the column labeled "Restructuring by Maturity Extension & Coupon Reduction w/Haircut", which is the second to last column in blue highlight and carefully read the figure for the "Decline in present value of cash flow for creditors". Booyah! And that's the unlevered losses. 5x leverage wipes you out several times over. It is rumored that the ECB is levered over 90x, just for the sake of discussion. I strongly suggest anyone interested in this space study this spreadsheet very closely. This level of analysis is probably not available anywhere else on the free Web.

Next up, I will revisit what the coming rate storm means to real estate that is already falling in most developed nations, even at near zero interest rates.

Last modified on Friday, 18 February 2011 13:39