The talk is that EU sovereign debt to be issued in the future would have the benefit of an insurance guaranty that covers the first 20% in the event of default. This guaranty would be backstopped by the EFSF.
The thinking is that a new bonds issued by Spain, Portugal, Ireland, Italy (and presumably Belgium but not Greece) with the guaranty would be widely perceived as a money good investment. As a result, huge amounts of capital could be raised in the global bond markets under very attractive terms (total = Euro 2+ trillion). Funding costs for the PIIBS would plummet as a result. With the debt market stabilized, economic prosperity would soon follow. I say "rubbish".
The enhanced bonds would be “Story” bonds. In my experience story bonds have a very limited investor interest. I have no doubt that ten of billions of these bonds could be sold, but Trillions? The USA Treasury market is the most liquid in the world. The total public float (excludes Fed and Intergovernmental) is about 9 trillion. The proposal is that an amount equal to 1/3 of the US public float of new EU enhanced bonds are issued in just a few years. IMHO that will never happen.
The global bond markets will have to figure out how to price this new debt. I’ve been pondering this for days. I can’t come up with a pricing structure that works.
Consider a newly issued ten-year Italian sovereign bond that has a 20% first loss guaranty by the EFSF. Assume that the German ten-year was 2% and Italian at 5% (about where we are today). You tell me, how is that new bond going to trade based on this?
This is not equivalent to 20% German risk and 80% Italian. That would be far too easy. But if the market were to trade it as an 80/20 it would imply that the new Italian Enhanced Bond (“IEB”) would yield about 4.4%. This would mean that the IEB/German spread would be 240bp while older Italian debt had a spread of 300bp. If that were the result, it would be a disaster. While 60bp is a big deal, it would do nothing to stabilize Italy’s long-term debt cost. For a new program to work, it would have to drive the IIB/German spread to 100bp.
In order to evaluate the 80% Italian risk and price it properly one must first make an assumption as to the probability of an Italian default over the next ten years. One must also make some assumptions regarding what losses might be incurred should there be a default.
Folks, those are very complex questions to answer. I’ll give it a shot.
Probability of Italian default over ten years = 20%
Probability for loss > 20% in the event of default =100%.
While I think that Italian default risk is relatively low, I believe that should it happen, the net haircut would be substantially above the 20% first loss protection. A country like Italy would not go through the pain of a default to achieve a 19% debt reduction. If push comes to shove and Italy decides it is best to default, the haircut would be in the 50% range (a la Greece).
Any investor who looks at the new bonds and concludes that they’re money good is just nuts. That will not happen.
My conclusion is that the new enhanced debt has to trade cheap. There is a massive amount of this story paper coming our way. That mountain of supply has to mean the bonds have to have a high yield. If one wanted a litmus test for this I would ask the Swiss National Bank. They have E200b in reserves. I bet they would not put a dime into these new securities. Neither would Singapore, Venezuela, Kuwait, Hong Kong or Saudi Arabia.
It’s quite possible that the new paper does very little for Italy. If that were the result for Italy (a relatively strong borrower) it would be the kiss of death for the weaker ones like Spain and Ireland.
What I find fascinating about this is that the deep thinkers in the EU are relying on the global bond market to price the new securities in a way that would produce the desired results. The deciders are going to trust Goldie, Citi and good old JP to price this swill on the rich side? Not a chance in the world.
After four agonizing years the inescapable conclusion is that complex derivative securities were at the heart of our problem (they hide risk). The response by the EU is to give us the largest derivative transaction that has ever been created. Talk about a sign of weakness.
The most amazing thing is that the global markets are lapping this up. Any confirmation (the silly Guardian story) that the Mega Monoline is in our future is a cause for celebration.
Wait and see how these new bonds trade. I think they will trade on the cheap. If I’m right, then you can kiss off the possibility of an EU soft landing. If the markets give the new bonds a thumbs down it will be the final act in the story. There’s an ‘event risk” to look forward to.
Note: The only way the new enhanced bonds can trade rich is if the ECB stands ready to buy them such that the spreads are very narrow to German paper. I see a very small chance that this would happen. But if they did step up, the markets would see through the charade in a NY minute. The lights would start to go out shortly after they started buying.
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The risk analysis on the street has come a mile since you left Bruce. This looks like a confused first-year student's finance homework.
ReplyDeleteBuying securities at random would leave you much better off than the buy signals stemming from this "analysis".
Quixote,
ReplyDeleteHow exactly has risk analysis evolved and improved in the past decade? The big banks still use VAR for godssake. There is a so-called 10 standard deviation move every 6 months. I prefer common sense analysis to theoretical technical jargon that betrays you every time the markets get volatile. Simple question, would you buy 20% wrapped Portugal 10-yr bonds at 7%? If not, then what's your point exactly?
VAR is garbage absolutely. Pricing a bond as 20% Germany and 80% Italian is arguably even more useless. Portugal is a sideshow - no one cares what happens to them. It's Spain and Italy that we need to discuss.
ReplyDeleteConsider the case of default. Bruce estimates 20% probability. I'll say 40% haircut. That means 96% expected payout (since the first 20% is insured). Clearly these bonds won't qualify for a lot of investment mandates, but they will qualify for a lot of others. Even at a 2% spread on the 10-year, there is still a ton of alpha to pick up there.
Some additional thought needs to go into the probability distribution of the timing of default, and calculations adjusted accordingly, but the thought process above is considerably more reliable than that outlined in the article.
I find probability distribution to be impossible in part because of the auto-correlation of defaults. Who is to say that the insurance will even be money good? What will happen with the roll over to ESM in 2013? What will happen to legacy bonds and what will happen to Euro banks if they sell off massively? What will happen to Core Europe yields (and ratings) as a result of the guarantees and how will this effect after-market trading in wrapped debt as well as future issuance? There are far too many complexities, correlations, and unconsidered consequences to use simply probabilities. Hence, I believe a common sense approach makes more sense.
ReplyDeleteThe simple question is, will a 20% wrap encourage enough buyers who are unwilling to buy periphery debt currently to do so at rates and quantity that will sufficiently mitigate solvency and liquidity problems? To me the answer is a simple no, but that is why they call 'em markets.
Normally people borrow money to do something productive. And this is borrowing money to save banks bad bets? Holy smokes! I hope people are not that asleep. There are no fire alarms in the media, from the governments. The EU is burning down while the central banks fiddle.
ReplyDelete