Deus Ex Macchiato

There has been a lot of negative comment about the Cyprus deal. That is understandable: you can reasonably argue that it will produce crippling austerity; that it is ridden with moral hazard; that it will create a bank run across most of Southern Europe. But what you can’t argue is that it was unexpected. After all, as Sony Kapoor points out, the standard template for bank resolution calls for bond holder and, if needed, uninsured depositor bail in together with liquidity assistance from the money printer. We got what was planned. If the plan isn’t a good one, there are bigger issues than Cyprus that we need to address.

Posted in: Economic Theory, Eurocrisis, Regulation by David /
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In July 2011:

Dexia was subject to the 2011 EU-wide stress test conducted by the European Banking Authority… As a result of the assumed shock, the estimated consolidated Core Tier 1 capital ratio of Dexia would change to 10.4% under the adverse scenario in 2012… the results determine that Dexia meets the capital benchmark set out for the purpose of the stress test.

And today, according to Bloomberg:

Belgium and France, wrestling for more than a year over the second rescue of Dexia, agreed on a 5.5 billion-euro ($7 billion) recapitalization of the bank.

As Jonathan Weil said last year, you can’t believe anything about regulatory capital benchmarks, in Europe or elsewhere, stressed or not. That’s because the capital ratio only makes sense if you believe the banks’ valuations and loan loss provisions are correct – and Dexia demonstrates vividly (as Wachovia and Lehman and Wamu and so many others did during the crisis) that they can be materially wrong for years.

Posted in: Accounting, Eurocrisis, Writedown by David /
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We might have speeded up, but that worthy prize winner the EU is delaying. Twice.

Bloomberg one:

The head of the European Central Bank said that common banking supervision in the euro area may not become operational before 2014 even if legislation is in place at the beginning of next year.

And two:

The European Union may consider pushing back when lenders need to start phasing in tougher Basel bank-capital rules by as much as a year after warnings that pressing ahead with the original timetable may drive up costs, according to three people familiar with the talks… European banks have said the original start date is “wholly unreasonable” given that the final details of the EU’s implementation of the measures is still unknown.

1/1/2014 would make a lot of sense for both of these.

Posted in: Basel, Eurocrisis, Regulation by David /
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Izzy Kaminska has a truly excellent post on FT alphaville about government policy in a downturn, safe assets, and investor perceptions. This very much fits with the central bank policy on the asset side theory that I have discussed before.

To see her point, let’s split the totality of investable assets into two classes, safe and unsafe. Now ‘safe’ can’t mean absolutely safe – no asset has any value if the earth is hit by a comet the size of the moon – but rather ‘thought of as safe enough’. This is of course a simplification, but a useful one.

At any time investors have a certain amount of money to invest (or divest), and a preference as to the proportion of safe assets they want.

What Izzy points out is if there is a substantially greater demand for safe assets than supply of them, there will be two effects. The first is obvious – safe assets get more expensive (think Bunds). The second is less so – that if governments let investors withdraw too far from risk, then the economy tanks, tax take tanks, and so government bonds become less safe. In other words, as Izzy says, the flight from risk can ‘compromise the safety of supposedly risk-free assets’.

There is no escape here: doing nothing, or even worse being austere, has its own dangers (as Krugman and DeLong among many others have pointed out).

How should governments respond? One possibility is a kind of Keynesian stimulus where the government steps in and buys risky assets, while providing more safe assets. In other words, they effect a transubstantiation in order to ensure that investors’ preferences are (closer to being) met. Of course, if they do this too much, government bonds become risky, but since ‘risky’ is an opinion not an objective fact, they can do some of it. Moreover the bigger the government, the more they can do of it. The Central Bank of Estonia can’t do much about risk in its economy by itself, but the ECB issuing jointly guaranteed Eurobonds could do a great deal.

If you buy this account, then you have to accept that QE isn’t a good tool. In particular it does nothing to address the mismatch between the supply and demand of risky assets. Indeed, buying long maturity treasuries with new base money arguably makes the problem worse by removing some safe assets from the system. What the central bank should consider instead is buying risky assets with that new money.

A good first step here would be having some idea of what investors’ aggregate safe/unsafe asset preference is at any given point. A comparison of that with the relative proportions of safe and unsafe assets in the local investable universe would at very least be an interesting piece of information for a central banker to have.

Posted in: Economic Theory, Eurocrisis by David /
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From the Euro area summit statement:

We affirm that it is imperative to break the vicious circle between banks and sovereigns. The Commission will present Proposals… for a single supervisory mechanism shortly… When an effective single supervisory mechanism is established, involving the ECB, for banks in the euro area the ESM could… have the possibility to recapitalize banks directly.

Mario, François and Mariano win this round.

Posted in: Euro, Eurocrisis, Mother of all Bailouts by David /
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From the FT:

LCH.Clearnet has raised the margin it requires from clients to hold Spanish government debt… The margin charged on 10-15 year bank debt will rise from 13.6 per cent to 14.7 per cent, for example…

LCH has previously imposed an additional margin requirement of 15 per cent based on a number of factors, including when the yield spread between 10-year government bonds and a basket of euro AAA government rated bonds rises above 450bp. Spain has been trading above that level for a number of days.

Posted in: Clearing and Collateral, Eurocrisis by David /
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Benoît Cœuré, Member of the Executive Board of the ECB, recently gave an important speech. It has quite a lot in it so even the bullet point version isn’t that short, but I promise you that it is worth thinking about his essential argument.

• Money markets around the world came under severe stress during the recent financial crisis and in the subsequent sovereign debt crisis, with interest rate spreads jumping to unprecedented levels and market activity declining significantly in many market segments.
• Opacity in banks’ balance sheets, coupled with uncertainty about the real valuation of their assets, led to acute tensions in the markets for credit instruments… Off-balance sheet entities became unable to roll over short-term financing in the US asset-backed commercial paper market. These events reinforced each other and generated uncertainty about both the solvency and liquidity of money market participants. Counterparties could not distinguish good banks from bad.
• Liquidity was no longer flowing from cash-rich banks to cash-poor banks.
• The Eurosystem introduced a fixed-rate full allotment regime in its refinancing operations, offering unlimited liquidity to banks at predictable cost against an expanded set of eligible collateral. The rise in the liquidity deposited with the Eurosystem after October 2008 was a direct consequence of this new regime and a symptom of a malfunctioning money market.
• Stress in the Euro unsecured money market continued beyond 2008, with a reduced turnover and preference for lending at shorter maturities.
• Dispersion in banks’ access to funding increased considerably in the euro area, with banks domiciled in countries under sovereign strains facing severe constraints even in obtaining secured funding.
• Deep and liquid money markets, not unlike other markets in the economy, play an important part in information aggregation and price discovery. They also help to ensure market discipline.
• Money markets play a central role in monetary policy transmission in the euro area.
• It is important that the Basel 3′s new liquidity regulations do not hamper the functioning of funding markets. This applies in particular to the calibration of the run-off rates for interbank funding and to the asymmetrical treatment of liquidity facilities extended to financial firms.
• The regulators’ welcome push to OTC derivatives towards CCPs may also have an effect on both the unsecured and secured money market segments. Such a move will lead to an increased need for high-quality collateral. The supply of safe assets is finite and the pool of “good” collateral is dwindling as the creditworthiness of certain sovereigns is questioned by market participants. The more good collateral is pledged to the CCPs, the less is left to use in the secured money market, and the fewer assets are available to other creditors in the event of default, making it difficult to obtain unsecured refinancing. This strengthens the need to find ways to identify or produce new assets that can be used as collateral and to mitigate the pro-cyclical consequences of credit ratings and of market valuation.

Posted in: Bank Run, Euro, Eurocrisis, Liquidity and liquidity risk by David /
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You wil have the news already. I am using this as a shabby excuse to post this picture:

Posted in: Euro, Eurocrisis, Photography by David /
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Apparently not. Spain now owes 100 billion euros more, give or take, but yields are compressing and stock markets are rising. Clearly the austerians have, in a limited sense, been defeated.

In the immediate aftermath, two things occur to me. First, this fits alarmingly into the pattern of doing enough to prevent an immediate crisis, but not enough to address the underlying problems, guaranteeing that another crisis will arrive in a few months. Second, I bet the Irish are exceedingly peeved by this. After all, they didn’t get a break anything like this, and have suffered huge pain as a result. Moreover the Spanish bailout doesn’t even give them hope that they can line up at the queue for that sweet sweet Euro-liquidity.

(HT FT Alphaville for the data.)

Posted in: Euro, Eurocrisis, Markets, Mother of all Bailouts by David /
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First, is the agreement the 26 have reached a good one? I tend to agree with Foreign Policy on this one:

Merkel’s short-sighted, audaciously Germany-first reaction to staunch the eurocrisis is the Germanization of European monetary and fiscal policy, foremost the codification of its obsession with tight money, fiscal purity, and budgetary orthodoxy. In spite of all evidence to the contrary, she insists that what’s good for Germany is good for everybody else, too. It’s clearly not. And with the world’s leaders begging her to do “whatever it takes” to stave off global calamity, she’s doing it with Sarkozy at her side and over the heads of the now completely irrelevant European “voters” (“subjects” is the more fitting word). This is a catastrophic mistake, which, politically, vastly expands the EU’s centralized authority while robbing it of even the fig leaf of democratic legitimacy it had sported. Moreover, the economics of Berlin’s Germanocentric prescriptions for the eurozone compound the very problems that landed Europe’s weaker economies in the mess they’re in right now.

In other words, it is politically dangerous – because it has no democratic legitimacy – and it probably won’t work in the long run (and maybe even the short run).

Second, what really caused Cameron to use his veto? The Economist has a lot more evidence here than we had on Friday morning.

By a certain point on Thursday night, I am told, a majority of countries were growing interested in a quick and dirty legal fix, suggested by the president of the European Council, Herman Van Rompuy. The fix was dreamed up by lawyers working for Mr Van Rompuy. They said that a legal device, known as “Protocol 12″, would allow the 27 leaders of the EU to agree most of the new rules and mechanisms for fiscal union in the euro zone by a simple, unanimous decision among themselves.

Suddenly, Germany looked isolated. Mr Van Rompuy, a former Belgian prime minister elected by EU leaders to chair their summits, decided to see if he could sweeten the deal for the wavering EU leaders, and asked Mr Cameron if he would consider dropping some of his requests. This made sense to some leaders in the room. Mr Cameron’s demands were already more than many of his colleagues would tolerate, and Britain had already said publicly it would tailor its demands to the scale of the treaty change on the table. Mr Cameron said he would not lower his ambitions, and that his demands would be the same in the event of Protocol 12 being used, or a full-blown EU treaty.

A hostile view of this is that Mr Cameron overplayed his hand. In this version of events, the British prime minister thought the mood of the room was running towards Protocol 12, and because Protocol 12 is decided by unanimity, he thought he had the whip hand.

Instead, my source tells me, the room turned on Mr Cameron. This, I am told, “was the point at which the Protocol 12 route, which requires unanimity, was effectively closed down and one country after another accepted a new treaty at 17+.”

Did Mr Cameron miscalculate? Did he want to end up with a treaty being crafted at almost 26, with Britain on the outside? My source is certain that was not Mr Cameron’s goal, and my source is not alone in this thinking.

It is now almost inevitable that separate structures be set up, with Britain on the outside, it seems. Talk in London of preventing the “Eurozone-plus” from using the Court of Justice is also a mistake, I am told. Article 273 of the treaty allows just this.

You can choose to believe this account or not. It comes from a single source, who is well-placed but clearly viewing this from a particular perspective.

Time will tell. But what a mess.

What Britain wanted was a return to inanimity for votes on certain issues in financial regulation; that was Cameron’s price for agreeing to Protocol 12. Clearly he overplayed his hand. The more you read about it, though, the more extraordinary it seems that a compromise could not be reached. Perhaps Cameron didn’t want an agreement in order to appease his backbenchers. (I typed ‘bankbenchers’ the first time I wrote that sentence, a telling error.) Perhaps the French waited for Cameron to go too far then shot down his balloon. In any case, the outcome – both in terms of what has been agreed and where it leaves Britain – is depressing and unsatisfactory.

One key point – a point I didn’t get on Friday – is that Cameron wasn’t trying to stop Sarkozy from doing something: he was trying to get agreement to change the voting system for financial regulation. He didn’t succeed. In other words, he annoyed the 17 (or more) and got precisely no gain for Britain. This, I suspect, is why Clegg changed his tune over the weekend. In any event, Cameron looks more incompetant now that the facts are clearer.

(Further, insightful comment on how well the pact will work can be found here, while this post has an interesting discussion of Cameron’s behaviour and its consequences.)

Posted in: Euro, Eurocrisis, Politics by David /
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The highlights, from the ECB:

• To conduct two longer-term refinancing operations (LTROs) with a maturity of 36 months. [3 years. Jeepers, 3 years!] and the option of early repayment after one year.
• To discontinue for the time being, as of the maintenance period starting on 14 December 2011, the fine-tuning operations carried out on the last day of each maintenance period.
• To reduce the reserve ratio, which is currently 2%, to 1% as of the reserve maintenance period starting on 18 January 2012. As a consequence of the full allotment policy applied in the ECB’s main refinancing operations and the way banks are using this option, the system of reserve requirements is not needed to the same extent as under normal circumstances to steer money market conditions.
• To increase collateral availability by (i) reducing the rating threshold for certain asset-backed securities (ABS) [so that basically any obligation up to and including dry cleaning receipts will be eligible collateral at the ECB] and (ii) allowing national central banks (NCBs), as a temporary solution, to accept as collateral additional performing credit claims (i.e. bank loans) that satisfy specific eligibility criteria. These two measures will take effect as soon as the relevant legal acts have been published.

I’ll give some comment tomorrow. Meanwhile though Reuters sets the tone: European shares fall on Draghi comments.

Posted in: Euro, Eurocrisis, Liquidity and liquidity risk by David /
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Let me explain. First, some news from Mayan archaeology:

The end is not quite nigh. At least that is the conclusion of a German expert who says his decoding of a Mayan tablet with a reference to a 2012 date denotes a transition to a new era and not a possible end of the world as others have read it.

The interpretation of the hieroglyphs by Sven Gronemeyer of La Trobe University in Australia was presented for the first time on Wednesday at the archaeological site of Palenque in southern Mexico.

Gronemeyer has been studying the stone tablet, which was found years ago at the archaeological site of Tortuguero in Mexico’s Gulf coast state of Tabasco.

He said the inscription described the return of the mysterious Mayan god Bolon Yokte.

Now, turning to the Eurozone, we have Angela Merkel’s comments yesterday:

Angela Merkel has vowed to create a “fiscal union” across the eurozone with wide-ranging powers to avert catastrophe, saying the process was already under way as part of the “marathon” effort to solve the European debt crisis.

The German chancellor said she was determined to push for treaty changes at next week’s EU summit.

It’s all pretty clear. The new Eurozone will begin in 2012 and, as per the prophecy, it will be a God amongst currency zones, with one bank to rule them all. Now I admit that ‘Bolon Yokte’ is not quite as catchy as the ‘Neues Eurozone’, but it could catch on…

Posted in: Euro, Eurocrisis, Fun by David /
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From Mario Draghi’s speech today:

Dysfunctional government bond markets in several euro area countries hamper the single monetary policy because the way this policy is transmitted to the real economy depends also on the conditions of the bond markets in the various countries. An impaired transmission mechanism for monetary policy has a damaging impact on the availability and price of credit to firms and households.

It is worth spending a moment on why this is true. First and most obviously, falling bond prices causes losses at banks which threaten their solvency – or at least the perception of their solvency. This in turn makes it difficult for them to lend, not least because it is difficult for them to borrow.

There are more subtle and possibly just as significant other mechanisms at work too though. As bond prices decline, repo haircuts increase, and that creates funding stress too. Banks are pushed to fund more at the central bank as less collateral becomes acceptable in the private markets.

Confidence bites too as banks delever so that they can claim to be relatively well capitalized. An arms race of competitive deleveraging can even set in. This is particularly toxic as it further impairs the monetary transmission mechanism: central bank money doesn’t go into increased lending, but rather into reducing private funding.

Liquidity alone is not enough in these circumstances: capital is needed too. That, I fear, will be one of the next steps in the unfolding saga of central bank intervention.

Update. In that context, Bloomberg’s account of the new EU rules on state support for banks is worth reading.

Separately, Bloomberg also reports remarks made by Mervin King today about yesterday’s intervention:

“This is not a solution,” King said at a press conference in London to present the Financial Stability Report. “All this can be is to help with temporary relief for liquidity problems, but those problems are a result of solvency issues.”

Posted in: Euro, Eurocrisis, Liquidity and liquidity risk, Mother of all Bailouts by David /
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The president of the Bundesbank has ‘firmly rebuffed international demands for decisive intervention in the bond markets by the European Central Bank to combat the eurozone debt crisis, warning that such steps would add to instability by violating European law’.

Jens Weidmann told the Financial Times that ‘only politicians could resolve the crisis, and he rejected the idea of using the ECB as “lender of last resort” to governments’.

All he needs now is a white cat to stroke.

Posted in: Economic Theory, Euro, Eurocrisis by David /
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The Guardian says:

Reports that Germany and France have begun talks to break up the eurozone amid fears that Italy will be too big to rescue

If this happens, it will make the aftermath of Lehman look like a day in the park. An utterly preventable disaster is now looking entirely possible. Truly our leaders have let us down.

Update. I strive not to be drawn into hysteria. As the economist says:

I hate to get this pessimistic about the situation. It feels panicky and overwrought. I can’t believe that Europe would allow so damaging an outcome as a financial collapse and break-up to occur… the window within which something could be done to prevent it is closing, and fast. I hope to be proven astoundingly wrong in my assessment, but I’m struggling to see alternative outcomes.

These folks are not known for proclaiming the end of the world on a regular basis. Neither is Brad DeLong, and he says:

I have been complaining for some time now that Reinhart and Rogoff think that the time is always 1931 and that we are always Austria–that the great fiscal crisis is about to erupt and send us [i.e. the US] lurching down toward Great Depression II.

Well, right now guess what? The time is 1931, and we are Austria.

The Federal Reserve needs to buy up every single European bond owned by every single American financial institution for cash before the increase in eurorisk leads American finance to tighten credit again and send us down into the double dip.

The Federal Reserve Needs to do so now.

A little historical perspective may be helpful. One of the first events in the Great Depression, and a major contributor to the loss of confidence, was the failure of Creditanstalt. This was a proto-investment bank, one of the largest in Austria; its collapse was unexpected – just like Lehman. So, um, yes Brad; it does look altogether too much like 1931 for comfort.

Posted in: Euro, Eurocrisis, Markets, Politics, Sovereign Default by David /
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Mario Blejer, a former Bank of England adviser who took charge of Argentina’s central bank after the 2001 default, has been reported on Bloomberg:

Greece should default, and default big,… Germany and France will have to bear the brunt of financing efforts to help Greece and other countries that default re-start their economies, he said.

For what it is worth, he has an interesting point. If default is inevitable, then get it out of the way, and then you can start to grow again. Clearly the lower recovery you give, the more debts are extinguished, and hence the better your chances of recovering. Sadly we have moved from ‘if’ to ‘when’ so my sense is that Blejer is right; an early default would actually allow us to move on from the Euro tragedy that is unfolding. (That’s a German word, right, Eurotragik?)

Posted in: Euro, Eurocrisis, Sovereign Default by David /
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Goodness, I like Charles’ comment to my previous post more than the original. Let us indeed go with the Geuro (pronounced ‘gyro’; it has got all the meaty countries in it) consisting of Austria, Estonia, Finland, Germany, Luxembourg, the Netherlands, Slovakia and Slovenia; and the Feuro (pronounced ‘furo’; the countries in it are going to take a bath) for Belgium, France, Portugal and Spain. As Charles says, if Belgium splits, then Wallonia has the Feuro while Flanders goes with the Geuro.

I’m not entirely sure I buy the line about Italy having to be out, though; or at least (sorry Charles), I don’t see the argument for excluding Italy as more persuasive than the one for excluding Spain. Indeed, the top half of Italy would perfectly naturally fit with the Geuro countries. It’s the bottom half that causes the issues…

Posted in: Euro, Eurocrisis, Politics, Sovereign Default by David /
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Making your mind up is difficult. Jonathan Hopkin gives us some help in a long and insightful post about the future of the Eurozone. He sees two possible outcomes:

The first scenario is disintegration: the reversal of the process of ever greater European economic integration and cooperation. In this scenario neither core nor periphery member states are prepared to meet the costs of staying together: German, Dutch and Finnish taxpayers refuse to sign up to the rescue of the profligate South, whilst in the periphery austerity packages founder on the rocks of collapsing output and/or political instability…

A second scenario can be traced, in which further integration provides the Eurozone with the necessary policy instruments to address the imbalances and weaknesses revealed by the crisis. What exactly would this integration involve? The most immediate problem – the risk of sovereign default in the periphery – will inevitably require a degree of burden-sharing and risk-pooling, most likely through the emission of Eurobonds backed by the governments of the entire Eurozone.

I agree entirely: this second scenario seems to me the most likely. There is a third, though, and that is where Buck’s Fizz come in. Various individuals have been in court recently disputing who has the right to use the Buck’s Fizz name. This of course followed various band members leaving, new ones joining, and more attempts at cashing in that you get at the average small town ATM.

So, what if instead of one country leaving the Euro, a split was amicably arranged? The North is rent asunder from the South. In the Neuro block we would have Austria, Belgium, Estonia, Finland, France, Germany, Luxembourg, and the Netherlands. The Seuro would be currency of Cyprus, Greece, Italy, Malta, Portugal, and Spain. Ireland, Slovakia and Slovenia might go either way, and the new accession countries could make their choice too. Both currencies would float; the ECB could remain as the central bank of the Neurozone, while perhaps Rome would be a good location for a newly created central bank of the Seurozone. On the day of schism the two blocs could agree that 1 Neuro = 1 Seuro, but this would rapidly change as the FX markets got to work. The Seuro would fall, restoring competitiveness to its members, while the Neuro would rise. If you got problems with pesky bondholders claiming that the split was a credit event, both blocs could even keep the name Euro; if two different bands both calling themselves Buck’s Fizz can tour at the same time, two currencies with the same name shouldn’t be a big deal. Vive la Rupture!

Posted in: Euro, Eurocrisis, Politics by David /
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John Lancaster in the LRB has a corruscating account of the worm’s eye view of the continuing Eurozone crisis:

From the worm’s-eye perspective which most of us inhabit, the general feeling about this new turn in the economic crisis is one of bewilderment. I’ve encountered this in Iceland and in Ireland and in the UK: a sense of alienation and incomprehension and done-unto-ness. People feel they have very little economic or political agency, very little control over their own lives; during the boom times, nobody told them this was an unsustainable bubble until it was already too late. The Greek people are furious to be told by their deputy prime minister that ‘we ate the money together’; they just don’t agree with that analysis. In the world of money, people are privately outraged by the general unwillingness of electorates to accept the blame for the state they are in. But the general public, it turns out, had very little understanding of the economic mechanisms which were, without their knowing it, ruling their lives. They didn’t vote for the system, and no one explained the system to them, and in any case the rule is that while things are on the way up, no one votes for Cassandra, so no one in public life plays the Cassandra role. Greece has 800,000 civil servants, of whom 150,000 are on course to lose their jobs. The very existence of those jobs may well be a symptom of the three c’s, ‘corruption, cronyism, clientelism’, but that’s not how it feels to the person in the job, who was supposed to do what? Turn down the job offer, in the absence of alternative employment, because it was somehow bad for Greece to have so many public sector workers earning an OK living? Where is the agency in that person’s life, the meaningful space for political-economic action? She is made the scapegoat, the victim, of decisions made at altitudes far above her daily life – and the same goes for all the people undergoing ‘austerity’, not just in Greece. The austerity is supposed to be a consequence of us all having had it a little bit too easy (this is an attitude which is only very gently implied in public, but it’s there, and in private it is sometimes spelled out). But the thing is, most of us don’t feel we did have it particularly easy. When you combine that with the fact that we have so little real agency in our economic lives, we tend to feel we don’t deserve much of the blame. This feeling, which is strong enough in Ireland and Iceland, and which will grow steadily stronger in the UK, is so strong in Greece that the country is heading for a default whose likeliest outcome, by far, is a decade of misery for ordinary Greeks.

This feeling of a lack of control, of understanding, of consent, is pervasive and ultimately potentially of huge significance. It is not just that most people don’t approve of the economic arrangements which shape their lives, it is that they had no idea what they were. Now that they are becoming aware of them, they don’t like them.

It would be a brave man who predicted that growing understanding of economics will bring political change, but at least the odds that it might are growing. Let me leave you then with Queen Anne, whose rule marked the development of much of the political system we have today. How long that system lasts could just possibly depend on how it deals with the economic disenfranchisement Lancaster discusses.

Posted in: Euro, Eurocrisis, Photography, Politics by David /
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It is the time of year for this kind of things so here’s my amateur global macro picks for 2011.

1. Eurozone fears are overdone. Many market participants are in my view overestimating the likelihood of Eurozone breakup, especially in the short to medium term. Long the Spain/Germany spread.

2. The developed equity markets are overbought. They are likely to continue that way for some time, so I like selling 3 or 4 year slightly out of the money calls on the Eurostoxx and SPX.

3. Japan might finally get its act together. OK, perhaps not that likely, but a medium sized punt on the Nikkei feels like reasonable value. Expect yen appreciation, though, so you might want to currency-protect that.

4. Liquidity becomes better priced. Basel will force banks to consider security liquidity more carefully, and thus liquidity premiums will increase. Hang on to assets with great liquidity characterisistics for now, and look to bleed them out via two way total return swap structures or similar as the banks get more desperate.

5. Sovereign CDS basis to increase on the best quality countries. The trend in the previous point will make govies more attractive while CVA hedging will increase the demand for CDS. This will cause the CDS/bond basis to increase. Consider the negative basis trade on govies.

Posted in: Eurocrisis, Markets by David /
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Brendan Moynihan (no, not Brian Lenihan) has an interesting suggestion for Eurozone debt restructuring on Bloomberg:

European countries should reduce the principal amount they owe by issuing gross domestic product-linked sovereign bonds as an incentive to creditors to take a haircut on the debt. Bondholders would accept, say, 70 cents on the dollar on their bonds and receive new debt paying the German bund rate and with a warrant that pays a coupon tied to the amount each country’s respective GDP exceeds, say, 2 percent. The warrants could have an assigned value at inception — based on a long-term call option on GDP — and be detachable and traded separately.

This is like a debt-for-converts swap. Existing bond holders are offered new bonds plus the warrants. If the warrants are long dated enough, you can reduce the principal sufficiently that the burden of payment drops signifcantly. A 30% haircut, as Brian suggests, is perfectly possible.

The problem, though, is that the warrants would be really attractive to hedge funds only if they were hedgeable, and you can’t short GDP easily. I wonder if inflation is a reasonable proxy. If instead the warrants paid out based on ten year cumulative inflation, then dealers could hedged using inflation-linked bonds, and the effect might be similar. This would also likely have the desirable side effect of making the linker market more liquid and hence decreasing linker issuer costs for governments. (I have not had time to look at inflation volatility and price up the option, but given the forward inflation curve is quite steep I imagine the maths could be made to work.)

Update. I couldn’t resist pricing up the warrant (which in itself wasn’t easy – you have to think hard about the replicating portfolio to get the right answer), and with a plausible HICP vol a 2% strike 10 year inflation warrant does indeed come out as being worth 30%. So the trade described above passes at least the first sanity check…

Posted in: Euro, Eurocrisis, Inflation, Sovereign Default by David /
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As was always very highly likely, Greek default has been averted. You might add ‘for now’, and certainly the omens are not entirely good. However in looking at the PIIGS one must understand the context: the Euro project, as we have previously commented, is not primarily an economic one. It is political. This means that things will be done which are perhaps not rational economically. If you bet against Greece, you are not betting on the Greeks failing to sort out their problems. You are betting against the rest of the Eurozone, and Germany in particular, not supporting them. Despite Germany becoming more selfish recently, this seems unlikely: a lot more unlikely than the markets are estimating, anyway. I still like selling first to default protection on the PIIGS: if Citigroup and JPMorgan are too big to fail, how much more so are Greece, Portugal, Ireland, Spain and Italy? The Eurozone may seem disorganised, slow to react, and sclerotic. It might have labour markets which frighten economists, pensions deficits going to the sky, and low growth. But it is one of the richest areas in the world, and it will remain such. It can afford to rescue its members, and my guess is that if push comes to shove, that is what will happen.

Posted in: CDS and Negative Basis, Euro, Eurocrisis, Markets, Sovereign Default by David /
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As I expected, given the primarily political rather than economic character of the Euro project, Greek has been propped up.

This is both rational on a standalone basis, and as a signal to the markets. If Greece had defaulted, the pressure would have been huge on the rest of the the PIIGS. Sell one year first to default protection on Portugal, Ireland, Italy and Spain before the spreads come in too much.

Posted in: CDS and Negative Basis, Euro, Eurocrisis, Markets, Sovereign Default by David /
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… is nearly three hundred billion euros of liquidity leaving the eurozone financial system. A great catch from Zero Hedge here:

Earlier today, the European Central Bank announced that it had drained a whopping €295 billion in an unscheduled, one-time liquidity-absorbring, fine-tuning operation.

The central bank weaning off has clearly begun, at least in EUR.

Update. FT alphaville points out that this is not that unusual, given that Tuesday wass the last day of the ECB’s latest reserve maintenance period: the ECB regularly drains cash from the euro zone banking system at the end of the period. All the same, this is a big number…

Posted in: Euro, Eurocrisis, Liquidity and liquidity risk by David /
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John Kemp thinks that Greece should default and reschedule. I wonder.

The idea has immediate appeal from the point of view of punishing imprudent lenders. But, attractive though that is, would it be the best thing for the Greek people? It rather depends on whether the incremental cost of raising money post default is larger than the savings available through defaulting. There is no reason so far as I am aware that Greece could not default and still stay in the Eurozone. But obviously if they were to go for the nuclear option, then the spreads of Italy and Portugal would go out hugely – probably Spain too. And a lot of rather unsavoury people would make a lot of money.

I doubt very much whether this will happen, even if it is rational. But I have been wrong about Greece before…

Posted in: Euro, Eurocrisis, Sovereign Default by David /
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