There is a story that Equador rather cleverly bought their bonds back in the secondary market after default rather than waiting for the restructuring. Essentially instead of having to pay 35 cents on the dollar, they paid in the 20s, and so saved the country a few hundred million dollars. Apparently the State Department thinks that this is market manipulation. Well, frankly, screw them and anyone who thinks like them.
Equador has GDP per capita of of $8,000 comfortably putting it outside the top 100 countries in the world by income per head. 33% of the population is below the poverty line. (Figures from the CIA.) It is only keeping its head above water thanks to the high oil price. If a country like this can extract a few hundred million out of emerging market bond holders through some smart trading then my view is good luck to them.
Anglo Irish December 10, 2010 at
The auction results are out on the Anglo Irish credit event. Roughly: sub recovery 18%; senior 75%.
The sub is clearly about right. The senior, though, is interesting. Would you rather have 75% for sure now or run the risk of getting 50% or less later in some Irish restructuring? On the other hand, if you think that the rescue will work, then a 25% haircut on the senior is penal.
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…
There were four horsemen, right? Well, the third has just cantered into the yard and asked if someone can sharpen his scythe. From LCH:
In accordance with the Sovereign Risk Framework issued on 5 October 2010, and in response to the yield differential of 10 year Irish government debt against a AAA benchmark, LCH.Clearnet Ltd has revised the risk parameters for Irish government bonds cleared through the RepoClear service. The margin required for positions of Irish government bonds will consequently be an additional 45% of net positions over the standard margin rate.
… is a great opportunity, in my view. Portugal 2y CDS at 375 over? Wave it in.
(Chart via Reuters.)
Spain and Italy look quite attractive too.
A careless journalist says:
If you’re a bank and the country you’re based in goes bust, then you’re going to go bust too.
Nope. Or, more precisely, if a sovereign defaults on foreign currency debt, then banks incorporated in that country do not have to default on their foreign currency debt too, and even more importantly they certainly don’t have to default on their local currency debt. If banks only have local currency debt, they may well be fine – especially if they have foreign currency assets which will likely appreciate vs. their debt, and if the central bank makes lots of liquidity available in local currency, which it might.
If the banks have foreign currency debt too, their default depends on their ability to service it (given any government action): if they have foreign currency assets too, and not too much funding liquidity risk, they might survive.
For all of these reasons, by the way, there is a case for some banks with substantial foreign asset bases to be rated through their sovereign of incorporation.
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.
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.
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…
Evidently not. From the FT:
Greek stocks and bond markets surged on Monday as investors flooded the government with demand for its first bond offering of the year… The coupon interest payment on the deal, expected to be worth €5bn, is likely to be 6.12 per cent – or 3.8 percentage points higher than equivalent German bonds. This is a record spread and underlines the premium Greece must pay over Germany, the benchmark market in the eurozone, for its financial troubles.
For Greece that is one challenge negotiated, at least. Fixed income investors are still hungry for yield, and Eurozone government risk at 380 over bunds is evidently attractive. High(er) yield issuers everywhere take note – if you are even somewhat generous, you can currently get long-dated deals done at yields that are in absolute terms delightfully low.
Freaky Friday? November 27, 2009 at
The markets are all over the place today. That spells opportunity. For me the glaringly good one is Greek sovereign CDS: as Ibex Salad pointed out in a comment on my previous post on spread widening, from a fundamental perspective, this looks like money for old rope. Yes, spreads could widen further, so don’t buy a product with a spread trigger, but otherwise selling protection on Greece for over 200 running looks like a no brainer.
Here’s the spread history, courtesy of FT alphaville:
If you have even stronger nerves, consider a short in gold (ideally priced in Euros or Yen…)
FT alphaville picks up some research from Paribas on sovereign CDS spreads. The claim is that spread widening in the peripheral EU countries are being driven by ECB policy:
The ECB signalled on Friday that it would soon start retracting some of the liquidity provisions it put in place last year, in a bid to stop some of its lower-rated members from using them for financing investments in their own local government bonds — something that had helped keep European sovereign spreads tight.
Certainly ECB action could cause a weakening in demand for certain government bonds as the ability to finance them cheaply and earn carry disappears. Spreads are definitely widening, as the illustration shows.
(This story would be a little more compelling if we could see the historical spreads for Greece, Poland, Slovakia etc., but it is safe to assume that these have blown out too.)
Is this all ECB driven?
I suspect not. In particular there is a popular credit derivatives product which packages up a leveraged sovereign CDS in a note. Essentially the buyer of the note gets an enhanced return in exchange for selling CDS on a multiple of their notional at risk. The catch with these products is that they do not just trigger on an ordinary credit event: in order to protect the selling bank, they also trigger on spread widening.
Thus for instance on popular version of the product in 2008 year paid Libor plus 1% or so in exchange for seven times leveraged exposure on Spain, with a trigger if the Spanish sovereign CDS spread hit 100 – a level it is perilously close to today.
These notes are reasonably subtle products in that they can seem to the naive like simple speculations on sovereign default – and no one expects Spain to default. But the spread trigger means that they are in fact rather sophisticated forms of credit spread option. The note issuers hedge by selling sovereign CDS on the other side. All else being equal, this should act as a brake on spread widening, as note buyers take advantage of better spreads to sell more CDS.
But who are the buyers of sovereign CDS on the other side of this and other trades? There is much less pressure to do negative basis trades on government bonds as there is little regulatory capital advantage. So what puzzles me about the spread action is who is paying these high prices to buy sovereign protection, especially on the better quality names. That is the real answer to the spread widening puzzle.
Ambrose Evans-Pritchard in the Telegraph has an article about Iceland. He notes that the Icelandic krona has fallen by half against the euro since the dark days of 2008, and as a result there has been something of a recovery in Iceland. Unemployment is high, at 9.1%, but still below the Eurozone average. The head of the central bank is quoted as saying: “If you lean back and look you can see that fall of the krona accentuated the shock at first, but it is also now working as a turbocharger for recovery.
So, when can countries devalue their way out of trouble?
One important factor is the currency of debt. If most of a countries’ debt is in local currency, then devaluation is more likely to be effective. Clearly you can use a combination of inflation and devaluation to reduce the real value of your debts. If you have a significant amount of debt – government or otherwise – in foreign currency, then things are a lot more difficult. This is partly why I am sceptical about buying the Icelandic recovery hook, line and sinker. (They are, after all, reliant on ever decreasing fish stocks too.) A lot of retail borrowing in Iceland was in Euros. The same applies to the Baltics and the Eastern rim of the Eurozone. Ambrose-Pierce admits this is a problem, noting that `Some 13% of households in Iceland hold mortgages in euros, Swiss francs, or God forbid, yen [and] some 70% of corporate loans are in foreign currencies.’ That strikes me as a fact pattern that justifies Iceland’s foreign currency debt rating. Clearly Iceland is on the up, but it is not out of the woods yet, and it won’t be until investors are confident that it can pay its debt in their currency of denomination.
I have made a bit of a sideline in highlighting some of the less helpful comments on the CDS market. It pains me to include a man I generally respect, Paul Krugman, in the list of people who have got the wrong end of the stick.
He first quotes marketwatch:
The spreads on credit-default swaps for U.S. government debt jumped to 97 basis points Tuesday, nearly seven times higher than a year ago and 60% higher than the end of last year, to a level roughly in line with those of France, according to data supplied by Markit.
Then he opines:
Has the risk of a US government default risen? Probably. Nonetheless, the people buying these contracts are crazy. A world in which the US government defaults would be a world in chaos; how likely is it that these contracts would be honored?
The answer is that it does not matter (much). Most CDS trading is about views on the spread, not views on default. People buy CDS on the US government because they think the spread will widen and they can close out at a profit, not because they think that default is likely. Therefore the CDS market often tells you rather little about default: what it tells you about is market participants expectations of spread movements. CDS spreads go out when there are more buyers of protection than sellers. That is the only reason spreads move. Any connection between CDS spread movements and expectations of default is a modeling assumption, and one that is particularly dubious at the moment.
Fascinating February 27, 2009 at
Corporates trading through their sovereign in the CDS markets, from Zero Hedge:
(R.I.P. subprime, alt-A, negative am hybrid arms and all those other delightful mortgage market innovations.)
Over on Calculated Risk, Tanta discusses the behaviour of U.S. home owners given the availability of negative amortisation mortgages. (Essentially an option ARM had very low initial payments, so you could buy a large house with one of these even if you didn’t have a large income, then if the house went up in value, sell it before the low interest period ended. If it went down in value, you just defaulted and tried again with a different property. The negative am part is that the reason the interest payments were so low was that some interest was capitalised into the loan amount.
It was the policy makers who didn’t recognize rampant speculation in the housing market. While we joked about “liar loans” here on Calculated Risk, the policy makers were congratulating themselves on the “ownership society”. I’d argue home buyers who used no money down option ARMs were making a rational choice: they were balancing the odds of a big payday with little financial risk – if the property continued to appreciate – with the stigma of a foreclosure on their record. Obviously many home buyers felt the stigma was worth the risk. I see that as […] a rational choice given the circumstances.
Now this is interesting: undoubtedly some people did behave this way, but was it a common phenomenon? This is a little like the sovereign default problem I discussed earlier: sometimes it is rational to default. However, just as there nations are held back by the stigma of default, so I suspect many people don’t default when they rationally should. This is part of risk aversion, a flipside of the phenomenon whereby students don’t go to University despite the availability of deferrable student loans whose repayments are based on income: a risk neutral analysis indicates one course of action, but people are not often risk neutral.
From the Guardian: World Bank president Paul Wolfowitz denied that there was a row with Britain, despite the announcement earlier this week by Hilary Benn, the international development secretary, that Britain would withhold £50m of funding unless the Bank started to lend money to poor countries without onerous strings attached.
This rang an ominous bell as I have just been doing some work on country risk. The problem is that ‘open market’, ‘transparency’, ‘corruption’ and so on are relative terms: what they mean depends on where you are standing. On man’s big risk is another’s irrationally and delightfully high spread.
Hilary Benn apparently believes that Wolfowitz has been rather laxer with some countries whose friendship the U.S. values, like Pakistan, than others. I have no view on this, but I do know that however you decide to write sovereign loan covenants, if you are the World Bank someone is going to be upset with you. Perhaps the answer is to negociate with all of the potential borrowers simultaneously, so at least there is a standard hurdle for everyone? But of course if Benn is right, that is the last thing Wolfowitz would agree too. At least, though, let us agree it is a game where, rightly or wrongly, the guy with the money makes the rules. And of course those rules determine when sovereign default is rational. For Pakistan, it probably isn’t. Other states, treated differently, may have another view.