To Forgive is Divine

By Marc Chandler

Markets rallied strongly in response to the European developments. Yet it is an exaggeration to think that risk appetites returned as the whole month of October has seen equities, emerging markets, commodities and foreign currencies trend higher, recovering from their neck-breaking, wealth-destroying plunge in September. Still the advance on Thursday was impressive, helping propel the euro and the S&P 500 through the 200-day moving average, allowing sterling to test its similar moving average and pushed the dollar to yet another marginal new record low against the Japanese yen.

We think the market is getting ahead of itself, but the technical momentum and positioning may allow for an extension of the move. Medium term investors may need to be patient, but the fundamentals will likely reassert themselves shortly.

This is to say we do not think the European agreement ends the debt crisis and there will be the need for an other emergency summit in the not-to-distant future. Exaggerated growth forecasts and inflated privatization revenue projections will require additional adjustments going forward. The agreements in principle still needs the details to be worked out, but the broad outline is less than the shock and awe that would rebuild the lost credibility. At least twice earlier this year, European officials said they would present a comprehensive solution and finally put some closure on the debt crisis. At least twice this year they have failed and we are not confident that the third time is a charm.

The 50% haircut to private sector Greek bond holders is unlikely to be the last. Even by their own admission, the Greece’s debt to GDP will be 120% in 2020. That is twice the Stability and Growth pact cap of 60%. That is simply not a sustainable solution.

Ironically the ECB purchases of Greek bonds and its refusal to accept a haircut means that the private sector has to take a bigger haircut to reduce Greece’s overall debt burden. The market does not know how much Greek bonds the ECB owns. The guesstimate 70-75 bln euros. That is roughly 20% of Greece debt that will not be lowered. It is as if the Federal Reserve carried it Maiden Lane assets at face value not market value.

There is approximately another 20% of Greece’s debt that is not covered by the scheme. That means that the burden falls to the other 60%. One of the larger holders with about 20% of Greek debt are the pensions. Greek pensions, which are thought to largely invested in governments bonds, are going to be halved of nearly so.

The Greek government, the only aid receiving euro zone country, that has not collapsed, is weak and vulnerable. Halving pensions may topple the government, especially if the finance minister and opposition leaders seek a super-majority (180 votes in the 300-seat chamber, while the government has barely secured a simply majority in recent months).

The other two main components of the broad agreement also appear to be smaller than what will ultimately be needed. First, it is not clear yet precisely how the EFSF will be leveraged to 1 trillion euros, but the amount of real capital it has remains limited and leverage implies risk that must be borne by someone, and we have seen how the ECB is reluctant to accept the consequences of it buying distressed assets. It is as if the Federal Reserve carried it Maiden Lane assets at face value not market value.

Second, European officials maintain that European banks need to raise only about 105 bln euros to reach the 9% Tier 1 capital ratio by the middle of 2012. Nearly ever other authoritative estimate, including the IMF’s, is for substantially more.

Another irony is despite the opposition to "too big to fail", European officials do not want banks to sell off assets to reduce their capital needs. There has been talk in the market in recent days that attributed part of the euro’s advance to European banks selling dollar assets to reduce their balance sheets and reduce their dollar funding needs, especially given the actions by US money markets to reduce exposures and/or tenors to European banks. Some banks, especially French banks, have replaced part of the funding that was provided by US money markets with borrowings from the ECB.

Another irony is by playing loose with the "voluntary" nature of haircut, they may have undermined the credit default swaps market, and contrary to its intent and interest, and will make it even more of a speculative market, even if they can effectively ban naked positions. ISDA says that the voluntaristic aspect is sufficient to prevent it from triggering the CDS. Therefore hedge/insurance function of the CDS market is questionable at best.

While undermining the legitimate function of the CDS market, there might be something to learn from the gaming of the haircut/default distinction. A voluntary haircut is nothing more than debt forgiveness. Banks, insurance companies, pension funds lent money to the Greek government. Recognizing Greece cannot pay it all back, they have said they will forgive half of the debt. While entirely self-serving, as mark-to-market would require even deeper losses, and there is the implicit and explicit threat of a hard restructuring, the forgiveness is noble.

Many investors/creditors scoff at the "voluntary" participation, but perhaps they would be better served by take the lesson of forgiveness to heart. Forgiveness of some part of the principle of US mortgages that are under water would go along way toward addressing the debt overhang of US households. With the help of creative officials, holders of US mortgages, including of course Fannie and Freddie, can help create incentives where forgiveness of part of the principle is in their interest.

The European agreement appears to be an attempt to remove Greece as a lightening rod and build a firewall around Spain and Italy. Ireland is regarded as having turned a corner and even the IMF thinks it will be able to return to the capital markets late next year or early 2013. What about Portugal? Why should investors not be asked to forgive it too, not completely of course, but partially?

The twisted logic and perverse incentives are clear. If a country succeeds implementing the necessary reforms to put it on a sustain fiscal path, it will be able to service its debt and not require forgiveness. If a country succeeds it does not need forgiveness and labors under its debt burden.

The model of this is not so much a prisoner’s dilemma, but a poker game. The one who loses the most in a poker game is not the worst hand. It drops out early. Rather it is the second best hand that loses the most. A country that implements tough austerity may have to pay back its entire debt while a country that does not implement the austerity with the same, can we say, enthusiasm, will see half their debt disappear.

It is not clear what will be the catalyst for the fundamental skepticism of Europe’s latest efforts to re-emerge as the key driver. It may be a reminder that the real challenge for Europe is to sustain growth in the face of austerity (like the real challenge in the US is sustain demand despite poor wealth and income growth and de-leveraging). This may come in the form of the ISM reports that point to an economic contraction in the euro zone.

It may come from countries revising down 2012 growth forecasts that may require greater austerity to meet budget target. France will soon officially recognize that growth next year, for example, will not be 1.7% next year but closer to 1%. This will require another 6-8 bln euros in budget saving measures. It may come in from a political shock, with Italy and Greece being the more likely candidates.