10/27/2011 @ 4:25PM |2,400 views
Why 'Voluntary' Haircuts On Greek Bonds Will Haunt Europe
Something seems a little off about the latest plan out of Europe, which features a 50% haircut for Greek bondholders.
A complete loss on Greek debt holdings was the other option offered to creditors by leaders like Germany’s Angela Merkel, so by agreeing to take 50 cents on the euro banks render the deal “voluntary.”
That one term carries a lot of weight, since it most likely means the haircuts will not trigger payment on credit default swaps (CDS) that investors purchased to hedge against nonpayment of Greek debt, and that may not be such a great thing.
Calling a 50% haircut “voluntary” may avoid a messy shakeout in Greece, but that relatively small bond market had a small amount of outstanding CDS and the development may have more worrisome implications in bigger bond markets like Italy.
“Risk departments are going to start to say – ‘if we can haircut Greece at 50% without triggering CDS we have to look at our models elsewhere,’” says Rich Tang, head of fixed-income sales at RBS Securities.
If lopping 50% off a bond does not trigger a payout, Tang says, “Who in their right mind is going to buy sovereign CDS protection as a hedge?” Such derivatives do not serve as much of a hedge if they will not protect against a 50% loss event. “Now the only proper hedge is selling,” he adds.
Setting aside the “voluntary” haircuts for a minute, the rest of Europe’s plan raises plenty of questions too. For one thing the planned strategy for recapitalizing banks has a major flaw even before you get to the fact that the ultimate backstop – a levered-up European Financial Stability Facility (EFSF) of about €1 trillion – has no concrete funding.
“The days of private capital coming to the rescue are over,” says Tang, and the Euro Summit plan calls for banks to tap private markets for capital first, followed by their own national governments and ultimately the EFSF. (See “EU’s Debt-Saving Eggs Are All In The EFSF Basket.”)
That private capital will not rush to pile into the European banking sector should not come as a major shock. For one thing, capital is scarce, and for another the scars of 2008 are still fresh. The investors who have capital to deploy are going to demand onerous terms – think Warren Buffett’s recent investment in Bank of America or his 2008 infusions into Goldman Sachs and General Electric.
“There is no more easy money to bail out banks,” Tang adds, “and investors are weary of trying to understand what’s under the hood” in terms of assets.
Too many deals struck on seemingly good terms during the last phase of the crisis – from BofA’s Countrywide buy, to Mitsubishi UFJ’s investment in Morgan Stanley, to David Bonderman’s TPG pumping billions into Washington Mutual just before its failure – for investors to be willing to give financial institutions the benefit of the doubt on their assets.
So considering all the holes still remaining in the grand European rescue, how do you explain Thursday’s surge in the market? And a surge it was, with the Dow Jones industrial average leaping 340 points to 12,209, the S&P 500 climbing 43 points to close above its 200-day moving average at 1,285 and the Nasdaq adding 88 points to 2,739.
Tang says the magnitude of Thursday’s move into risk assets – the euro also popped, jumping to $1.4188 – came as a bit of a surprise since the plan was “the worst-kept secret in the world.” Perhaps investors were encouraged by the fact that Wednesday’s marathon negotiating session of Europe’s leaders did not water down or sidetrack the details of the deal that had leaked out.
To Lionel Mellul, a partner at broker-dealer Momentum Trading Partners, attributes the pop to rally-chasing, as money managers leading the wrong way throughout a strong October finally felt the need to get on board. Thursday’s move, with no concrete details on the EFSF’s funding, “is not a conviction-based rally,” says Mellul, and he expects the market will continue to be marked by a high correlation both within and between asset classes. What could change that? A “strong commitment” from China, sovereign wealth funds in Asia, Brazil or elsewhere to provide funding for the EFSF, Mellul believes.