Tuesday, April 19, 2011
Just when we thought it was safe to Nancy around in the open rather than heading for the shelter it started raining fire. Shrapnal damage, but we are alive. Ratings agencies really are the scourge of the financial markets. You have to wonder how long it will be before they step just a little too hard on the wrong toes and befall some unfortunate "accident" in a public place that everyone denies witnessing. TMM think that Obama's playlist has a lot more "Hit 'em Up" by Tupac on it these days and that the IRS and latex glove wearing contingent of the TSA will be instructed to give extra special treatment to S&P employees.
The other great debate du jour has been "Greek Restructuring"...
TMM have been hearing a lot of noise about default and restructuring recently and have noted that when “default” comes up it seems to affect the market more than the word “restructuring”. Well, TMM are going to let you in on a little secret: there is absolutely no difference between the two. As soon as a corporate or nation is not paying the full principal, full coupon or paying them on time that is a default under the original indenture of any debt instrument that at a bare minimum specifies when you get paid, how much and in what currency. All restructurings are a default – they are just waived by the bondholders (or not, in some cases). So with that in mind, what matters in a restructuring? Restructuring is all an NPV game – you are basically reducing the NPV of the cash flows of a bond or loan by either extending out the maturity, reducing the coupon or reducing the principal.
TMM have played with the Greek 10 year here and its pretty easy to see that even in a serious haircut or coupon reduction the risk adjusted yield looks pretty interesting but note you can get the same all-in return on reduced coupons or principal or both.
In corporate restructurings debtors will often accept these terms but there is something else they can get their hands on – equity. The problem is that getting the equity of a country is pretty difficult though the French tried in the Ruhr which did not work out so well for them in the longer run. One suggestion that is very popular in the faculty club particularly amongst the likes of Robert Shiller is having some kind of GDP linked warrants – much like equity, if the restructuring works and the country recovers you get some upside. This has its merits but suffice to say when the warrants are linked to the GDP of the country and that GDP is recorded by the country its about as easy as collecting tax on swimming pools in Greece. So for now let's just assume this is not on the table.
So, when should a country restructure? There is plenty of literature on this and the likes of Nouriel Roubini (before he went tabloid) and Ken Rogoff is a good place to start. However, TMM think that two conditions have to be met to make a restructure worthwhile:
- You have an ungodly amount of debt. Depending on the pattern of savings in your country this could be <80% of GDP (Latin America in the 70s and 80s) or >200% of GDP as is the case of Japan. It all comes down to how long and how low people will lend to you – if you are a deflationary country where the savings all go back into bonds at ever lower yields then the game isn’t up until your private sector is a net borrower and the yields start widening (helllllloooo Mr Kan). If your borrowings are mostly offshore, in a different currency, come from foreigners and your economy is volatile the game is up whenever borrowers freak out, your economy weakens significantly and or your currency does (ask any friendly Latin American about the 70s and 80s where credit risk resembled being short a put on the CRB Index).
- You have exhausted all other options to increase GDP. The usual tricks here are weakening your currency (not an easy option if you have foreign currency debt issues), wages (never an easy sell – just ask the Greeks, Portuguese or Spanish now) or cutting rates (tough call when you don’t print your own currency and no one but your central bank wants to buy your debt). The usual way to get out of such a crisis is to let your currency go to hell – Asia did this during the financial crisis which led to a lot of immediate term pain but an incredible rebound in GDP as Southeast Asian countries became competitive again, particularly with China. Similarly, Iceland is doing OK now. These cases are ideal for GDP warrants since the bounce back is generally quick though transition costs are high – it’s a bit like Chapter 11 in the US but with rioting. Getting people to take a haircut on wages is never that easy and cutting rates is seldom doable in a crisis.
As you can probably work out by now the FX devaluation get out of jail free card is not available in Europe so what does one do when you want to default but don’t want to wipe out your local banking system? How, in effect, do you default without taking just about everything including the government with you?
First, if you don’t want a riot you ensure your local banking system can either a) take the hit, or b) sells its deposits to someone who can. Argentina’s devaluation and default wiped out people’s savings and wrecked havoc on the economy for years because of it. If you sell the deposits then people are materially less likely to burn down the central bank.
Second, you try to ensure that foreigners hold as much of your bonds as humanly possible because they do not vote and ultimately have little pull in the restructuring. Ultimately a country will have to come back to the market and if it runs a primary deficit then it has to do so almost immediately post restructuring – otherwise you end up printing money and going into a hyper-inflationary spiral. So, with that in mind you can either complete a restructuring with the consent of your borrowers who know that the next best option is watching the people burn your capital or, if you run a primary surplus you can do more or less as you wish – just remember that lenders have long memories, especially Elliott Associates.
Third, you don't default on supranational bodies like the EU and IMF or on bilateral loans. The reason being that these guys are the lenders of last resort and can block your access to capital markets, trade and even in the extreme cases, send a gunboat to make you pay. Iceland is currently perched upon this precipice with respect to its Icesave obligations, but given the unrealistically high debt level that is involved in this particular instance, TMM reckon that the UK & Netherlands will settle for 20c on the EUR or so.
Which brings us to the most important point. Generally, it is in no-one's interests for restructuring to be "involuntary", whereby creditors and debtors cannot agree on a restructuring, or the domestic political and social situation prevents such orderly restructuring. It screws your economy and it screws your access to financing. And it is just this sort of outcome that markets have particularly worried about because memories are scarred by Argentina's acrimonious involuntary default and before that, Russia's. The trouble with assuming that the headline "default" or "restructuring" implies and Argentina or Russia style outcome is that these are the utter worst case scenarios. Neither of those countries had a particularly good history of rule of law nor a particularly good history of economic management. That said, it is easy to label Club Med as not having particularly good economic management, but TMM would argue that the presence of the ECB has at least removed inflationary monetary policy from that sphere, even at the expense of not being able to devalue (this point, of course, is contentious).
Furthermore, neither of these countries was a member of the EU, a construct that already sees large fiscal transfers between its member states and a shared monetary policy, for better or worse. TMM reckon that this point is particularly important in ruling out the possibility of "involuntary restructuring". Private investors know that with IMF and EU oversight that reform programs will be enforced as best as they can, and the idea that the Zombies need to restructure is hardly a new one. For that reason, TMM argue that the only restructuring that will go on is the negotiated "voluntary" type in which Argentinean or Russian-like recovery rates are not in the picture. This ensures that financing continues without the "sudden stop" effects upon the economy that were seen in Argentina and Russia.
The far more likely shock is Ireland deciding that if Mangler wants to bail out Hypo and Deutsche, she can do it directly. Forcing Ireland to back its insolvent banks is ridiculous and it would be a lot easier to just sell the deposits to RBS, Deutsche, Santander or similar and de-lever the economy. While bondholders would squeal at this, it might be for the best – it is hard to see Irish land values rebounding when the country is saddled with debt and has to go through a fiscal consolidation materially worse than it would be otherwise. To that end, watch the Eurobanks – TMM considers the possibility of rude shocks to be far more likely in the bank senior debt market than the sovereign space.