Friday, April 15, 2011

Pricing Zombie Nations

Equation of the day:
PIIGS = IS + Zombies

We suggested yesterday that as the European periphery succumb to bailouts and aid packages they effectively become the financial equivalent of Zombies. The living dead, slowly decomposing but threatening the living with their bite. The Zombie Nations.

Each nation is drawing up plans to battle its Zombie status and TMM are now in a position to share what their insiders have gleaned as to how things are progressing.

Greece's working paper can be found here, Portugal's here, and Ireland's here.

Now TMM have been short of barge-poles for a while and so were intrigued to notice that barge-pole sales have collapsed as investors have declared that they wouldn't touch Zombie Nation debt even with a bargepole. Intrigued, TMM thought they would have a closer look at this Zombie Nation debt to see if it really is as toxic as a bottle of "Fukushima Spring" or whether there may be something worth salvaging.

Now, much of this stuff has been covered elsewhere, but TMM still get the impression, given the rumours flying around the past day with respect to Greek or Irish restructuring, that - outside of the credit market - many market participants have not actually done their homework when it comes to working out roughly what is priced into Zombie Nation bonds. So in the interests of shining some light on the them, TMM have dusted off their bond pricing spreadsheets.

So the first task is to work out what a cured Zombie would trade at as a spread to Bunds. TMM reckon that any IMF/EU-negotiated voluntary restructuring would aim to put the Zombies on a fiscally solvent and sustainable path, but not necessarily one that is Maastricht compliant and, as such, TMM reckon that broadly, these spreads to Bunds are likely to be roughly in the region of where Italy trades (currently 130bps). Additionally, idiosyncratic factors such as prior fiscal responsibility (in the case of Ireland), and making up the numbers (in the case of Greece) will likely lead to specific tiering. In 1999, Greece traded at an average of about 190bps at a time when it was generally uncertain that they would meet the Maastricht criteria to enter the Euroarea, and applying TMM's MDI (Moist Digit Indicator) to add an additional 30bps of risk premia, reckon that a "clean" Greece would trade at about 220bps above Bunds. TMM only have data on Portugal going back to 1997, a time at which Portugal traded about 125bps over Bunds. Given the structural weaknesses in Portugal's economy ( similar to Southern Italy), TMM's MDI reckons 150bps is probably the right number for a "clean" Portugal. Lastly, Ireland's past fiscal prudence and flexible labour market in the context of a 1990s average spread to Bunds off 105bps make TMM's MDI think that a "clean" Ireland should trade roughly flat to Italy, at about 130bps.

TMM recognise that this is all very subjective, but at least will be the right sort of order of magnitude.

So what is priced in?

First, Greece... The below chart shows the implied loss-adjusted spread to Bunds (y-axis) given an assumed haircut (y-axis) and time to default (z-axis). Eyeballing the chart, were Greece to immediately restructure, in order for the loss-adjusted yields on its bonds to be high enough to meet TMM's 230bps spread to Bunds, the haircut would need to be about 40% or less. Obviously this number creeps up the longer the default is delayed. TMM's base case is that Greece restructures with a haircut of 45% when the EFSF expires in 2013 and should that scenario play out, TMM's model reckons that 10yr Greece is adequately priced, offering a loss-adjusted yield of around 5.6% and around the 220bps to Bunds they reckon is appropriate. Not bad, and certainly worth a punt.

Ireland's underlying fiscal position is nothing like Greece's, and TMM reckon that in any case, should push come to shove, that the Irish Government will spin out the depository assets of its remaining banks to Santander or RBS or whoever, and allow bank senior creditors to wear their share of the burden (and this is something TMM feel very strongly that the Irish should do). In any case, TMM reckon an Irish restructuring in a year's time of about 30% is the most likely of restructuring scenarios, and one that would provide a loss-adjusted spread to Bunds of about 135bps which, again, is about where TMM reckon a "clean" Ireland should trade. Also worth a punt (or rather, a Pund).

Finally, Portugal... again, the problem here is less out of control fiscal policy and made up numbers (in the case of Greece) or banking-related problems (as with Ireland), but low trend growth and structural rigidities. TMM assume that the IMF and EU will continue to pressure Portugal to reform, but they don't have a central view as to if/when/how Portugal will restructure. But for the sake of comparison, a restructuring of 30% occurring upon EFSF expiry would leave 10yr Portugal trading at just 104bps above Bunds, which is too low given TMM's view of a "clean" Portugal trading at about 150bps over...

So there it is... eyeballing the charts, TMM reckon that Ireland and Greece price in some pretty severe restructuring scenarios, while Portugal is well on its way to doing so too. It's also worth pointing out that owning this stuff here gives you the wildcard option that restructuring is less aggressive than those scenarios or even that they manage to pull things off without restructuring...

Either way, there may just be a Dawn for the Dead:

8 comments:

Right Field said...

Read Throughs are Deteriorating…Risks Off Mindset For Me ---- The backtracking in Fed inflation rhetoric by noted hawks yesterday continues to be a clear talking point. The article in the Financial Times today about how the Fed distances itself from commodity prices and the weaker than expected US CPI data just now is a continuation of this new potential theme. The key for this step-change to have further legs though is at 1:30 today when Hoenig speaks, while not a voting member he holds the most symbology due to being the most hawkish of all members. Point being, any softening in his stance will be a viewed as significant and while the short covering in UST (mainly 5’s and 10’s) is already far along, this type of event would argue new longs and duration would need to be expressed.

Financials are down six days in a row, arguing a counter-trend today is just fine but ask yourself who has the new SEC mortgage settlement modeled for next week. Using the recent 550mm settlement with a noted firm on a noted CDO transaction, what if a series of banks are hit with something even close to that? This sector crushed the soul for many this week in my opinion and next week is now a black box. Crude Oil weak, China tightening, Europe sovereign creating some weekend noise, etc. are just incremental negatives for today…

While the sampling is small thus far, the earnings releases highlight that the quality of the earnings is not strong enough to show economic gain and is tilted towards not being able to show resiliency. Point being, with top down growth expectations continuing to be downgraded, earnings need to forecast something other than future instability. INFY is a 40 bln market cap and down -10% pre-market, GOOG -5% and we heard from JPM, BAC and AA. Beating an analyst estimate is not enough and another week of these types of releases and the micro expectations and analysts reports could start to mirror the top down downgrades.

Anonymous said...

Yes,the markets given a pretty harsh thumbsdown to earnings at this early point and that tax data release I posted the other day seems to suggest the disappointments won't stop here.
Appears to me we are at that point where the analysts projections have outstripped the pace of this economic recovery. That doesn't actually make me Mr Uberbear ,but it does make me think that equity needs to spend at least enough time consolidating that earnings and recovery can play catchup. Of course the market is s..te at waiting is it not?
On balance this looks to me to be a soft patch perhaps through to the autumn months and wait for it how about a regrouped rally Oct to March by which time the US housing market might actually look start to give rise to some hope of recovering volumes.
Certainly after nearly 2 years going up looking for 6 months to consolidate gains doesn't appear to me to be unlikely.I see that rather than new rally highs increasing valuations to even more unachievable levels.

Anonymous said...

Loving the zombie theme, but you know how the saying goes: nil nisi bonum and all that ;)

LB said...

Hmm... some cogently expressed thoughts, but despite how reasonable they appear, we are going to take issue with each one of them. Perhaps one might beg to differ, anon?

"On balance this looks to me to be a soft patch perhaps through to the autumn months"

In terms of the economy, probably correct, let's be clear about the fact that the economy and the market are often quite different entities, and respond to different variables.

" and wait for it how about a regrouped rally Oct to March "

Possible, of course, but that is out there in the most completely impossible to predict time-frame in terms of the market, b/c of the likelihood of CB interventions and the hand signals that normally precede same. We may be in recession by Q4 with rising U3 and U6, but who knows what that might trigger?

"by which time the US housing market might actually look start to give rise to some hope of recovering volumes."

I have no idea where you get this from, really. Extremely unlikely that we see recovering volumes in the Fall, unless the Government gives clear indications that the banks are to hold a fire sale so that the market can clear its vast stocks of still highly over-priced inventory. This sales season already seems to be DOA in many parts of the country and this may continue for several years until the US govt. decides to promote price discovery. Based on recent history this seems unlikely.

"Certainly after nearly 2 years going up looking for 6 months to consolidate gains doesn't appear to me to be unlikely."

A 6 month sideways grind seems extraordinarily unlikely, although a one month grind during earnings is possible. Remember the Street gets paid by volatility, not stability and heaven knows there are enough volatility catalysts (and Pink Flamingoes) out there.

"I see that rather than new rally highs increasing valuations to even more unachievable levels."

Given that (a) the Fed is still injecting liquidity via the Qe2 program, and (b) interest rates are still historically low, then new highs with astronomical valuations followed by a bumpy landing this summer is exactly what I can visualize. Short-term we may see some weakness, but many here have pointed out the very strong support levels at SPX 1295 and SPX 1250 that would trigger increasing volume.

Anonymous said...

LB

"Short-term we may see some weakness"

"then new highs with astronomical valuations followed by a bumpy landing this summer "

Yours above.

"Possible, of course, but that is out there in the most completely impossible to predict time-frame"

Your comments on my 'predictions'

Spot the difference?
No,because there isn't one.We're both full of shit really,are we not?

Really what I was saying is this. I would expect the entire property enviroment to be better in it's seasonally strong Market SPRING 2012 compared to 2011 and i would expect the Oct-Mar equity bias to anticipate that and expect that to give next years earnings a boost compared to the one's being released right now which look sufficiently mushy to call for an extended soft spot in trading pending the above.In terms of half yearlies this is not the strongest half for equities.Within that context earnings are lagging recovery.
Really that's it.Accept the Fed is still out there cheerleading ,but most of the QE2 is already in the market anyway so I suspect a market becoming more of a two way bet for the next half year doesn't look unlikely to me as perhaps we see a few more people willing to get short in this 'weak' season.There's not been much of that for awhile ,I suspect because of the Fed.

Charles said...

Your reasoning is impeccable but it looks like you get your recoveries by simply haircutting the debt to the Maastricht 60%. The problem is that the "Zombie Nations" still cannot produce a current account surplus after that. Their industries are still not competitive because of unfavorable product mix and cost rigidity. You would need a, say, 40% haircut on ALL domestic debts AND production prices(especially salaries) to achieve a competitive advantage. This is what is achieved in a currency devaluation (like in Asia in 1998). If the adjustment variable is only government debt, with all other debts, especially mortgages, made whole by domestic debtors, the haircut necessary for debt sustainability could be much higher.


This being said, it may not be a straight line to the bottom, so why not playing a temporary post restructuring rebound...

CurmudgeonlyTroll said...

I just want to know what you use to do those awesome charts!

Anonymous said...

Good old excel (2007 onwards)