Friday, April 15, 2011
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.
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...