Sovereign Debt

Summarizing The "Reasons" Behind The Latest Overnight Risk Melt Up

Greek riot resumption? Debunked European bailout rumor? Spain downgrade? Apple miss? Failed German Bund auction? Continued freezing in the interbank market? No, none of these are enough to dent risk appetite overnight, driven one again exclusively by the EURUSD, which has picked over 100 pips overnight. The driver? THe same old that always drives the EUR higher: hopes, rumors and hopes that the rumors are true. Here is Bloomberg with a summary of reality and the opposite, lately better known as "capital markets."

Deutsche Bank To The Rescue: "Will PrimeX Deliver The Next Big Short Miracle Many Of Us Missed In 2007?"

From Deutsche Bank: "The PrimeX indices have experienced a sharp decline since the beginning of October despite an 11% rally of the Standard & Poor’s 500 Index, the biggest two-week rally since 2009. The price drop can be viewed as a catch-up to the overall market selloffs following investors’ growing fear over the sovereign debt crisis in Europe, increasing likelihood of a global recession, and a weak US housing market. The Fitch’s report on the prime RMBS sector published on October 5 and a subsequent article by ZeroHedge on October 7 fueled the panic selloffs in the last few days, during which we have received far more inquiries about PrimeX than the combined inquiries about PrimeX and ABX over the last two years. It appears to us that many investors have suddenly turned their attention to the PrimeX. Investors from around the world have been wondering whether the PrimeX of 2011 will repeat the ABX miracle of 2007."

Moody's Downgrades Spain Two Notches To A1, Outlook Negative

Since placing the ratings under review in late July 2011, no credible resolution of the current sovereign debt crisis has emerged and it will in any event take time for confidence in the area's political cohesion and growth prospects to be fully restored.... Moody's is maintaining a negative outlook on Spain's rating to reflect the downside risks from a potential further escalation of the euro area crisis. The rating agency expects that the next government to emerge after Spain's parliamentary elections on 20 November will be strongly committed to continued fiscal consolidation. Spain's rating would face further downward pressure if this expectation did not materialise. On the other hand, the implementation of a decisive and credible medium-term fiscal and structural reform plan coupled with a convincing solution to the euro area crisis would trigger a return to a stable outlook. In Moody's view, Spain's sovereign rating is more adequately placed in the A rating category than the Aa category given the potential for contagion from further shocks and the domestic fragilities. Long-term economic strength -- a key input into Moody's sovereign methodology -- is no longer considered to be very high but only moderate given the expectation of a lengthy economic rebalancing process. Moody's also notes that most sovereign issuers with a Aa3 rating have much stronger fiscal and external positions than Spain, including very low public debt, sound public finances and a net creditor status vis-a-vis the rest of the world. This constellation renders them far less vulnerable to a confidence-driven funding crisis than Spain.

Guardian Report That Europe Has Agreed On EFSF-As-Insurance-Policy Sends EURUSD Surging

And here we go again. Wondering what caused the surge in the market? Nothing short of this latest rehash of all the previous rumors, this time focusing on the EFSF as an insurance policy, only this time with the added twist that Europe has agreed on implementation (of something which as analyzed previously just does not work). From the Guardian, (and please note the bolded word in the middle): "France and Germany have reached agreement to boost the eurozone's rescue fund to €2tn as part of a "comprehensive plan" to resolve the sovereign debt crisis that the eurozone summit should endorse this weekend, EU diplomats said. The growing confidence that a deal can be struck at this Sunday's crisis summit came amid signs of market pressure on France following the warning by ratings agency Moody's that it might review the country's coveted AAA rating because of the cost of bailing out its banks and other members of the eurozone. The leaders of France and Germany hope to agree a deal that will assuage market uncertainties or, worse, volatility in the run-up to the G20 summit in Cannes early next month. France would now have to pay more than a full percentage point – some 114 basis points – more than the price paid by Germany to borrow for 10 years as the gap between the two country's bond yields widened to their highest level since 1992." Said otherwise - this is simply the last ditch "plan" proposed by PIMCO parent Allianz to use the EFSF as a 20%-first loss insurance policy, which as we already demonstrated using arcane concepts such as mathematics, DOES NOT WORK. But hey, it is Groundhog Day all over again.

There Is No Bailout Spoon: The Math Behind The €2 Trillion EFSF Reveals A "Pea Shooter" Not A "Bazooka"

The latest and greatest plan to bail out Europe revolves around using the recently expanded and ratified €440 billion EFSF, and converting it into a "first loss" insurance policy (proposed by Pimco parent Allianz which itself may be in some serious need of shorting - the full analysis via Credit Sights shortly) in which the CDO would use its unfunded portion (net of already subscribed commitments) which amount to roughly €310 billion, and use this capital as a 20% "first-loss" off-balance sheet, contingent liability guarantee to co-invest alongside new capital in new Italian and Spanish bond issuance (where the problem is supposedly one of "liquidity" not "solvency"). In the process, the ECB remains as an arm-length entity which satisfies the Germans, as it purportedly means that the possibilty of rampant runaway inflation is eliminated as no actual bad debt would encumber the asset side of the ECB. A 20% first loss piece implies the total notional of the €310 billion in free capital can be leveraged to a total of €1.55 trillion. So far so good: after all, as noted Euro-supporter Willem Buiter points out in a just released piece titled "Can Sovereign Debt Insurance by the EFSF be the "Big Bazooka" that Saves the Euro?" there is only €900 billion in financing needs for the two countries until Q2 2013. As such the EFSF would take care of Europe's issues for at least 2 years, or so the thinking goes. There are two major problems with this math however, and Buiter makes them all too clear....Buiter's unpleasant, for Allianz, Merkel and Sarkozy conclusion is that "that would likely not fund the Spanish and Italian sovereigns until the end of 2012. It would not be a big bazooka but a small pea shooter."

S&P Downgrades Over 20 Italian Banks, Says Difficult Climate Is Neither "Transitory" Nor "Easily Reversed"

Another day, another pervasive downgrade action by S&P. "In our opinion, renewed market tensions in the eurozone's periphery, particularly in Italy, and dimming growth prospects have led to further deterioration in the operating environment for Italian banks. We also think the cost of funding for Italian banks will increase noticeably because of higher yields on Italian sovereign debt. Furthermore, we expect the higher funding costs for both banks and corporates to result in tighter credit conditions and weaker economic activity in the short-to-medium term. We do not believe that this difficult operating climate is transitory or that it will be easily reversed. In our view, funding costs for Italian banks and corporates will remain noticeably higher than those in other eurozone countries unless the Italian government implements workable growth-enhancing measures and achieves a faster reduction in the public sector debt burden. Consequently, we envisage a situation where the Italian banks may well be operating with a competitive disadvantage versus their peers in other eurozone countries. At the same time, we think all banking systems across the eurozone, including Italy, may raise their commitment to reinforcing banks' capitalization."

Because The Financial Short Ban Was Not Enough, Europe To Proceed With CDS Short Selling Ban Imminently, Accelerate Terminal Unwind

Just because Europe did not learn any lessons with the financial shorting ban which made everything much worse, here comes this...


This means that cash Sovereign bonds are about to go bye bye as the only recourse will be to short the living daylights in good old-fashioned govvies. And so we move one step closer to the final unwind courtesy of idiot European bureaucrats who are handing free money on a silver platter to the skeptics...

A Morning Rant - EFSF, Enron, AIG, CDS Clearing

We are still waiting to see the final form of the "Grand Plan" and what novel ways the EFSF guarantees will be applied to save the day. At the risk of sounding incredibly stupid, I have this feeling that Europe didn't actually work on any details until this past week, and Germany is suddenly realizing how bad the details are for them. Is it possible that some politicians got so caught in the moment of "saving Europe" and "fighting the speculators" that they kept promising more and more, without thinking whether they could or should deliver? You would like to think they didn't, but since none of the politicians are detail oriented, most of their contacts at investment banks are high level, former bankers, rather than traders, it is quite possible they didn't realize what they had agreed to. If some new EFSF is created, all of the future bargaining power in Europe will be shifted from France and Germany to PIIS. (it is a shame Ireland wasn't named Shamrock, it would make the acronym so much better).

Here Is Why The Futures Are Down

No surprises this time in the overnight sessions with treasuries higher into the New York open as Moody’s signaled France’s Aaa rating is at risk and China’s economy grew at the slowest pace in two years, both events reported previously and still occupying the market. Futures are down solidly ahead of Bank of America (which Bloomberg has been caught doing some big shennanigans - see below) and Goldman. More on why numbers on our screen are red, aside from the horrible Crocs guidance of course, is below, courtesy of Bloomberg.

Naked In Europe

So Europe is getting closer to announcing some form of ban on naked CDS. What they hope it will accomplish and what it will actually accomplish are two very different things. so what do they hope to get by banning naked shorts? They expect CDS to tighten. That will likely be the initial reaction. They expect a tightening in CDS to lead to improved purchases for bonds. That is unlikely to occur. Let's take a close look at Italy to show why their expectations are likely to be disappointed. First, it is important to remember that CDS on Italy trades in $'s and their bonds are denominated in Euros. That is a key difference. If you buy (or sell) CDS on Italy, the flows are in $'s. So as Italy widens you make money on the CDS. You would also make money being short Italy in the bond market. If the correlation between Italy widening, and Euro weakening is high, the CDS is a better way to be short. This creates a basis that is far more complex than a straightforward CDS where the CDS is denominated in the same currency as the underlying bonds. Unintended Consequences seems to have taken on a new meaning.  Unintended consequences means to me, that a lot of thought went into the consequences and the end result surprised.  I no longer believe that significant thought goes into the potential consequences.  The analysts see what they want and get tunnel vision on the series of consequences they want to see, rather than really trying to figure out what might happen.  Europe is not only behind the curve, they act like they are playing checkers with a 4 year old, when the markets are a game of chess, and they should be seriously analyzing the moves and countermoves that can occur before determining their next move.  They also have to remember the risk side.  So much focus is on the possible benefits of a “Grand Plan” that no resources are being devoted to what happens if that plan fails.  Maybe they should strive for less potential upside to the plan in order to sure that this isn’t the last plan they can try.

Daily US Opening News And Market Re-Cap: October 17

Appetite for risk was observed during the Asian and European sessions on enhanced prospects that the eight-day deadline given by the G-20 leaders to resolve an ongoing Eurozone debt crisis would bring some positive outcome before the EU leaders' summit on October 23rd. Nikkei (+1.41%) closed higher and European equities also received a boost, with financials as one of the better performing sectors, which was further helped by comments from Moody's that accelerating talks to recapitalise European banks are credit positive for the banks. News that China has offered to spend tens of billions buying European infrastructure projects and government debts strengthened the appetite for risk. However, later in the European session, comments from the German finance minister and a German government spokesman that a concrete solution for the Eurozone crisis couldn't be found by the EU summit dented risk-appetite. In the forex market, after trading lower during early European trade, the USD-Index ventured in positive territory, which in turn weighed upon EUR/USD, GBP/USD and commodity-linked currencies, however GBP did receive support following a sharp jump in the Rightmove House Prices from the UK overnight. In other news, CHF received a boost across the board following market talk that SNB's president Hildebrand may resign, whereas CAD received support on news that the Canadian finance minister and the Bank of Canada governor may go beyond inflation-beating monetary policy measures. Moving into the North American open, markets will look ahead to key economic data from the US in the form of Empire manufacturing, industrial production and capacity utilisation.

Any Greek Restructuring Should Be Designed To Trigger A Credit Event

As talk about an actual restructuring of Greek debt increases, the EU continues to think avoiding a CDS Credit Event is a good thing. More and more stories and leaks indicate that a real restructuring of Greek debt is on the table, with write-offs of as much as 50%. Whether it will be real, permanent reductions in principle this time, or some other form of principle protected rollover with a subjective NPV calculation like the 21% haircut, remains to be seen. In any case, the EU continues to head down the path of bending over backwards to avoid trigger a CDS Credit Event. They are wrong to be avoiding a Credit Event on the Hellenic Republic. If they are really pushing for a true restructuring where banks and insurance companies are for all intents and purposes forced to accept a big haircut, they should want to trigger a CDS Credit Event. They are allegedly avoiding a credit event because it “could unleash a cascade of losses” according to a bloomberg article. That just makes no sense. It also seems that pride plays a role as the EU doesn’t want to be impacted by the stigma of a default – a 50% write-off is even, but they don’t want to be called defaulters. That is plain silly. They also seem to want to punish speculators, and this is where they really have it wrong, not only are few hedge funds short Greece via CDS at this time, the problems this creates for bank risk management desks is big and will have long term negative consequences for sovereign debt demand.