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Pricing the EU WI bonds
It appears we are getting a Monoline to solve the problems in the EU. For the life of me I can’t figure how this will work, but we are about to find out. There are no details on this as yet, just planted rumors.
The talk is that EU sovereign debt to be issued in the future would have the benefit of an insurance guaranty that covers the first 20% in the event of default. This guaranty would be backstopped by the EFSF.
The thinking is that a new bonds issued by Spain, Portugal, Ireland, Italy (and presumably Belgium but not Greece) with the guaranty would be widely perceived as a money good investment. As a result, huge amounts of capital could be raised in the global bond markets under very attractive terms (total = Euro 2+ trillion). Funding costs for the PIIBS would plummet as a result. With the debt market stabilized, economic prosperity would soon follow. I say "rubbish".
The enhanced bonds would be “Story” bonds. In my experience story bonds have a very limited investor interest. I have no doubt that ten of billions of these bonds could be sold, but Trillions?
The USA Treasury market is the most liquid in the world. The total public float (excludes Fed and Intergovernmental) is about 9 trillion. The proposal is that an amount equal to 1/3 of the US public float of new EU enhanced bonds are issued in just a few years. IMHO that will never happen.
The global bond markets will have to figure out how to price this new debt. I’ve been pondering this for days. I can’t come up with a pricing structure that works.
Consider a newly issued ten-year Italian sovereign bond that has a 20% first loss guaranty by the EFSF. Assume that the German ten-year was 2% and Italian at 5% (about where we are today). You tell me, how is that new bond going to trade based on this?
This is not equivalent to 20% German risk and 80% Italian. That would be far too easy. But if the market were to trade it as an 80/20 it would imply that the new Italian Enhanced Bond (“IEB”) would yield about 4.4%. This would mean that the IEB/German spread would be 240bp while older Italian debt had a spread of 300bp. If that were the result, it would be a disaster.
While 60bp is a big deal, it would do nothing to stabilize Italy’s long-term debt cost. For a new program to work, it would have to drive the IIB/German spread to 100bp.
In order to evaluate the 80% Italian risk and price it properly one must first make an assumption as to the probability of an Italian default over the next ten years. One must also make some assumptions regarding what losses might be incurred should there be a default.
Folks, those are very complex questions to answer. I’ll give it a shot.
Probability of Italian default over ten years = 20%
Probability for loss > 20% in the event of default =100%.
While I think that Italian default risk is relatively low, I believe that should it happen, the net haircut would be substantially above the 20% first loss protection. A country like Italy would not go through the pain of a default to achieve a 19% debt reduction. If push comes to shove and Italy decides it is best to default, the haircut would be in the 50% range (a la Greece).
Any investor who looks at the new bonds and concludes that they’re money good is just nuts. That will not happen.
My conclusion is that the new enhanced debt has to trade cheap. There is a massive amount of this story paper coming our way. That mountain of supply has to mean the bonds have to have a high yield. If one wanted a litmus test for this I would ask the Swiss National Bank. They have E200b in reserves. I bet they would not put a dime into these new securities. Neither would Singapore, Venezuela, Kuwait, Hong Kong or Saudi Arabia.
It’s quite possible that the new paper does very little for Italy. If that were the result for Italy (a relatively strong borrower) it would be the kiss of death for the weaker ones like Spain and Ireland.
What I find fascinating about this is that the deep thinkers in the EU are relying on the global bond market to price the new securities in a way that would produce the desired results. The deciders are going to trust Goldie, Citi and good old JP to price this swill on the rich side? Not a chance in the world.
After four agonizing years the inescapable conclusion is that complex derivative securities were at the heart of our problem (they hide risk). The response by the EU is to give us the largest derivative transaction that has ever been created. Talk about a sign of weakness.
The most amazing thing is that the global markets are lapping this up. Any confirmation (the silly Guardian story) that the Mega Monoline is in our future is a cause for celebration.
Wait and see how these new bonds trade. I think they will trade on the cheap. If I’m right, then you can kiss off the possibility of an EU soft landing.
If the markets give the new bonds a thumbs down it will be the final act in the story. There’s an "event risk” to look forward to.
Note: The only way the new enhanced bonds can trade rich is if the ECB stands ready to buy them such that the spreads are very narrow to German paper. I see a very small chance that this would happen. But if they did step up, the markets would see through the charade in a NY minute. The lights would start to go out shortly after they started buying.
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Sounds like a dreaded 'race to the bottom.'
Or a euro sock hop ...
Rosie said it better than I....how can more debt get them out of debt? This is a stroken mess. These countries are living in a dream that is beyond comprehension. And markets, FX and comm's are trading off this, well more dreamng!
Big melt up in 3...2...1...
aaaaand Rosy's wrong again.
what exactly is rosie wrong about this time? or are you just making shit up to sound like you know what you're talking about?
Have no fear Bruce, Ben and Tim will guaratee the bond auction...Fed will buy that garbage hand over fist to ensure the auction goes just fine... I love zh but it occured to me that all the articles here have such great gravitas because they point out how the rumors, earnings and plans break the rules of finance, politics and mathematics...reality is however, THERE ARE NO MORE RULES...lying is okay in the name of doing whatever is necessary to avoid a depression. Burning up your brain cells on trying to rationalize anything right now is a waste of time. Between the BOJ, ECB, Fed and China, almost anything can be SAID to be guaranteed and that is all the markets care about.
Problem is that still isn't working ... it's just a temporary holding mechanism in an evolving debt-deflation collapse process. This is a still unfolding depression ... and it has barely begun.
The realistic US unemployment is closer to 18.5% and that is 2/3rds of the way to the 1930s peak and there is zero indication it'll reduce any time soon, and a lot to suggest a major (worse) double-dip is pending, with it's new surge in UE and BK.
Buying recycled paper crap 'assets' and telling endless lies isn't working ... never will, it has no basis for success ... this is obvious except to paulkrugites ... and the 99% know this is really the process of delaying the loss of the state's lie-support apparatus and the overthrow of the mouse-clicker-in-chief over at the Fed/defacto-Treasury.
zh's "great gravitas" and bottomless pit of disgust are appropriate and necessary ... it's the broke and unemployed that matter, not some sham ponzi market ... all this pseudo-'investment' lie-talk distracts from this simple in-your-face human reality. The rage will be maintained.
At this stage in the political process, if Ben and the cheat buy this garbage, they will be removed from office and very possibly prosecuted. Major Depressions destroy figures on the wrong side of popular opinion.
Everything is explained (or not, as the case may be) here Bruce:
There Is No Bailout Spoon: The Math Behind The €2 Trillion EFSF Reveals A "Pea Shooter" Not A "Bazooka"
Tyler,
has the Fed released a schedule for the 400 billion in POMO as well as their proposed reverse POMOs? If so where is that information? Thanks in advance.
I read that when it came out. It was part of the reason for posting this. Look at the complexity of the issues you described. How can markets price this at low spreads?
My question to you:
Today Sov Germany/Italy 10 years is +300.
How would you price a WI Italian 10 yr with a 20% Monoline 1st guaranty?
If you say 300 we are dead.
If you say 200 we are in big trouble.
If you say 100 I have $2 trillion of bonds to sell you.
b
Hmmm ...
The US issues US bonds: America has its problems but it's still America w/ hotdogs and baseball ... and F16s. America -- and cluster bomblets -- is 'inside' all the US bonds.
What's an 'EFSF'? Does it have its own game? Is there a 'Hollywood' with hookers inside the EFSF? (Don't answer that question.)
These are 'Unicorn bonds' that don't have a price. They work by magic and if you don't believe you just don't understand.
Who knows, the entire scheme will probably be abandoned for something else equally hair-brained by Monday: Rumpelstiltskin bonds.
...
All concerned:
Seriously, as a veteran of the collateralization business, most specificially CBO, CDO, CLO, CwhateverthefuckO they call them at the Mo-ment-O's, there are some very basic fundamentals. At least which have (supposedly) been heretofore adhered to.
In order to get a rating (again by the "usual suspects" under "usual circumsatnces") there needs be an equity layer in the deal... first loss so to speak. No matter what it is called, dressed as, termed, sold as, posed.... there is one.
And guess whose putting in the equity layer? The same institutions whose debts are/have been becoming questionable.
Hmmmmm
Hmmmmm, indeed. (Where were you on the night of...?)
The equity is used to support a series of tranches which as one proceeds UP the heirarchy (priority of payments in reverse) of ratings, ultimately usually rests with a senior (secured, whateverelse some dingaling geek at the ratings agencies ((note plural*)) calls it) piece with a very high as in attractive to buy rating.
"maybe" just as attractive BTW, as the MBS deals that were rated and sold? Oh... you're getting the picture:).
Now, if the paper backstopped by this pool of borrowed money, since Gubamint's have no equity and all comes from the tax paying peasantry, or by further debt issuance (WTF?) there is no way under the sun that....
The first losses on the sovereign paper backstopped by the WahtevritisO will not first wipe out deal's said equity layer, causing said deal to terminate (wth prejudice).
Unless said rules to game are changed and the Charades becomes even more Charadier.
Moreover, its gonna be by and large, the same folks buying the deal's debt issuance who already hold the questionable paper.
So lemme tell ya'll sumptin'... and I really don't mean to be a Killjoy...
The reason nobody can figure thiis shit out is that it ain't gonna work.
Can't take all shit, rewrap it with more shit from the same shitty shits and expect after the shitty shits buy back their own shit that's still isn't simply no longer shitty.
I tried.
* PS. This like most of the other structured deals will probably need to be rated by more than one agency... so the further the structureal terms are pushed, the harder it gets. And believe me anything Quite Innovative will be difficult to pass more than one agency. Like solving a Venn Diagriam with a whole buncha circles... the solution set gets real small.
That was a truly great moment in financial journalism.
"Can't take all the shit, rewrap it with more shit from the same shitty shits and expect after the shitty shits buy back their own shit that's still isn't simply no longer shitty."
Knuckles, I know you're not an economist because that made entirely too much sense
>the solution set gets real small.
That post was a thing of beauty. There are only two solutions where the numbers actually work. One, Euro-bonds which will require a fiscal union where seventeen countries vote to give up their sovereignty (when Hell freezes over and I'm quite sure they don't have that long). Two, some type of EU break-up. Anything else you hear is bullshit non-sense.
+1... I Learned Something
Thanks for the detailed lecture on the intricacies of the shity shit market, Professor knukles...
Yep, playing with paper and matches always leads to a fire sale, period. Have physical assets or a business that many people depend on for survival. eventually compensation alwasy finds its way back to people and countries that are worth a shit.
Well either that or war.
Damn hard divesting of all paper, sort of straddling many paper and physical markets right now.
"Have....a business that many people depend on for survival"
sell SNAP cards?
Markets? There are no longer any markets, only Rube Goldbergesque-like facades of markets. As for the idea of pricing, why, they simply won't tell once the absurdity is obvious, or they'll lie, or both.
Is that a picture of a young Angela?
(I know, she has a PhD in Physics ... and that explains things)
as the complexity increases geometrically, the risk increases expentionally.
http://expose2.wordpress.com
That´s Pippi Longstocking - the strongest girl in the world.
From Wiki:
Eight-year-old Pippi is unconventional, assertive, and has superhuman strength, being able to lift her horse one-handed without difficulty. She frequently mocks and dupes adults she encounters, an attitude likely to appeal to young readers; however, Pippi usually reserves her worst behavior for the most pompous and condescending of adults. She turns white around the nose whenever she gets angry, though this rarely happens. Pippi's anger is reserved for the most extreme cases, such as when a man ill-treats his horse. Like Peter Pan, Pippi does not want to grow up.
Pippi does not want to grow up.
///////////////////////////////////////////////
Who wants to become a US citizen when a child?
http://i.telegraph.co.uk/multimedia/archive/01842/merkel-bull_1842500i.jpg
Great picture....now that's a parade I would go and watch!!
I love all this posturing to try and get rid of bad debt with crazy new structures that just steal real wealth from the system. Yep...that'l work well in the long run.
Till there is wealth to suck out.
testing new avatar on old post