UBS' Stephane Deo has rapidly become of one of the most vocal, and luckily most erudite, critics of the veritable rumor-a-palooza that Europe has become: a continent that is now desperately throwing anything and everything at the wall in hopes it will stick and generate another intraday EURUSD short covering squeeze to perpetuate the illusion that Europe is viable for at least one more day. His note today effectively puts an end to the most current approach whereby Greece will see a 50% haircut on its debt (the 21% haircut proposal from July 21 is now dead and buried as we had suggested back then). With that, he forces Europe back to the drawing table to come up with a plan that is endorsed by the market, with just 9 short days until the Eurogroup Summit on October 23 at which point kicking the can into the future will no longer be tolerated and the market will finally judge Europe not for promises, rumors, lies, innuendo and hyperbole, not necessarily in that order, but on actual decisions and policies. Alas, if the 50% haircut idea, which is now proposed by Germany (in diametrical contrast to a month ago), and staunchly opposed by France whose banks, unlike Deutsche Bank, have not been able to dispose of legacy exposure, is killed before it is even implemented, look for a spike in panic in Europe which will now have to redo everything from scratch.
As to why Herman Van Rompuy should be panicking, here is Deo's summary:
For more than a year we have argued that Greece will not be able to avoid a default. In this piece, we look at how this could be done. We think a 50% haircut makes little sense: if we take into account the lenders that cannot participate in the haircut (IMF, bilateral loans) and the bank recapitalisation it would trigger in Greece, we find that a 50% haircut would actually reduce the stock of debt by only 22%. Rather, we think a large restructuring of the debt (i.e. a “super PSI”) is the solution. It would reduce the financial needs of Greece, postponing for decades the redemption of bonds. It would also cut the deficit if coupon payments were reduced sufficiently. This would come with manageable needs for bank recapitalisation. Finally, such a step would remove the need to default, or rather, it would be akin to the default we expect.
why a 50% haircut does not work At the time of writing, Greece has total debts of €346.4bn. About a third of this debt is in public hands (34.8% is attributable to the IMF, ECB and European governments), roughly another third is in Greek hands (28.8%, essentially for banks) with the remainder (36.4%) held by non-Greek private investors.
The problem with the above is that some of the debt cannot be included in a haircut. This is almost certainly true in the case of the IMF debt. It has been suggested that the IMF debt could actually be included in the restructuring, but this would be unprecedented and we attach a very low probability to such a decision. Similarly, the bilateral loans are de jure pari passu, but we think it is nevertheless difficult to envisage a haircut on that part of the debt.
More debatable is the ECB case: the ECB has not been party to public-sector involvement (PSI), as it was a “voluntary” exercise and the ECB did not volunteer. However, in the case of a coercive default, it would be legally difficult for the ECB not to participate. Hence, in Chart 6 below, we provide two simulations: one with ECB participation and the other without ECB participation. In the case of ECB participation, if we assume the ECB holds €55bn in Greek bonds, and has purchased these bonds at an average of around €¢70, it would mean that a 50% haircut would leave the ECB with a loss of about €11bn.
Last, while the Greek banks would naturally be subjected to any haircut, the difficulty is that they are undercapitalised. According to our equity analysts, Greek banks currently have a core tier 1 ratio of around 8% (Marfin Popular Bank – 8.6%, National Bank of Greece – 8.5%, Alpha Bank – 8%, EFG Eurobank Ergasias – 6.4% and Piraeus Bank – 7.2%). This means that any haircut affecting their debt portfolio would push their capital lower and trigger the need for a recapitalisation. Consequently, every euro saved by the government on its debt via the haircut would be injected into the Greek banks. This is equivalent to having the Greek debt in Greek banks excluded from the haircut.
In short, as shown in the above chart, a 50% haircut effectively equates to a 22% reduction in existing debt once the banks have been recapitalised. This is far from enough. Or, to put it another way, to achieve an actual 50% reduction in the debt, Greece would need to implement a 100% haircut, i.e. repudiate its debt totally.
And just when it seemed that the rumor mill would be a little calmer for the next week...