From Mark J Grant, author "Out of the Box and onto Wall Street"
The Increased Risks of Owning European Sovereign/Bank Debt
Many lessons are available to learn from the Greek debt crisis. Several more are probably to come as the intended and unintended consequences of what the Europeans have done begin to infect the bond markets. I point this morning to the vast differences now between the ownership of American debt and European debt and, as the immediate effects of the LTRO begin to wear off, several dawning realizations that I think will cause European debt to gap out against American debt regardless of the yields of Treasuries.
The first issue is structural. In exempting the ECB and the EIB from the “Collective Action Clause” the European Union has demonstrated that they are above the law and that they do not share the same consequences as the private sector. It is not just some academic discussion that the Rule of Law has been abrogated but a very real distinction that has now been cemented in the sand for all bond holders. I point out again that if this clause in a sovereign indenture can be applied at will by the EU that then they can do anything they like with ANY clause and if they can do it for Greece then they can do it for ANY country and most probably for any bank. Let us suppose for a moment that a major European bank got into trouble; we could find a retroactive “CAC” mandating that the ECB and then the EU Stabilization Funds got their money back before private debt owners. It is not just the factual comment now that private debt holders have become subordinated to the whims of the European Union but that retroactive measures have been implicitly approved by the EU with no objection coming from any country in the nations using the Euro or even the larger group of nations. British or Swiss law may have the last word but there was not one national voiced raised in objection to the pilferage of the private sector. I think there will also be a very negative reaction to “local law” bonds as investors shy away from anything not governed by American or British law though British law bonds may also trade at a discount as there have been no objections to what was done with Greece from anyone in London.
Now let us turn our attention from structure to credit and from the sovereigns to the European banks. I will state my conclusion first; the credit quality of European banks has massively eroded due to the new European policies and any debt ratios based upon their balance sheets now has zero accuracy. This would be as incorrect, a fallacy and not even close to reality. I make my case:
- The European banks are, in most cases, carrying sovereign debt at cost and they are not marking the bonds to market.
- A tremendous amount of “covered bonds” have been issued in Europe and the assets pledged to those bonds is no longer available for senior creditors.
- The LTRO program concocted by the ECB has demanded collateral and all of the collateral pledged to the ECB is no longer available to the unsecured holders of the debt of the European banks.
According to a report issued by Barclays [14], and pre-LTRO, on average the major European banks have encumbered twenty-one percent (21%) of their assets. Now since many banks have not released their LTRO funding amounts it is not possible to know exactly how much of their assets are encumbered now but it is obviously an even larger number. For all of the above reasons mentioned I suggest that you take very long and hard look at exiting the debt of the European banks en masse before spreads widen further and before someone or another gets in trouble as the assets guaranteeing the senior debt owners continues to rapidly diminish. Also bear in mind that the three year ECB loans will have to be paid back and how that actually gets accomplished now is anyone’s guess. I also point out that the collateral standards at the ECB have declined past any point of prudence so that “hand backs” will surely be forthcoming as many securitizations at the ECB default or become impaired. In the shortest of runs European sovereigns and banks have tightened but this will not last, cannot last, as the initial injection of liquidity dries up.
For those of you who are more aggressive and want a bigger play then I suggest shorting the debt or equity of the European banks. My best picks here are Spain, Italy and France. My calls, as usual, are generally early but I think some rather large rewards can come from this bet. I am forbidden, by compliance, from making specific suggestions but I am sure you can ferret out the appropriate plays.
The ECB will not tell us of course and the banks in Europe have remained mum but I think the collateral pledges are now down to bank name stamped pen sets, signed lithographs of Charles de Gaulle and teller window #17 at some branch in Rome.