default

Next year, IMHO, we are going to see a further sharp decline in residential home prices as the tide of foreclosures begun in the past year starts to clear the courts and move to market via involuntary sales. The same thing is happening in Spain, by coincidence.

As a disclaimer to this update, I just want to reiterate once again that I firmly believe that the Euro is not viable, at least certainly not the way it is designed and I think the flaws in its conception are so profound that dissolution makes the most sense. With this assumption in mind, let us look at what the solutions are to the current woes. The individual bail-out route is not an option. When dominoes fall in panic the speed at which they fall tends to accelerate exponentially. Rewind the tapes to late July 2007: American Home mortgages files. The market goes on to make new highs but in January Bank of America takes over otherwise soon defunct Countrywide and by March Bear Stearns is belly up. The forced hand out to JP Morgan appeases the market temporarily, but by early September Fannie and Freddie are de facto nationalized, and so is AIG, Lehman collapses, Wamu is taken over by JP and at that point the government has no choice but backstop the entire system. Well, this is not unlike what we are witnessing here: We first had Iceland in November 2008, then Greece in the spring of 2010, now Ireland. Make no mistake if you let that fester enough or decide to bail them one by one without attempting a larger scale resolution by January Spain Portugal and possibly Italy will have been downgraded several notches, LCH will have raised the margins on all those bonds, and French and German banks will start dragging their country down the same slope. - Nic Lenoir

This is an extensive post designed for those who want to truly comprehend what I perceive to be both the root causes and the practical solution to the Irish sovereign debt problems and the threat of Pan-European possibly global financial and economic contagion.

Harrisburg, PA, whose bankruptcy is now about a year overdue, has just hired bankruptcy counsel: New York law firm Cravath, Swaine and Moore. The financial advisor has not been decided yet although the pitches there must be fast and furious, and probably involved every single bankruptcy advisory firm which recently has had exactly zero work courtesy of Ben Bernanke providing convertible DIPs at negative rates. Cravath took a tricky strategy to beat out other law firms: it would advise the city pro bono on its imminent Chapter 9. But don't think of it as money lost: think of it as league table credit, which will send the firm to the top of the ranks, and allow it to charge $1,000 an hour when the muni dominoes start tumbling left and right: after all Harrisburg is just the proverbial cherry pop. After it - the deluge. And the bankruptcy advisory vultures are already licking their chops over what will make the Lehman fee bonanza (now in the billions) seem like Greenspan's stingy monetary policy compared to Bernanke's global paradropping of Bennies.

In September 2008 the US came to a fork in the road. The Public Policy decision to not seize the banks, to not place them in bankruptcy court with the government acting as the Debtor-in-Possession (DIP), to not split them up by selling off the assets to successful and solvent entities, set the world on the path to global currency wars. By lowering interest rates and effectively guaranteeing a weak dollar through undisciplined fiscal policy, the US ignited an almost riskless global US$ Carry Trade and triggered an uncontrolled Currency War with the mercantilist, export driven Asian economies. We are now debasing the US dollar with reckless spending and money printing with the policies of Quantitative Easing (QE) and the expectations of QE II. Both are nothing more than effectively defaulting on our obligations to sound money policy and a “strong US$”. Meanwhile with a straight face we deny that this is our intention. It’s called debase, default and deny.

This is the math, the reasoning and the logic behind a nearly inevitable default by Greece. Why hasn't this been present in the mainstream media?

Maybe, just maybe, this will light a fire under the ass of Attorney General of Florida and force him to initiate an injunction on the law firms that perpetrated the frauds… What is it that William Black said?

“The Best Way to Rob a Bank Is to Own One“

Well How about this…

“The best way to stop a criminal investigation is to become one of the investigators“

Old school private equity guy-turned-hedge fund manager, Michael Tennenbaum, was on Bloomberg TV, discussing his perspectives for the distressed debt market (yes, such a thing did once exist, before HY bonds of 20x levered companies starting trading at par+). And all those who believe that courtesy of the Fed's intervention in every market there will never be another bankruptcy, let alone a bond yielding more than 10% take heart: according to Tennenbaum a full $50 billion in distressed debt may go Chapter in the next two years, although this is probably more good news for all the mini restructuring boutiques who overhired last year only to see the administration make bankruptcy illegal. The math: "Over the next five years $1.2 trillion in non investment grade debt comes due, of which $200 billion are due in the next two years, and of that a quarter or $50 billion are issued by companies rated rated B or lower. The experience that we and others have had is that this leads to default." Of course, Tennenbaum is a traditional debt-for-equity investor is more than incentivized to see this occur: he is currently sitting there doing nothing, as not only does nobody need DIPs or other rescue financings (why, when you can issue new B3/B- debt at 8%), but no company is willing to part with equity when every pitchbook it sees tells it can progressively refi current debt into paper that may eventually pay a 0.001% coupon. On the other hand, this, as well as every other contrarian outlook is predicated on the assumption that the Fed will be able to control the demolition of the US economy, which it won't. Which is why we are confident that not only will Mike be correct (eventually), but the full amount of HY paper that will default will boggle the mind when the dominoes really collapse. Until then, study learn (and earn) the Bernanke Moral Hazard Put: learn it and love it.

And the euro seemed so happy after its recent surge, that it completely forgot it is backed by an insolvent continent. Luckily, here's Ireland to remind us stuff is much, much worse than expected. According to the Irish Independent the Labour Party, Eamon Gilmore, came very close to suggesting that Ireland is considering defaulting on its debts "when he talked about the Government "negotiating'' with bondholders in Anglo Irish Bank." Additionally, the same newspaper also reported that Ireland is on the verge of calling in the IMF for a bailout, citing "a report from Barclays, one of Europe's largest banks, said Ireland may yet need financial help from the IMF or the EU if conditions got any worse. But a spokesman for Finance Minister Brian Lenihan said last night: "The Government's strategy for dealing with the economic and financial challenges has been commended by the EU Commission, the European Central Bank and many other international experts." In other words, domino #2 has at most a few more days. Net result of all this: Irish-Bund spread explode, and gold hits a new all time high of $1,282.

An interesting observation that has developed over the past year is the ballooning spread between default risk for the US as a standalone entity (based on the country's CDS spread, which was last seen just inside 50 bps), and the cumulative risk of the constituent states that make up the US, once again based on their own standalone spreads, when adjusted by GDP contribution. This can be seen on the chart below. The computation takes the 16 states with quoted spreads from CMA (with the remaining states assigned the US spread itself), juxtaposed to the CDS of the US itself. As is evident, the spread continues to widen, and at last check was around 100 bps, just marginally tighter compared to the all time wides seen in June of 2010 when it hit over 120 bps. In retrospect this should not be all that surprising, as the general US CDS looks at the country as a whole, and gives benefit to the possible intervention that the Fed can (and does) do on a daily basis to prevent increasing default risk to the US as a whole: after all the US can always monetize its own debt, while California... can't. Nonetheless, if these spreads continue to diverge, we expect that convexity alone will start dragging the CDS of the US wider as well.

British-style military impotence, Habspurg-like default or French-echoing revolution?

There is one major problem with putting houses of card back together - they tend to fall...over and over. And while abundant liquidity in May and June served as an artificial prop to return European core and PIIGS spreads to previous levels merely as mean reversion algos took holds, the second time around won't be as lucky. CDR's Tim Backshall was on the Strategy Session today, discussing the key trends in sovereign products over the past few months, noting the declining liquidity in both sovereign cash and derivative exposure (we will refresh on the DTCC sovereign data later after its weekly Tuesday update). Yet the most interesting observation by Backshall is the declining halflife of risk-on episodes, which much like the SNB's (now declining) interventions, are having less of an impact on the market, as ever worsening fundamentals can only be swept under the carpet for so long before they really start stinking up the place, and indeed, as Tim points out at 5:30 into the interview, even the IMF now realizes that soon the eventual second domino will fall, and it is better the be prepared (via the previously discussed infinitely expanded credit line), than to have to scramble in the last minute as was necessary in May. In other words, the storm clouds are gathering and only fools will invest in risk asset without getting some additional clarity on what is happening in Europe. The bottom line as Backshall asks is: "do they default now or default later." And that pretty much sums it up. Buy stocks at your own peril.

One of the stealthier developments over the past months has been the ever wider creep in Greek CDS, especially in the longer-dated part of the curve. In fact, everything to the right of the 3 Year point is now wider than it was both on the eve of the Greek semi-default, and just after the announcement of the European Stabilization Mechanism (ESM). How is it that with so much firepower, better known as free money, thrown at the problem, have spreads not declined? The CFR provides one interpretation, which speculates that once European banks find a firmer footing, that Greece, with the blessing of Europe proper, will be allowed to finally sever its mutated umbilical cord, and default. The catalyst would be Greece getting its primary deficit under control, at which point ongoing bad debt funding would no longer be necessary. Of course, this hypothesis is based on two very critical assumptions: European banks, especially in the periphery, as the second attached study from Goldman indicates, are still locked out. To think that Europe will be able to get to an equal footing for all countries seems like some wishful thinking at this point, especially if the market does consider the implications of what a Greek default will do to peripheral banking. Additionally, the ramifications to the euro in the case of a default will be dire, although that may be precisely what Europe is after all alone. Regardless, that is how the CFR sees things, rightly or wrongly. Keep an eye on Greek spreads in the coming weeks to see if the theory is validated.

While the merits of its conclusion are at best questionable, and at worst, completely worthless, the IMF study presented earlier provides one statistical curiosity vis-a-vis sovereign defaults. Specifically, in "Default in Today's Advanced Economies: Unnecessary, Undesirable, and Unlikely" the author Carlo Cottarelli presents an observation which could be classified as a "Hindenburg Omen" type of signal for sovereign default. Unlike the real H.O. observation (which incidentally has now been experienced 5 times in the past three weeks) for stocks, the one relevant for sovereign bankruptcy has a much simpler gating threshold: 1,000 bps spread in credit risk. And just like in the Hindenburg Omen, this is a necessary (but not sufficient) condition for a crash: only in this case it is not the market that collapses, but a country's solvency. Cottarelli finds that since the first Brady deals in 1991-92 there are 36 instances in which a country’s spreads rose above 1,000 basis points. "Of those instances, seven eventually resulted in default; in the remaining 29 cases, however, the spreads stayed high for a few months and eventually fell back well below 1,000 basis points, with no default." The 1,000 is logically an inverse gating factor: no single country defaulted with spreads being below the 1,000 threshold. In other words, once a country passes 1,000 bps, it has a one in five chance of defaulting, roughly in line with the crash expectations of the traditional Hindenburg Omen.

Debt/GDP ratios are too backward-looking and considerably underestimate the fiscal challenge faced by advanced economies’ governments. On the basis of current policies, most governments are deep in negative equity. This means governments will impose a loss on some of their stakeholders, in our view. The question is not whether they will renege on their promises, but rather upon which of their promises they will renege, and what form this default will take. So far during the Great Recession, sovereign (and bank) senior unsecured bond holders have been the only constituency fully protected from partaking in this loss. It is overly optimistic to assume that this can continue forever. The conflict that opposes bond holders to other government stakeholders is more intense than ever, and their interests are no longer sufficiently well aligned with those of influential political constituencies....Investors should be prepared to face financial oppression, a credible threat against which current yields provide little protection. - Arnaud Mares, Morgan Stanley