Guest Post: EFSF Bond Buying Won't Work, Is August 20th Default-Day?

From Peter Tchir of TF Market Advisors

EFSF Bond Buying Won't Work, Is Aug. 20th  Default-Day?

So there is growing support for using the EFSF to buy bonds on the open market.  I assume the plan is to buy bonds at a price and then use that discount to forgive some debt to Greece.  If the EFSF bought a bond at 70% of par, and then forgave Greece some of that principle, or exchanged the bonds for some new security with a very long maturity and a low coupon, I could see how that would benefit Greece.  It wouldn't even be too bad for the EFSF, at least not optically.  The question is who would sell them bonds and at what price?

The bonds are held by 3 groups right now.  The ECB, mark to market institutions (hedge funds, mutual funds, and some big sophisticated banks), and hold to maturity institutions (old school banks and insurance companies). 

I currently see the Greek 2yr bond at 68, the 5yr at 50, and the 10yr at 53.  So the first question is, would the hold to maturity accounts sell bonds at these prices?  The obvious answer is no.  If they wanted to sell the bonds at or near these prices, they could already be doing it.  If they sell a bond they have to monetize the losses.  Since they still hold bonds and have demonstrated an unwillingness to monetize any loss via the rollover discussions it is safe to assume they won't be in a rush to sell to the EFSF at current prices.

So, that leaves it up to the mark to market accounts to sell to the EFSF.  Maybe they will, but you now have the hedge funds and sophisticated banks negotiating prices with a fund that is trying to fulfill a government mandate and is run by people with minimal to no trading experience.  This will be better than shooting fish in a barrel for the traders.  Liquidity is low, there is a "dumb" motivated buyer, and one set of potential sellers has a price target much much much higher than current market prices.  By the time EFSF is set up to do this, I guess they will be paying 85 for the 2yr, and 75 for the 5yr and 10yr bonds.  This will be a huge bonanza to the funds who seem to be either long Greece outright, long Greece vs CDS (basis trade), long Greece vs short Italy/Spain, or have Greek curve trades.  The EFSF will provide a windfall gain to the funds, and they will own those bonds at a discount, but not enough of a discount to be able to provide Greece much of a benefit. 

The low discount is bad enough for the EFSF, but they will only be able to accumulate a small position anyways.  The bulk of the bonds, held at non market to market accounts will remain there.  They have already demonstrated over the past year a complete lack of willingness to sell bonds when they had the chance.  They do NOT want to lock in losses - that is how they think.  They will see the EFSF helping Greece, the Troika helping Greece, and greed will get the better of them and they will hold their bonds.  Then in 3 months or 6 months, Greece will vote down austerity, and even with the slightly reduced debt load, they will be in trouble.  And guess what, the non market to market banks will still hold their positions and governments around the world will either have to figure out some fresh way to save the banks from contagion or finally let them face the consequences of their own greed. 

It is better to let them deal with their own greed now rather than making a big wealth transfer to funds who don't need it.  EFSF buying bonds in the secondary market and using the discount to help Greece will not help, because the big non mark to market holders won't sell, and the fast money that does sell, will be so much better at trading that they will get prices they never dreamed of when the accumulated the bonds.

To get the hold to maturity banks to sell and lock in losses, the EFSF would have to pay such high prices it would almost be criminal and would certainly spark political backlashes in all of the countries that have to provide guarantees to the EFSF. 

The banks have had their chance to take losses and participate in a long term solution.  They failed to do it. They keep hoping the politicians are so weak that they continue to bail out Greece and let the banks get out whole.  This EFSF idea is unlikely to work and will just waste time and some taxpayer money.  I am becoming more convinced that the weekend of August 20th will be the weekend Greece defaults.  Signs out of Greece show they need debt forgiveness - G. Pap's letter, the minister of finance pointing out that asset sales aren't going as well as hoped, and continued dissent from the populace.  The EU and IMF are making it clear that they want some form of losses at the banks, and if they can't get it voluntary, then letting Greece default is an answer.  They could line up an agreement to provide Greece with post default financing. They could get first priority on asset sales etc.  A default by Greece on the weekend of August 20th with IMF/EU secured financing in place would solve a lot of problems.  Greece would get actual debt reduction and only have to re-prioritize who gets proceeds from asset sales.  The IMF/EU would become secured or at least senior, making it more likely they get repaid on debt they have already promised to issue anyways.  The IMF/EU can tell the banks that next time they ask for some voluntary help, they better get it, and they can tell their citizens they were tough on their own banks and on Greece.  August 20th has about 8.5 billion euro of principle and interest payments due from Greece, and we all know the Troika likes weekends for big announcements because they have the most time to explain their plans and spin their story while the markets are closed.