From Peter Tchir of TF Market Advisors
The Maginot Line, Part Deux
It looks more and more like Greece will finally be allowed to default. Over the past few weeks, the rhetoric out of Europe has shown a growing willingness to admit that it cannot be avoided. It seemed to culminate this week as the CEO of Deutsche Bank admitted that it felt like 2008, Merkel’s party did poorly in elections, and although the EFSF was not deemed illegal by the courts, it was made clear that the politicians were pushing the envelope of what could be done. Greek 1 year debt and 2 year debt continued to trade to levels that indicated default was virtually unavoidable.
If Greece is finally going to be allowed to default, what is the realistic impact? First, this is good news for Greece. They will arrange some new financing. I suspect some of their more liquid collateral will be used to obtain interim financing while they negotiate settlements with existing bondholders. Their banks will likely go under, but the institutions can be resurrected with government money to serve the state and the basic needs of their citizens. There is likely to be less rioting going forward, as any pain felt by the citizens will not be the result of some austerity promise made to IMF bankers that none of the citizens liked. In the very near term there may be some problems, but I really believe that in a relatively short time, Greece will be in far better shape than they are today. Not servicing €330 billion of debt will help.
The real key is going to be whether the EU can stop the contagion. The impact of a Greek default will be felt in two ways. The debt of the remaining PIIGS will drop quickly. There will be increased risk that more countries default once one goes. No matter what people say about this being priced in, it is NOT priced in. Too many people just never truly believed a country could default. They felt that somehow, someway, this would be avoided. People who long ago realized that Père Noël, or Sinterklaas, or Santa Claus didn’t exist, still clung to the hopes that some miraculous EuroBond would appear to save the EU. No one dared define what the Eurobond would do – replace all existing sovereign debt or just be used selectively for weak countries? No real details ever emerged on who would be responsible for paying it back – each member responsible for a portion, or Germany and France willing to pay it all back? There were so few questions ever asked or answered about EuroBonds that is was clear that this was the last bit of hope for those not willing to be short the market. Any solution that lets Europe start to rebuild needs to address the other PIIGS.
Protecting against a run on the remaining PIIGS will be difficult. The first thing that the EU and ECB have to realize is that worrying about the price of 10 year bonds, or even 5 year bonds is relatively meaningless. Yes, it is comforting to see 10 year yields below 10% or 5% or whatever number each country is worried about, but it has no immediate impact on the country. The countries have locked in the coupon on their longer dated bonds. Spending ECB money to “fix” that isn’t going to help. It does mean that those countries won’t be able to issue new long term debt and that citizens in those countries will have difficulty borrowing long term, but that fight is too big and too hard to win. The EU and ECB and IMF can provide support at the short end. They have to supply it and they have to stop focusing on austerity measures, etc. Everyone understands that they don’t want to throw good money after bad, but clearly the situation in Greece showed that all the austerity measures and constant meetings to determine whether they had qualified for another tranche of money did nothing but give the market reasons to sell off.
Portugal with €156 billion of debt outstanding and Ireland with €112 billion are both much smaller than Greece and are both in better shape. In conjunction with providing short term debt relief, maybe an agreement can be reached where banks forgive a certain percentage of the debt. It has to be forgiveness – no more rollovers into exotic structured vehicles, just a deal where banks take a loss and the country has reduced debt. Against that, maybe the ECB and EU can pull back on the concept of a transaction tax or some other draconian measures that have been discussed. While it is not clear exactly how to stop the contagion in Ireland and Portugal, both are better off economically than Greece and smaller, so a combination of short term, no austerity strings attached money, with some pressure on reasonable write-offs for banks, and this can be fixed.
Italy and Spain are in a league of their own. They are extremely big, far too big to fully bail out. They are also in much better shape. Until recently, yields of 5% for 10 years were the norm, not a sign of trouble. It is only in this uber low rate environment that these rates are viewed so pessimistically. The ECB and EU must stop trying to determine where longer term rates go. The FED, which can print USD, and can purchase Treasuries, and works with Treasury on the new issue schedule, has difficulty directing where long term rates go, there is next to nothing that the ECB or EU can do about the longer term rates of these countries for any period more than a few weeks. They should not spend their money on something that cannot be helped and as mentioned earlier, doesn’t change the true cost of funds for these countries. Short term money has to be provided, and the possibility for exit from the Euro has to be addressed. In spite of the potential initial horrors this might create, maybe it is what is needed. Italy could pay off their existing debt in Lire (while avoiding a CDS Credit Event) and gradually build an export economy (not good for US or Germany or France). That may be what is best for Italy. Italian banks hold a large portion of Italian debt, so the devaluation, although painful, could be somewhat contained. Spain could also look at doing that, but it would trigger CDS contracts.
The other key impact will be the banks that hold the Greek debt. They will finally have to write down their holdings of Greek debt. Weak banks will have to be allowed to default. Any solution that doesn’t wipe out the weakest banks is likely to drag the problem on. Now is the time to let the weakest, most overexposed banks fail. They should fail. The last 3 years has seen politicians spending an inordinate amount of time working on proposals to keep these banks alive. Let these banks fail and let their CEO’s finally worry about their own jobs rather than what seats they will get for the next UEFA Champions League game. The weakest banks need to be allowed to fail so that stronger banks can thrive. I suspect, that in spite of the recent stock price, Deutsche Bank is fairly well prepared. Ackerman is too good to have casually mentioned it felt like 2008 again if his bank wasn’t as prepared as possible.
Countries will have to offer support for their big banks. They may need to offer debt guarantees (similar to when FDIC expanded their protection to US Bank bond issues back in 2008). The countries need to charge appropriately for this. Some banks may also need to raise capital. The countries should be there for them, but only on terms that are better than what Buffett got for his recent BAC deal. If a bank needs to go to the government for money, the terms have to be better for the government (and the citizens) than Buffett got for himself and his shareholders. That may be horrible for the shareholders of those banks, and the dilution could be huge, but that is the price they have to pay to clean up the system. On the other hand, no bank should be made to take government money. If some banks are well prepared for this opportunity, let them capitalize on it, in the free markets.
Governments should also make a big effort to let new banks start, or if they really feel the need, to create their own banks. My first choice would be to see new banks allowed to be created. Entrepreneurs may see this as a great opportunity to build new banks. The infrastructure and people would be there on the cheap – Barclay’s became a powerhouse in the US corporate bond market by picking up the people from Lehman. The markets are resilient, and the people who have shown themselves to be most prepared for this situation should be allowed to thrive.
If Governments decide that they want to create their own banks, they should create them with a very limited scope. Germany seems the most likely candidate to create some form of new bank. The Landesbanks have been a disaster for years. I suspect some of them will be brought down by their exposure to Greece. It may be hard for the government to let them go, but if they deserve to be, then they should be allowed to fail. Germany, if it wants a bank to fund its own companies, can do that, and in many ways starting a new local bank would be the best. Too many of their existing government sponsored or government guaranteed banks have branched out way past their original mandates, and trying to reign them in will prove to be an exercise in futility – too many people have too much to lose by letting that happen. Let them fail, and if you don’t believe the private sector will rise to the occasion (which I think it will) then create a bank, but one with the limited scope of helping individuals and the smallest companies in a country. The big companies have been served well by the big banks, and will continue to be so.
The biggest risk I see with “ring fencing” the banks is to not let enough banks fail, to charge too little for the banks that can survive but with assistance, or to force the best banks to do things so the other banks “don’t look bad”. It may be a difficult task, particularly as many of the politicians staunchest supporters are fundraisers will be ones asking for favors for their banks, but if the politicians can do this right, they can leave the banking sector in much better shape. There will be some initial shock. Bank share prices will plummet. If they do too much, too soon, for too many, it will likely only be a matter of months before we are facing a new banking crisis. They will need to be brave, but once the market figures out that they have the resolve to weed out the weak, for the first time in years, the market could truly look forward.
They should also implement rules for derivatives to be cleared on exchanges ASAP. It is ridiculous that 3 years after Lehman they have left the counterparty risk issue out there. I don’t believe the counterparty risk issue is as big as some make it out to be, but it is real and would easily be eliminated or reduced if the regulators just forced it on to exchanges. That may hurt bank profits, but haven’t we learned anything since Bear Stearns was gobbled up by JPM? Banks will revert to the old ways if they can, because it is in the interests of banks to make as much money as possible for themselves, and for their shareholders, and it should be. That is their job. But we have also spent 4 years worrying about banks being too big to fail and worrying about how much damage a failed bank would do to an economy. So push derivatives wherever possible to exchanges and clearing. The banks might not like it, but it would solve much of the problem. CDS on banks, as I mentioned the other day creates such a high correlation risk, it should be the first one addressed. For any counterparty that buys CDS on a bank from another bank, unless they have a collateralized ISDA, they create credit exposure to the counterparty that sold them protection as the bank CDS spreads widen. That can cause them to buy protection on the counterparty, putting further pressure on bank CDS spreads. Even a rational investor has to wonder who is exposed to what. After letting Greece fail, and the weak banks, it has to be a priority to get this business moved to exchanges and clearing ASAP. If just the ES futures contract (an effective notional of about 50k per trade) can have daily volumes of over $150 billion with moves as large as 5% and no rumors of counterparty risk, there is no reason most CDS trades couldn’t be moved to a more transparent forum quickly. Collateral provisions might be higher for some big trading counterparties, and certainly higher for banks who largely avoid collateral, but all that would do is reduce the size of the business – possibly not a horrible idea. It would also allow new participants, which might actually grow the business over time. If banks have grown too reliant on their one way margin agreements that they are reluctant to move to a clearing system, than, well, tough luck. We cannot continue to spend so much time and energy worrying about problems that are easily fixed.
The Maginot Line failed because it was inflexible and was largely designed to fight the last war. As Europe braces for a potential default from Greece it has to be strong, yet flexible enough to adapt to this particular situation. We learned a lot from Bear and Lehman about what can be done to contain financial panic, but not all the tools will be equally applicable here. Ironically, for all the talk about how bad it was to let Lehman fail, the U.S. banks seem in far better shape than European banks. Maybe as Europe prepares to ring fence its banks, it should remember that letting Lehman fail may be the reason US banks are in better shape now than in 2008. Citi and BAC, which required the most government support – and got it – are our weakest. Europe can use this time to reshape their banking industry and if they are willing to deal with enough short term pain, the ultimate outcome will be a banking system that can prosper and provide true long term growth opportunities for the Euro Zone – whatever that may ultimately look like.