Heads I Lose, Tails I Flip Again

By: Michael Ashton | Mon, Jun 27, 2011
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Another week of Greekwatch begins with everyone seemingly convinced that the inevitable is simply too awful to contemplate and therefore will not happen. It is a happy thought, a faithful thought; wouldn't it be wonderful if disasters never happened because it would be so bad if they did?

And so investors were cheered by the work over the weekend by French banks and the French government, who have developed a plan under which French banks would agree to roll over some part of their Greek debt into longer-dated bonds. This is another necessary condition - among many - for the Greek crisis to be temporarily defused again. The plan, according to reports, would involve banks reinvesting half of the Greek debt they have that is maturing in the next three years (note: these will be the ones with the prices closest to par!) into new 30-year Greek bonds yielding 5.5% plus a 'kicker' of up to 2.5% if the Greek economy expands.

Clearly, this is not a 'voluntary' conversion in any normal sense of the word. With Greek 30-year rates at 11.35% in the market (according to Bloomberg), a 5.5% coupon should trade at a price around 50.50, implying that a par bond being exchanged would involve an economic loss of about 50%. If the maximum 'kicker' is achieved, the 8% coupon would be worth 71.65. Aside from the numbers, just contemplate whether it is reasonable to imagine that a bank would voluntarily exchange 1-year securities, trading at 98.00, for 30-year bonds, issued by an entity the market believes has an 80% chance of defaulting in the next 5 years (judging from CDS), trading at 50.50 or 71.65. If any bank would "voluntarily" take that large a hit to a position, I want to deal with them - as a counterparty, not as a client! There are some other parts of the plan but you can stop reading it at that point.

The French plan has been warmly received as the German banks are also looking at it and carefully considering it while most of us scratch our heads, look at our neighbors, and say, "really?"

Meanwhile, in Greece, the next couple of days will be filled with debate in parliament while riots rumble outside. The debate will culminate in a vote on whether to accept the new austerity measures that Prime Minister Papandreou agreed to after his recent jeopardy in the government confidence vote. Remember how keyed up the market was about that dramatic confidence vote? Well, it turns out that a loss would have been devastating, while the win turns into just another opportunity for a loss. That's a serial game that I wouldn't want to play since the outcome seems fairly obvious ("heads I lose, tails I flip again") but Papandreou seems to enjoy. Anyway, after three days or so the parliament will vote on the new austerity measures. The Papandreou government enjoys a five-seat majority with four of those legislators already declared opposed to the plan. It ought to be an interesting week.

So there are multiple chances to lose. Papandreou can lose his vote, which would probably clarify things rather quickly. No one seems to think this is possible because it is just unthinkable. Or the measure could pass, and the EU could falter because it can't agree to the rollover plan. Everyone regards this as absurd: how could the EU fail to meet such an easy test once Greece has done her part? Or, the EU rollover plan could be agreed on, and the rating agencies could reasonably state that Greece is in default anyway, triggering CDS and forcing the ECB's hand on their prior position to refuse to take defaulted securities as collateral. "Surely," the thought process seems to go, "the rating agencies wouldn't destroy the concept of a united Europe simply because their rule says that 'voluntary' means this-and-so? Surely they will make an exception?"

All of these steps may be plausible, but collectively sums to a long shot in my mind. And so I look askance at the level of equities and of implied volatilities (especially!). And I wait for the first time "heads" comes up.

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One of the topics that has been drawing a lot of attention has been the question of whether a Greek default would be a good idea for Greece, or not. We all think we know that it is bad for Europe, and certainly for the other PIIGS, but there seems to be a concerted effort to persuade the consensus to come around to "a Greek default is bad for Greece, too!" This is akin to the campaign to persuade deeply-under-water mortgagees to eschew "strategic default," even though for many of them there aren't any alternatives to default, whether today or in the future. And so it is with Greece.

The Economist had an article recently ("If Greece goes...", June 23, 2011) in which this argument was made:

"While the EU's leaders are trying to deny the need for default, a rising chorus is taking the opposite line. Greece should embrace default, walk away from its debts, abandon the euro and bring back the drachma (in a similar way to Britain leaving the gold standard in 1931 or Argentina dumping its currency board in 2001).

"That option would be ruinous, both for Greece and for the EU. Even if capital controls were brought in, some Greek banks would go bust. The new drachma would plummet, making Greece's debt burden even more onerous. Inflation would take off as import prices shot up and Greece had to print money to finance its deficit. The benefit from a weaker currency would be small: Greece's exports make up a small slice of GDP. The country would still need external finance, but who would lend to it?"

But the argument is flawed. If Greece defaults, how would the plunge of the drachma make its debt burden more onerous? There wouldn't be a debt burden! The budget would be in balance, or at least dramatically closer to it without the overwhelming interest costs, and so it isn't clear why the country would need external finance. Anyway, they wouldn't need much. There would undoubtedly be some inflation, perhaps even a lot, but there is an upside to that in the case of Greece. One of the nation's big problems is that many Greeks refuse to pay their share of taxes, so taxes need to be raised much more dramatically on those who actually pay.¹ But inflation - also known as the 'stealth tax,' means that all Greeks would bear the burden without any need to file a tax form. Arguably, this single fact makes a departure from the Euro and an outright default not only a bearable outcome but perhaps even a fair outcome. At least, from the perspective of Greece.

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With that drama unfolding slowly overseas, and a vacation weekend coming up, tomorrow's release of Consumer Confidence for June (Consensus: 61.0 vs 60.8) is not likely to be as big a market-mover as it can occasionally be. But the consensus seems very rosy to me. I think it is based on the recent decline in gasoline prices, which some economists think has an important effect on consumer confidence. It does, but the labor market situation and equity prices also have an impact (and probably home prices, although that is harder to track). A very simple regression I ran with those three variables since 1983 suggests that the 'historical' relationships argue that Confidence probably ought to fall by around 5 points. That's not an economist's forecast but a trader's forecast: that is, I am trying to look at the risks for the number, and to me the risk appears to be that we see a lower number than the consensus estimate.

 


¹One might make a reasonable observation that a similar situation exists in this country, although it isn't because taxpayers evade taxes but because the tax code requires only the top quarter of Americans to pay very much tax at all. Therefore, raising taxes "on the rich" simply cannot balance the budget without huge increases and the concomitant dramatic effect on the economy.

 


 

Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
E-Piphany

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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