Excerpted from John Mauldin:
On Wednesday, October 28, 2011, the market reacted like the European banking problems were solved. But if you look deeply there is more to the market "melt-up" than simple euphoria and relief. There is an unintended consequence that will come back to bite us. And it may well involve derivatives and credit default swaps.
The ECB seemed to indicate that after the summit it would continue to buy Italian and Spanish debt. But that commitment was rather vague. Italian paper was just north of 4% in July. Today Italian interest rates rose to 5.88%, even with apparent ECB buying. More on the reason for the rise later.
They did agree at the summit that private bondholders should lose 50% on their Greek debt. This mostly means banks, pension funds, and insurance companies, along with the €35 billion owed to the Greek pension system.
The summit decided that the Greeks should also privatize another €15 billion in national assets, on top of the €50 billion they are already supposed to have done, but on which no progress has been made. All the while finding €17.5 billion to fix the hole in their pension funds, which was already so deep that no daylight could seep in.
When Leverage Is the Kind-of Answer
The Europeans also agreed to leverage the EFSF by some amount, but they were unclear on the details as to what that actually meant. The concept is that they will guarantee the first 20% of losses on any newly issued debt. It was left unstated whether that includes the loans committed to Ireland and Portugal but not yet issued, or just new commitments.
Somehow, by a mechanism not revealed, this is to be leveraged up to about €1 trillion, which is about half of the lowest estimate I have seen of what is needed. Thus the desperate hope that the ECB will step in, because that is the only real source for the money that will be needed.
Further, if you are a market participant thinking of investing in sovereign debt, when was the last time you saw a sovereign country write down less than 20% of its debt? Answer: Never. If a sovereign debt goes south, it's for a whole lot more than 20%. It seems that whatever the EFSF guarantees is almost certain to turn into a loss. What self-respecting country would write off less, if the hit is taken by entities that have no votes in the national parliament? 20% becomes the starting point. There will be lots of screaming when those losses come home.
Merkel and Co. are selling the whole proposition on the premise that the problem is simply one of confidence, and that if the EFSF restores confidence in the various nefarious government debt schemes, then all is saved. Well, except for Greece, which has already been flushed. The problem is that it is not a lack of confidence, it is a lack of solvency. There is too much debt in Greece and Ireland and Portugal and Spain and Italy. And ultimately France.
"Data released by the European Central Bank show that real M1 deposits in Portugal have fallen at an annualized rate of 21% over the past six months, buckling violently in September. Portugal is rapidly descending to Greek status. Yet another banking crisis looms.
There is a universal assumption in Ireland that the country will get debt relief. That is a €60-billion hole in the ECB balance sheet. From Businessweek.com:
"Why is it acceptable to write down Greek debt, when the Irish pay private bankers' debts?" Gerry Adams, leader of Sinn Fein, said in parliament on Oct. 25. Kenny told Adams he's seeking debt reduction on a ‘number of fronts.'
"The government has already signaled it may seek to shift some of the costs of bailing out the banking system to Europe, relieving the burden on the taxpayer. [And putting it squarely on European taxpayers as a whole!]
Think that will sell to Spain, when they have to figure out how to back their banks, which are for the most part basically insolvent? What about Italy?
Never assumes the rules are what you think they are just because they are written down, if someone else can change them. The final thing that happened at the summit is the rules got changed. The banks "voluntarily" took a 50% haircut. Voluntary in that Merkel, Sarkozy, et al. told them that the alternative was a 100% haircut. "That's the offer, guys. Take it or leave it." And because the write-off was voluntary, there would be no triggering of credit default swaps clauses. Because if it's voluntary it's not a default. Huh?
And that smooth move, triggered a rather significant unintended consequence, which resulted in the market "melt-up." Let’s walk through this rather bizarre world of derivative exposure without causing anyone’s head to explode:
Let's say you bought credit default swaps on a certain bank's debt (let's use JPMorgan, but it could be any bank) because you think that Morgan is exposed to too much credit default swap risk. Just in case. Now, if Goldman sold you the CDS, they could and would in turn hedge their risk by shorting some quantity of Morgan stock, or perhaps if the risk was sizeable enough, the S&P as a whole. It would depend on what their risk models suggested. But as of yesterday, the risk evaporated: there would be no CDS event. So why buy CDS?
Further, the risk to financials was cut by a large, somewhat murky amount. But it was definitely cut, so risk assets (equities) were bought. Which puts any long/short hedge fund in a squeeze, especially those with an anti-financial-sector bias. But because of the nature of the hedge, the whole market moves. It involves rather arcane concepts that traders call delta and gamma. (Remember that the recent rogue traders, most recently at UBS, had been at delta trading desks?) Guys at those desks can calculate that risk in a nanosecond. You and I take a day just to wrap our head around the concepts.
And it just cascades. The high-frequency-trading algorithm computers notice the movement and jump in, followed quickly by momentum traders, and the market melts up. Because a significant risk was removed. But not without cost.
Let's go back to where it was noted that Italian interest rates are rising even as the ECB is supposedly buying. What gives (demand SHOULD drive rates down!)? It is clearly the lack of private buyers, and a lot of selling. Because now you can't hedge your sovereign debt. If you ever need that insurance, they will just change the rules on you, so why take the risk?
Destroying the credit default swap market will make it harder to sell sovereign debt, not easier. Those "shorts" were not the cause of Greek financial problems; the Greeks did it all to themselves. As did the Portuguese, and on and on. Now admittedly, rising CDS spreads called attention to the problem, much as rising rates did in eras long past. And that did annoy politicians. And clearly, banks that had exposure to that market got the "fix" in to make their problems go away.
John Mauldin’s conjecture is that a major writer of sovereign CDS were German Landesbanks. Think Merkel didn't have that report? As did Sarkozy, on French exposure? It was a very high-stakes poker game they were playing this week. But one side of the table could rewrite the rules. There is no way to prove or disprove these speculations, because there is no source that can really plumb the depths of the situation. And that is a problem.
An event like the Eurozone summit changes an obscure rule with some vague clauses about triggering a credit event – and the market reacts. This time it was a melt-up. Next time it could be a meltdown, as it was in 2008.
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