Peter Tchir

Prudence versus Reckless Abandon

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As much as the current round of negotiations are being framed as “France vs Germany” there is more to the story than that. The battle is forming up along the lines of those who are trying to show some restraint and prudence and are willing to deal with the consequences of that decision against those who want to do everything possible, giving the highest chance of “success” with absolutely no downside protection.

The prudent camp seems to realize that all these new plans do is shift the power to the debtor nations as the good countries are taking on obligations that could bring them down. They realize lenders who made bad decisions in regards to Greece need to pay the price. Not only so that Greece can achieve sustainable debt levels, but to reduce the moral hazard that the banks believe they will always be protected for every bad decision. The prudent camp seems to realize that no matter what they do in terms of EFSF or other plans, there is a risk it fails to stop defaults, because it doesn’t address the problems, and they want some ammunition in reserve for this. So far Germany and Finland have come out in support of the prudent camp.

The ECB continues to do some reckless things (more secondary market purchases to no apparent affect with no obvious direct benefit to the country whose debt is being bought), but does seem to realize that providing massive leverage to EFSF is not a good idea. It is either with recourse and margin which risks collapsing the EFSF, or it is non-recourse which risks the ECB. Again, if the plan was 100% certain to work, the ECB wouldn’t worry, but they at least seem to be getting scared of the large numbers and are aware of the downsides of the plan, and seem to be lining up in the prudent camp and saying that enough is enough and we need some credibility and resources if this doesn’t work.

Portugal, Ireland, and Greece, with a combined €54 billion of EFSF guarantees, are unlikely to participate (they are “stepping out” countries) but in any case have lost any voice in the debates. They can default if they want, that is in their control, but they cannot shape the EFSF or any further part of the rescue plan.

Slovakia, Luxembourg, Slovenia, Cyprus, Estonia, and Malta, will contribute a whopping €18 billion of EFSF guarantees. In the end, they are irrelevant. Although there is still some pretense about this being a Eurozone decision, what these countries want is meaningless. A deal will power ahead with or without them. The most likely scenario is that the EFSF will provide them funding equal to or greater than their own guarantees to ensure that on the surface the EFSF has full support, but the reality will be the countries are neutralized on their commitments so it would be all for show. Of these countries, only Luxembourg, with €2 billion is AAA rated.

Italy and Spain are “interesting” to say the least. They have promised to guarantee a total of €232 billion. So even the most optimistic, rose colored glasses wearing analyst would have to admit the headline number of €780 billion needs to be cut to €726 billion to account for the “stepping out” countries. If these two countries, expected to receive a big chunk of the protection step out, the headline number drops to €494 billion. That number is not nearly as impressive, so they won’t step out, but realistically how much value does their guarantee have? If the EFSF was buying some uncorrelated risky assets, the Italian and Spanish guarantees would be useful, but since the EFSF intends to buy Italian and Spanish debt, their guarantees are not particularly useful. In any case, as big potential beneficiaries of the EFSF, they will likely go along with any plan, it will only be whether they are ecstatic with the plan or merely happy that is at stake.

The reckless abandon camp is led by France, with Belgium an eager follower (they have no choice after bailing out Dexia). These two countries represent €186 billion of the EFSF commitments. Belgians contribution is relatively small and given the trajectory of their own credit they may well soon be a beneficiary of the EFSF. The Belgium 10 year bond was yielding as low as 2.2% in September 2010 and is now at 3.8% which is the highest yield over that period. Not yet PIIG-like, but concerning. And they have about €330 billion of debt and are running at about 100% of Debt to GDP, so their motives are clear.

France’s headlong rush down the reckless abandon policy is more confusing. If anything, it seems that this has become way too personal for Sarkozy and has gone to the point of being something more than policy and has become a crusade. If he was a trader, he would have been stopped out long ago. His decisions have not been working, and rather than cutting back, and pausing to think about a new strategy, he just keeps rolling forward. He, more than any other leader except Papandreou, continues to focus on speculators and CDS as the core of the problem. That is pure nonsense, but he in particular seems to see the world in that way. Maybe sipping wine with other exquisitely dressed rich bankers in a smoke filled room with the occasional dismissive wave of the hand and comments of “if only ze speculators were crushed, all would be tres bien” has influenced him. In any case his focus seems directed in the wrong direction. The fact that the country with the biggest problems at the bank level is the biggest proponent of turning the EFSF into a bank is also somewhat ironic, if not ludicrous. Maybe he has some friends at the big banks looking for a less stressful, but high profile and high paying job, and what better way than creating a bank? Imagine the field day someone as witty and smart as Sarkozy would have if someone he was up against was caught proposing such wild plans. In the end, he seems to believe that Europe can do something, anything, and everything that can “solve” the problem with 100% certainty. That is the problem with his stance, nothing is 100% certain, except debt and taxes (except in Greece where taxes at least, are optional). He is going down a path that leaves no plan B, and that is scary. The fact that most of his plans fall flat when discussed amongst people who would be buying the bonds of all the whacky entities and structures has totally fallen on deaf ears.

Austria and Netherlands have not taken a stand so far. They remain strangely quiet. With €66 billion of commitments they are not trivial. The fact that their commitments are rated AAA makes them even more important. I suspect they remain quiet because they are in the “prudent” camp. The “reckless abandon” camp has the benefit of any good crusade – the ability to say that they are saving the Eurozone. I would bet they are in the prudent camp and are hoping that, Germany who has the most to lose in the reckless abandon plan, and Finland which has already demonstrated a willingness to fight for themselves with collateral demands, win and they don’t get blamed for the near term problems that result.

In the meantime, Italian, Spanish, German, and French yields are all higher again today (not good) and Spanish and Italian spreads are wider as well, doublenotgood.

The market feels positioned extremely long. I think there are a lot of closet longs. It is cool to say negative things about the possibility of Europe resolving anything, but people are long or have cut hedges dramatically, just in case, but aren’t willing to admit it. That is away from the crowd the believes Europe “gets it” and is long on the back of that. Without a doubt, there is a willingness to try and figure it out, but it seems that they waited way too long to look at any actual details, and things are so dire, that no plan has a high probability of success, and many have extreme downside risks.

Copyright © 2011 · Peter Tchir

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