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April 30, 2010

Greece - The End of the Beginning

"How did you go bankrupt?" "Two ways, gradually and then suddenly."

The Sun Also Rises - Ernest Hemingway

“Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”

Sir Winston Churchill - Speech in November 1942

On the morning of 29 May 1453, the small postern called Kerkoporta was left open by accident or treason, allowing the first fifty or so Ottoman troops to enter the city of Constantinople. TheOttoman-Turks raised their banner atop the Inner Wall and opened fire on the Greek defenders of the peribolos below. This spread panic, beginning the rout of the defenders and leading to the fall of thecity.

Doukas (c. 1400 – 1462)

Perhaps more than anything else, failure to recognize the precariousness and fickleness of confidence- especially in cases in which large short-term debts need to be rolled over continuously - is the keyfactor that gives rise to the this-time-is-different syndrome. Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang! - confidencecollapses, lenders disappear, and a crisis hits.

This Time is Different - Carmen M. Reinhart and Kenneth Rogoff

Introduction - Greece is the Word

If you had read “This Time is Different: Eight Centuries of Financial Folly” by Reinhart & Rogoff,none of the current alarm over Greece’s debt situation would come as any surprise. Indeed the book shows that Greece has been in default roughly one out of every two years since it first gainedindependence in the nineteenth century. However, as the quote above illustrates, it is never knowablein advance at what exact moment the tipping point is reached.Today, the government of Greece is burdened with approximately

€

275 billion of debt, equating to115% of GDP, are running a nearly 14% budget deficit for 2009, [Eurostat, April 2010

] and S&P has downgradedtheir debt to BB+/B - junk status! Up until March, theworld bond markets had taken a remarkably sanguineview of this situation. In January, the Greeks sold

€

8 billion worth of bonds at a rather high (historically)6.25%, while there was demand for

€

25 billion. Butshortly afterward, the situation deteriorated rapidly.On April 22nd, Eurostat, the EU statistics agency, revisedGreece’s fiscal deficit upwardsby a full percentage pointand cast doubt on thequality of dataprovided by theHellenic Republic. This was the straw that broke thecamels back. Greek 5-year CDS promptly jumped to arecord high of 505Bps, and the difference in Greek vs. German 10-year government bond yields roseto 520Bps, near a 12-year high. Greece’s hand was forced, and on Friday April 23rd, they succumbedto the inevitable, and Prime Minister Papandreou formally requested the activation of the EU/IMF bailout mechanism.EUR/USD 1.3297EUR/JPY 124.76EUR/CHF 1.4327EUR/GBP 0.8706EUR/NOK 7.8505GBP/USD 1.5270USD/JPY 93.860

CurrenciesBonds 10YR Gold (Troy Ounce)Oil (Barrel)Euities

US 3.65%Germany 3.01%Japan 1.29%UK 3.85%Greece 8.94%USD $1180EUR

€

890ICE Brent $87.44 NYMEX WTI $86.15S&P 500 1187DAX 6136FTSE 100 5553 NIKKEI 11057SHANGHAI 2870

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April 30, 2010

Greece - The End of the Beginning

Bailout Uncertainty

The EU/IMF bailout mechanism however, has, at time of writing, yet to be finalised. The uncertaintyover it’s terms and likely implementation have meant the calm that the activation was meant to bringhas been lost. The bond markets have shown no mercy. Today the 2-year Greek bond yieldsapproximately 13%, the 5-year CDS in close to 750, and the spread between the German 10-year isclose to 6.5%. The market is reflecting the tremendous difficulties inherent in such an unprecedentedaction.First, it involves almostimpossible coordinationamong all the major powers within the EU & theIMF. It requires the unanimous pre-approval of all the EU heads of state & some parliaments. Itinvolves the European Commission, theEuropean Central Bank and the International Monetary Fund(IMF) all visiting Greece to perform financial assessments, and coming to agreement.Germanyis themain stumbling bloc in this process, with the majority of German politicians & the publicdead setagainstthe bailout, and even if this obstacle is overcome, there is a legal case waiting to be lodged before the GermanFederal Constitutional Court. Interestingly, asFelix Salmonof Reuters notes, it is not strictly in Germany’s interest to bail any profligate member out. This must be playing in the back of Angela Merkel’s mind daily.Second, even if overall agreement can be reached, and as of time of writing this looks likely, willGreece be able to agree to and enforce the austerity measures necessary to receive the aid? Today theGreek government have in principle agreed to a

€

24 billion austerity package. Amazingly though,even at this late hour it seemsGreek negotiatorswere still trying to delay timetables and dilute some public sector reforms. The IMF had little sympathy. The bigger concern now of course is how theGreek publicwill react. They are known to strike regularly and en masse, sometimes evenriot

, butwill this lead to serious civil unrest? And how will the government tackle the crucial problem of taxevasion? There are many issues here left unresolved.Finally, the tenure, size and structure of the overall aid package is in doubt.TheEconomistmaintains that a minimum of

€

75 billion over 3 years is needed. But in fact, if this is to be a 3-year package,gross Greek funding requirements through to the end of 2012 run to

€

110 billion, and almost three-quarters of that is to cover redemptions. There are well foundedrumors, though nothing concrete, thatthe head of the IMF, Dominique Strauss Kahn has orchestrated a

€

120 billion package in jointcooperation with the EU. But the loans are not nearly enough, the structure is also important. If EU &IMF loans, as is usual, take priority over all other bondholders, then private money would have noincentive to lend, stymieing a crucial aim of the overall package - to get the bond markets to reopenfor Greece. However, in a highly unorthodox move, theIMF loan appears to be junior to existingdebt. This would be an interesting departure from historical norms. There was talk of bondholderstaking loses, but that has now been swept aside. We will of course know all the details very shortly.It is crucial to realise that the market is now expecting a minimum of

€

100 billion over 3 years. The package announced must fulfill these expectations. It also must be realised that by making the loanscontingent on Greece meeting budget cut targets, the EU/IMF run the risk of undermining confidencein the whole package. The market fears most of all Greece’s ability to change, and essentially has nofaith in getting its money back under the current regime. At this point only unconditional support willdo, but that is unacceptable to Germany. It’s no wonder that the process so far has beendisorganised,rancorous & completely reactive.

A Restructuring (or default) is Inevitable

So, where to from here? It will be obvious in a moment, that some form of restructuring of Greek debt is inevitable in the long run. But in the short run, there are really only 2 scenarios that I see aslikely;The bailout is agreed - this buys time, approx 2-3 years max until a managed default can be arranged.The bailout falters - Greece goes straight to an unmanaged default.But first, why is a restructuring inevitable in the long run? Martin Feldstein, a professor of economicsat Harvard, former Chairman of President Ronald Reagan's Council of Economic Advisors andPresident of the National Bureau for Economic Research, puts it best;

“There simply is no way around the arithmetic implied by the scale of deficit reduction and theaccompanying economic decline: Greece’s default on its debt is inevitable. In the end, Greece, the eurozone’s other members, and Greece’s creditors will have to accept that thecountry is insolvent and cannot service its existing debt. At that point, Greece will default.”

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April 30, 2010

Greece - The End of the Beginning

A Restructuring (or default) is Inevitable cont’d

For some more quantitative analysis, we turn to Wolfgang Münchau,writing in the FT on April 18th;

“The bail-out prevents a default this year, but makes no difference whatsoever to the likelihood of a subsequent default. Just do the maths: Greece has a debt-to-gross domestic product ratio of 125 per cent. [Eurostat figure is 115%] Greece needs to raise around

€

50bn ($68bn, £44bn) in finance for each of the next five years to roll over existing debt and pay interest. That adds up to approximately

€

250bn, or about 100 per cent of Greek annual GDP. But even if the Greek government were to present a credible long-term stability plan, the risk of default would remain high. This means that some form of debt restructuring is unavoidable. Restructuring is a form of default, except that it is by agreement. It could imply a haircut – an agreed reduction in the value of the outstanding cashflows for bond holders. The Brady bonds of the late1980s, named after Nicholas Brady, a former US Treasury secretary, worked on a similar principle. An alternative to restructuring would be a debt rescheduling, whereby short and medium-term debt isconverted into long-term debt. This would push the significant debt rollover costs to well beyond theadjustment period.The best thing you can say about the rescue package is that it buys time to negotiate an orderlydefault. Restructuring and rescheduling is probably the only chance for both Greece and itsbondholders to come out of this mess still standing.”

Indeed the market is already pricing some from of restructuring in. Prices for Greek debt will onlystabilise when clarity is brought to the fore. Despite assurances from the various authorities that“restructuring is off the table”, in the long run, it is unavoidable, and the market knows this.Interestingly, according to Erik F. Nielsen, chief European economist at Goldman Sachs;

“PM Papandreou is planning to appoint a central coordinator for the government’s interactions withthe IMF and the European counterparties. According to the FT, highly respected outgoing ECB vice- president Papademos has turned down the offer of the post, which – if confirmed - makes me wonder whether Papademos sees what I see, namely an overwhelming probability that we are indeed heading towards a debt restructuring, and being in the middle of this mess is just not the way he wants to end his fine career.”

Back to the Future

Now that it’s understood that some form of default is assured, onwards to my 2 scenarios. As I saidearlier, even is the bailout is agreed & implemented, this only buys 2-3 years max. What happensthen? In the first scenario the politicians and the various Greek debt holders come to the realisationthat there is simply too much debt, that full repayment is an impossible task, no matter what thetimeline, and they mutually agree to restructure. In scenario 2 however, the Greek public areunwilling to make the sacrifices necessary, and mobilise against the regime, leading to agovernmental collapse and economic chaos. This has a strong precedent in Argentina and numerousother developing countries.

Scenario 1 - Managed Default

•Other PIIGS and possibly Austria immediately see their cost of funding rise, and stay high.•Market seeks credible & concrete reassurance from Eurozone core on other PIIGS debt butdoes not get it.•Cascade of managed defaults across the PIIGS as debt is restructured.•Greece stays with EUR while austerity measures are acted out, with funding from IMF &EU.•Steady decline of EUR vs. every other major currency.•Bunds widen (prices fall) as Germany seen to be “on the hook” for all bailouts.•Banks across Eurozone need further bailouts.•Inflation begins to hit Eurozone in earnest.•Current Eurozone stays intact up to & until austerity measures become too severe causing aPIIGS member to leave. (Argentina Scenario - see end of piece)