A Breather And Some Time To Sort Through Some Details…

Details continue to leak out, making it somewhat easier to analyze what is coming out of Europe.

It looks like the ECB and National Central Banks will get preferential treatment.  The ECB has already allegedly exchanged their bonds for new ones, though I don’t see a reduction in notional of existing bonds – which could be a fact that they haven’t settled yet.  It will be interesting to know definitively what the ECB owned.  And then the NCB’s since they were kind enough to do the swaps (whether legal or not, particularly in the case of English law bonds) on different days.

Greece did take the time to announce that the budget deficit will be 6.7% of GDP instead of the 5.4% that had been projected.  With a real GDP of €225 billion in 2010 that would have been about €3 billion, but with GDP dropping so quickly, it is less additional money needed than you might think (positive thinking).  The fact that they cobbled together this whole deal based on a base case that is unattainable and worse than anyone expected just 3 months ago shows the power of being locked into a negotiating stance.  Even Germany must feel a bit guilty that they put a puppet in charge of Greece whose sole function was to negotiate this deal and didn’t actually spend any time to see if there was a better alternative for Greece than more austerity and decreased sovereignty.  Killing with kindness.  Also on the European economic data front, European PMI was below 50 for the composite, services, and manufacturing.

The European Investment Bank said that Greece needs a Marshal Plan.   They kicked in €2 billion last year and seem prepared to kick in more this year.  That is reassuring that someone is focused on growth, and thankfully we live in a world where entities like the EIB can exist and issue as much debt as they want based on guarantees and promises, without impacting the credit of the guarantor.

Speaking of that, how much is the EFSF going to come up with for the Greek bailout?  It is hard to tell where all the money is coming from (at this stage – though I assume we will get more clarity any day), but Germany in particular just added a lot of debt.  If you want to assume that Italy is really participating, then Italy is on the hook for about 20% of the money coming from the EFSF (and I assume from the EU).  In that case Germany is only on the hook for 30% of the money.  If the money is really coming from those countries still mostly AAA (including France) then Germany is on the hook for 50% of the EFSF/EU money, and Italy is not burdened.  I’m sure Sarkozy is quietly hoping no one in France, or the rating agencies, notice just how much more debt France has committed themselves to.  He has been awfully quiet during this process.  The Dutch seem to be getting more involved, but seem to be leaning more towards the Finnish view, than the save Europe at all costs view.  The benefit of the current structure is that it is hard to pin the specific obligation of any one country, but in some real world of finance (that is no longer seems to exist), some countries just saw their debt burden rise.  Fortunately in the world of unlimited central bank liquidity it may not matter how much debt anyone takes on (until the day it does).

After months (it seems like years) of trying to avoid a CDS Credit Event, it looks like one is inevitable.  The Greek 5 year CDS is at least 70 bid which may be the highest ever.  The game plan seems to be that Greece will put in retroactive CAC laws.  The PSI will come in below 100%.  Greece will trigger the CAC clauses on the Greek bonds, and we will get 100% participation in all those bonds, and we will get a Credit Event.  The interesting part is that depending on what they manage to do with English law bonds, the only bonds outstanding (not in the hands of the central bank only bonds, and troika loans) will be the new bonds.  If they start CAC’ing each bond, it is possible that there will be no existing bonds outstanding left.  Settlement would be based on the new bond (yes, ISDA has a Sovereign Restructured Deliverable Obligation clause – Section 2.16 of the definitions).  With the amortization schedule in place (and not including any value attributable to the GDP strippable warrants), I get that the new bonds would trade at 30% of par with a yield of just over 13%.  I would be careful paying up for CDS here, because settlement will be against these new bonds, not existing bonds if every old bond is CAC’d.  And given the attitude out of Greece late yesterday, and harsh IMF demands, we may well see that.

The ECB’s secondary market purchases have slowed to a trickle.  Without a doubt, the fact that the market is trading so well has played a role.  They haven’t needed to buy bonds.  That is good, but will they resume their buying if markets show any weakness?  With everything that is going on with their holdings of Greek debt, they may not be so eager to return to active SMP.  They have given the banks the ability to buy whatever they want (with LTRO) and maybe that will be enough?  Draghi’s responses to questions about their Greek bond holdings have lacked for any finesse.  He seems annoyed with the situation and being caught in the middle.  For the “integrity” of the ECB’s core mandate (and yes I’m laughing as I type) they may shy away from building a balance sheet of direct holdings of sovereign debt (as collateral for loans to banks, they have no problem).  I don’t think they like being caught in the middle as a direct lender, have felt like they are being ordered around by a bunch of politicians, and at this stage he can still largely blame the whole mess on Trichet in his memoirs.  I still think they will do SMP, but I think they will be a little more reluctant than in the past, and will use bank lending tools to try to calm markets, rather than direct intervention in sovereign debt markets.  Besides, that is the EFSF’s responsibility, if the EFSF still has any money left.

Some noise about this being the last LTRO?  I’m sure it won’t be the last LTRO if or when we get another round of fear, but makes sense with things so calm to start ratcheting down expectations.  We will see what the demand is for the February 29th one, and how much LTRO money is used to add assets as opposed to just managing funding risk.

In the meantime, I’m not sure how central banks solve the deteriorating situation in Iran, and since they are the only ones who seem to be able to accomplish anything we should continue to watch developments there.  And although less exciting, probably more important, is figuring out if China can really manufacture a soft landing.  Expectations that things are under control there seem high, relative to evidence that all is not good.