Italy – Weak; But How Would A First Loss Insured Auction Have Worked?

Well, we are now into the second day of the new Era. We continue to wait for details on the exact IIF plan. We wait for details on what the EFSF will look like, particularly the leveraged guarantee portion. We are also waiting to fully understand who will be doing the secondary market activity – the ECB, the EFSF, or both?

The jury is still out on how successful the IIF restructuring will be, but we do know it has affected the Sovereign CDS market as the willingness to structure a solution around the CDS Credit Event language impacts how useful Sovereign CDS is for economic risk management at banks. Since the regulatory capital associated with sovereign debt is ZERO, then the only reason banks would have bought CDS is for economic risk management, so this is a big deal. The Greek “basis” went from about 100 to only 93 (the sum of the price of a Greek 5 year bond + points up front on CDS). If the IIF program is successful I would expect to tighten much more than bonds. I wonder if some banks are selling their basis packages to hedge funds, who wouldn’t have to commit to the program? Those funds could keep the bonds and the CDS. Eventually the bonds would have to get paid at maturity or Greece would risk a Failure to Pay Credit Event. Greece will likely still be unwilling to create a Credit Event so they will repay the bonds in full, especially on any bonds that the ECB owns. It is a weird precedent when holdouts might receive much better treatment than the participants. It would be interesting to see if any of this occurs. One other thing, that is worth pointing out, is that for mark-to-market banks, it is possible that they will have a slight gain on the exchange (if the new bonds are worth close to 50% of par) as they will write-up their asset side. They are losing on their CDS side as that tightens.

The one element that I’m having the most trouble figuring out what it means longer term, is that the ECB’s bonds will not be subject to the IIF proposal. I never expected the IMF to participate. They have been cautious all along, have bilateral loans, and if anything have been trying to be senior to regular bonds, so that didn’t surprise me. The fact that the ECB is going to keep existing bonds caught me off guard. The willingness to treat different “investors” differently is a big deal. I suspect longer term it is bad for public confidence when the rules aren’t clear. On the other hand, it is a step towards cranking up the ECB printing press. From a “free market” perspective, I don’t like it, but I’m not sure if it is a good or bad thing in terms of making this “solution” work more than a few days. If the EFSF takes over the role of secondary bond market buying, this ability to be a protected investor will need to be clarified.

Yesterday was clearly a massive “risk-on” day. Virtually every risky asset had a great day. SPX is the most overbought since early July. One asset that failed to participate was Italian debt. That trend continues today. While the risk-on trade was relentless, it is worth paying attention to the fact that one of the key assets the plan is supposed to help, failed to respond.

Sources: Bloomberg, TF Market Advisors

So the plan made Italian CDS a lot tighter. It is now trading tighter than the Italian 5-year bond spread. That is encouraging, but largely meaningless. The fact that the spread to Bunds increased is a bit frightening. Not only are yields increasing, but the spread increased as well. As we have mentioned before, getting the CDS tighter doesn’t ensure that the bonds will trade tighter, particularly when the move in CDS is largely manipulated rather than based on improving fundamentals.

The Italian bond auction today was poor. The 3-year bonds priced to yield 4.93%. Not only the highest in more than a decade, but also higher than the 4.68% back on September 29th. The DAX opened that day close to 5600 and is now over 6300. A big move in risk assets, at least in part in response to a “solution” that doesn’t seem to be solving what it is supposed to.

Although the EFSF insurance facility isn’t up and running, it is worth thinking about how it would have worked here. For simplicity, I’m going to assume it is a more “normal” wrap and not the crazy thing with extra bonds issued and held in custody.

We haven’t seen what the wrap will be. If it is directly associated with a specific bond, than I would expect the wrap to make payments of principal and interest on the original schedule. That is reasonably standard (though first loss wraps on specific assets aren’t the norm – they are typically done on pools of assets). If the wrap is going to be applicable more broadly, almost like a CDS contract, then it better have language a lot tighter than the CDS contract. Lets assume it is a 25% first loss wrap.

I’m going to assume that the new “wrapped” bonds would price at 25% of France (as middle of the road of the AAA wrappers) and 75% of straight Italian debt. I’m going to assume that part of today’s weakness is that the market is already treating these new bonds as structurally inferior to the wrapped bonds, so I won’t assume a further sell-off. That would give me a yield of 4.04% (75% of 4.93% and 25% of 1.38%). I suspect the yield would be a bit higher as French yields likely to go out further once the EFSF starts issuing guarantees, and Italian secondary markets may be weaker still once the new, preferential paper is issued. The ECB may cut rates by then too, just so that the yields would be lower. Over 4% for 3 year money isn’t bad, but it doesn’t seem like a game changer. Especially since Italian banks will have to fund being benchmarked to the subordinated Italian yields and that “insured bond” yield will be isolated to that particular bond and won’t flow through the system.

In theory, the wrap could be made to cover any Italian bond. Assuming this auction was 10 billion Euro, that would provide 2.5 billion of “wrap” available to cover 1.6 trillion euro of debt. I don’t use enough decimal places to show the impact on the yield of the entire Italian debt market if only 2.5 billion of guarantee is “freely” tradable. (Please see our earlier write-up on how the insurance could work and the potential impacts at www.tfmarketadvisors.com).

So it will be interesting whether what the EFSF will be able to accomplish once it goes live and if it will live up to what seem like very high expectations.

Everyone seems to be taking 250 billion of AAA rated first loss guarantee and assuming we get to 1 trillion of wrapped issuance. There is a very strange thing about wrapping a single asset. If a country is doing poorly, let’s say Portugal for example, how much could they raise through this mechanism. Current 4.2% coupon 5 year bonds trade at 65% of par. How high of a coupon would you need to get to buy a 20% first loss protected note? It would have to be very high. As an investor, you might still prefer to buy the bonds trading at 65 in the secondary market. If you buy the bond at 65, all you can lose is 65. It is clearly trading at those levels for a reason – high likelihood of default or “forced voluntary” restructuring. If you buy the 25% first loss protected issue at par, you could still lose 75 points. You would need a very high coupon to make up for that extra risk, and the opportunity cost of price appreciation of the low-priced bond. First loss works well on a pool of assets, because some defaults can occur and the 2nd loss buyer may not have losses. Insuring first loss on a single asset is strange, because if there is a default, the 2nd loss holder will lose money as well. The idea works well when people aren’t thinking there is a real chance of default, but as that increases, the EU may wish they had stuck to their original plan of having raised 440 billion of cash that they could lend directly. Basically, if the markets deteriorate, the first loss protection, is worth more, but provides less leverage.