The T Report: The Greek Election is Irrelevant but FROB Isn’t

Does the Greek Election Still Matter?

The market still wants to believe that the Greek elections are an important catalyst for the market. That if one side wins, the Greeks stick to the original plan and continue to destroy their country, but make the markets happy. If the other side wins, conventional wisdom, is that there will be a Grexit causing problems for the world’s markets.

They are both wrong. The market is choosing to ignore more and more politicians who say that the deal will get renegotiated in any case. The EU and Greece have both finally done some analysis of what a Grexit could be and they are scared. The EU isn’t scared for Greece’s sake, it is scared because it and the ECB have lent so much money to Greece that any exit is horribly messy for the EU and the instant spillover into Spain and Italy is too much to handle.

No matter who wins the Greek elections, the deal will be renegotiated with the latest deal in Spain as a template. Greece will not leave the Euro yet, and the renegotiated deal will give some hope to the people that the plan has a chance of succeeding. The ECB could make one simple decision that costs them virtually nothing, yet would have a huge impact on Greece and the market as a whole. They could convert their remaining GGB holdings into PSI bonds at cost.

Will the markets see this before the weekend? Probably not. The market is likely to thrash about based on election predictions and then the results, but it seems far more likely that the election results won’t have a material difference on the outcome.

Evidence suggests FROB is a major shift in the EU attitude

There are still virtually no details on the deal struck last Saturday, but what little we have should actually be very encouraging to the market, and so far it hasn’t been. The chatter out there is that the loans to FROB will have final maturities of 15 years and will be zero coupon for 5 years before going to cash pay at 3%. Here is what we should be thinking about:

1. FROB was used rather than the sovereign as a way to retain and control what the money is used for – the purchase of common equity and CoCos in Spanish banks. This isn’t a general bailout to Spain, this is specific, asset based lending and represents a shift in mentality.
2. While you cannot solve a debt crisis with more debt, you can help by replacing short maturity high coupon debt, with long maturity low coupon debt. Low coupons relieve the immediate budget problems, and longer maturity gives time for plans to work out. A fifteen year loan is appropriate for the purposes of taking equity stakes in banks and giving time to sell the stakes and repay the loans. Again the low coupon and long maturity represent a very big shift in EU attitude.

In the end, maybe the details won’t match what little positive has leaked out so need to be cautious, but be careful about underestimating what this program is trying to do. It may become a model throughout Europe. It would not be surprising to find out that they institute a similar program in Greece post election in an effort to separate the bank bailout from the overall bailout.

Italy is NOT borrowing at 6% to lend to Spain at 3%

There is a lot of confusion about who is lending to who, how it is unsustainable, or how it is massively subordinating existing holders, etc. The lack of details aren’t helping, but neither is ignoring some details.

Here are the yields on 10 year EFSF bonds. 3% for 15 years does seem aggressive given the recent move, but at 2.74% EFSF continues to trade and borrow at reasonable rates. It just issued €1.5 billion of 25 year debt at about 3.375% yesterday.

EFSF is convoluted. Like everything else in Europe, but as a quick reminder, the EFSF has €726 billion of committed guarantees. It uses those guarantees to get a rating and to issue bonds to the market. No country actually provides money up front to the EFSF. The EFSF has effectively committed to capping issuance at €440 billion which is less than the combined guarantees provided by Germany, France, the Netherlands, Austria, Finland and Luxembourg. It is this over guarantee that creates confusion. The total amount of guarantees that the EFSF has to play with to secure funding is much higher than the amount of funding it is allowed to access. In the end it relies on the guarantees of the 6 best countries.

So is Spain lending to Spain? Again, the answer is not really. Spain’s guarantee is largely irrelevant since no one buying EFSF bonds is relying on it. The other issue, is that the EFSF would be lending to FROB which although it has a Kingdom of Spain guarantee is an issuer in its own right, with its own assets that will be used to pay back the loans (in theory).

The ESM is more confusing as it has some “paid-in” capital. We have been laughing at the paid-in capital concept since the day it was announced. Visions of some fully funded vehicle are just wrong. The ESM actually looks a lot like the EFSF.

The ESM is supposed to maintain a leverage ratio of 6.67:1. So for every €1 Euro of paid-in capital, it can borrow €6.67. If the entire €100 billion was coming from ESM, then ESM would need €15 billion of paid-in capital. Italy is about 18% of the paid-in capital, so Italy would have to come up with about €2.7 billion of money. So, Italy would have to borrow €2.7 billion at 6% for example. Italy would then receive net “profits” on about €18 billion of loans to FROB. With that amount of leverage it takes only a small margin above cost for Italy to break even.

In the end, the initial capital call will be larger. I cannot figure out the latest (it will be adjusted based on the amount used up by EFSF), but haven’t seen a figure bigger than €40 billion. On €40 billion, Italy would need to come up with about €7 billion, and Spain itself would need to come up with just over €4 billion, but the ESM would be allowed to lend €267 billion on that. For costs and ease of use, giving the ESM direct access to the ECB would be helpful.

In any case, it is all circular and relies on guarantees, but Germany and France bear most of the risk, and the ECB’s involvement is key to whether it buys much time or not.

It is all a giant ponzi scheme, but with the ECB as the hub, their willingness to lend at low rates and print money can keep the ponzi going far longer than it should.

Contingent Liabilities

The whole use of guarantees makes everything far more complex and opaque. It is hard to tell how much any country really owes since it is difficult to determine what they have guaranteed and how likely those guarantees are to be called on.

The whole concept of second loss is a pain. If I guarantee an SPV with treasuries as its only asset, I am highly unlikely to ever be called upon to make good on that guarantee. If that SPV uses the money to give money to whoever asks, the SPV won’t have any money left, and I, as guarantor, will have to pay back the full amount of the guarantee.

We do not know what the value of FROB investments will be. Given the risky nature, it is hard to believe they will be sufficient, once sold to pay off all the debt, but with IMF involvement, it may be overly pessimistic to assume that the FROB won’t be able to pay back any of the money it borrowed from its purchases. The 15 year nature of the loan and the fact that it is PIK (pay in kind) for first 5 years, gives the FROB a lot of time for its investments to play out.

I’m not trying to be overly optimistic, but being overly pessimistic isn’t a good investment strategy either.

JPM and the Whale Tale

Will we learn anything new today? The best thing the market could find out is that JPM has made a lot of progress in terms of cutting the positions in the CIO’s office, including the available for sale book. I’m not sure that he can or will say anything about the current state of the CIO’s positions, but given the numbers thrown around about the potential size of the losses, and how difficult it is to unwind, I think there is a chance for upside surprise here, especially if they are taking down the size of the AFS book at same time as unwinding the CDS trades.

I’m sure most of the questions will be very negative and strike fear into anyone hoping banks won’t face more regulations. I’m also sure that we will see a lot of smug faces from people who just asked a nonsensical but impressive sounding question. It should make for some entertaining theater especially if the normal Jamie Dimon shows up and not the pod Jamie Dimon that stumbled through the May 10^th conference call.