Trader’s Review of the Week; 28 and 29 May 2011

[private] Saturday 28th Possible solution to the Euro Zone debt/banking crisis

With about E350bn of debt, Greece has a major solvency crisis and must effectively reduce its debt load by at least 50%, though closer to 70% is a better target, given the continuing structural changes that are needed to make the country efficient enough to compete (indeed survive) in the future.

Greece has not been, how shall I put it, “totally honest”. They have lied constantly and basically the EU/IMF/ECB are fed up, not surprisingly. However, for the Greeks, the game is up and I actually believe that they are beginning to understand that. Never over promise and under deliver or in Greece’s case, LIE – always a recipe for a disaster, though clearly the tactic used by the Greeks to date.

Indeed, they should have under promised and over delivered. As a result, the Troika (EU/ECB/IMF) are now working on the principle that the Greeks will continue to lie and, as a result, will take appropriate action.

Let me say, I have absolutely no sympathy for Greece, given their extremely bad habits. However, how does Greece/Euro Zone move on?

Over the last few days, I have got the impression that Germany is seeking to find a solution, particularly given the comments by the (initially) highly sceptical Finance Minister. The problem in the Euro Zone is that there are so many people making comments/expressing their views, that it is a total nightmare. Clearly, there should be just 1 spokesperson and a (small) committee established to sort out this mess. However, this is the Euro Zone, so don’t expect them to follow sensible procedures.

Jean Claude Junker, the head of the Euro Zone Finance Ministers and Luxembourg’s PM (and the person who stated that you have to LIE when things get tough – I kid you not) stated last Thursday, that, in effect, the IMF may not provide the next trance of aid to Greece.

Maybe he has not realised that he has not taken over from DSK. He is clearly trying to frighten the Greeks and his other Euro Zone colleagues, but such comments are totally irresponsible and make him totally unfit for his job.

On Friday, Reuters issued a report from an “informed source”, who attended the meeting of all the Greek political parties. The informed source claimed that the opposition would not back the Government in respect of the E6bn of additional austerity measures. Here we go again. The Greeks must really believe that there is a free lunch, accompanied by Ouzo etc.

Greece has also promised to raise E50bn from privatisation – don’t hold your breath. Indeed, even the EU is highly sceptical and is suggesting that these assets are ring fenced into some kind of structure which will actually implement the proposed privatisation – hopefully NOT CONTROLLED and/or MANAGED by the Greeks. Sure national pride/sovereignty issues etc will be raised, but the Greeks have, for decades, proved themselves to be TOTALLY UNRELIABLE – a view that most people in Europe now totally get.

The assertion is that there is not enough money around to fund a bail out of Greece and other Euro Zone countries. Yes, resources are limited, but I believe there is enough money to solve this issue. What you need is a comprehensive programme, strictly adhered to, with tough incentives/disincentives to force countries such as Greece to comply.

First, the EFSF has to buy Greek and other peripheral country bonds at a steep discount, in addition to providing these countries with financing – as there are no other sources available. They can do this by stating that EFSF financing will rank in priority to other existing debt (similar to the IMF). Current bondholders will then have to consider whether they take a large haircut today (though get something back) or risk getting virtually nothing in due course.

I believe bond holders will take the money now and, as a result, will sell their bonds to the EFSF. This must be done on a “voluntary” basis to avoid an act of default – there is much current debate as to this issue, but I believe it is achievable. The bonds acquired by the EFSF will then be restructured so as to reduce the principal and interest rate and the maturity profile.

The interest rate charged by the EFSF has to be significantly lower than current rates – perhaps a few bps over their cost of borrowing and nearer the IMF rates.

The Greek banks will become insolvent – shareholders will be wiped out and bond holders will be forced into debt/equity swaps. No one guaranteed equity and bond holders a return of their investment and this whole problem of “moral hazard” needs to be addressed once and for all.

If necessary, the EFSF and/or another European organisations must subscribe for new equity in Greek banks, which no doubt will be needed. The Greek banks will have to include non Greek professional managers in senior executive roles to avoid the Greeks doing what they would do otherwise.

In time, the EFSF is likely to make money on its equity holdings in the Greek and banks in the other countries, which they inject capital into. Just to be safe, the recapitalisation of Greek banks may need to be conducted through a new company – God knows what rubbish is in the banks – I would suspect an enormous can of worms.

Greece and other countries need to grow out of this mess – there is no point (particularly given where they are) forcing a contraction of the Greek economy, as it will just make the debt situation much worse.

In addition, the population is unlikely to take more pain and there is a serious risk of additional civil disorder on an increasingly violent scale – which inevitably will spread to other Euro Zone countries. Indeed, it is starting to happen.

A comprehensive structural reform programme + (realistic) fiscal targets will need to be agreed (at the outset and conditional upon gaining Euro Zone financial support) with incentives if Greece meets the targets, but with HUGE disincentives (penalties, but also exclusion from receiving structural payments from the EU and/or common agricultural payments to farmers etc, for example).

This programme should be monitored on a daily basis – no point taking Greece’s word for it. Personally, I believe that a clause should be inserted that will allow the EU to kick out the Euro of any country that does not meet its obligations –  indeed, I would suggest the EU itself.

A haircut on Greek bonds will bankrupt the ECB, but they can either print money (the monetary hawks will hate this, but they have caused untoward pain unnecessarily, by following an out of date dogma) and/or the Euro Zone will have to subscribe for new capital for the ECB – there is no other alternative. I really am going to love this one.

A similar programme should be put in place for Portugal. In Ireland’s case, the country must be allowed to force senior bondholders to take a haircut and/or enter into debt equity swaps (will inevitably occur) – current plans require Irish banks need to reduce the size of their balance sheets by some E76bn over the next few years – complete nonsense. Such a plan will just result in additional pain, which will contract the economy further, and which is exactly the opposite of what is needed. Irish banks may also need to be recapitalised.

A number of people suggest that it is still to risky to talk about/implement haircuts, particularly given the state of Euro Zone banks. Yes, there is a risk, but the market is not stupid – it knows that there will be haircuts and debt/equity swaps and even some bank failures – the only crucial issue is to ensure that depositors (particularly in the large banks) are made whole  – forget equity and debt holders.

Some banks may need to be merged, closed down etc, but in any event, these issues cannot be ignored any longer. Euro Zone banks will need to be recapitalised and, in addition, regulators must force banks to clean up their balance sheets over a predetermined (not too long) period of time. Then force them to increase capital, probably by banning the payments of dividends, bonuses etc. The upcoming European Stress Tests are simply not good enough.

In addition, every systemically important bank should be subject to a Stress Test every year – failure means restriction of div payments/bonuses etc. I believe that it will take a minimum of 2 – 3 years to fully achieve this objective, but this process must be started immediately. At the same time, it must be made clear to investors (both equity and bond) that they will not be bailed out in the future. This will force the banks to de risk.

Currently, regulators are backing off imposing much needed additional regulation on the banks – this has got to stop and indeed, reverse. The European public will not stand for another bailout of banks at their expense – indeed a programme, such as that described above, will attract public support, especially if the banks take a hit – great politics and I really don’t see why Euro Zone politicians don’t understand this. However, they will in due course.

The current patch up, uncoordinated, shambolic policies have to stop and a sensible plan introduced.

I have not gone through the entire scheme, but the above concept is something I believe will be undertaken, sooner or later. Markets are awaiting a plan of some kind – it is also accepted that their will be haircuts, debt/equity swaps etc. It’s the continuing uncertainty that makes the situation worse.

Sunday 29th (am) Russia/Libya – interesting comments by the Russian President

Bloomberg reports that the Philippines and Vietnam are to begin drilling in areas of the South China seas claimed by China – they are 3 times closer to Vietnam than they are to China – I am getting worried that China’s grab for natural resources may result in a conflict.

The US Fleet is patrolling the area and Mrs Clinton declared in Hanoi recently that “a national interest in the freedom of navigation and unimpeded lawful commerce” in waters claimed by China, which is making S.E.Asia countries more assertive. China’s moves will also push a number of countries towards the US. However, this is getting dangerous.

What’s going on in Russia? President Medvedev stated at the G8 meeting in Deauville that Gaddafi had lost his legitimacy to rule and supports NATO efforts. Russia is also trying to negotiate the exit of Gaddafi apparently. Obviously politics, but a view, I suspect, which is not shared by Putin.

As expected, Russia (the worlds 2nd largest wheat exporter) has announced that it is to end the ban on grain exports on 1st July – forecasts are for an increase in the crop by nearly 30% this year. Good news, given all the weather related problems elsewhere.

More Greek antics – the main opposition parties have repeated that they will not support further austerity measures. Personally, I believe that Greece should be left to their own devices, but I suspect the odds of a deal being cobbled together remains the (just) favourite.

The EU/ECB/IMF (the “Troika”) are due to complete their assessment of the Greek fiscal position possibly even as early as next week. Their positive assessment is necessary for the next tranche of E12bn of aid to be distributed to Greece. However, I believe there is a near 100% chance that the Greeks have undoubtedly missed their targets, yet again!

As a result, the Greeks popped up with their privatisation plan. However, the idea that Greece will raise E50bn through privatisation – complete pie in the sky, believe you me – I did this stuff for over 20 years. I will repeat, the Greek unions will oppose it tooth and nail and the Government will not help, the businesses will be a can of worms, including being used as an employment scheme (i.e. massive redundancies will be required).

It will be grossly inefficient and hugely corrupt, but most importantly, there will be no buyers, particularly at the Governments inflated values and given the huge uncertainty. Indeed, most prospective investors would be mad to get involved. However, Greece does have over 100 tons of gold – much more interesting – certainly would be my focus for collateral.

Spanish PM, Mr Zapatero has just announced that he will support Mr Alfredo Perez Rubalcaba (the deputy PM) to be the head of the socialist party at the next General election – to be held by March 2012. Mr Rualcaba lead the efforts against the Basque terrorists (ETA). Polls suggest that he is better regarded than Zapatero – need to check him out.

German inflation declined (unexpectedly) in May to 2.4%, from 2.7% in April and well below expectations of 2.7%. Good news and should help Trichet/ECB from not being silly (although he is Trichet) and announcing a July rate rise of 25 bps at the forthcoming June meeting.

Furthermore, April money supply growth weakened in April, which Trichet should pay attention to (M3 rose by 2.0% YoY, lower than the 2.3% YoY in the previous month). Personally, I believe that money growth is a far better prospective data point, than inflation, which is historic info.

Euro Zone executive and consumer confidence weakened for the 3rd straight month to 105.5 (forecast 105.7), from 106.1 in April – once again signalling a slowing. Euro region manufacturing sentiment fell to 3.9 in May (5.6 in April).

Services declined to 9.2 from 10.4 in April. However consumer confidence rose to -9.2, from -11.6.Overall, order books, prospective consumer confidence and employment indices declined.

UK consumer confidence soared in May (to +10 from -21 in April), the most in 18 years. Expectations also rose significantly to -3, a rise of 11 points – Royal Wedding related and unfortunately unlikely to be maintained.

The ECB is to announce its interest rate decision on 9th June. Most analysts believe that Trichet will utter the infamous “strong vigilance” phrase at the meeting, signalling that rates will be increased by 25bps in July. However, I believe that the ECB will not – more likely a statement that “the ECB will monitor very closely” etc.

It is clear that the recent 25bps ECB rate rise was a huge mistake. The impact on peripheral Europe is even more pronounced – exactly the opposite of what is needed. The ECB should get off this macho stuff and get real. Whether this has sunk in is debatable, but I believe that even those clowns at the ECB must realise that a further rate rise will just make the situation much worse, particularly for the crisis ridden peripherals.

I will follow ECB statements closely over the next few days, but I believe that the Trichet will remain on hold (currently believe (odds on) that he will not utter the “strong vigilance” phrase, though I accept that the market is of the opposite view).

US consumer purchases rose less than forecast +0.4% in April (+0.5% expected), due to higher food and energy prices. Incomes rose by 0.4%, in line with expectations. The US is clearly slowing down. The savings rate remained at 4.9%, the lowest since October 2008 – consumers are being forced to dip into their savings to pay for higher essential products.

I remain of the opinion that a QE3 in the US (with stimulus measures in Europe, China indeed, and the ROW) is likely, possibly even later this year.

The US Treasury declined from naming China as a “currency manipulator”, though stated that China is making “insufficient progress” in letting the Yuan rise. They added that the Yuan remained “substantially undervalued”. The release, before the Memorial Day holiday, was purely coincidental off course – yeah really!  Same old.


I suppose the focus will remain on Europe over coming weeks – Greece clearly needs the next tranche of money, but without opposition support this is difficult. In addition, their fiscal targets will have been missed. Expect stories of “black holes” in the Spanish semi autonomous regions in coming weeks, following the losses suffered by the Socialists, which could raise the issue of spreading contagion, yet again.

The Finns demand to ensure that future financing of the peripherals will require collateral (supported by other countries) is going to be interesting – must be right, particularly for Greece. However, the odds are (just) that something will be cobbled together, but a longer term sensible plan is required urgently.

The US May non farm payroll data on Friday (3rd June) will be important – may well prove disappointing.

Markets have been subjected to so much bad news re Europe for example, they are becoming somewhat immune and therefore could well bounce (for how long?) – Certainly playing for exactly that, though.

Sunday 29th (pm) It’s the banks, stupid

The crucial issue in Europe is that a Sovereign debt default will negatively impact the European banks and potentially wipe out their capital, making them insolvent – so what’s new, a number are insolvent at present, if they made the necessary provisions on their banking book (approx 90% of their assets), which they have not.

We all know, that Greece and other peripherals (certainly Portugal) will have to default. The current debt load is unsustainable, even if they were back to their normal potential GDP growth. As a result, I would argue that you have to allow these countries to default and sooner rather than later.

This will require the EFSF (most likely) to have to finance the relevant countries for a period of time, subject to strict conditions and with incentives and, in particular, massive disincentives if countries do not live up to their obligations. Furthermore, a verification process must be introduced simultaneously to avoid countries, such as Greece from lying.

Essentially, you have to establish a mechanism to allow these counties to grow out of this problem and not, as presently structured, force them to contract, which will just make the situation worse. A growing economy will also result in fewer prospective bad debts from existing commercial loans and mortgages, quite the opposite from the present situation.

The risk of civil disorder if even tougher austerity measures are introduced cannot be understated – it’s already happening and, indeed, spreading. Too much civil disorder (which I assure you is a real and present threat) and politicians will do a U Turn, in any event, believe you me.

Clearly restructuring/default etc will make a number of banks insolvent. The EFSF or some other European mechanism/organisation has to be able to recapitalise these banks (if individual countries cannot) or, at the very least, act as underwriter to ensure that the relevant banks raise the necessary money, if banks try to do so in the markets.

However, it is inevitable that the EFSF will need to inject a massive amount of capital into the banks, as the markets simply will not have the capacity to do so, especially when a number of banks seek financing, all at the same time. Extremely strict capital rules and appropriate regulation must be introduced to avoid these kinds of events in the future.

Clearly existing equity and debt holders will have to take the 1st hit. In addition, the fresh capital will probably have to be injected into a new entity, which will take over the deposits of the bust bank – other assets to be considered, only following extensive due diligence to make sure the new bank is not inheriting a can of worms.

Losses in respect of the existing operation will be the responsibility of the relevant country, which just means that the haircut on restructuring/default increases.

Bankers run shy of this argument – apparently there is not enough money around – their main (and only) argument – that simply is not true, there is and, in any event, the ECB can print it, if absolutely necessary – yes, an anathema to the Germans/ECB, but that’s life. In any event, it will happen at some time – better to deal with it now and move on.

Indeed, I suspect a number of market participants expect exactly this scenario. Credit Suisse estimates that an average haircut of around 30% of Greek, Portuguese and Irish bonds would cost banks E200bn, approx 1 years of profits of European banks and well within the EFSF capability. Indeed, some banks could be merged with others, reducing financing requirements.

Once you do this, or something similar and, at the same time, introduce strict fiscal policies (with automatic sanctions for breaches), the capital markets (currently totally shut and with no sign that they will reopen given the present situation) will open up sooner than most alleged experts think.

The key is to introduce a comprehensive, sustainable and credible programme right at the outset.

Furthermore, you will have sown the seeds for economic growth, something which is desperately needed.

Politicians are wary of bailing out the banks, as they fear a backlash from voters. However, you can introduce, effectively, banker bashing measures (politically very acceptable and quite frankly needs to be done given the quality of the senior bankers around), which gets around this, I assure you.

Indeed, it will have to be a necessary component of such a scheme to gain public support, which will be vital. I know a number of you remain sceptical, but I firmly believe, sooner or later, something along these lines will be enacted.

There is no alternative.

By the way, a scheme of this kind, accompanied by strict fiscal discipline, with automatic sanctions (including kicking people out of the Euro/ EU) will enable the creation of a Euro Zone bond market.

That’s when the Euro becomes an alternative reserve currency and that’s when the US will face real pressure and will have to cut spending and raise revenues.

However, there is time for this. The current Euro Zone policy (if there is one) just creates more pain for much longer. I am not saying that my plan will not create pain – it will, but the recovery will be much faster – great for the global economy (which is showing increasing signs of stress and is definitely slowing), as Europe does still count.

A plan along these lines can be put together in a relatively short period of time – there are more than enough smart people out there. The real problem, based on my experience and in my humble opinion, is that 99%+ of people in the financial services sector don’t know how to sell it to politicians – that’s the key.

In terms of existing Greek bondholders, I believe they will sell out, even at a 50%+ discount and/or exchange their debt for say EFSF bonds at a similar (possibly even larger) discount. 10 year EFSF bonds were sold around 3.50% the other day.

Greece and other countries can be effectively charged a few (say 25bps more and not the really penal current rate), still well below anything they can finance and politically acceptable as it is not a subsidy – indeed, other Euro Zone countries will be making a margin.

The alternative for current bondholders is that they get less later on. Certainty and cash in hand are the only arguments for most bond holders. A mechanism to avoid a technical default will have to be structured as well.

Greek bonds (depending on their maturities) are trading at a discount of between 45% and 75%, so who’s kidding who. The arguments from those who say it’s too risky, is flawed. The market expects it and, indeed, has priced most of it in – not all, I accept.

Some bank shares may well decline, but hey they made the investment in the first place. Indeed, a restructuring, accompanied by an announcement that banks will be recapitalised, will result in a significant equity market rally.

I would really love to be involved in this stuff.


Trader X is a pseudonym. The author is a former senior corporate financier at a prominent London investment bank who now manages his own money from his homes in London and the West of Ireland. [/private]