"A child of five could
understand this. Fetch me a child of five."
Groucho Marx
"A horse! A horse! My
kingdom for a horse!" William Shakespeare,
Richard III
At long last, the good folks
at the International Swaps & Derivatives
Association (ISDA) have arrived at the conclusion
that Greece did indeed default on its sovereign
debt by agreeing its most recent rescue package,
which effectively wiped out a substantial portion
of the money (principal balances) owed to private
investors while extending the maturity on monies
owed to official creditors such as other European
governments and the International Monetary Fund.
This decision reversed an earlier one,
taken on March 1, whereby through a technicality
the committee had ruled otherwise - ie that
there had been no
Agreement between the country and its bond
investors, therefore a Restructuring Event had not
taken place; this despite the well-publicized
announcements by Greece of its explicit strategies
with respect to precisely such an event.
A
number of lawyers I am acquainted with sport
particularly pained expressions on their faces
when they try to explain the ISDA position as
being legally and technically correct; but of
course that is not the point of my criticism.
It is obvious to the average five-year old
that a default has taken place in Greece because,
well, they haven't paid on time and have also told
everyone that they are not going to pay the
amounts owed on the bond certificates. What is
more, and unlike in the case of other situations
such as Freddie Mac and Fannie Mae's
conservatorship in 2008 that also triggered credit
default swap (CDS) contracts, the situation in
Greece is that bond holders would have money taken
straight out of their pockets through the
writedown of principal.
The supporters of
the original ISDA decision posit that it was
always possible that every single investor in
Greek bonds would voluntarily accept having their
bonds written down in value; thereby negating the
need for a CDS trigger. This ignores basic common
sense - ie, why would ALL investors ever accept
that situation. It also ignores the market's
version of common sense, that is, game theory: why
wouldn't some purchasers of CDS protection who
would stand to lose all the value of their
contracts simply not buy some bonds cheaply, and
explicitly by voting against the Greek
restructuring proposals, effectively force the CDS
trigger?
Think of it: you own $100 million
of protection on Greece, so your counterparty
(usually a European bank) owes the value lost by
Greece restructuring - in this case, say $70
million. If all bondholders agreed to the
restructuring voluntarily, then as a CDS holder
you wouldn't have a trigger and your counterparty
will owe you nothing.
Now, if you buy some
$10 million of Greek bonds for the current price
of say $3 million (because everyone expects a
default) and then explicitly vote against the
Greek proposal, then by definition the Greeks will
have to push you towards acceptance by invoking
the dreaded Collective Action Clauses (CAC).
But this would in turn force CDS to be
triggered, and you would get $70 million for your
pain; plus around $3 million in new bonds for the
position you own. Only an idiot would not have
done that to protect his position and thankfully
outside the corridors of power in Brussels and
Frankfurt, it appears there aren't a lot of idiots
in Europe.
Five-year-old horses
All of this though got me thinking about
what other aspects of the market are obvious but
still ignored by the majority of folks. In my
view, the most obvious one is the levels at which
government bonds issued by rich countries
currently trade. A quick look at the following
table tells you what I mean:
Government Debt/GDP
10-year bond yield
United States
68%
2.26%
United Kingdom
80%
2.37%
Japan
208%
1.05%
France
82.3%
2.97%
Germany
83.2%
1.97%
Italy
118.4%
4.86%
Spain
61%
5.19%
There is no obvious relationship
between the total volume of debt and its current
cost; logically you would expect that
more-leveraged borrowers would pay a higher rate;
this observation is only partly true - for example
when you look at where Italy borrows relative to
where Germany does - but it doesn't explain a
number of other countries, Spain and Japan being
the most obvious exceptions on either end of the
scale.
There are a number of reasons for
this to be the case, including the breadth and
depth of the local bond markets (which helps Japan
and the UK); the current trajectory of deficits
(which hurts Spain) and so on.
However,
the objective of this article is to construct a
simple framework for examining risks and in this
regard one would look at the following factors:
a. Extent of social welfare (the "structural"
component of the deficit as against the "cyclical"
component which is caused by falling revenues
typical of a recession); b. Sustainable growth
rates (which would help the economy to recover
from its current recession and expand the balance
sheet enough to buy its way out of debt); c.
Unused capacity (which would explain the potential
for inflation as the above factors adjust against
each other); partly this is related to the
demographic factors so beloved of historians.
There is reason to be confident about the
US relative to France for example in that the
structural component of the deficit is lower; but
by the same token, one can also surmise that a
failure of the economy to create more jobs and
return to a higher growth trajectory would mean an
increase in the structural factors as the
government would have to increase spending on
medical and pension benefits for the population.
The best indicator of whether higher growth
prospects are on the cards would be the stock
markets.
In the case of Japan and certain
European countries (Italy and Spain), it appears
that demographic factors along with structural
deficit issues augur a long-term decline in gross
domestic product with concomitant increases in
government debt burdens.
That puts these
countries on the path to either hyperinflation
(unlikely because of the low consumption that is
suggested by an aging demographic) or market
shocks (as investors lose confidence in the
ability of the government to pay them back).
Considered in that cold light, it is obvious that
borrowing costs for these countries are currently
way too low to create the impetus for meaningful
reforms.
Bond yields also don't make any
sense when one considers their impact on the
demographic. Low yields mean low returns for
savers - who are too old to do anything else with
their money. Hence rather than promoting
consumption (as it would do for younger
demographics), low yields actually cut
consumption.
Then there is the accounting
impact - calculation of pension liabilities are
usually driven off government bond yields, which
means that at current low rates, governments'
pension obligations have risen massively and well
beyond any levels at which they can fund the
obligations.
Put that combination into
your pipe and smoke it - aging populations, rising
pension obligations, demographic decline in
consumption and hence tax base. In effect, there
is no place for government bond yields to hide. We
are probably looking at a doubling of bond yields
over the next three to six months. Markets,
though, have adopted an extremely short-term view
of the problem and avoided staring the obvious
facts in the eye.
Where are the
five-year-old bond traders when you really need
them?
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