28 October 2011

Euro summit: kicking the can down the road once more

1. The agreement
As for a well written movie script, the 4 am press conference concluded weeks of discussions, haggling and wrangling about this Greek drama. Like the other 10 or so summits about the eurozone crisis, this is meant to be the final shock and awe response to years of denial, the ground-breaking decisions.
The agreement can be summarized as follows:
  • Nominal write-down of 50% (EUR 100bn) of Greek debt in private hands; Greek debt owned by official lenders not touched (so the ECB will not need to be recapitalized)
  • Remaining Greek debt will be refinanced at preferential rates
  • Bond swap to be done by end-January 2012
  • Closer supervision of Greek adherence to the program
  • EFSF to be levered 4-5 times
  • No ECB involvement in EFSF 
  • President Sarkozy will speak with China on EFSF
  • EFSF will have both a direct insurance and SPV element; looking for EM/IMF support for the SPV
  • Estimates of EFSF firepower ranged from EUR1.0-1.4 tn
  • Italy to deliver specific budget 
  • Banks will raise EUR 106 billion of Core Tier 1 capital by the end of 2012 to reach a 9% capital ratio (plus an additional EUR40 bn capital buffer).
Thursday, market reaction was enthusiastic with bank stocks gaining double digit (Crédit Agricole up 23%!) and the EUR jumping 2% vs. the USD. This looks however more like a relief of not being dead than anything really of substance so far since there is a lack of detail and a lack of surprise. Today’s (Friday) Italian bonds yields are reaching 6% again and French bond spreads to Bund are widening close to 1%.
Finance Ministers will decide details in November: as always the devil is in the details.
2. Analysis

  • The 50% haircut the private sector will “voluntary” write-down represents EUR 100 bn (EUR350 bn - EUR70 bn Troika loans - EUR75 bn held by the ECB)*50%: this pushes the debt/GDP ratio down to 120%.
  • The press release indicates: “…with an objective of reaching 120% [the debt/GDP ratio] in 2020”. So, if I correctly read this section of the press release and based on September IMF numbers, it means that the Greek situation will not improve for the 10 coming years or so at double the Maastricht Treaty criteria and back to where the ratio was in 2009. In addition, I doubt that structural reforms, if really implemented, will produce results before years to come and a GDP decline is to be expected for the next 1-3 years in the absence of currency devaluation.
  • Finally, according to IMF projections, and nothing beyond the EUR 100 bn forgiveness has changed, the debt/GDP would reach 143% in 2012.
  • Investors could question the quality of the EFSF guarantees (which only apply in case of default) since the ISDA declared that the 50% haircut being “voluntarily” gun-to-my-head does not constitute a credit event therefore a default. The same thinking could apply in the future to the guarantees provided by the EFSF on bond purchased from Greece (or other Eurozone countries). In addition:
    • Since it is meant to be voluntary, some could choose not to exchange their current holdings for new bonds weakening this frail restructuring if numerous enough
    • No detail on how it would be structured: maturity of new bonds, interest rate, guarantees if any, ruling law, to name a few
    • Other EZ countries could give up and ask part of their debt to be forgiven
     Despite the EUR100 bn debt default, this is not going to have much impact on the Greek budget: for over a year, Greece has not borrowed on capital markets but with the Troika and short term T bills at c. 5% and not at secondary market rates of 20%+.
Saving: EUR106 bn*5% = EUR5 bn i.e. +/- 25 % of current interest payments or 2% of GDP.
This will leave the country with a negative primary budget running at about EUR1.5 bn/month or 30% of state’s revenues.
  • All this is gaining some time, but does not address the issue of the lack of state cash flows generated by the absence of growth, a weak central state and a large black as well as uncompetitive economy.
  • EUR106 bn of new core capital will not be enough if other Latin European sovereign debt is marked-to-markets (just think Italy).
All this edifice also assumes no AAA downgrade for France, which I do not believe: France does not deserve a AAA rating.
This week’s measures bring some short-term relief but are far from being the shock and awe required and is short in details: European leaders once again kicked the can down the road, farther this time, I admit.
The winner is China that will have a strong hand with Europe while protecting its largest market from collapse as well as its EUR 600 bn of European debt.
As a side comment, European leader were prompt (and rightly) to name and shame leverage as the culprit of the financial crisis and are doing the same with the EFSF.

European BankingAuthority: The EBA details the EU measures to restore confidence in the bankingsector


26 October 2011

European banks’ recapitalization

When the EBA stress tests on 90 European banks were published in July, I titled them a mockery. I conducted my own analysis according to a 50% and 75% haircut on sovereign debt in PIIGS countries to abide by the 9.5% core capital to be reached by 2019 according to Basle III rules (many banks said they would get there well ahead of time): this analysis produced the numbers I mentioned in several articles on this blog.
In the table below, let’s look at German and French banks’ exposure to the Greek sovereign debt (being the main holders, I do not include other banks):
A 50-75% Greek default would result EUR 36 and 40 billion new capital required, split 1/3 for Germany and 2/3 for France. This does neither take into account their exposure to the banking and private sector nor guarantees/commitments/derivatives (including CDS). The German situation is not much worse with respectively EUR 9.7 billion additional exposure (including EUR 2.1 billion with Greek banks) and EUR 5.3 billion; French banks’ are in a much more difficult position with EUR 43.5 billion (including EUR 1.6 billion for banks) and EUR 8.3 billion.
To be fair, these numbers reflect the situation at the end of December 2010 and French banks have significantly reduced their exposure on their Greek sovereign debt during H1 2011: BNP Paribas from EUR 5 billion to EUR 3.5 billion and Société Générale from EUR 2.7 to EUR 1.9 whilst producing a net 6 months result of EUR 4.7 billion and EUR 1.6 billion, so enough to absorb a 100% default. However, as for Dexia that went under mainly because of its exposure to the non-sovereign credit book, I do not know what the quality of the private book is.
Let’s add a 100% default on Greek banks and 15 % on the private sector (guarantees and commitments included but not derivatives), the banking needs required to abide by Basle III rules is north of EUR 50 billion for German and French banks that were subject to the EBA stress test.
The total number of EUR 100 billion rumored to be in the starting blocks to recapitalize European banks is probably right on a Greek basis alone. In order to weigh the minimum possible on government budgets already under dramatic strain, this recapitalization should be undertaken via profits, cutting dividends to zero and reducing bonus payments (say by the same amount as the Greek default). It is however far from addressing the rest of BIGSPIF sovereign risk.
Nevertheless, the EUR 100 capitalization does not address the core of the matter: the sovereign insolvency and lack of economic competitiveness. More on this in a forthcoming article: France - EZ weak link.
BIGSPIF = Belgium, Ireland, Greece, Spain, Portugal, Italy, France

09 October 2011

Who should be single A rated: Italy or France?

I am amazed that France rating has not been downgraded as yet: it does not deserve a AAA by a long margin.

First, have a look at current rating for European countries (please note that since this table was published, Moody’s downgraded Italy 3 notch to A2 from Aa2, i.e. the same as Poland or Cyprus). This downgrade is probably justified in itself, but I am questioning how France can retain the top rating.
From data published by the OECD in May and the IMF in September, France is in a worse shape than Italy according to many indicators.

1. Debt/GDP

If the debt/GDP is the Achilles heel to Italy, its growth is nowhere comparable to France’s which is catching up quickly: +6% for Italy for the period 2000-2012 and +52% for France.
2. Real DGP growth

France is much better off with GDP growth twice the pace of Italy during 2000-2012 at 1.5%. French growth is however mainly due to domestic consumption spurred by the state welfare that France can no longer afford.
3. General Government Financial Balances

The French welfare state largess translated into higher budget deficits whatever the Government (France hasn’t had any balanced budget since 1978): the Maastricht 3% deficit ceiling was respected only 4 times since 2000, France doing much worse than the eurozone average since 2008 (-5.9% vs. -4.6%); - Italy fared better with -4.1%.
Analyzing further the budget, the situation looks even much worse for France: its primary budget balance has been negative for 10 years whilst Italy had always been positive (note that Italy’s primary budget is even much better than Germany). The IMF does not expect France’s primary budget to become positive before 2015.
4. Trade balance (goods & services)

This indicator is not helping out France’s precarious position, to the contrary. Since 2005 France has experienced increasing trade deficits, together with Italy but with an incomparable magnitude: USD 489 billion cumulated, 2.3 times more than Italy; Germany in the meantime accumulated a USD 1550 billion surplus. In percentage of GDP the analysis is the same.

True France enjoys a net investment income whilst Italy is negative, which translates into a comparably better current account for France.
5. Unemployment rate

Unemployment is another indicator where France is not comparing well with Italy, underperforming since 2003.

France does not deserve the top rating with the three main rating agencies (by the way, when European politicians accuse these agencies of an American plot against Europe, beyond being a “scapegoating” affirmation, they should remember that Fitch belongs to a French company, Fimalat).
According to the indicators presented, France should hardly be better rated than Italy.

Add guarantees to be given by France for Dexia’s failure (where France should bear most of the burden since most of the problem arises from Dexia CLF - the French part of the group with 259 x leverage!) and I do not see how and why France will keep its AAA. Belgium is under watch for possible downgrade following Dexia’s bankruptcy. It is also quite “funny” to watch France arm twisting Belgium to bear most of the burden in order to keep its AAA (that it will loose anyway): how guarantees for the EUR 95 billion impaired portfolio will be shared (EUR 66 billion in Dexia CLF balance sheet)…

The “funniest” of all is that Dexia CLF is going back to CDC (the French state owned financing vehicule) where it originally came from under the name of CAECL. From privatization to nationalization, 20 year of incompetent board of directors that let an incompetent management expand all around the world into risky businesses without the means (read capital) of their ambitions.

Please note that I do not blame the new management that arrived after the 2008 rescue since Dexia was doomed: there was not much they could do, and they probably did what they could with the legacy they got.


WSJ: S&P Cuts Italy's Sovereign-Debt Rating


IMF: World Economic and Financial Surveys


© Markets & Beyond
OECD: OECD Economic Outlook No. 89


Markets & Beyond: Dexia in 2 slides and a few words


05 October 2011

Dexia in 2 slides and a few words

I warned about Dexia weeks ago, and during private discussions over the summer I discussed with a top official in Luxembourg about its demise and breakdown.

Leverage core equity / total assets: 75 x! (36x if using the Basle II Tier 1 capital definition): so, doomed in a recessionary environment where nearly 50% of loans are with local authorities that have difficulties to balance their budgets.
The French part of Dexia (formerly Crédit Local de France) is where most the group mess is coming from: the same ratio is much worse at 259 x!!! Even LTCM was not leveraged like this…

Dexia BIL (Luxembourg) is rather sound with a ratio of 18 x and its exposure to PIIGS (EUR 5 billion including EUR 536 million of sovereign debt) is manageable. DEXIA BIL will be bought by a bank like ING. I guess that Dexia BIL “legacy portfolio” (EUR 10 billion) will be consolidated with the other ones of the group into a bad bank.

Prima facie, the consolidated “legacy portfolio” does not look so bad: “only” EUR 7.7 billion non-investment grade; well, (1) what is investment grade today may rapidly become sub- investment grade tomorrow (see Greece) and (2) the EUR 4.1 billion allocated capital to the “legacy division” is not sufficient to match a 30% loss on the NIG loans.

In 2Q11, Dexia’s portfolio was reduced by EUR 6.8 billion vs. end of March 2011 with a loss of EUR 4 billion, i.e. ~60% mark-down.

Greece was provisioned for 21% (the IFF* agreement); the final loss will be between 50% and 75%, somore losses to come.

Short-term Funding need down EUR 47 bn which can only be funded with central banks, since I guess that Dexia is shut down from the interbank market.

This is a remake of the Irish banks: Dexia successfully passed the 2011 EBA test which was meant to be much more stringent: a joke I wrote in July.

* Institute of International Finance: the international professional organisation of banks

After Irish banks last year, Dexia situation exemplify the inadequacy of EBA tests which were politically motivated. For 3 years, the policy of denial followed by policy makers regarding Greece default and banks recapitalization has spurred volatility in markets: investors are reacting to hard facts and hate uncertainty and lack of action. Markets do not want words but acts.

It also shows how the poor quality of blinded European politicians made a limited disease become metastatic.

Continue to stay clear of European financial stocks (if you are a long term investor, there is better value elsewhere – if you are a trader volatility is always good): with Basle III and other rules, the finance industry will deliver lower long term returns on equity as written on this blog for 2 years.


Dexia Group: semi-annual report June 2011


Dexia CLF: Rapport financier semestriel au 31 juin 2011


Dexia BIL : Rapport semi-annuel au 30 juin 2011