Soothsayer: “Beware the ides of March” - Julius Caesar Act 1, scene 2, 15-19.
Whilst market reaction to yet another set of Greek bailout headlines was favourable, it is crucial to note two very significant issues. First, completion of the bailout is dependent upon a successful conclusion to the ’voluntary’ (PSI) proposal that private sector creditors accept losses of up to 75%, and second, projected reductions in Greece’s overall indebtedness over the next decade are predicated on highly unrealistic assumptions.
I feel that there is only a very small likelihood that the PSI proposal will succeed without forcing mandatory participation on recalcitrant creditors, rightfully disgruntled that the European Central Bank (ECB) and other official agencies will escape completely unscathed. I would therefore expect this to trigger an event of default in March in both rating agency and ISDA (the body responsible for governing credit default swap markets) parlance, with unforeseeable and potentially highly destabilising consequences. It should also be borne in mind that this will pave the way for a potential withdrawal of bailout funding, an opportunity I feel that Greece’s northern European creditors may welcome at this stage given the likelihood that Greece is likely to require substantial additional support in the years ahead. (blog continues below)
As for the LTRO, some 800 eurozone banks took around €530 billion in collateralised three-year loans from the ECB (at effective rates of circa 1.5-3% factoring for collateral haircuts) in this round, only to immediately place these funds back on overnight deposit with the ECB at 0.25%. When you consider that a healthy bank with good collateral can borrow in the repo market at circa 0.15%, it should become obvious that usage of this facility is the very opposite of a demonstration of strength by the participating banks. Indeed, whilst banks are clearly willing to pay to hoard liquidity that they cannot obtain anywhere else, we are also minded to think that banks also regard this negative carry as a relatively small cost of entry to the too-big-to-fail club, a bluff that I am unconvinced will not be called by politicians, when and if focus returns to underlying solvency.
I have continued to avoid any exposure to European and US banks. This has been something of a painful trade year to date as subordinated bank paper without any discernible fundamental value (that I can see) has rallied the most sharply. Those who recommended a long position in financials all the way down are having a banner start to the year (assuming survival of the past few years of substantial draw-downs), and I can only marvel at such fortitude. However, with tremendous uncertainty over the outcome in Greece this coming month, I would reiterate that in our view this is not the time to be long financial risk.
While I cannot discount the possibility that 2012 signals the birth of a new market paradigm, we have all seen this dash for trash before and it seldom ends well.
Charlie Kerr manages the Newscape Strategic Bond fund.