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Greece will not be ‘allowed’ to default until policy shores up the Irish bond market

Just look at Tracy Alloway’s imagery at FT Alphaville, and you’ll know what’s expected: an imminent Greek default. I still argue no, although European policy tactics are quite enigmatic and their next move is really anyone’s guess. Alas, here’s mine.

Assuming that Greece does not secede from the Euro area, I give you three reasons why Greece will not be allowed to default soon (at least the next 12 months, given current market conditions). I say ‘allowed’ because true to the IMF legacy, EU/Euro area officials very likely see restructuring as a ‘gift’ for good fiscal behavior.

(1) Moral hazard is an important issue in Europe, and Greece has only begun its austerity program. We’ll need confirmation that they are not on track in order to assess the timing of default, in my view.

Ironically, the EU/IMF/Euro area are sticking to the ‘exports will grow the Greek economy’ story. I say ironically because Greece was exporting a larger share of GDP before the recession, average 22.6% spanning 2005-2007, than it is now, 19.8% in 2010 (average Q1-Q3).

(2) The banking system’s not ready. Unless the Germans want to instantly recapitalize the Landesbanks this year, I’d argue that the Euro banking system remains overly exposed to mark-to-market accounting (i.e. holding the assets at fair value not wishful thinking) for all of the crappy debt that it holds on balance.

In fact, the German banks purchased 11bn 1.1bn euro in Greek sovereign bonds in January. That’s the most current data available; but I bet they’re simply moving debt out of the Greek banks and corporates and into the sovereign as the probability of default rises (see chart below).

(3) This one’s critical: policy makers must shore up Ireland and Portugal in order to avoid a quick contagion across the European banking system. They haven’t done that yet. In fact, the Finnish election results exposed the tenuous negotiation process overall.

See, the Greek yield curve is inverted – so are the Portuguese and Irish yield curves, albeit to a much lesser degree. The point is, that Portugal and Ireland are very close to the Greek brink.
(read more after the jump!)

Inversion matters. Currently a Greek 10yr bond yields 14.5% with a euro price of 59, while a 2-yr bond yields 21.4% with a euro price of 73. Bond investors are going for the cheapest bond not the highest yield (at the end of the yield curve) as a bet on a binary situation: haircut or no haircut. When a curve is inverted, it’s all about price not yield.

Portugal and Ireland are already inverted and close to the Greek brink. If Greece were to restructure without a full-fledged backstop from the Euro area governments, the Portuguese and Irish curves would swiftly turn over. And if European policy makers could stop the contagion there, then that would be a true feat….

Spain, the economic ‘line in the sand’, would be next. We saw last week how markets view the Spanish sovereign, still risky. Bond yields on the Spanish 10yr broke out of a 4-month trading band, hitting 5.55% on April 18 (latest number is 5.47%).

More on Ireland

I assure you, that it’s too early to deem the Irish sovereign as impervious to the Irish banking system’s fake asset base. The banking system is living on emergency liquidity assistance (ELA) and the ECB’s marginal refinancing operations (currently Irish banks can borrow as much as they want on a short-term basis from the ECB at the current rate, 1.25%).

By my calculations, the Central Bank of Ireland (via the ELA) and the ECB are subsidizing – I say subsidizing because market funding costs are proxied by the sovereign borrowing costs of 10% – 16% of the Irish banking system’s balance sheet. As such, profit margins are thin, and mortgage rates are running low at 3-4%. (see CBI website for plenty of data.) These funding costs are not sustainable – not to mention the Irish stress tests assume that they remain fixed at Q4 2010 levels (see exhibit 2 in Appendix C of the stress test documentation). Nonperforming loans will rise.

I leave you with this illustration of possible non-performing loans when mortgage rates rise on the following:

(A) ECB rate hikes – mortgages are tied to 12-month euribor and most Irish mortgages are variable.
(B) the dissipation of record-low bank borrowing costs (this also is another post, but the ECB has yet to release its medium-term funding program for Ireland).

Note: if/when they do default, Kash at the Street Light blog provides an overview of some technical considerations.

Rebecca Wilder

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Egyptian CDS in line with Portuguese CDS

It occurred to me that some Angry Bear readers may be interested in a short analysis of the Egyptian bond market. Professionally, I’m a macroeconomic analyst and portfolio manager on a global fixed income team. Since we do trade emerging market debt, of which Egyptian debt is categorized, I’ll be happy to comment.

The gist of the article is this: markets are pricing the probability of default in Portugal and Egypt similarly – I’d sell protection on the Egyptian debt. At this point, I should state the following disclaimer: this is not a trade recommendation, nor does this represent my firm’s views on Egypt or Portugal.

Some bond market developments of late:

  1. Egypt holds a BBB- rating on its local currency debt by Fitch and S&P (BB+ on its foreign currency debt). The local currency debt in Egypt is at the lowest of the investment-grade ratings, while on January 20, 2011, Fitch put Egypt on credit-watch negative.
  2. The Egyptian pound is heavily managed. Over the last week, the USD gained just 0.9% against the pound. Maintaining a stronger nominal currency is common in developing economies to temper the effects of import prices (in this case, food).
  3. The 5.75% 10-yr Egyptian international bond, which is denominated in USD, sold off 7% over the last week. According to JP Morgan, Egypt is well underperforming the index (Egpyt is roughly 0.5% of the index): the year to date total return on the Egyptian international bonds is -10%, while that of the JP Morgan Emerging Market Bond Index Global (EMBIG) is -0.7%.
  4. Credit default swap spreads jumped 50% over the last week to 454 basis points (bps), according to one Bloomberg source (no link, subscription required). CDS are bilateral contracts between two parties, so pricing varies somewhat – but the trend is the same among all sources: up. This means that it’s becoming increasingly expensive to buy protection against Egyptian sovereign default.

If you want to know more about CDS, please see a helpful 2009 publication by Deutsche Bank.

And this is where it gets interesting: it currently costs the same to buy 5-yr protection on Egyptian bonds (454 bps) as on Portuguese bonds (456 bps). And Portugal is rated A- (negative outlook).

(more after the jump)
The chart above illustrates a panel of CDS data for countries with similar market risk, where S&P’s local currency rating is listed in the legend. The CDS quoted above are priced in USD, rather than the local currency; but the spreads do quantify the market’s assigned probability of default : 29.3% for Egypt vs. 29% for Portugal (with a 30% recovery rate on both).

Generally the decision to default comes in two flavors: the ‘willingness’ and ‘ability’ to pay. Also, default can take many forms, like missed coupon payments, terming out debt liabilities, or bankruptcy (corporate).

Willingess. A quick analysis of ‘governance’ indicators at the World Bank says that on the face of it, Portugal is probably more willing to pay its debts. The governance measures are corruption, government effectiveness, political stability, regulatory quality, rule of law, and voice and accountability. Read about the methodology of the governance indicators here and get the data here.

In sum, Portugal ranks much higher on the total of the World Bank governance indicators, 6.4, compared to -2.6 for Egypt (I use a strict sum of the 6 components).

Ability. According to the IMF’s most recent World Economic Outlook (October 2010 database), Egypt is expected to grow an average 13.9% per year in nominal terms over the next three years (2010-2013). In contrast, Portugal is expected to grow just 1.7% on average for the next three years.

According to Bloomberg, on January 27, 2011, the yield on a Portuguese 1-year local bond is 3.42%, while that for a local Egyptian bond is 10.99%. I’ll take odds of payment on the one with nominal growth that exceeds the payment – Egypt.

A quick look at the WEI shows the following statistics for 2011:

Country Subject Descriptor 2011
Egypt General government net lending/borrowing -7.622
Portugal General government net lending/borrowing -5.232
Egypt General government net debt 60.993
Portugal General government net debt 82.864
Egypt General government gross debt 71.725
Portugal General government gross debt 87.086
Egypt Current account balance -1.605
Portugal Current account balance -9.171
International Monetary Fund, World Economic Outlook Database, October 2010

The 2011 outlook demonstrates the following: government deficits are similar in Portugal and Egypt; government debt is higher in Portugal, a country that has no monetary sovereignty; Portugal has relatively fewer reserves (comparing gross debt to net debt); and the current account deficit in Portugal dwarfs that of Egypt.

If I was an investment bank, I’d rather sell protection on Egypt than Portugal at these prices.

Rebecca Wilder

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