For the majority of a nerve-wracking summit that dragged on more than 10 hours, from 6 PM CET Wednesday to 4 AM CET Thursday morning, all attempts at progress to stem the crisis appeared to hit a wall.
But EU leaders finally made a breakthrough.
At 3:30 AM CET, we heard that they were closing talks with bank representatives on “voluntary” 50% haircuts on holdings of Greek bonds. Then we started hearing about leverage, and suddenly — at 4 AM CET (10 PM EST) — we finally got word of some agreement.
So here’s the rundown of what leaders decided (EU leaders were still pretty vague about all the numbers, however, citing estimates for most things):
– 50% haircuts on private holdings of Greek bonds through 2020. Evidently this will still be voluntary. It would cut Greece’s debt by €100 billion ($139 billion). German Chancellor Angela Merkel said EU leaders aim to see the credit swap take place in January.
– Leverage will increase the firepower of the European Financial Stability Facility by 4-5 times, to somewhere in the range of €1 trillion ($1.4 trillion).
– China and the IMF could play a huge role in the bailout. Not only has the IMF expressed interest in playing a role, French President Nicolas Sarkozy told reporters that he will call Chinese Premier Hu Jintao around midday tomorrow, presumably to discuss this.
– Greece will receive €130 billion ($180 billion) in fresh aid. We’re thinking this includes the nearly €110 billion ($150 billion) it was promised back in July.
– EU leaders believe Italy’s commitment to debt sustainability and encouraging growth, even though Italian PM Silvio Berlusconi didn’t propose any new measures to accomplish these goals in a letter he wrote to some members of the summit today.
– The European Banking Authority estimates that only €106 billion ($147 billion) in funding will be needed to recapitalize European banks and help them meet capital requirements of 9%. Turns out it didn’t actually conduct new stress tests accounting for adverse scenarios this time around. European Council President Herman van Rompuy told reporters that banks must reach this 9% ratio with only the “highest quality capital.” We’re hoping he means Tier 1 capital and will not allow banks to use riskier convertible bonds to meet this number.
– We aren’t likely to see a final roadmap on EU treaty changes until March 2012.
– A statement from the summit can be found here.
Clearly there’s still a lot more progress to be made towards truly solving the crisis. None of these steps alone — or even altogether — will do that, not to mention that the numbers we’re seeing here have not all been written in stone. Indeed, until we see EU authorities start to execute some of these proposals, it will be difficult to bank on their success.
That said, the fact that EU leaders actually made (at least preliminarily) plans on a lot of the issues they said they would — particularly after all the negative news today and earlier this week — will reassure markets that these leaders are indeed capable of accomplishing something when pressed.
Looking forward, we will be looking to see EU leaders make good on these proposals, without diluting them to ineffectiveness. In particular, treaty changes — probably the most controversial of any measures we’ve heard discussed thus far — will be key to actually mending the broken bones of the euro area.
Like many derivatives products dreamed up by Wall Street’s financial innovators, the Developed Market (DM) Sovereign Credit Default Swap (CDS) market was borne out of the desire to transfer risk off the books of banks to investors suited to managing those risks. Following the successful establishment and effectiveness of risk transfer in the corporate CDS market, the onset of the Asian Financial Crisis spurred growth in trading in Credit Default Swaps on Emerging Market countries’ debt. However, legal documentation issues relating to the 1998 Russian bond default hinted at the structural problems embedded in the contracts, subsequently confirmed when the economically coercive 2001 Argentinean so-called “Mega-Swap” did not trigger CDS. Indeed, even though Argentina eventually repudiated its debt unilaterally, many protection buyers’ swaps had already expired by then, and trading volumes in EM CDS fell substantially, only really recovering post the 2003 overhaul of ISDA’s rulebook.
It is then, perhaps, surprising that despite proven complications related to the terms under which EM Sovereign CDS would pay out that market participants extended the concept to cover Developed Market Sovereigns in 2006. Arguably, along with its siblings ABS CDS, made famous by Hedge Fund manager John Paulson’s multi-billion dollar bet against the US Subprime market, trading in DM CDS took off as a way to hedge the risk of countries who had been forced to assume the liabilities of their banking systems coming under pressure themselves. But as with earlier EM-specific non-triggers, the Icelandic government’s decision to put its banks into administration in November 2008 rather than default on its own debt, resulted in its CDS falling from as wide as 1400bps to current levels closer to 320bps. The LSE’s Professor Willem Buiter, a former Bank of England MPC member, in early-2009 asked the question “Is the London Reykjavik on Thames?”, leading to CDS on the UK to spike to as high as 166bps, but this sparked many to point out that the UK’s debt was denominated in Sterling, which the Bank of England could print an unlimited amount of. A month later, in March 2009 the Bank of England’s decision to purchase £75bn in its Asset Purchase Programme seemed to support this view, despite a second widening of UK CDS in the run up to the 2010 General Election as investors worried about the UK government’s commitment to its medium term solvency.
Nevertheless, the incoming PASOK-led Greek government revealed in November 2009 that the country had under-reported its deficits, triggering the onset of the Eurozone crisis, and Greek CDS began to widen, culminating in the April 2010 EU/IMF bailout of Greece, and a month later, in the face of contagion to other European government bond markets, the establishment of the European Financial Stability Facility (EFSF). An explosion in trading of DM CDS on Eurozone peripheral countries’ debt ensued as hedge funds sought to speculate upon the likelihood of an eventual Greek default and banks sought to hedge their exposures to those countries built up over the preceding decade.
Inevitably, faced with the political cost of bailing out foreign countries, European politicians lashed out at the CDS market, blaming it for breeding panic and allowing speculators to “bet” against bond markets and the Euro. As seen in the 2008 Global Financial Crisis, banks under pressure, along with politicians, blamed short sellers and speculators for spreading rumours and exacerbating the situation, while speculators argued that the market was merely “the messenger”, pointing to fundamental problems with balance sheets. As financial market pressures became ever more severe, European policymakers resorted to short selling bans and attempted to implement a ban on CDS trading. The debate continues to rage over whether the CDS market caused or exacerbated the Eurozone crisis, or whether the crisis was inevitable.
But what eventually killed the Developed Market Credit Default Swap market in the end, was the agreement with the Institute of International Finance (IIF), representing banks owning Greek bonds, to accept a 50% haircut on their holdings. The possibility that despite such a large haircut on Greece’s debt, that CDS contracts would not trigger, led many investors and bank hedging desks to question the value of their CDS contracts. The repercussions soon spread, as those institutions that believed they had hedged their bond holdings, or bet upon a Greek default, rushed to sell their contracts before the price collapsed. Volumes soon collapsed as it became evident that developed market governments had the ability to force their banks into taking haircuts without rewarding what they view as speculators.
Developed Market CDS soon faded into history alongside Perpetual Floating Rate Notes, Libor-cubed Notes, Asset Backed Collateralised Debt Obligations, War Loans, Endowment Mortgages and other financial products that were found wanting.
Following last night’s big meeting — which is being greeted with a strong rally — here’s what to watch next:
We would expect the next 24 hours to be driven by how the Sarkozy call to China President Hu Jintao goes, how investors analyze the sustainability of Greek debt under this program, and the reception that the EFSF proposal will get. We are a bit surprised by the enthusiasm given the lack of detail and lack of surprise. We are also wondering how seriously investors will take the EFSF guarantees (which only apply in the event of a default), given that the banks were strongly encouraged to declare the current restructuring voluntary. Investors may fear that the EFSF – guaranteeing – governments will similarly contrive to avoid paying out on their first-loss guarantees.
- Europe’s new debt crisis agreement: the good, the bad, the ugly (curiouscapitalist.blogs.time.com)
- EU to leverage EFSF to 1 trillion euros: report (marketwatch.com)
- Watch for Sarkozy-Hu Jintao headlines (forexlive.com)
- Europe crafts debt deal that pleases markets (seattlepi.com)