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Tuesday, 12 April 2011

YORGO THE DEMON BARBER OF LOMBARD STREET AND OTHER ADVENTURES

Another day, another LOL in the Vassal State. The guys over at Alphaville still have their knickers all tangled over the causes of the recent 'Greek-out' which saw spreads rocket godward, and now that the dust has settled at about waist-level, and I've digested most of my Easter feasts, I'm happy to pontificate on why this happened and what it might mean.

First of all, our deficit figures came out, but they were no surprise at all as the troikans had made sure to leak them out ahead of time in order to manage expectations. That can't be the reason.

Then teh evil specuLOLtors at Citigroup showed up, telling one of their clients that there is 'a lot of noice' about a supposedly imminent restructuring (which there was), by way of explaining the day's market turmoil. Apparently we're now threatening to sue them, just like our MPs threatened to sue Moody's, or like those other six idiots threatened to sue Focus (of Focus Finger fame) for claiming we cheated our way into the Eurozone. Good luck making the entire Greek people look like MUPPETS in an unwinnable court case. Sue this guy too while you're at it, or maybe sue the Commission for suing us about our dodgy numbers.

Or perhaps it is the small but vocal minority of new defaultniks that have alarmed the markets? I must admit in the early days of this story I was worried that we may be looking at a bit of a movement, hence the time I took (with apologies to regular readers) to rebut it. Some domestic players may have been spooked for a while. But as it turns out interest in default porn has fizzled out, despite the triumphalism of its producers. Especially compared to gadget porn, not to mention actual porn.

Much more relevant was the announcement that a report will be coming out in June examining the case for a restructuring. There's nothing like a date to sharpen the mind as nonspecific threats are mistakenly believed to be less serious and less likely to be carried out than specific ones. One finding that interests me by way of interpretation is the fact that as events move closer, people's focus tends to shift from payoffs to probabilities. While restructuring was remote, many would have focused on counting exposures. Now with a looming deadline they are focusing on the chances of default. Which as it turns out are 100bn%. In other words 'shit jus' got real!' More on what this might mean for market psychology here.

It also did not help that Vasso Papandreou (no relation to Yorgo), the veteran socialist MP and Chair of the Greek Parliament's Economic Affairs Committee openly called for a restructuring (in English here), as right as she may be. That this taboo was broken signalled to many that default was imminent.

Side note: in our present context, I find it deliciously ironic that in her past life VP has been honoured by the Belgians with the Grand Cordon of the Ordre de Léopold. That's Leopold II, the man who brought you the triumph of humanity that is the Congo.

But the chief source of panic in the system is the fact that, while everyone and their (lap)dog knows Greece can't pay back our debt and will have to restructure or default, no one knows how this is supposed to work. It's just never been done before at this scale and with this sort of stakes. The more certain default becomes the more people start to worry about how it's going to happen.

First, no one with any sort of power or official authority in Greece, Europe or the IMF is really allowed to discuss restructuring until the very moment we're ready to do it, for fear of creating the world's biggest-ever arbitrage opportunity and spoiling the party. Hence, any delayed official response to fresh rumours will cause panic because market participants will assume the time is upon them.

Second, with sovereigns, seniority is a pretty fluid notion and in effect they can choose who they pay and when. Politics dictates that things like pension funds and retail banks must be protected, but that's about it. Third, CDS issuers have a massive incentive to steer the terms of the restructure away from any event that would force them to pay up. And of course they can, by lobbying, scaremongering or simply refusing to co-operate, in the case of banks holding Greek debt.

(Still, here's a recent batch of scenarios for those who like a little light reading.)

There are some things I believe will definitely happen and are rarely discussed. Before you read them, please take a moment to at least download this paper on enhancing scenario planning. I would suggest reading it too. It's not that long and it will help you avoid being biased by my ranting.

First, we will restructure in more than one go as per my central scenario here. I am now beginning to this the second haircut will be equal in size to the first, but I've got nothing to base this on except the sheer amount of debt we're taking on. This is important because rumours of and calls for 'the restructuring' assume one episode. In fact the amount of money debt to be written off is so large that it can't be made manageable unless it's broken into chunks. As Benjamin and Wright (2009) point out, defaulting sovereigns tend to exit default more indebted than when they went into default, hence serial defaults are often inevitable.

Another reason why this will happen in two goes is because our debt is now divided into two piles. One which is market-traded and one which is not. According to this excellent study by Bi and Zhang, renegotiating market-traded debt with healthy secondary markets typically takes one year, while renegotiating non-market-traded debt typically takes seven. I'm counting 2009 as the start of the renegotiation, which brings us to 2016 as per the central scenario.

Second, GR pension funds and possibly banks will at some point be given the chance to swap the bonds in their portfolios with new, post-default ones, of the same (in the case of funds) or possibly slightly lesser (in the case of banks) nominal value.  The idea is that the same debt at lower levels of dilution should be worth more, and post-default dilution should fall. The idea is also to avoid massive amounts of civil unrest. Even libertarians know that the limits to human nature are an economic constraint. People have to eat, take shelter and shag. If they are too poor to do one of the three they will riot.

Third, it will be very difficult for our debt to the troika to be subject to a straightforward default as the politics of defaulting on 'the people of Europe' are nightmarish and will prohibit Europe from rescuing any other nation in the future. This is not a chance Europe will take. Ditto with the IMF, which is already taking heat from the populist press for indirectly committing American and British taxpayers' money (to name but two examples) to bailouts.

Rather this debt is most likely to be rescheduled or transferred to the ECB or EFSF. Of these two the ECB is the most likely because in the popular imagination its funds are not taxpayers' money. Few people, after all, realise it needs to be recapitalised by the Member States (see here and here). In fact in the eyes of the defaultniks it is part of the problem. It also conveniently happens to already own 12% of our debt.

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