1. The price charged by central banks for saving the world is seniority. The ECB did not take haircuts on the Greek debt it had bought as part of its SMP bond buying programme. Did you spot the clause in your bond documents that said that you were buying the subordinate tranche of the government bond market? Of course it never existed – in extremis, which is exactly where we are – the law is torn up and rewritten (see point 2). Historically you wouldn’t have worried too much about being subordinate to the authorities, but that was before the age where over a third of the gilt market is owned by the Bank of England, and where the Fed owns large portions of both the Treasury and mortgage markets. Given sovereign recoveries have been below 40 percent on average (in the world before QE) if 40 percent of the outstanding bonds are now senior to private sector holdings of government debt, that leaves much less for investors. Recoveries will be lower going forward.
2. The ECB is an anti-democratic institution – thank goodness. The Eurozone cannot cope with crises through its democratic structures. Treaty changes are needed for even modest increases to fiscal union, and treaty changes require referendums (Ireland’s referendum on the Eurozone fiscal pact announced this week will take three months to organise. It may well not pass, and hence any one member state can stop integration). The anti-democratic organisation can therefore be the boy with his finger in the dyke. But think of the ECB as the pain-killer, treating symptoms rather than dealing with the illness. Only democracy will be able to deliver the surgery that is fiscal union.
3. It looks as if the sovereign CDS market might work! For a long time it looked as if Greece would restructure in a “voluntary” arrangement with its creditors. Whilst the rating agencies would likely still have called this a default, the credit default swap market’s committee (ISDA) might well have decided that this, because voluntary, was not an event of default, and thus not triggered the CDS contracts. If that had been the case, then buyers of protection (insurance) might have found that the hedges they had for their collapsing Greek government bond holdings were worthless. The fact that new laws were hastily written to allow for majority votes of bond holders to bind minority investors to the same actions means that these CACs (collective action clauses) can force investors to take losses on bonds, and so if a default is eventually declared by the committee, the sovereign CDS market remains credible. However, yesterday ISDA declared that we hadn’t yet seen an event of default – but it looks like this is simply because the CAC hasn’t formally been triggered itself yet. However, if we’re wrong and vested interests succeed in not eventually triggering a CDS payout, this would be very negative both for the continued existence of the sovereign CDS market, and more importantly for peripheral bond prices. If your CDS hedge is useless you might well liquidate your long positions as soon as you can.
4. Ken and Carmen were right. I saw Ken Rogoff, who co-authored ‘This Time is Different’ with Carmen Rheinhart, speak again on Monday. Don’t start getting all cheerful yet. The key points from that book were that the sovereign default rate was abnormally low, and that we should expect it to rise sharply, and that once debt to GDP gets above 90 percent growth slows and inflation rises. Rogoff expects more than one other Eurozone member state to default. But the 90 percent threshold approaches for even highly rated sovereigns. A deliberate policy of keeping real interest rates negative (as they are now), and a tolerance of inflation, will help get debt burdens down – at the expense of real returns for bond investors.
5. The Greek population was the real loser, not the bond investor. This was a bad deal, not because bond investors took losses, but because the losses they took were too small. Even under heroic growth assumptions Greek debt to GDP will barely get down to 120 percent. The population will live with austerity for years and Greece will probably default again anyway. And as others implement extreme austerity too, we’ll see the rise of extreme politics across the Eurozone. One lesson that policy makers across the world keep missing is that imposing punishment on moral hazard “sinners” is a luxury we don’t have in the middle of this series of crises. There have rightly been comparisons made between the terms of the Greek restructuring and the reparation terms that Germany was forced to accept after the First World War. The biggest wave of defaults has yet to happen – not in the bond markets, but with the breaking of promises (retirement ages, pension entitlements, healthcare) made to complacent western populations.