Friday, January 27, 2012

Restoring confidence in the Eurozone's sovereign credit markets

Portuguese bonds continue to sell off as the market focuses on Portugal becoming the next Greece. Portuguese spreads have completely decoupled from the rest of the Eurozone periphery.

Portugal vs. Italy 5y spread to Germany

But Portugal is not trading down in a vacuum - the valuation of the nation's bonds is tied to the outcome of the Greek restructuring process.  The markets are not only reacting to Portugal's insolvency but also to the market structure uncertainty. The sovereign credit markets in Europe are broken and two key events must take place to restore confidence.

1.  The ISDA Committee must do the right thing and trigger the Greek CDS (call this a "credit event"). Even without the Collective Action Clause on Greek bonds, this is a default and should be treated as such. The impact on the market may actually be positive because it will mend (at least in part) the broken sovereign CDS market. This has implications for Portugal as investors will once again view sovereign CDS as potent protection against default (similarly to stock put option holders having the ability to exercise their puts). At least in some cases, holders of Portuguese bonds may choose not to dump their holdings because of the availability of a reliable CDS market (which now trades at 39 points upfront).  Just as important is the fact that banks who are lenders to Portuguese corporations will have a reasonably liquid hedge for their assets. Since there is little CDS traded on Portuguese corporate bonds, a reliable sovereign market could be a good proxy.

2. The ECB must take the same haircut on Greek bond holdings as the private bond investors. It's bad enough that the market views sovereign bond holders as being subordinated to the IMF, the EFSF, and in the future to the ESM. Now also being subordinated to the ECB makes the sovereign bond market look completely rigged. A BNP Paribas research note put it quite eloquently:
BNP Paribas: The ECB has no legal right to be treated as a preferential creditor. Others who bought Greek debt at the time, or who held onto debt they already held, should have been appraised of the ECB’s preferential treatment. The ECB’s standing should have been made clear in law. Not to have done so in advance is not only unfair, but it also distorted the markets. If the ECB knew in advance that it would be treated more favourably than the private sector sellers it bought its bonds from, then it acted unfairly and abused an asymmetric information advantage;
Yes, Germany and others in the Eurozone will be upset because the ECB's loss in Greek debt will wipe out more than a year's worth of earnings and may require an injection of public funds.  But the ECB must take a loss in order to assure investors that private holdings are pari passu with the ECB's positions. Otherwise investors will be constantly worried about the amount of ECB's holdings to determine the size of the ECB's "senior tranche" vs. their "junior tranche". The same bonds having two seniority levels depending on who holds them is not a viable market. Not only will this further impair existing Portuguese bonds, but will make it impossible for Portugal and Greece to return to the markets even after they restructure.

The Eurozone must take other steps as well to restore confidence in the sovereign credit markets, but these two actions are critical not just for Portugal but for the rest of the euro area periphery.