Tag Archives: Debt

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Survey of sovereign debt default issues, paper

A nice survey of literature on sovereign debt, issues and defaults, from the Chicago Fed:

- Government debt made up almost 22% of the global total in 1950, but fell to 11% in 1978. From its nadir in the 1970s, sovereign debt has grown in prominence and now accounts for about 19% of global financial assets…

- almost 70% of all debt in 2000 was denominated in U.S. dollars, and the five most important currencies (Dollar, Yen, Euro, Special Drawing Right, and Deutschmark) accounted for more than 90% of the total…

- there were 251 defaults by 107 distinct entities. The most frequent defaulters were Ecuador, Mexico, Uruguay, and Venezuela…

- There is substantial variation in the observed lengths of defaults, with the standard deviation 10.5 years. The distribution is also right-skewed with a skewness coefficient of 2.1…these facts suggest that the distribution of default lengths is approximately exponential. An exponential distribution of default lengths would result from a model in which the probability that a sovereign emerges from default is constant through time…

- Do debt restructurings improve a country’s welfare? Depetris, Chavin and Kraay (2005) study 62 low-income countries between 1989 and 2003 and find no relationship between debt relief and indicators of country welfare such as GDP growth, investment rates, and public spending. Conversely, Arslanalp and Henry (2005) find large (60% on average) appreciations in the stock markets of middle income countries following debt relief under the Brady Plan…

Empirical Research on Sovereign Debt and Default. Full text here.

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US consumer debt continues to fall

Consumer debt fell by $74 billion in Q3, a four year downward trend, the latest household debt data by the New York Fed shows.

As of September 30, 2012, total consumer indebtedness was $11.31 trillion, 0.7% lower than its level in the second quarter of 2012 and down $1.37 trillion from the 2008Q3 peak,” says the report.

“Mortgage balances shown on consumer credit reports continued to drop, and now stand at $8.03 trillion, a 1.5% decrease from the level in 2012Q2. Home equity lines of credit (HELOC) balances dropped by $16 billion (2.7%). Non-mortgage household debt balances jumped by 2.3% in the third quarter to $2.7 trillion, boosted by increases of $18 billion in auto loans, $42 billion in student loans, and $2 billion in credit card balances,” explains the report.

Delinquencies fell slightly to 8.9% from 9%.

Some 354,000 new consumers were designated as gone through bankruptcy in Q2, a 16.3% drop from Q# in 2011.

No wonder today’s consumer confidence was glowing shiniest since 2008.

Full report, charts here.

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Lack of safe assets fuels Emerging Market debt paper

This year’s top 2 asset performers so far have been debt paper with the Emerging Market (EM) debt leading the gains (12.8%) with high yield global bonds just behind in gains.

Hungry for yield and relative safety, the fixed income people have been scooping paper of countries that several years ago one would hardly consider to be paragons of safety let alone their sketchy credit history. Yet debt paper of likes of Poland, Mexico, Peru and Russia are hot: Polish paper is flirting with negative yields while, may we recall, Mexico and Russia have had their bouts with defaults.

In a world with zero yields and very little of available AAA paper, stuff that is just above junk is commanding the premium.

For example, JPMorgan’s USD Emerging Markets Bond Fund (EMB) is heavy on Philippines and Peru paper and the overall rating concentration is inside the BBB and B- range yet the chart of EMB is of envy.

So is the chart of another dollar denominated debt ETF – the PowerShares EM sovereign debt portfolio (PCY).

These two ETFs are not interested in holding paper issued in local currency so should these countries get into trouble like experience sudden capital outflow or get high inflation the debt itself will become questionable.

Now, rally in these ETFs is in its third year, so the question is whether we are close to the top and if so is it worth investing our marginal dollar into these instruments.

Some people, of course, may feel queasy at holding debt paper of unknown governments when they harbor mistrust in their very own, but based on what some economists are saying the rally in these ETFs is not just demand driven but lack of supply and prospects for continuation of such scarcity may drive these shares still higher.

In April 2012, IMF has concluded that the “safe asset demand is expanding at the same time that the universe of what is considered safe is shrinking.”

Of course, the key problem here is what is the definition of “safe” and whether going down the credit ratings food chain is the way to satisfy the safety criteria.

Still, between all of the QEs and cash sloshing the bank reserves, to fixed income demand from insurers and pension funds, “it is clear” the IMF says “that the demand for safe assets is subject to considerable upward pressure.”

Is there enough supply?

Well, as the graph below notes, the AAA-rated paper among the advanced economies has shrunk from 68% to 52% – a $15 trillion contraction in supply – while the lower AA-rated debt in emerging markets went up by 5% obviously an insufficient offset.

Using CDS spreads, IMF projects that by 2016 safe paper could drop additional $9 trillion while private sector “safe” debt is seen, at best, flat.

What happens in the emerging markets?

“In emerging markets, prudent fiscal policies together with ongoing improvement in domestic financial infrastructure—including legal certainty, clearing and settlement systems, and transparent and regular issuance procedures—will support further deepening of local sovereign bond markets. Over the longer run, these improvements will facilitate the use of such securities as safe assets both within their domestic context and possibly in global markets,” say the IMF.

In other words, IMF sees a generally rosy fiscal and regulatory picture for the EMs which, of course, is bullish for their existing dollar-denominated debt paper.

Yet all these countries are loath to issue any new debt a prospect that signals no new significant debt issue by these. In fact, as of 2009, EMs accounted for 40% of the global GDP while their debt accounted for 20% of the advanced markets.

Then again, all of these issues that IMF wrote in April are likely to have been discounted into the price of EMB and PCY and as a result we have an overextended chart above all major moving averages as well as a persistently overbought relative strength measure.

Supposing a resolution to the Eurozone problems, lots of cash will be set to exit these ETFs. Absolute Return Partners Niels Jensen alludes to this powerful set up.

“If structured correctly, a Eurozone exit is not the Armageddon it is so often portrayed to be. When the perma bears realise that, and as they begin to see the benefits bestowed upon the first mover, the mother of all equity bull markets will be unleashed in Europe. As I have frequently pointed out in recent months (see for example here), European equities are extraordinarily attractively priced at levels not experienced since the dark days of the early 1980s. We are just waiting for the catalyst, but remember one thing – banks will not be the place to be,” notes Jensen in his June outlook.

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Anemic growth caused by lack of securitization, S&P

The anemic recovery in growth should, in large measure, be blamed on the regulators which eliminated the concept of the special purpose entities and with that choked up asset securitization channel that is now depriving consumer access to credit says S&P Capital IQ Global Markets Intelligence group.

“The current subpar economic growth may result partly from the wholesale loss of asset securitization, which previously was both a facilitator and accelerator of the consumer credit pipeline, in our view,” the group says.

Data that backs this claim is the consumer credit securitization as percent of all of consumer credit.

Back in 2003, this ratio stood at 32%, meaning that nearly 2/3 of consumer loans were securitized. This ratio was drifting downward to a February 2010 low of 23.8% but, in March of 2010, this ratio fell off the cliff (chart above).

“This shift occurred after the Financial Accounting Standards Board eliminated the existing concept of a ‘qualifying special-purpose entity’ that enabled the positioning of securitized assets off-balance-sheet. With this decision, economic policymakers appear to have shot the economy in the foot; it’s essentially been hobbling along since the start of this recovery,” says the group.

Historically, the group points, consumer credit exhibits much more robust post recession growth then it does now so loosening up the securitization channel would increase availability of funds to consumers.

“Considering current low and historically acceptable levels of consumer credit default, many investors might welcome increased availability of this once popular asset class,” the group recommends.

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Fed says US fiscal policy unsustainable

US fiscal spending is unsustainable because its is escalating too high too fast but the threshold that would make the US a basket case is unknown.

“There is some level of debt that is high enough – although we don’t know how high that is – that generating the required amount of future surpluses required would be infeasible,” says Richmond Fed Economic Brief.

The problem with determining the threshold is because the market may suddenly realize that the government is unable to repay its loans and, as we have seen in the case of the European sovereigns, may too suddenly turn on selling.

At issue is the federal debt held by the public based on the current laws versus the expected laws.

Based on the current laws, public is seen holding, over time, less debt while based on expected laws, the percent of debt that the public is expected to hold goes exponentially higher (graph above).

As a result, Fed says that there is a divergence between belief and expectations: the belief is that by 2042 debt held by the public as percentage of GDP is to sink below 50% whereas the expectation is that it will explode to 250% of GDP… and the Fed may be impotent.

“In practice, however, a central bank’s credibility cannot constrain fiscal policy in any meaningful sense. It cannot stop fiscal policy makers from running budget deficits that continually expand the debt,” warns the Fed.

Ostensibly, minding its mandate, the Fed is concerned that the break-down in the belief that the US debt is unsustainable may cause inflation, yet it warns the politicians that such inflation may wreck havoc across the economy.

“That situation would inevitably invite monetary policy makers to intervene since inflation presents one possible source of revenue. In fact, economic research suggests that high debt levels ultimately could overwhelm a central bank’s efforts to keep prices stable, an effect discussed next,” says the Fed.

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Pesky subordination may spiral Spanish yields higher, Italy’s too

Yesterday’s sharp dip in US 10-year note, particularly in the early trading, signaled inflow of cash into the US debt space on the news, deemed initially positive, that Spain got a “line of credit” to recapitalize the banks but interpreted as negative in the bond world where the pesky issue of subordination (see video below) may have spooked debt holders to dump Spanish debt (and Italian) and park cash in US.

For bond folks, at issue is the source of the “line of credit” because, fear is, they may come from the European Stability Mechanism (ESM) where point 13 of this Treaty stipulates the packing order that creditors must take (emphasis added):

Like the IMF, the ESM will provide stability support to an ESM Member when its regular access to market financing is impaired or is at risk of being impaired. Reflecting this, Heads of State or Government have stated that the ESM loans will enjoy preferred creditor status in a similar fashion to those of the IMF, while accepting preferred creditor status of the IMF over the ESM. This status will be effective as of the date of entry into force of this Treaty. In the event of ESM financial assistance in the form of ESM loans following a European financial assistance programme existing at the time of the signature of this Treaty, the ESM will enjoy the same seniority as all other loans and obligations of the beneficiary ESM Member, with the exception of the IMF loans.

Now, there are all sorts of legal wrangling about this including claims like:

- If part of the cash comes from EFSF then ESM subordination superiority goes null

- ESM Treaty comes in effect in July based on states signing it which is legally different then ratifying it

- The most reassuring: public statements by EU officials that bond people should not fear!

Besides noting that another EU country is soon to go by way of Greece, Lee Buchheit, the lawyer that renegotiated Greek debt and many others, also notes in his paper, from experience of course, that no country “would lightly consider a change of local law as an easy method of dealing with a sovereign debt crisis”. Buchheit also warns why:

- “If done once, future investors will fear that it could be done again.”

- “A dramatic change in local law by one country might allow a worm of doubt to slip into the heads of capital market investors in other similarly-situated countries, driving up borrowing costs around the board.”

- Fear that the law will “unleash the forces of contagion and instability upon other countries”

Taking these legal points all together, selling Spanish and Italian bonds ASAP may be prudent if one expects the subordination issue to begin dominating the Spanish bailout debate, and by implication, the Italian one.

Fitch is already warning that policymakers are losing their grip and, of course, one sees a bailout paradox emerging out of this – a policy intended to do good contaminates the sovereign debt and spiral the financial situation out of the reach of containment of policy makers thus reinforcing the cliché that the path to hell is indeed paved with good intentions.



At any rate, another, more macro issue, is percolating about the funding source itself.

If EFSF + ESM = €700bn, and Spain used up €100bn while Spanish total funding needs are €370bn through 2014, the bailout source is left with €700bn – €100bn – €370bn = €230bn.

With Italy needing €620bn in funding then the source is short by €230bn – €620bn = – €390bn.

With the Spanish “luck” of a first draw, no wonder eyes are on Italy now and its yields are rising.

For US equities, rough ride ahead…

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Delusion as part of EU bailout plans

“Yesterday, the credibility of the euro won, yesterday the future won, yesterday, the European Union won,” declared Spanish PM Mariano Rajoy after asking for a bailout over the weekend before fiercely opposing it.

Rajoy dared not call the bailout “the bailout” and by referring to it as a “line of credit” he wasn’t the only one injecting delusion into bank bailouts but rather opened new vistas for it - Spanish economy minister mentioned that as a “line of credit” the 100 billion Euros will not be part of the deficit.

Few hundred miles to the north, at the big bank confab in Copenhagen, Institute of International Finance (IFF) figures were self-congratulating themselves on the “success” of the Greek debt “restructuring” noting that this big bank advocacy group achieved a 100 billion Euros in debt forgiveness, success worthy of a pursuit of a bigger role in any future debt restructuring deals for themselves.

Of course, Greek restructuring was so successful that now Athens want the debt deal restructured… and so may Ireland, Portugal…

Nor is it clear whether 100 billion Euros is the bazooka that will eliminate the Spanish financial stench or simply deodorize it.

Then who gets the cash is also murky as the government already took over some banks while it is forcing others to merge, a process that looks to be planned as it goes along.

… and what about pricing the bank “assets” when the loan market is affected by the escalating unemployment and falling GDP while the value of the underlying collateral of the loan is, in some cases, nearly impossible to ascertain because people are not buying real estate in Spain.

Then bond people are already worried that bailout funding will push over senior bondholders back in the claims line because, according to European Stability Mechanism, if money comes from ESM, bondholders are automatically subordinated… which brings us to the issue of “subordination credit event” that some in the market are already questioning whether CDS will get triggered.

On the other hand, it is worth pondering whether it is worth it to pump in so much cash into banks that are not even systemic or would it be more prudent to simply let them go.

“The unhealthy banks should be brought down or some banks should be possible to chop up. There must be a possibility to restructure the banking sector because it doesn’t make sense to recapitalize banks which are not capable of running,” notes Finnish Prime MinisterJyrki Katainensaid.

… or is there a more devious plan here! more notably, that propping up the banks is systemic, not to the banking sector, but to the government.

“The system … is the Spanish government bails out Spanish banks, and Spanish banks bail out the Spanish government,” Nobel Prize-winning economist Joseph Stiglitz said.

So we’ll see what happens when two drowning men pull on each others’ hand thinking that the other guy will save him.

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Greece on road to issue own money, ex-official

Greek default and a slow, painful Euroexit seems almost inevitable and the Argentine default looks like the tip of the iceberg if it is considered as a template for what awaits Greece, says Andres Velasco, Chile’s former finance minister from 2006 to 2010.

“But, with debt still unsustainable, the next round of Greek default could well make Argentina’s look positively Teutonic in its orderliness,” says Velasco.

He says that Greece is entering the period where a quasi currency is set to be introduced that will float right along the Euro and trade at a deep discount.

“In Argentina, the number of pesos needed to buy one dollar rose by more than 300%. Greece posted a current-account deficit of nearly 10% of GDP in 2011, despite the domestic depression. The real devaluation necessary to restore external balance will be enormous, perhaps larger than that in Argentina,” says Velasco.

Despite allegiance to the Euro, the quasi currency will be introduced in Greece if foreign funding is cut off which will trigger the ECB to no longer accept Greek bonds as collateral – and that will remove the last support for the banks.

Seeing that, the public will run on the banks which could force them, and the government, to issue IOU slips which would become tradable currency.

“At one point, more than a dozen quasi currencies were in circulation [in Argentina],” notes Velasco.

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Is Europe running out of AAA paper?

Now that the credit rating has been downgraded for most of the Eurozone countries the 4 remaining with the AAA rating may not offer sufficient amount of debt to maintain good enough liquidity of such high rated paper.

Germany, Finland, the Netherlands and Luxembourg remain the only AAA Eurozone sovereigns with total debt offering among them at 949 billion Euros. Of that amount, Luxembourg claims a negligible 4 billion.

Will we see a run up on these debt issues? Perhaps but funds may also change their investment guidelines now that there is an insufficient amount of AAA rated debt.

With most Eurozone sovereigns experiencing funding relief post-downgrade, Portugal’s dependence on the EFSF and a perception that it is next in line after Greek (dis)orderly default may be contributing to its higher funding costs.

Is the lack of Eurozone AAA debt paper the cause of the ever widening trend between the equities and the 10-year yield?

Probably because many funds and central banks are on an automatic pilot and would buy only a certain amount of top rated debt … but to what extent is Eurozone’s lack of worthy paper driving the equities-yield wedge is unclear now.

These two things tend to correct themselves at some point hence nervousness some traders are expressing at the current equities rally.

With a striking distance of a 100% retracement of May 2011 highs some clarity on this issue may be gotten in the second half of this month.

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Vulture funds betting on Greek default

In another signal that Greece may soon default – vulture funds are buying up chunks of Greek debt looking to profit by holding out during default negotiations.

From Reuters:

Distressed debt funds are building up blocks of Greek government bonds with an eye to holding out against, and ultimately profiting from, a restructuring of Greece’s debt.

No massive action on Greek debt is seen yet, trader says, but the bid-ask spread is large and liquidity is low so accumulating a position is hard.

“I’ve seen a lot of buying in Greek bonds in the past few weeks. When stuff starts trading at 30 cents on the euro, people are looking to get involved. The market is very illiquid though, so it takes time to build up a large stake,” said a head of European rates at a major bank.

Greek debt is differentiated between paper issued under the English law, the GGBs, and those governed by Greek law.

In case of a default, the paper governed by the Greek law can be declared worthless by the Greek parliament, so GGBs look attractive to the vultures.

“To be honest, the pressure for banks to get rid of GGBs is very strong, because shareholders don’t exactly thank you for holding these positions,” he said.