Tuesday, March 22, 2011

ESM / EFSF: An Inverted Capital Structure

I've been meaning to write about this for quite some time, but it's been really hard to have the time to sit down and do it. I've let perfect be the enemy of good and so here I'll try to lay out a rough sketch of what I think are some of the possible risks of the EFSF / ESM.

From Reuters:
The euro zone's permanent bailout fund, the European Stability Mechanism ... which will have an effective lending capacity of 500 billion euros, will be backed by 80 billion euros of paid-in capital and 620 billion euros of callable capital ... It will offer loans at funding costs plus 200 basis points for loans up to three years and plus another 100 basis points for loans longer than three years.
What you are seeing here is what Michael Pettis described as an "inverted" capital structure in his excellent book, The Volatility Machine. What that means is that there is positive correlation between the need for funds, the cost of funds and the credit quality of the facility. This is problematic because it could cause reflexive price action in the bonds of the aid recipients, lowering the value of the EFSF holdings and furthermore deteriorating its perceived credit quality. This is also sometimes referred to as "wrong-way risk" when talking about CCPs. In other words, "the risk that different risk factors be correlated in the most harmful direction." AKA a vicious cycle.

Here's some numbers from the June 7, 2010 EFSF execution agreement. They represent the subscription amount and percentage to the EFSF.  The EFSF is just a legal entity where various countries contribute capital and become equity holders (with unlimited liability). The contributed capital and proceeds from bond issuance are used to make loans to countries that need aid. The bonds are guaranteed by the full faith and credit of the EFSF, the EFSF equity holders (EUM member states), the EU, and have the EFSF holdings as collateral. The table below is a breakdown of the contributed capital so far. Issued debt is to be overcollateralized at a rate of no less than 120% by AAA Holdings and AAA guarantees. There is also to be a cash reserve that equals the NPV of the margin of the EFSF loan and service fee. The EFSF is available to all EMU member states.

ECB Member State Capital subscription Contribution Key %
Kingdom of Belgium 2.4256 3,475494866853410%
Federal Republic of Germany 18.9373 27,134106588911300%
Ireland 1.1107 1,591454546757130%
Kingdom of Spain 8.3040 11,898297070560200%
French Republic 14.2212 20,376693436879900%
Italian Republic 12.4966 17,905618879089900%
Republic of Cyprus 0.1369 0,196155692312101%
Grand Duchy of Luxembourg 0.1747 0,250317015682425%
Republic of Malta 0.0632 0,090555440132394%
Kingdom of the Netherlands 3.9882 5,714449467342010%
Republic of Austria 1.9417 2,782143957358700%
Portuguese Republic 1.7504 2,508041810249100%
Republic of Slovenia 0.3288 0,471117542967267%
Slovak Republic 0.6934 0,993530730819656%
Republic of Finland 1.2539 1,796637126297610%
Hellenic Republic 1.9649 2,815385827787050%
Total 67.8266 100,000000000000000% 

Where is the risk? Well, the risk here is that everyone is guaranteeing everyone. So, if Ireland Portugal and Greece need aid, their guarantee is pretty much worthless, and they are now users of the fund. If another state were to need aid, another piece of the guarantee would become worthless and need for funds would increase. This would increase the cost of funds, which would be passed on to aid receivers. Unless the states receiving aid are running a budget surplus, this would translate to increasing borrowing needs to cover additional debt service costs, furthermore deteriorating their quality.

Of course, losing Portugal's guarantee is unlikely to be disastrous, but if Belgium and Spain were to find themselves in trouble too, that would put additional pressure on the remaining members, affecting their own credit quality. While it might be no more than an inconvenience to Germany or France, it could adversely affect smaller economies. It could, in essence, leave France Germany and Italy holding the collective bag. I have no clue as to the probability of this happening, but the risk is present and shouldn't just be ignored. If we were to think of bonds as way deep out-of-the-money options (this model goes beyond of the scope of this post), you would notice that you are basically short a lot of gamma here. As the situation deteriorates, the speed at which it deteriorates increases. Of course there is the possibility that it will all work out, which is what the EU is banking on.

I'm not going to get into the gritty part of of this until I have more time, but I think the best way to think about it is as a highly-levered, short way-out-of-the-money put on the EU sovereigns. The probability of going into moneyness might be remote, but the damage in that case would be catastrophic. Buy the paper at your own risk.

Sunday, March 13, 2011

Economic Implications of the Japanese Earthquake & Tsunami

I'd like to start this post by point out I am not a macroeconomist. I did obtain a B.S. in Economics from Northeastern University, but my transcript is anything but impressive. Please question everything I say here and if you see any flaws in my logic be sure to point them out to me in the comments.

The first reaction I saw in the twitter finance / economics crowd was that, while the destruction was very tragic, reconstruction would act as Keynesian stimulus, possibly helping the economy. Some even joked that the combination of increased demand and stimulus in ZIR environment could cause hyper-inflation. So, let's try to step through this piece by piece:

There was massive destruction of the capital stock of Japan. This helps nobody, we are all collectively poorer as a result. There is simply less goods in the world now than there was a week ago. The same can be said for wars. The economic damage to Japan is likely humongous, but that's partly because Japan is a very wealthy country.

Replacement of the damaged capital stock will likely take years, but certain things will be replaced quicker than others, like insured cars, homes, household staples and durables. This sudden replacement will goose demand in the short term, providing stimulus to the economy, putting people to work and utilizing capacity.

A large part of the money for cleanup, reconstruction and replacement will come from exposed insurers and re-insurers. These companies will pay out claims from their assets. Some of the claims will be paid out from their most liquid assets, like cash and cash-equivalents or highly liquid instruments, including but not limited to, sovereign paper. If there is need for additional liquidity to pay out claims, other assets will have to be liquidated. I am no insurance expert, but common sense would dictate that insurers would be likely to liquidate the most liquid and least risky assets first, and then gradually adjust their risk and liquidity exposure in order to avoid paying too much for liquidity or having to take unfavorable bids (I started writing this before the TSE opened, but as of now the JPYUSD has already hit 80.80 and the Nikkei was almost 200pts down).

The initial move up in the Yen is hardly surprising. However, repatriated currency and any carry unwind help support JGBs, especially the front of the curve. Additional liquidity provided by BoJ does the same (Y7T and counting). As supply is set to increase there will be a firm bid for safe haven assets. Risk assets will have it more difficult, especially until losses are sorted out, especially financials.

Overall, this will essentially be bearish for JGBs in the long term. The economy's Supply capacity was just reduced (S curve moves left) and demand is about to be goosed (D curve moves right). Because of increased demand and reduced supply, I'd expect to see price increases. I'm not talking about price gouging, but pricing power is moving to suppliers, both of goods and of labor. Whether this will be enough to shock the country out of the deflationary trap remains to be seen, though.   If it does succeed, the natural thing to expect would be a gradual uptick in nominal rates, which would be bearish for JGBs in Yen terms. The currency is a different matter.

At first, as we are seeing already, JPY is going to be strong. JPY is a flight-to-quality  currency and a carry funding currency. Any unwind of carry will come with demand for Yen and supply of the carry currency, putting upward pressure in the Yen. The carry trade is so big that there's no way in hell BoJ can do anything about it. After this, though. I see a bearish path for the JPY. What you are going to inevitably end up with is an increasingly indebted country and a reduced capital stock.  Best case scenario the crisis kickstarts the economy and deflation ends, but--again, in the long term--inflation will be bearish for the currency from a PPP standpoint.

PS: anyone telling you that the flight-to-quality is going to lower exports is in the wrong time frame. Techinically, yeah, a strong JPY would hurt exporters, but there's about to be such a HUGE boost to internal demand, that it ain't no thang.

For those of you that like to play, here's some long ideas. (no short ideas because if you short disaster victims you're a real asshole)
Managed timber; Durables and materials retailers; Equipment sales and leases; Construction; Auto dealerships; furniture retailers; electronics (TVs, computers, etc retailers). Basically go long the people who are going to sell the stuff that needs to be replaced and were either undamaged or probably protected by insurance. Also, anyone that rents out heavy machinery.