MARCH 2012                                                                                                               

Singing the Blues.


The PSI deal in Greece raises fundamental questions relating to our current understanding of the market’s capital structure and the purpose of specific instruments. Although we are told this deal is a ‘one off’ investors must maintain extra vigilance and assess their allocations accordingly.

The global markets are based on a clear understanding of capital structure and how to operate within it. The Greek PSI deal has effectively taken an axe to one of the traditionally most secure ends of the capital structure - sovereign debt; this cannot be good. 

I was invited on Friday morning onto CNBC Europe to talk about the PSI deal and what the fundamental ramifications are for what has just happened.

A Judgement Call

A Greek default / restructure has been on the cards for at least 12 months. A judgement was made that if Greece had been allowed to go bust then systemic risk would have entered the European banking system. Protecting the banking system has been one of the key policies that has been followed since 2008 and it is why investors in bank debt have received back substantially more (if not all) their money and the holders of Greek sovereign debt now find themselves with a 70% haircut.

Now we enter into the three-card Credit Default Swap monte. If Greece had been allowed to default then there is no doubt that investors who had taken the CDS insurance would have been paid, this would have been the functioning of a normal market.

Why has this not been allowed to happen? The answer is that the current fragility of the banking system trumps the sanctity of the capital structure.

You say default....
The CDS that was bought by investors in Greek debt is the equivalent for one’s house. Now we are standing next to the smouldering ruins of the house to be told by the insurance company and the fire department that the fire that has burnt down the house was in fact not a fire at all - it was a ‘restructuring’ of the house into ash. It would have been absurd if the International Securities and Derivatives Association (ISDA) had not agreed to trigger the CDS. If they had not it would again have undermine the capital structure and possibly fatally wound the CDS market.

Rules of the Game
The judgement call of supporting the banking system over Greece has been made. However, it only holds good if this was a one off. We are told that this is indeed is the case - but history suggests something else. Surely Portugal, Ireland, Spain and Italy would also all like to write off 70% of their debt without triggering a large CDS event.

So now we are operating in a market where the rules of the game have been changed mid way through because some of the players did not like the probable outcome. Fundamental pillars of the capital structure are being shaken and instruments that we thought provided us insurance are becoming worthless, like so many of the pretty bonds that we all have seen on the walls of expensive boardrooms.

Fool me once
This whole episode brought to mind a famous song by BB King which contains the apocryphal lines:

“Fool me once, shame on you - fool me twice, shame on me”.


We may have got caught out once by Greece - this is forgiveable - but to get caught out again by Portugal, Spain, Ireland or Italy would be unacceptable.

The ECB and the market is telling us to disregard B.B. King’s advice, we say whom do you trust?

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