Tuesday, 17 July 2018

UP FRONT: Taking the pain

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  • ECB meets JCM

To cut or not to cut the ECB? That’s the dilemma facing those involved in Greece’s debt restructuring. Naturally, the private bondholders, represented by the Institute of International Finance, would like to see the monetary authority share some of the burden of the eventual haircut.

The IMF has weighed in with its two-penneth worth. With considerable irony, given its own preferred creditor status, its chief, Christine Lagarde, has called on the ECB to take its share of the pain. “If the level of Greece’s privately held debt is not sufficiently renegotiated, then public creditors, holders of Greek debt [read ECB], will also have to participate in the financial effort,” she said.

It’s a thorny issue. Without the ECB Greece would have officially defaulted months ago – it still will, the only question is how orderly the process will be – and its banks would be bust. It’s also highly likely Greece would no longer be in the eurozone without the ECB’s largesse, estimated to be about €40bn.

Noises coming out of Athens suggest one idea may be that the ECB returns the profit it has made on its Greek bonds, thereby not making a loss itself but helping to reduce Greece’s overall debt by about €10bn.

For its part, the ECB claims that a write-down would monetise Greek debt – though how that differs from its securities markets programme and the LTRO, which is quantitative easing by the back door, is anyone’s guess.

There is, of course, another reason why the ECB opposes the move. Its balance sheet is already €2.7trn and if it maintains its bond buying and bank lending that number will be on course to hit €3.5trn by the end of the year.

With a capital and reserves base of €81.5bn (that’s for both the ECB and the national euro system of central banks), it doesn’t take a genius to realise that, as a hugely leveraged institution, any losses could lead to big trouble. Sure, it can print money. But at what point does the world start worrying about Europe’s supposed saviour?

Bonus time

You could forgive Credit Suisse executives for raising a collective eyebrow when they learnt the details of their new compensation plan.

There was no sign of a return to bumper cash bonuses. Instead, they’re getting paid this year partly via an opaque fund referencing derivatives counterparty risk.

There are, of course, some pitfalls to the scheme. The underlying reference pool is confidential (although 94% is investment grade) and the tenor of the note is fairly long – nine years with a four-year call.

It also goes without saying that bankers would have preferred cash in place of such an exposure, although even some within the institution admit they would be pushed to find a better yielding asset to invest in.

But several things about CS’s innovative “PAF2” structured note point to it being a smart move. By syphoning 18% of its derivatives counterparty risk off its balance sheet, the Swiss bank should enjoy a decent chunk of capital relief under the Basel III rules. Freeing up this capital should benefit the firm in the long run, and so by extension its employees and shareholders (who are often the same people).

On the face of it, the structure also seems to align the incentives of the bank and its staff. By absorbing the first US$500m of losses, CS has a sizeable amount of skin in the game. The executives who receive the PAF2 bonus should also be encouraged to manage the bank’s counterparty risk prudently.

Under Basel III all banks are going to become increasingly capital-constrained. Innovations of this kind are only going to become more prevalent in the brave new world.

LatAm on a roll

Latin America’s bond markets are on a roll. Nine deals priced last week alone, with Brazilian steelmaker CSN in the market as IFR went to press.

Together, these transactions raised US$4.75bn, excluding CSN’s US$500m tap of its 2020s, bringing the year’s total to just under US$15.5bn. Another nine borrowers have announced mandates.

What particularly stands out is the variety on offer to investors. This year’s deals include heavyweight sovereigns such as Brazil and Mexico, as well as Colombia and Peru, high-grade quasi-sovereigns, pure corporates (both investment-grade and high-yield), financial institutions, straight bonds, subordinated bonds, perpetuals, even Basel III-compliant debt.

Of course there are risks. Liquidity is abundant, maybe too much so. Consider Braskem’s US$250m tap of its 2021s that was 10 times oversubscribed, even though the new issue concession was just 10bp. And default rates could rise if growth stalls.

But not so long ago no one would have used the word “sophisticated” to describe Latin America’s debt capital markets. Yet that’s increasingly what they are.

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