14 July:

 

It’s not over. The deal agreed by the Eurogroup with Greece will need the creditor parliaments and the Greek parliament to vote and approve before the governors of ESM can approve it. The Greeks will likely approve it although Tsipras 149 votes will likely not all be yes, it is expected some 30 will vote against, the 106 pro Euro opposition will be sufficient to carry the motion. As for the creditors, only Finland looks risky. Under normal circumstances an ESM bailout requires unanimity but the ECB can and in the event of dissent will likely decide that the action is a threat to the stability of the union and force the vote into a special motion requiring an 85% majority. The potential dissenters will unlikely get beyond 3% of the vote. And so the Greek bailout will likely be ratified.

The ESM’s response to the proposal is not unequivocal and there are potential uncertainties in the language which suggest that there could be further negotiations.

While in the short term the deal will likely be approved by the Greek parliament the fact that the deal Tsipras has achieved is worse than the June 26 creditor proposal and indeed worse than any deal in the negotiations thus far poses a risk to his leadership. The deal involves no debt write down, no end to austerity, a restart to asset sales and this time under the strict supervision of the Troika and the continued monitoring of progress by the creditors, something that was deemed humiliating and demeaning. Syriza is itself a coalition and the integrity of this coalition must certainly come under pressure given the quality of the bailout deal. One can reasonably expect a shakeup in the Greek parliament and possibly new elections.

Even assuming that all parties were agreeable it is difficult to see how Greece would comply with the budget targets. It is one thing to agree to something but another to have a plan to achieve it. So far both creditor and debtor have focused on targets without devising the means to achieving them. Few countries have achieved what the Greeks are aiming for, not even their largest creditor Germany.

The probability that Greece gets into a financially distressed situation at some stage in the not too distant future, under this plan, is quite high.

 

 

15 July:

 

Having had time to sleep on this I’m beginning to have doubts that the Greek parliament will pass it. Tsipras began with an anti-austerity platform and coalition party. He’s now ended up with a tighter austerity program than he bargained for at the start of negotiations. Parts of Syriza will vote against the creditor plan. He is counting on the opposition to support this pretty draconian plan. Now the opposition may have been for austerity when they thought it might work but the capital controls have taken the Greek economy off the cliff, not near it, off it. ELA is frozen, thankfully not retracted, and with TARGET2 off limits the Greek economy is essentially is containment. I am simply not sure anymore if the opposition New Democracy will support what is an unworkable creditor plan.

 

The plan itself is incomplete, which under these dire conditions is actually a source of hope. As it stands, without a write down, the plan is unworkable and seems to have been put together either by amateurs or creditors seeking Chapter 7 instead of Chapter 11. Trying to raise cash by selling assets is a great idea on paper but is impractical. Once the seller is identified as a motivated seller, the bids will tumble to fire sale levels that no credible creditor would agree to if they believed they had claim to such assets and their proceeds of sale. If the sale program was sufficiently determined, the proceeds will fall well short of the 50 billion EUR envisaged. If the sale was attempted at reasonable prices, the fact that the assets for sale are earmarked for sale would mean that the deals will not get done and it is likely that there will be recriminations over the speed of the asset sales and the motivation of the debtors or the creditors.

 

A credible plan would see the following principles:

 

1. As close as possible to a commercially viable deal that an arms length investor would fund.

2. A long term solution as long as the longest maturing debt that will be issued as part of the restructuring.

 

My plan would include:

 

1. Debt restructuring:

* Issue of senior secured bonds with first claim to a proportion of tax revenues and a sinking fund under control of creditors.

* Issue of senior unsecured bonds with zero coupons for first 10 years and coupons stepping up thereafter.

* Issue of mezzanine GDP linked bonds.

* Legacy bonds to be written down by X% with immediate effect and the recovery value financed by the new bonds above. X could be substantial, circa 30%-50%.

2. Pension reform.

*  No new defined benefit pensions to be issued. All defined contribution schemes to be frozen (not cancelled) at this point (that is, any indexation to stop.)

*  Introduction of defined contribution pensions. Employers pay 15%, employees pay 15%. Assets held in an independent safe custody vehicle beyond the reach of government or state.

* Phased withdrawals of state pensions. Private annuity options.

* Medical insurance part funded from this pool.

3. Social security.

* Unemployment benefits and other social welfare benefits separately funded by payroll taxes.

* Medical insurance part funded from this pool.

4. Taxation.

* VAT proposed in current creditor plan.

* Corporate taxes to be cut when possible. Ideally 1% cut each year in primary surplus till 20%.

* Tax holiday for specific industries – tech, biotech, industries likely to bring investment.

* Social security tax for employers cut from 28% to 10% to compensate for 15% contribution to employee pension fund.

* Social security tax for employers replaced by compulsory pension contribution. This is a simple reclassification.

* Personal allowance of 5,000 EUR.

* 2% cut to all marginal income tax rates.

5. Investment.

* Infrastructure investment funded by private participation in infrastructure bonds and equity.

6. Anti-corruption.

* Anti-corruption campaign. This to address tax collection and tax liability as well as general rule of law.

 

7. Financial system recapitalization.

*  The banking system will have to be recapitalized. That much is clear. The recapitalization will have to come from first from the government and then from private sources. The banks will issue equity underwritten by the government and simultaneously issue tier 1 capital and mezzanine debt.

The government’s biggest expenses are on pensions, medical insurance and social security. By moving from defined benefit to defined contribution, the burden of pensions is shifted to the people, as it should. Medical insurance is split between being funded by the pension pool (individual responsibility) and the social security pool (collective responsibility). These measures will lessen the collective burden and improve the state finances allowing for a reduction in marginal tax rates.

 

If the creditors are unhappy with the debt write-down and the issue of further debt and the latitude for Greece to run smaller surpluses or indeed small deficits in an interim adjustment period, then they should just eject Greece from the euro.

 

 

 

On June 26, had Greece agreed to these terms a deal would have been done. Instead Tsipras calls a referendum and seeks a No vote from his people. Before the vote, Tsipras goes back to the Eurogroup to accept the terms. Merkel says that they have to wait for the referendum since Tsipras would, in the spirit of democracy, have to respect the Greek people’s decision. The people give Tsipras his No vote. He comes back to the table effectively accepting the creditor terms (in the June 26 proposal) confounding the No vote he had obtained at home.

This behaviour gives a clue to what it must have been to negotiate with Tsipras and Varoufakis in the preceding 6 months. Varoufakis probably resigned when he discovered Tsipras was going to accept the creditor terms after the No vote.

The behaviour also explains why Germany may be sceptical about the representations of the Greek government. If the Greeks agree to the bailout terms, there is no guarantee that they will comply with the very terms they have agreed. A logical strategy is to ask Greece to leave the Euro, provide Greece with some level of support, but require Greece earn its way back into the currency union.

On a slightly separate note, I think the Greek experience has shown that the world needs a better sovereign bankruptcy process and a better definition and design of sovereign capital structure. I would like to see the emergence of a sovereign covered bond market with claim on sovereign assets as well as a sovereign ABS market where default would result in the assignment of portions of tax receipts to creditors or tranched ABS where cash flows are prioritized over tranches in a waterfall structure and additional cash flows are used to capitalize sinking funds under the negative control of creditors.

On July 2 I wrote that I expected Greece to vote Yes in the referendum. I expected the Greeks to vote in favour of anything that would restart the ATMs and get cash flowing through the banking system once again. As it turns, the Greeks voted no. Why did I and many professional investors expect a Yes vote? Because we have substantial savings. I made a forecast apparently empathizing with the average Greek but without a good understanding of the average Greek and an understanding of their circumstances.

5 years of austerity had not yielded more jobs. The probability of getting a job was low. There was little in the bank to protect or release anyway. And the Eurozone finance ministers had been making a concerted case basically threatening the Greeks into voting Yes.

This last factor could cynically be interpreted as an intentional strategy to jettison the Greeks from the currency union if one were inclined to conspiracy theories. Perhaps the Eurozone was trying to correct an earlier error, that of bending the rules to admit the Greeks in the first place. Perhaps they had just tired of negotiating with a deadbeat who was seeking aid on its own terms. Perhaps the Eurozone had tired of subsidizing Greece (the details are beyond this discussion but yes, there were net transfers to Greece), and unable to eject Greece under the current rhetoric of unity at all costs, needed to force Tsipras to the edge, and then force the Greeks to voluntarily eject themselves. If this is true, then job done. You should see an aid package (the Eurozone will not abandon an erstwhile member) involving debt forgiveness, which is what Greece had sought in the first place, but which the Eurozone could not give and then retain Greece in the union. As important as keeping its members firmly in the union is ensuring that members pay their dues and respect the bye laws.

With a No vote Tsipras can negotiate more aggressively but whether the creditors will be accommodating is another matter. If the conspiracy theory is correct then he has given Merkel her wish and maybe the negotiations will be less confrontational. This is unlikely. The tensions if anything may intensify. A lot depends on Tsipras approach. He may cock a snook at the creditors and refuse to pay, Greece is after all already in default. There is not a lot that the Eurozone can do, short of gunboat diplomacy, something that is unfashionable these days and especially with the Eurozone. A martial solution is something the West has long lost its stomach for, and a German led coalition would never make it past the broadsheets and blogs.

The creditors may recognize that even in the face of an acquiescent Greece that never went to the polls, or a Yes vote, they were never going to get the full face value of their debt back, and that they have now got the Greeks off their backs, some reasonable write down of the debt is acceptable. A more sinister scenario exists. It may have been necessary to induce the Greeks to eject themselves from the union to encourage responsible behaviour among existing Eurozone members but it may now also be necessary to deter further exits by demonstrating the high price of leaving the union.

As I have said before, Greece has always had a choice between austerity in Drachmas or austerity in Euros.

 

Greece will conduct a referendum on July 5 regarding a creditor plan of reorganization. The referendum is framed as a Yes/No vote to either accept or reject the creditors’ proposals.

1. The vote as it is framed is strictly about accepting or rejecting the creditor proposal. However, the consequences of either a Yes or a No go beyond the creditor proposal, they go to whether Greece intends to be a part of Europe, or not.

2. There are a number of scenarios:

a) Yes. Tsipras government resigns. A new government will have to be formed which is happy to comply with the referendums implications. Financial and liquidity support will resume and details of a bailout will be finalized and implemented.

b) Yes. Tsipras government does not resign. Syriza has campaigned for anti-austerity and recommend the people vote No so a Yes vote would destabilize the government. It is unclear how the creditors will proceed in negotiations with Syriza. Syriza would have to honour the implications of the Yes vote and negotiate accordingly. The ECB may not be as quick to lift the suspension of ELA and negotiations would have to continue to finalize details. These negotiations could be problematic if represented by Syriza.

 

c) No. Tsipras government will have a strengthened mandate. The ECB would certainly ringfence the Greek financial system and maintain suspension of the ELA. Greece may be explicitly removed from TARGET2 which would isolate its financial system. There are many possibilities under a No vote since it would imply chaos and a likely exit of Greece from the currency union and perhaps from the European Union as well.

 

3. Short term effects: Equity markets will likely react well to a) above. The uncertainty of b) above means that any upside is likely to be fragile. Volatility could persist until a clear deal could be reached. In c) above the immediate impact will likely be a sharp sell-off as investors seek to de-risk and avoid any potential Black Swan events. “We know how bad it is and it ain’t so bad, but we don’t know what else we could have missed…” would be the likely thinking. European markets are still on average about 10% in the money year to date and investors will want to protect that.

4. European equities will correlate closely with BTP and BONOS spreads versus Bunds in each of the above scenarios. For 30 year BTPs, spreads could tighten below 100 under a) or languish in a 100 – 150 range under b). Under scenario c) the immediate impact could be big. Spreads were over 400 in 2011 but with the ECB’s OMT, QE and LTRO operations a widening to 200 would be extraordinary and would be a trigger to buy the spread. A similar analysis applies to 30 year Spanish spreads.

5. Longer term positioning.

a) Scenario a) provides Greece a lifeline. Depending on the final nature of the bailout the outcome could be long term negative for Europe, if for example, the creditor plan was unrealistic, draconian and would cause Greece to require another bailout in a few years’ time. A realistic deal would see some form of debt write-down with conditions to rehabilitate the Greek economy. Such a scenario would be long term positive.

b) Scenario b) could not realistically play out over the long term since the raison d’étre of Syriza was anti-austerity.

 

c) Scenario c) presents the most interesting long term investment opportunities.

I) The Greeks might soften their demands but the probability of this after a No vote is small. The probability that the Eurozone would soften their demands following a no vote is similarly remote given the contagion risk of moral hazard to Spain, Italy, Portugal.

 

II) Greece is already de facto in default and a No vote would formalize this. Negotiations would begin, or in this case, resume, with creditors. In this case, creditors would be quite powerless to negotiate for anything except to eject Greece from the union and suspend all aid. Keeping Greece in the greater union but not the Euro would provide a template for subsequent member exits and is therefore unlikely to be supported by Germany or France.

 

III) Greece would have to mint its own currency, which would probably depreciate some 40%-50% instantaneously. Some form of capital controls will be needed to ensure the success of the new currency.

 

IV) At this point but not before, Greek assets and legacy debt might present value.