Sovereign Debt and Market Confidence
When EU Finance Ministers met in Brussels on 16 February to consider Greece’s budget deficit and public debt divergence from the Maastricht criteria, they took little persuading that Greece's previously proposed reforms, largely directed to revenue-enhancing measures as opposed to public spending cuts, would not achieve the required 4% reduction in the budget deficit for 2010. In order to underscore their lack of confidence, Ministers recited the failures by Greece to deliver on earlier requirements.
The meeting concluded that, by 16 March 2010, the Greek Government had to produce a revised budget for implementation this year. To Greece’s credit, they announced the € 4.8bn of new cuts on 3 March, and launched a ten year bond issuance. The fact that the call was comfortably oversubscribed is hardly surprising, since it is paying an eye-watering 6.4%, reflecting the near 290+bps spread over German bonds.
As if Greece did not have enough to contend with, there is no sign that the European Central Bank is going to moderate its collateral requirements, following its decision in December to reinstate the original A- (or equivalent) credit rating qualification by the end of 2011: a decision widely credited with triggering the sell-off of Greek bonds, after they were downgraded to BBB+ at the end of last year. In the meantime, there is the threat that Greek bonds could be downgraded further, following the downgrading of all four of Greece’s main banks to BBB-, which would put Greek bonds out of eligibility from even the present scheme.
The real question is whether Greece can actually deliver the first wave of cuts to public sector wages, pension reform, healthcare reforms, public administration, as well as measures to reform the product market, the business environment, productivity and employment growth. And this will still leave the deficit at 8.7%, and a further plan expected by 15 May 2010, detailing proposals to bring the remaining deficit and debt back within acceptable limits by 2012. At the time of writing, CDS spreads were at 298bps, which is still high, but is down 25% on the previous week.
All of this has operated against the backdrop of an increasingly sceptical European political class, especially following the reminder that Greece entered into currency derivative transactions in 2001 as a means of flattering its balance sheet prior to joining the Euro. But President Sarkozy went out of his way on 7 March to signal clear support for Greece, compared with a rather more muted message from Chancellor Merkel. What is more, politicians have joined in the clamour to clamp-down on the, so-called, ‘naked’ CDS market in Sovereign debt, which they say is responsible for some of Greece’s woes. The truth is that this is little more than ‘naked’ political opportunism.
What does this mean for the average investor? Well, in the short-term, higher yields on Greek paper, which are always welcome.
Problems with Contingent Capital
Whilst I have got your attention, I thought I’d share some reservations about the new kid on the regulatory block, namely the Contingent Convertible, or ‘CoCo’. To some this is the latest wheeze in clever hybrid capital instruments. To others, it is fraught with problems. Let me list seven of them for you to reflect on:
- The Liquidity Problem: If a CoCo converts it will likely exacerbate a stress scenario. Publicising that a trigger event has occurred could well disrupt the liquidity/lines available to the bank.
- Risk Determination: Investors are not going to be able to determine the risk involved with CoCos:
Definition of Core Capital: if capital definitions keep changing, how are investors going to be able to judge the implicit likelihood of the potential switch into equity if the rules are not yet set?
Quantum of Core Capital: While regulators are still assessing the level of core capital that banks should maintain, what is the right level at which investors would be comfortable to subscribe? If the trigger is set very low, given historic level at which banks have run their core tier 1 ratios, there would be no benefit from issuing CoCos, until the crisis reaches a point where conversion to equity may not have any significant benefit.
- Demand: Many traditional hybrid and subordinated debt holders may not be able to hold CoCos, due to their embedded equity conversion option. However, they may appeal to hedge funds, who will seek to hedge the bonds by shorting the underlying stock.
- Pricing: CoCos would come at a hefty premium over their host securities. The only recent issue required investors to take up the CoCos by exchanging bonds that would otherwise not receive coupons or be called. Therefore, the premium on the CoCos was much cheaper.
- The Disclosure issue: How far in the capital forecast does the conversion get triggered? If a bank realises that it may breach the trigger level 12 months forward does it disclose the breach that could potentially cause obstacles for further capital issuance.
- Cash flow: Regulators have agreed to allow these CoCos to be mandatory pay securities (Tier 2 or even Senior debt), so cash will continue to exit the business to pay coupons, which is exactly what the EC wanted to stop. Furthermore, if hefty premium are allowed to be paid on CoCos, even more cash would leave the business.
- Ratings: if CoCos do not contain an objective threshold for conversion enabling an investor to reasonably measure the risk associated with conversion, Moody’s may not rate the CoCos, which will further limit the demand with investors. S&P have cautioned institutions that CoCos are not a replacement for permanent capital.
So, before you rush off to buy yourself a Co-Co, will it really do what you want?
Edward Bowles - Head of Public Affairs, Europe, at Standard Chartered Bank
The views expressed here are the writer’s own and do not necessarily represent the views of Standard Chartered Bank.
