Monday, 12 January 2015

Citi, Goldman, ICAP And Others Prepare For Grexit... Again

Every couple of years the same identical European drill repeats itself: 1) Greece makes loud noises as it approaches an election, 2) Europe says it couldn't care what the outcome is and that Greece should stay in the Euro but if it exits it won't be a disaster, 3) the ECB reminds everyone of the lie that it is not preparing for Plan B (it is) despite holding on to over €100 billion in "credibility-crushing" Greek bonds, 4) panicking Greek banks say the deposit outflow situation is completely under control (adding that "The Bank of Greece along with the European Central Bank are monitoring closely the developments and intervene whenever this is necessary," which is code word for far more familiar, five-letter word), and meanwhile 5) all non-Greek banks quietly start preparing for the worst case scenario.

So far this time around, we had everything but step "5". We do now.

According to the WSJ, "banks and other financial institutions in Europe are stress-testing their internal systems and dusting off two-year-old contingency plans for the possibility Greece could leave the region’s monetary union after a key election later this month. Among the firms running through drills are Citigroup Inc., Goldman Sachs Group Inc. and brokerage ICAP PLC, according to people familiar with the matter."

And soon enough Bloomberg, because who can possibly forget the mysterious appearance of the "XGD Crncy" in June of 2012, only to disappear moments later after a few hurried phone calls from Frankfurt...

But back to the banks: "The firms’ plans include detailed checks on counterparties that could be significantly affected by a Greek exit, looking at credit exposures and testing how they would provide cross-border funding to local operations."
Some firms are also preparing for the impact on payment systems and conducting trial runs of currency-trading platforms to see how they would cope with adding a new Greek currency or dealing with potential capital controls.

The moves come as Greek leftist opposition party Syriza continues to lead in recent public opinion polls ahead of national elections on Jan. 25. The ruling coalition government has framed the election as a de facto poll on whether the country stays in the eurozone, saying Syriza’s antiausterity policies would force a break with eurozone partners. Syriza, though, hasn’t campaigned on an exit and most Greek voters want to stay in the monetary union, according to recent polls.
Summarizing Europe's only strategy for the past 5 years is Frederic Ponzo, managing partner at consultancy Grey Spark: "Hope for the best, plan for the worst."

At some European banks, that currently means dusting off plans drawn up a couple of years ago, when a eurozone breakup was a hot topic. In 2011 and 2012, banks, brokers and companies with significant exposure to Greek assets put in place contingency plans to minimize the fallout from a breakup.

Which is smart, because absolutely nothing has changed in Europe where not even "Mr. ECB Chairman got to work" but merely verbally hypnotized the bond vigilantes into a state of paralysis, and as a result, nothing at all has been fixed, aside from the idiotic low yields on European bonds all of which have been bought to ridiculous levels on what is now a 3 years frontrunning of an ECB action that has been three years in the coming, and which many say will never actually arrive: the outright - and illegal according to Article 123 - monetization of European sovereign debt across the board.

It goes without saying that should the worst case scenario take place, the immediate question is who is next, and will the "XIL" be the next ticker everyone eagerly awaits:
The head of currencies trading at a large European bank said that reintroducing the Greek drachma to its trading system wouldn’t be too difficult, but dealing with a larger breakup would be more challenging.

“Italy could follow Greece’s steps if the exit will prove successful in providing some relief to the country’s economic crisis,” he said.
Italy... or Spain. Earlier today we got news that Spain's own equivalent of Syriza is surging in the polls and has left the ruling socialist party in the dust: "A poll published on Sunday showed that leftist up start Podemos was again in the lead to winSpain's next general election, which could result in the formation of party pacts, or even the country's first coalition government."
The Metroscopia poll of 1000 people, published in the left-leaning newspaper El Pais, showed one-year-old Podemos (We Can) would take 28.2 percent of the vote, up from 25 percent in December when it fell back to second place behind the Socialists. Podemos stood at 10.7 percent of the vote when it was first included last August.
So assuming Europe survives the Greek election in 2 weeks it has a Spanish redux to look forward to in less than 12 months:
Spain has a general election due by the end of the year and a regional and municipal election expected in May. Most of those who told Metroscopia they would vote for Podemos said they believed Spain needed to get rid of its two-party system.
If only Americans shared the same sentiment.

And yet while democracy has always been the Achilles heel in Europe's artificial political and monetary construct which works in an ideal world dominated by technocrats, it is not even the Greek, or Spanish, elections that may be the biggest risk.

As Reuters also reminds us, a "landmark" legal opinion this week will remind the European Central Bank as soon as Wednesday of the limits it faces as it advances towards money printing. With expectations high that the ECB is on the verge of buying government bonds with new money to shore up the economy, an influential adviser to Europe's top court will give his view on Jan. 14 about an earlier unused bond-buying scheme.
"It is the latest chapter in a long-running and increasingly bitter dispute about quantitative easing (QE) between the ECB and Germany, the largest member of the 19-country bloc, that is likely to limit the size or scope of such a program. As the debate continues, the euro zone economy is all but grinding to a halt. Germany is expected to announce modest growth on Jan. 15 for last year."
Here is how SocGen summarizes the threats from just the European Court of Justice decision this week, and its potential downstream affects:
“Whatever it takes”. This was the promise made by ECB President Draghi on 26 July 2012 and cemented by the OMT on 6 September 2012. Since then, market participants have placed their faith in this promise. On 12 September 2012, the German Federal Constitutional Court (GFCC) announced it would examine whether the OMT is an ultra vires act stretching beyond the limits established by the German Act approving the ESM (link to decision here).

A still lengthy process ahead, but the GFCC will have the final say: Fast forward to 7 February 2014 when the GFCC delivered its decision on the OMT (link here), referring the case to the European Court of Justice (ECJ) for a preliminary ruling (for more on the  process click here), but maintaining that in case of an ultra vires act, the GFCC is competent to rule on the constitutionality of the OMT. The next key date is 14 January, when Advocate General Cruz Villal√≥n delivers his opinion in the case (link to ECJ proceedings here). A final ruling from the ECJ will follow only months later, and the Advocate General’s opinion does not have to be followed. Only then will the GFCC give its final ruling and it may, by then, well be 2016.

If the OMT is not adapted, the GFCC is very likely to reject it: The GFCC decision already concluded that the OMT in its current form exceeds the ECB’s mandate, by encroaching upon the responsibility of the Member States for economic policy, and by being incompatible with the prohibition of monetary financing. The GFCC also suggested a possible interpretation in conformity with Union Law. In essence, it identifies three points to address.

1. Introduce a maximum limit on OMT purchases: In presenting OMT, the ECB declared it “unlimited”. In statements submitted to the GFCC, however, the ECB noted that given that OMT can only buy debt with a maturity of up to 3 years, this de facto sets a maximum of €524bn (for Italy, Spain, Portugal and Ireland). The GFCC is nonetheless concerned that this “implicit” limitation could easily be circumvented by increased sovereign issuance on shorter maturities. 

SG view: Introducing an explicit limit on the potential size of OMT is likely to address  GFCC concerns on “unlimited”. A limit of €500bn is, in our opinion, unlikely to trigger significant market concerns as this would still leave the OMT well armed to offer targeted support to a member states under an eventual ESM program. 

2. Set a locking period around issuance: The GFCC flagged the potentially blurred line between purchases in primary and secondary markets. The former is prohibited under the Treaty while the latter is allowed. In its statements, the ECB noted that a locking period will be determined in a guideline, but not published. 

SG view: A clear commitment to a locking period should suffice on this point. 

3. Limit pari passu: A key strength of OMT is the promise to be pari passu with private investors in the event of a debt restructuring. In its statements to the GFCC, the ECB claimed that liability risk to national budgets is minimised by sufficient risk prevention, but added that should losses nonetheless occur they could be carried forward and balanced with revenues in the following years. The Bundesbank in its statements disagreed, noting every loss that it incurs burdens the German federal budget. The GFCC support this view highlighting that “the possibility of a debt cut must be excluded”.

SG view: To our minds, the pari passu status of the OMT is unlikely to survive the various court proceedings, marking a blow to Draghi’s “whatever it takes” promise and increasing loss-given-default for private investors. Note, that the decision by the GFCC on the ESM excludes the possibility of the ESM assuming OMT credit risk as this would de facto leverage the mechanism. To change this, the ESM Treaty would need to be renegotiated, with all the complications that this would entail.

Somewhat surprisingly, the GFCC decision had essentially no market impact when it was released back in February. Market faith in euro area government’s efforts to deliver growth and sustainable public finances offers one possible explanation. Given significant fears on sustained lowflation, we believe that more recently it is the promise of a large sovereign QE program that offers support to market confidence.
None of the above is even remotely influenced by the subsequent Greek elections and the ECB's potential QE announcement on January 22 (which SocGen summarizes as follows: "QE unlikely to be both large scale and pari passu").

For simplicity's sake, here is the full calendar of risk events in just the next 2 weeks, any single one of which has the potential to send the market soaring... or crashing.

Source

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