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A Euroblather Arbitrage

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No human can realistically be expected to understand or focus on the constant stream of Eurozone gyrations and in fact humans increasingly don't, with the half-life of blather-driven euphoria decliningrapidly. The latest gyration seems to be that Germany is contemplating letting the Eurozone collective rescue funds think about maybe one day putting up for discussion the possibility of considering buying bonds of distressed countries directly to try to drive down funding costs for those countries.

This seems to have helped Spanish yields more than did the announcement earlier this month that those funds might consider giving Spain €100bn in special senior debt to get its banks sorted, for sort of obvious reasons. If the EFSFSMCBFFFFF is buying hundreds of billions worth of Spanish bonds right alongside whatever brave dopes are buying them already, that buying pressure should push up prices and push down Spanish borrowing costs and improve Spanish sustainability in a virtuous circle etc. etc. If the EFSFSMCBFFFFF is instead putting in its money at a more senior level than those bondholders, then those bondholders are subordinated and, empirically, sad about it.

One weird thing though is that there is little assurance that "EFSFSMCBFFFFF buying the same bonds that everyone else is buying" is actually the same thing as "EFSFSMCBFFFFF ending up with the same bonds that everyone else is buying." The (not yet ratified!) ESM treaty maybe requires the ESM to be senior to market creditors (maybe!), but also maybe allows it to buy market bonds, which generally are not senior to themselves. Seniority is ordinarily a matter of contract: if you buy one of a series of totally fungible publicly traded bonds, you generally expect to be treated pari passu with the rest of those publicly traded bonds.

Ordinarily! Of course the European public sector has a record of owning publicly traded bonds and getting treated better than regular holders: in Greece, ECB-held bonds were not haircut the way that privately held bonds were, even though they were contractually the same bonds. Greece just negotiated a prior exchange with the ECB, turning them into not the same bonds at the last moment.

But of course before that moment the ECB was buying Greek bonds in the same market and at the same prices as everyone else - if you wanted Greek bonds, you were competing with the ECB, and so theoretically that would push down rates. (Not enough but whatever.)

David Murphy has this wonderful round-up of capital arbitrage strategies that is worth reading if you plan to arbitrage your capital, or arbitrage anything really, and it got me thinking about the leveling effect of this trade. Eurodudes buy contractually senior debt = panic junior debtholders. Eurodudes buy contractually pari passu debt = support debt markets. If the result that you intend is "get money into Spanish banks," then perhaps you don't care about that choice; if it is "help Spain keep access to debt markets" then buying pari debt is theoretically and empirically much better. If as a practical matter you end up in the same place in terms of getting your money back - as you did with Greece - even better. You've managed a strange structural arbitrage, investing at a senior level and protecting your principal, while convincing more junior creditors that you're right there with them. In effect you buy regular bonds and magically transmute them into quantum-possibly-more-senior bonds without anyone being entirely sure if that's what you've done.

Eventually people figure this out and the arbitrage vanishes and your buying fails to push down rates as much as it otherwise would. But maybe you've stabilized the continent by then?

By the way, all of this looks a bit odd from the American experience, where big publicly announced made much of support announcements for troubled thingies tends to be in subordinated forms, while senior lending has been somewhat secret. So TARP involved locking every big banker in a room until they promised to (1) sell subordinated pref and common stock warrants to the government and (2) act happy about it, while the amount of secured loans the Fed was making to TARP recipients was dragged out of officials tooth and nail. Europe, on the other hand, makes a big deal out of its senior status lending and seems to disdain the notion that it should be equal to, or heaven forbid junior to, regular investors.

Some of this is driven by legal possibilities, and much is driven by the difference between sovereign and bank bailouts - after all, you can take equity in JPMorgan, but you can't really take equity in Greece. (And, of course, European banks are actually being recapitalized, in part by governments injecting money obtained by senior sovereign borrowing into bank equity.) But some of it may be a matter of style - it's not hard to find European officials who still blame markets for their continent's crises. For their funds to be treated like gross market participants may be too much to ask.

Germany set to allow eurozone bailout fund to buy troubled countries' debt [Guardian]


One Last Greek CDS Post Before It All Goes Poof

One of the side benefits of Greece taking whatever somewhat irreversible steps it is now taking is that something will happen to CDS written on existing Greek debt and that will mean that we can stop talking about what will happen to CDS written on existing Greek debt and start talking about more interesting things like quasi-CDS written by the EFSF on shaky Eurozone government debt. For now, though, we've got at least a few more weeks of surprisingly and unsurprisingly ill-informed fretting that triggering the $4bn of Greek CDS will Bring Down The Entire Global Financial System. That seems sort of silly because notionals aren't that big, mark-to-market collateral is mostly being posted, and at this point the marks are pretty close to what you'll get from Greece so it doesn't look like there's tons of unknown unrecognized losses lurking out there. On the other hand, we're mostly through with the speculation that not triggering Greek CDS will Prove That CDS Is Worthless and thereby Bring Down The Entire Global Financial System, so that's nice. The reason that's mostly over is that it sure looks like Greek CDS will in fact trigger, as Athens has moved to adopt a collective action clause that will flip the Greek restructuring from "voluntary, heh heh heh" to "involuntary" and thus trigger the ISDA restructuring event definition. You can argue that the mechanics of the cash settlement auction will mildly screw CDS holders but I'm not so sure, and in any case this is pretty solidly in the category of derivatives nerdery rather than Bring Down The etc.