Approaching the Italian endgame | FT Alphaville

Approaching the Italian endgame

Amid EFSF revamps, Greek politics, and ECB rate cuts, remember that in the end, it all comes down to Italy.

In particular, 10-year Italian government bond yields remain well over 6 per cent at pixel time.

The Italian endgame is getting nearer and a crisis is “increasingly probable, and would do much to expose the inadequacies of the bailout mechanism as a whole”, warns Citigroup’s Matt King (he of the seminal “brokers are broken” thesis from 2008 that we put back together on Wednesday).

King worries that the Papandrendum sets a precedent for future political leaders (“who can be against asking the people?”). He thinks China and the IMF will both think twice before funding the EFSF given political risk in Athens.

He’s also worried that the new EFSF is too big

Its major flaw, judging from the few details we have, is its need for funding. At present, selling even €3-5bn of straight EFSF bonds seems to be a struggle. And yet the proposed SPV-structure would seemingly rely on selling hundreds of billions in much more complicated bonds. Technically, we see very little difference between these and senior CDO tranches, yet this one structure alone would have a size larger than the whole of the existing CLO market. The undiversified nature of the asset pool the SPV would invest in suggests that a large equity tranche would be required, meaning that 4-5x leverage might be hard to achieve, and that spreads on the senior notes ought to be really quite high.

… and too weak:

The guarantee proposals likewise seem better at first sight than when examined closely. The idea put forward in the EFSF Q&A2, suggesting that investors will want to buy protection from the EFSF simply because it (currently) carries a AAA rating, and without regard for wrong-way correlation exposure, flies in the face of universal market practice. As everyone knows, if you want to buy protection on Greece, you don’t buy it from a Greek bank. Such problems could be offset by collateral posting to some form of escrow account, but this would add to the EFSF’s overall funding needs. And no amount of collateral is sufficient compensation for the risk that the EFSF guarantees themselves are far from watertight: the idea that the EFSF might not use ISDA trigger definitions but adopt its own definition of default, as described in the Q&A, simply lacks credibility.

But these aren’t top of the worry list. Italy is. King notes that “BTPs have been close to these yields before; spread levels have not”:

Here’s King’s reminder of why this matters (emphasis ours):

We are also quite close to the point beyond which other sovereigns have found it very difficult to return, when yields breach 6% (Figure 3). This is partly because feedback loops kick in and additional widening could easily accelerate. For example, if spreads of 450bp on 10-year governments are exceeded for five consecutive business days, LCH haircut requirements for banks borrowing against Italian collateral will rise by 15%. If banks liquidate their BTP holdings, this will simply exacerbate the problem. If instead they choose to seek funding at the ECB (for example, if they are running short of collateral), publicity around different countries’ banks’ usage of ECB facilities seems likely to lead to more selling in both the banks and the countries concerned. This is part of the reason why when Portuguese spreads breached this point, not only did the sovereign yield quite rapidly back up further, eventually breaching 10%, but the rating agencies followed up with sovereign and bank downgrades for good measure. Admittedly this was all part of Portugal’s losing access to markets and applying for a bail-out, but we see no reason why the feedback loops should operate any differently for Italy.

Unsurprisingly, King — like probably everyone apart from the man himself — doesn’t think Silvio Berlusconi can stop this rot, and regardless, the “reform” measures will only cut Italian growth further. This leaves — guess who! — Super Mario. King thinks further, “quite aggressive” bond purchases are possible and “in theory, [the ECB] could easily do much more”. But

…we struggle to think that a complete change in strategy lies immediately around the corner. Politically, the image of the new Italian riding to the rescue of Italy, at the expense of the ECB’s hard-earned German credibility, just seems too poisonous. Having lost two Germans over the issue of SMP purchases, they dare not risk losing a third. And we still believe that Draghi, like Trichet, fundamentally considers the job of rescuing sovereigns to be one for governments, not the central bank. He might cut rates, or increase repo purchases or try to help in some other fashion, but these seem likely to alleviate the market’s fears rather than resolving them.

In sum, we find ourselves largely back to where we were a couple of months ago. Really drastic action becomes possible only if a much larger crisis is priced in. In the meantime, markets are likely to become steadily more aware of the likelihood of recession next year, magnified by the combination of ever more fiscal tightening, bank deleveraging and diminishing corporate and consumer confidence. While we continue to see value in spreads from a long-term perspective, unless the macro risks can be sorted out, we suspect that most investors will not dare to touch them.

Well, the ECB board did unanimously cut rates on Thursday, and Draghi was more ambiguous than his predecessor on whether the central bank could continue buying bonds after the eurozone’s new bailout mechanism comes online. But he also made abundantly clear (he fired a question back at the FT’s man in Frankfurt!) that the central bank does not see itself as the lender of last resort that can solve the eurozone crisis.

Accelerating toward an endgame while going back in time — only in the eurozone.

Related links:
Italians: your country needs you – FT Alphaville
Italy’s Berlusconi faces mounting pressure to go – Reuters