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Greece - Now What

Submitted by George Kintis of Alcimos

Greece - Now What

For those of you who like fast-forwarding to the end of the film, here it is:

  • Grexit was never on the cards. Even less so after the recent European Summit decisions and the Greek bank recap recently put in motion. This is mainly on account of the dual surpluses Greece currently runs: the current-account and primary budget ones. Even if one could push a magic button and kick Greece out the euro, there is nothing that would prevent Greece from immediately reintroducing it, Kosovo- or Montenegro-style. The only impediment would be the funding of the banking system, but this is being taken care of.
  • There has been a decoupling of a large part of the Greek economy from the sovereign issue; for example, exports of goods and services, accounting for around 30% of the Greek economy have been growing at 9% a year. Investors readily recognize this in publicly-traded assets (most Greek corporate bonds are trading well above the sovereign ceiling), but are so far oblivious to it when it comes to non-traded ones (e.g., loans, receivables, etc.). This is a “ginormous” arbitrage opportunity—one just needs to put in a bit of legwork to identify, diligence and acquire such assets. Sorry, you can’t do it off your Bloomberg terminal, or over lunch at Cecconi’s.
  • Greece does not have a functioning banking system—credit has been contracting for years, while new origination is practically non-existent. This depresses asset prices to ridiculous levels—even prices of assets which are uncorrelated to the sovereign situation, per the previous point. This reversal of this situation is likely to start in Q2 2016, post the Greek bank recap, which we expect will be coupled with a bank bail-in—and the mother of all NPL trades.

Those of you who think that it’s the journey that teaches you a lot about your destination, read on.

In our recent analyses in the Greek situation, we got many things right—and not just that Grexit will not take place. For example, we had predicted that Tsipras will do an about-face even before the elections, but we also warned that GGBs are not the way to play this on 24 February (unless one has inside information on political decisions). We then advised people on 24 February to stay away from anything that has to do with the public sector and the banks. On 5 April we discussed why investing in Greek banks makes little sense–and then explained why we think Greek banks will be bailed-in on 17 July.

We also got some things wrong: the outcome of the referendum (for better or for worse, there’s a clear bias in our circle of friends towards people with a positive balance in their bank accounts) and the imposition of capital controls (which we believe to be completely illegal).

Here’s why we were wrong in predicting that capital controls wouldn’t be imposed: our working assumption in predicting various outcomes at every step of the way of the Greek saga, is that all players are totally selfish, as well as ruthless and shameless in pursuing their own interests. We realize that the ruthlessness and shamelessness of Greek politicians knows no bounds—we’ve known quite a few of them personally for way too long to have any illusions. We assumed, however, that European politicians had a modicum of dignity; that’s where we got it all wrong.

We did not, for example, expect that Ms. Danièle Nouy, head of the Single Supervisory Mechanism, would go on record as recently as 7 June proclaiming Greek banks “to be solvent and liquid”, but then the Euro Summit of 12 July would identify in its statement the need for the “the establishment of a buffer of EUR 10 to 25bn for the banking sector in order to address potential bank recapitalisation needs and resolution costs”. Where did these guys get that €25bn number—if not from the head of the bank supervisory mechanism? We’d never think that the ECB would cut off financing to banks it considers solvent, saying that they do not have adequate collateral. If they were solvent, how could they not have adequate collateral? Substituting ELA for deposits can have no effect on the solvency of the institution; if the institution was solvent—and therefore its deposits were safe, then the ELA which substitutes these deposits should be safe, too. Anything else is financial alchemy, of which we did not think an institution like the ECB would partake.

Nor could we have imagined that the ECB would refuse to disclose the rationale behind its decisions to freeze Greek ELA, citing as reason that “[i]f the ELA ceiling determined by the Governing Council and the related deliberations including the names of the credit institutions receiving ELA were to become known to the public, market participants could infer from this information the liquidity situation of the credit institutions, with immediate detrimental effects on financial stability. Even if such ELA ceiling determined in a particular situation were to be disclosed ex post, such publication could have detrimental effects on the Governing Council’s opinion-building and decision-making in future similar situations.

The ELA ceiling would be an indication of the extent of stress that the credit institutions were facing, and in particular if market participants were able to monitor the development of the ELA ceiling over time, an upward trend would be interpreted as a signal of increasing stress. Hence, publication of such information would negatively impact the banks’ ability to borrow funds from the market and thereby reinforce their liquidity problems”. This, at a time when the ceiling on Greek ELA is leaked to Reuters and Bloomberg immediately after the relevant ECB decisions, is reported on the Bank of Greece balance-sheet published on a monthly basis, while all four Greek systemic banks recently reported their ELA funding to the Athens Stock Exchange (see for example here).

Who needs another “signal of increasing stress“, when the Euro Summit itself has adjudged “potential [Greek] bank recapitalisation needs and resolution costs [to be between]€10 to 25bn”? Of course, the irony of claiming that “publication of such information would negatively impact the banks’ ability to borrow funds from the market and thereby reinforce their liquidity problems”, when said banks have been locked out of credit markets for months, while their liquidity problems have been a direct effect of the contested ECB decisions, was lost on them. But we are digressing…

We now know better: we are convinced that all players in the Greek drama are thoroughly unscrupulous. Once one analyses the Greek situation through this lens, it’s hard to get predictions wrong. You can only go wrong when certain players turn out to be even more ruthless than you would have imagined.

Once one agrees that both sides (i.e., Greece and Germany) are only self-interested, the dynamics of the current Greek negotiation can be analysed within the framework of a prisoner’s dilemma. Greece does not want the structural changes (austerity and the like), while Germany wants to avoid a haircut at all costs. “Cooperation” would then entail Greece swallowing its medicine, while Germany continues to happily fork over money for as long as needed. “Defection” would mean that the Greek government only pretends to be discharging its obligations under the various memoranda, while Germany is forced to accept a haircut. Now, someone who’s even remotely familiar with game theory can easily predict how this will end: both sides will lose. But let’s follow the various steps.

Germany, as we all know, won the Euro Summit battle: Tsipras surrendered and capitulated (in theory) to all German demands. Germany, has, therefore, “punished” Greece in the prisoner’s dilemma framework. Now we think Greece will retaliate—with the help of the IMF.

Here is how:

We have previously analysed the ongoing tug-of-war between Germany and the IMF (read: the US) on a possible haircut on Greek debt as part of the (supposedly) ideological conflict between “austerity” and “Keynesianism”. Germany has said, no deal without the IMF. The IMF has said, no deal without a haircut. Germany has said, no haircut under any circumstances. You can see where that leads: Greece will pass through the measures, but the creditors will find it difficult to agree between themselves on a new package. We may have a few more bridge loans (in the grand can-kicking tradition of Greek negotiations) but the music will eventually stop. Then Germany will be faced with the stark choice between:

(a)    a Greek default, which will result in Greece going to the IMF for help, which “stand[s] ready to assist Greece if requested to do so”, which then leads to an effective subordination (read: haircut) of Germany’s bilateral loans to Greece due to the IMF preferred-creditor status; and

(b)    a haircut on Germany’s loans to Greece, which will allow the IMF to participate in the Greek bailout.

Germany is, therefore, free to choose between a haircut and a haircut—even Die Zeit seems to agree with this. A haircut is of course political suicide for Merkel, but the latter version can be sugared with some grand-European-vision talk, so we think she will go for this. We also claim, however, that whatever she does only affects her chances of political survival and not Greece. Here’s why:

Despite all the talk, Greece (still) runs a healthy primary surplus (Jan-Jun 2015) and a current account surplus. The former means that if there was no deal with the lenders, the Greek government would keep on functioning; any new money lent to Greece goes back to repay existing debt. The latter means that Greece will still have the euros it needs to pay for its imports, irrespective of any agreement with the lenders. The only leverage Germany has over Greece, is through ECB financing of Greek banks. That last card has been played—we claim to the benefit of large European banks. Greeks banks will be recapitalized (read: bailed in) no matter what, and bought out by large European banks. Their funding no longer will come from the Bank of Greece, but from the parent—which also has access to the ECB. That bullet has been spent.

Here’s where that leaves us: Greece stays in the Euro, but Greek banks are sold off, properly recapitalized at last. Here’s the back-of-an-envelope calculations behind this:

As at June 2015, the Greek banking system had loans to the private sector of €220bn and total provisions of €41bn. There’s a 35% NPL figure being bandied around, but we have long believed the real number to be higher. How higher—God knows, but let’s assume it’s 50% (it’s probably even higher, but a good part of those NPLs may be strategic, so let’s settle at 50%). To the €41bn of existing provisions one should another €30bn (equal to 8% of total liabilities which, per article 44(5) BRRD, need to be bailed-in before the public purse can be accessed) and the €25bn which have been set aside for the Greek bank recap per the 12 July Euro Summit statement and you get to a figure of €97bn in capital available to absorb losses on an NPL book of €110bn—translating to an NPL coverage ratio of 88%.

The big NPL trades, the ones everyone (and their mothers) has in vain been coming to Greece for since 2010, will finally arrive, probably in Q2 2016.

As to the Greek economy: it’s doing very well, thank you, having grown at 1.6% y-o-y in Q2 2015. It will do even better, when Greece has a functioning banking system. Stay tuned.