Greek Debt Deal Falls Short

At some point, possibly in the next several weeks, Europe will run into a major flaw in its plan to shore up the region’s finances: Some euro-area governments, such as Greece, simply aren’t going to be able to pay their debts.

The sooner Europe’s leaders recognize this and take appropriate action, the less expensive the solution will be.

This week’s main event in Europe has been a standoff between Greece and its private creditors over the terms of a “voluntary” debt-relief deal. Agreement is crucial to avert a Greek default on a 14.4 billion euro payment due March 20, and to keep open the financing spigot from the European Union and the International Monetary Fund.

Whatever the outcome of those negotiations, though, it won’t solve Greece’s debt problem. TheEuropean Central Bank, the IMF and other official creditors aren’t taking part in the deal, so it will affect only private creditors. They hold about 200 billion euros of Greece’s 338-billion-euronet government debt. In other words, even the 50 percent writedown Greece is seeking will reduce its debt burden by only 100 billion euros, or less than 30 percent.

That’s not enough. Any country’s solvency is a function of its debt load, interest costs, growth rate and fiscal policy. In Greece’s case, assuming an interest rate of 4 percent (the rate it may get out of the debt talks) on its remaining 238 billion euros in debt, and using the IMF’s projections of economic growth, the government would have to run a primary budget surplus(not counting interest payments) of 3.2 percent of gross domestic product indefinitely just to keep its debt burden stable.

Primary Surplus

Don’t count on that happening. Greece has managed to run a primary surplus that large in only six of the past 24 years, when economic growth was much stronger. To meet such a goal now, it would have to reduce its deficit by some 10 billion euros a year, the equivalent of about two-thirds of its spending on social programs.

Portugal, which is not currently in line for debt relief, faces a similarly daunting task. To maintain a stable debt burden, it would have to run a primary surplus of 2 percent of GDP, something it has done in only two of the past 16 years.

The dire state of the two governments’ finances raises a troubling question at a time when German Chancellor Angela Merkel and French President Nicolas Sarkozy are trying to fast- track a new fiscal compact for the 17-nation euro area: How can the agreement, which seeks to toughen budgetary discipline, restore confidence in Europe’s finances if at least two of its signatories are insolvent from day one?

It’s possible that Merkel and her ideological soul mates at the ECB are hoping that, by keeping strapped governments dependent on official financing, they’ll have more power to push through austerity measures. Problem is, heavy debt loads are making the budget-cutting measures much more painful than they need to be -- and probably too painful to put in place.

The likely result: slower growth, greater dependence on official creditors and bigger losses for European taxpayers down the road. Not to mention the deleterious effect the ongoing uncertainty will have on the finances of core euro-area countries, European banks and ultimately the ECB itself. At any moment, doubts about the euro’s survival could trigger a financial catastrophe.

A quicker and more honest reckoning would stand a better chance of stopping the rot and creating the conditions for a successful fiscal union. We have advocated writing down the debts of Greece and Portugal by 70 percent and 40 percent, respectively, leaving them with the much more realistic task of achieving primary surpluses of about 1 percent of GDP. This can be done only if official creditors take losses alongside their private counterparts. With all euro-area governments on a solvent footing, the ECB could then step in with credible guarantees to recapitalize banks and calm market jitters.

All these elements will eventually be needed if the euro is to survive. Enacting them now would dramatically increase the chances of success.

Read more opinion online from Bloomberg View.

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Generali - Still The Best Way To Hedge For The Upcoming Italian, And European, Contagion

Back in December, when noting the first material blow out in PIIGS spreads following the first Greek bailout 6 months earlier, we touched upon Italy, and specifically looked at a way to best play the coming shift in Eurozone contagion from the periphery to the core, coming up with one unique corporate name. Back then we said: "We all know what has happened to Italian bond prices in the past weeks: as of today, Bund spreads have just hit a fresh all time high. But all this is irrelevant since the bank must have a capital buffer to accommodate the losses. After all, what idiot would run a company with almost €300 billion in Euro-facing bond exposure and not factor for deterioration in risk after the events of May... Well the ASSGEN CEO may be just such an idiot. The company's balance sheet as of 9/30 discloses that the firm had a mere €10 billion in tangible capital (excluding €10.7 billion in intangible assets). So let's recap: €262 billion in Euro bonds on.... €10 billion in tangible equity! A 26x leverage on what is promptly becoming the most impaired asset class in the world." In a nutshell, Assecurazioni Generali, one of Italy's largest insurers, is a highly levered windsock for Italian and other PIIGS stress, and better yet, can be played in either equity or CDS. Now that the European bond vigilantes are once again looking beyond Greece and focusing particularly on Italy (especially based on recent Sigma X trading), none other than JP Morgan (which just cut its estimates on GASI.MI, a very appropriate equity ticker) validates the thesis that Generali (or ASSGEN per its memorable corporate/CDS ticker) is the best proxy for contagion: "Generali is one of the most sensitive stocks to both the sovereign debt crisis and the implications for the financial sector through both its government, corporate and equity investment portfolios...Generali’s sovereign exposure is mainly concentrated in Europe with Italy accounting for the largest share (37%; home market bias)."

The chart that confirms that GASI is nothing but an inverse bet on Italian viability:

A reminder of ASSGEN's sovereign exposure:

The same data in tabular format:

Some points from JPM's Andreas de Groot van Embden:

Generali’s main risk exposure to sovereign debt outside of Italy include Greece, Portugal, Ireland and Spain. The sovereign bonds are valued at market (accounted as Available For Sale). In aggregate, Generali has €12bn of gross exposure to troubled sovereign debt (excl Italy) and €2.1bn of net exposure (post tax and policyholder participation) accounting for c.14% of TNAV. We have assumed in our analysis that Generali would be able to share the impact of any potential impairments on its sovereign and financial (eg bank) exposures with policyholders given the decline in the minimum guarantees we have seen over the past few years (avg guarantee 2.3% in 2010). In practice the actual allocation will depend on the location of the bonds, the local country profit sharing rules and the level of buffer capital available in those entities (such as the free RfB buffer in Germany).

The Greek exposure is €3.0bn on a gross basis (per year end 2010) and €500m after policyholder participation and tax (based on amortized cost). This accounts for 20% and 3% of 2011e tangible book value on a gross and net basis respectively. We estimate Greek bonds will be valued at an estimated c50% of par based on a 6 year duration at end of 2011 Q2 with an estimated €160m unrealized loss included in shareholders’ equity after policyholder participation and tax. Should the debt rollover discussions be judged a credit event by either the rating agencies or auditors, we estimate that a €160m impairment would be realized through the P&L - assuming the haircut is in line with the market value of the bond. The overall impact on shareholders’ equity would be neutral (as it is already included).

Only if there is an additional haircut on the sovereign exposure that shareholders’ equity would be affected by additional impairments. In solvency terms, Generali includes unrealized gains and losses in its Solvency I and Solvency II calculations and the impairment of Greek debt should already be largely incorporated in our Q2  shareholders’ equity assumptions. Aggregating the main sovereign credit risk exposures outside Italy we estimate this factors in an unrealized loss of €3.2bn gross and €343m net unrealized losses in shareholders’ equity per end of 2011Q2 (see table below). The gap between the gross and net is material but is equivalent to 74bp of traditional life technical reserves. Substantially higher gross losses than those described below might belong more to shareholders than policyholders.

The bottom line, with appropriate sugarcoating:

Overall, a write down in line with current marks on the Greek sovereign debt exposure will not have any incremental impact on the solvency ratio of the group as the debt is already included at market value. However, further swings in the value of sovereign debt, Spanish and Italian in particular will continue to affect TNAV and solvency until the situation stabilizes.

There is much more in the full JP Morgan report but this is the gist: anyone who wishes to play the developing contagion and awakening bond vigilantism via either equity or CDS, this is without doubt the best proxy.

And for those curious how ASSGEN correlates with Italy CDS, here it is:

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