Follow the Money

Hoffman and Redford as Watergate sleuths Bernstein and Woodward,

All the President's Men

The advice of Deep Throat, the legendary Watergate informant, to "follow the money" is useful in any era and particularly at this time, when European financial ministers ("fin mins" in insider parlance) are loudly proclaiming that the region's sovereign debt crisis is under control. Earlier this morning, officials in debt-strapped Greece announced that government bonds maturing later this month--bonds with zero chance of face-value redemption--will be swapped for long-dated bonds and warrants in a kick-the-can restructuring. Losses finally will be taken. Private creditors are looking at a haircut of about 70%, which would send €100 billion to money heaven.

But that may not be the end of the destruction. The new Greek bonds have no more chance of paying interest than the old ones did, and in the grey market this morning they are bid at 20 percent of face value. Moreover, the warrants, or "sweeteners," attached to the new bonds will add value only if Greece can return to GDP growth. But how likely is that? The Greek economy has been shrinking for the past five years and shows no sign of a turnaround. Capital flight has afflicted all the PIIGS, as the chart below shows:

Money is leaving the periphery.

Today's debt swap is a precondition for a second bailout of Greece. But most of that bailout dough will pass GO (Greece does not collect the $200) and proceed directly to senior holders of the maturing sovereign debt. Meanwhile, the short-dated debt next in line is still priced for default. Stuck with this crapola, European banks have engaged in a different kind of swap--call it trash-for-cash--as part of a Long Term Refinancing Operation (LTRO). The distressed debt gets posted as collateral with the European Central Bank, which lends cash to the banks, which use some of it to roll over their own corporate debt. Any remainder appears to be getting redeposited back to the ECB:

Money is being parked here.

The lending facility is not being used for investment in the regional economy, which bodes ill both for Eurozone GDP growth and Greece's ultimate rescue. In fact, the lendable "remainder" is getting called back by the ECB, as collateral continues to lose value. ZeroHedge, which has been all over this story, describes it this way:

"The rapid deterioration in collateral asset quality is extremely worrisome...as it forces the banks who took the collateralized loans to come up with more 'precious' cash or assets (unwind existing profitable trades such as sovereign carry, delever further by selling assets, or subordinate more of the capital structure via pledging more assets - to cover these collateral shortfalls) or pay-down the loan in part. This could very quickly become a self-fulfilling vicious circle...."

Money is needed for margin calls.

Where is the money going exactly? How about around and around, then down. Flush job.

[update, 03-12-12--]

Barclays has a research note out (via ZeroHedge) explaining how the ECB's lending liquidity facilities are merely a short-term fix for Europe's banking system. By cannibalizing available collateral and subordinating other bondholders, they drive up the banks' borrowing costs:

"Bondholders face increasing subordination from this balance sheet encumbrance, reinforced by depositor preference laws (in some countries) and imminent legislation on bail-in bonds. Combining these factors suggests that unsecured funding cost for banks will remain high – potentially too high for some business models to make economic sense."

[update, 03-15-12--]

Bloomberg explains in a story today how the serial bailouts of Greece have gradually (and, shall we say, insidiously) shifted exposure from private-sector banks and insurers to European taxpayers. As one economist is quoted, "the longer we wait for these restructurings, the worse the deal gets for the public." The reckless lenders who should be taking the losses use the delay to wriggle off the hook--extend and escape, if you will. Minyanville's Peter Atwater calls it the re-syndication of risk.