Director's Cut: The Credit Father

Some believe a credit event occurs when a new card hits their doormat. Others might imagine a debtor repaying less than half of what it owed.

But if that debtor happens to be Greece, which wants to pay bondholders just 15 Euros for every 100 they own, plus 30 Euros in new bonds with a very low interest rate and long maturity, perhaps not.

A credit event is whatever the collection of bankers and hedge fund representatives that constitute the ISDA—the International Swaps and Derivatives Association—decides it is. On Thursday night, this body will determine whether the Greek deal is a ‘temporary selective default’ or a technical default.

The difference isn’t merely academic. The terminology determines who gets to benefit from a default, who pays if there is one and, potentially, who becomes the next French president. As with every twist and turn of this particular Greek tragedy, it will impact stockmarkets around the world if it isn’t approved.

The largest holders of Greek debt are French, German and Greek banks. Why would they agree to such a deal?

Presses on

The European Central Bank (ECB), so long obsessed with inflation, has done a Bernanke and is letting the presses rip. Its Long Term Refinancing Operations—the European term for quantitative easing—recently injected over 500bn Euros into the banking system.

The liquidity flood is hitting the European banks’ balance sheets, just as Wall Street, the munificent beneficiary of its own greed and stupidity, benefited from Bernanke’s quantitative easing. Italy’s and Spain’s cost of debt is falling as a result.

This is the latest quid pro quo of international finance: Take a haircut on Greek debt and you’ll get a load of cheap money courtesy of the ECB, which you can invest in government bonds. That may convince the banks to accept the deal but the hedge funds, many of which own credit default swaps that would pay out if default is declared, are less inclined to go along.

Whatever happens, there is the sense that none of this is meant to fix the problem, just to make it appear that way.

Greek debt to GDP is currently about 160%. If the deal goes through it will fall to 120%, which, by sheer coincidence, happens to be the extent of Italy’s debt, although it is largely domestically financed and thus more manageable.

Unsavable

Nevertheless, the troika of the European Union, the International Monetary Fund (IMF) and the ECB cannot reasonably maintain the fiction that Italy or Spain will be fine without also insisting that Greece will survive at similar levels of debt.

It almost certainly won’t. For the latest bailout to succeed, Greece must comfortably service a debt-to-GDP ratio of 120%. For this to occur the IMF—one of the country’s principal creditors—predicts, and supposedly expects, the Greek economy to grow by between 1.7 and 2% this calendar year.

Right now, Greece and its people are in the midst of an economic apocalypse. In one of the worst recessions any country has ever known, the economy is expected to shrink by an historically unprecedented 7% (annualised) in the fourth quarter, blowing a hole of magnificent proportions in the IMF’s model.

With a new round of austerity about to hit, there’s no way Greece can afford to service a debt of 120% of GDP. So why the pretense?

Every effort is being made to keep the Greeks within the Eurozone and avoid a ‘credit event’ that signifies technical default. That, at least, is how it appears.

There is no one explanation for this. It could be that European leaders don’t want to face facts, or that they’re buying time so that one half of the Merkozy alliance is given the best shot at winning the French presidential elections later next month. More likely, the Troika needs more time to recapitalise European banks to shore them up before a Greek default.

Technical default

In the end, the odds favour a technical default. It would allow the country to benefit from a proper currency devaluation rather than an internal devaluation, which for ordinary people means lower wages, less benefits and price deflation. Either way it will be painful, but one can’t imagine a proud people ceding power to the Germans and French for much longer.

Is this of any concern to local investors?

Only in the way that the collapse of the US banking sector, the seizing up of international credit markets and the subsequent rapid fall in sharemarkets was a concern in 2008. The Euro crisis could be of a similar magnitude. So yes, it’s a worry, which is why we devote a little time explaining it and advising on how to prepare for it (see Director’s Cuts Wearing protection from 6 Dec 11 and Preparing for uncertainty from 14 Sep 11).

There is, however, an upside to the downside. Seth Klarman, in Dangerous state of affairs, his latest Baupost Group letter, says that:

‘Today's dizzying and daunting market volatility is driven by astonishingly short- term investor thinking. Over the course of 2011, the S&P 500 Index fluctuated 2% or more on 35 days (based on closing prices) only to end up almost exactly where it started.’

Mr Market’s bipolar moods have never been more obvious. On some days, the fear of the problems of excessive leverage is palpable. Then governments and their agencies step in, usually with more liquidity, and the rally starts, only for fear to resume on the next round of bad news, of which there is plenty.

Jeremy Grantham, in what he titles Investing advice from Uncle Polonius, part 1 of GMO’s latest quarterly letter, offers some valuable strategies to deal with such an environment:

1. Believe in history: First, he says that Santayama is right and that history does repeat itself: ‘The market is gloriously inefficient and wanders far from fair price but eventually, after breaking your heart and your patience (and, for professionals, those of their clients too), it will go back to fair value. Your task is to survive until that happens.’

2. Neither a lender nor a borrower be: ‘If you borrow to invest, it will interfere with your survivability. Unleveraged portfolios cannot be stopped out, leveraged portfolios can. Leverage reduces the investor’s critical asset: patience.’

3. Don’t put all your treasure in one boat: Obvious really, which is why we issue strict portfolio weighting guides with each recommendation.

4. Be patient and focus on the long term: In investing, this advice is so common as to be a cliché. But what it really means is following the basic rules and ‘outlasting the bad news’. Investors need to stay stronger for longer.

5. Recognise your advantage over the professionals: Luckily, investing probably isn’t your chosen career. You don’t have a job to protect, which means outlasting the bad news is easier than for the pros. It also means you don’t have to act if you don’t want to. Professionals on the other hand, with their focus on short term performance and need to do something, anything, because they’re paid to act, are handicapped. Nathan Bell offers his own example:

‘I have a relatively large position in QBE with which I’m quite happy. But as the analyst on the company and as research director, I have fellow professionals assailing me with their opinions, members selling out, telling me I’m crazy, and media headlines saying the end is nigh. The time to panic was when the stock price was $36, not $12. Professionally, it’s more difficult for me to stand my ground. But personally, it’s easy. The only person I have to justify my decision to is myself.’

6. Try to contain natural optimism: Grantham was picked up by local media when he said, ‘Tell a European you think there’s a housing bubble and you’ll have a reasonable discussion. Tell an Australian and you’ll have World War III.’ Optimism has served the species well but we struggle with uncomfortable truths. Daniel Kahneman’s book, Thinking fast and slow, explains why and what to do about it.

7. On rare occasions, try hard to be brave: On 05 Aug 11, the height of the panic, we upgraded QBE Insurance and Macquarie Bank to Strong Buy. As Grantham says, ‘if the numbers tell you it’s a real outlier of a mispriced market, grit your teeth and go for it.’

8. Resist the crowd: Cherish numbers only: Crowd psychology is embedded deep within us but it’s vital to resist the lure of short-term news and the actions of others, even if they are getting richer more quickly than you. Trust not intuition or emotion, only data and the well-reasoned opinion that stems from it.

Grantham concludes by saying it’s quite simple really, showing a table that compares his 10-year forecasts of 2001 with actual performance. Despite the tumult of the GFC, in each case real returns exceeded forecast, which, in Grantham’s view, endorses his eight points.

If ever there was a how-to list for dealing with such tumultuous times, this is it. Members can read the whole thing here.

Note: Next week, because we didn’t want to make this Director’s Cut too long, we’ll be publishing a reporting season wrap-up and a review of a few important recommendations.