Thursday, October 27, 2011

The European News: A Game-Changer or Bull Trap?

In the after hours yesterday, news leaked out about an apparent impasse between the banks and European leaders, and markets seemed poised to sell off again on another European snafu. By 9pm details emerged that a deal had been cut with the banks regarding haircuts on Greek bonds, and the mood in Asian markets quickly turned around. By the time I woke this morning, a plan had been hatched in Europe that put the markets into celebration mode. Risk assets love the fact that a tangible plan has finally emerged, and today markets are partying like it’s 1999.

Some of the key parts of the plan are:

  • Private investors have agreed to realize 50% haircuts on Greek Bonds.
  • Banks are required to recapitalize using a 9% threshold of the highest quality capital.
  • EFSF will provide bond insurance for some amount of bonds from Euro issuers, and could potentially lever the EFSF to just over 1.4 trillion USD.
  • Greece will get slightly more bailout money than what was agreed upon in July.
  • The ECB will keep buying Sovereign Bonds as needed.

As always, the devil is in the details, and looking under the hood there are already some relevant questions being asked about the plan. For instance, why is the International Swaps and Derivatives Association (ISDA) not going to consider the 50% haircut a credit event on Credit Default Swaps (CDS) insuring Greek bonds? If ISDA refuses to recognize this effective default, will there be unintended consequences coming from holders of defunct insurance that take a loss with no insurance? If banks are forced to raise capital, will they do so by curtailing loans which could spill into the European economy? For that matter, is the 9% capital a sufficient amount in an economy that appears to be decelerating rapidly? Etc., etc.

We will spend the next few days parsing the language of the plan, monitoring credit market relationships for signs of divergences or confirmation, reviewing key technical measures, and assessing a variety of respected analyst opinions. Now that that European news has finally hit, it is time for Pinnacle to assess whether this plan is a game-changing event or a bull trap for investors who are late to the party.