Tuesday, December 13, 2011

Why Wait to Reduce Your European Credit Exposures?

Seriously - why wait?

The plans for "fixing" the inherent problems with the EU invariably consist of a scheme for Germans to bear the loss on bad loans to Mediterranean countries. Losses that have already been incurred but not recognized.

Since these losses are enormous even in relation to German GDP, the plans are invariably nonstarters. As Hussman very aptly put it, investors want someone to buy the bad debt "and willingly take a loss on it so the money doesn't ever actually have to be repaid." Thus, the market currently prices in a complacent scenario, when it is actually very hard to imagine a way for the Euro to survive intact, or for loans made to the PIGS countries to be repaid in real terms.

Meanwhile, investors are lending to the PIGS, to highly leveraged banks with tons of PIGS loan exposure, and to individuals and corporations in the PIGS countries - all at single digit rates of interest. (Well, not to Greece anymore.)

I've written in the past about the loans to individuals and corporations in the PIGS countries as an area of particular concern that is ignored by the market. The value of a mortgage loan is the present value, at an appropriate discount rate, of the periodic principal and interest payments over the life of the loan.

With a loan made in Greece or Italy and denominated in Euros, there is a very high probability that the cash flows will switch to a devalued currency sometime during the remaining life of the loan. Because of this risk, investors should be much more wary of financial institutions that have significant non-sovereign debt exposures in the PIGS countries.

The best way that I have found to play this is to short a structurally inferior security (the noncumulative preferreds or NCPs for short) of European financial firms that are massively leveraged and have exposures to PIGS debt that are multiples of their market capitalization.

Look at a NCP from the perspective of the bank that issues one. They have the option at any time to stop making coupon payments. They can suspend them indefinitely. The preferreds are perpetual, so the coupon payments are the only source of value.

The buyers of the NCPs are short this option!! And they have sold it for a yield premium of a mere one or two hundred basis points.

I have been thinking about this from a game theory perspective. The equilibrium is that no one is ever able to issue a NCP because there are no suckers dumb enough to buy one; certainly not at a yield that would make sense for the issuer. However for some reason, the market broke out of this equilibrium over the past decade and now these securities exist again. The new equilibrium is for the issuers to suspend the coupon payments, let the price of the NCPs crater, and then buy them back at a huge discount. It's like the fable of the scorpion and the frog.

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