Greece would be Irrational to not Default with that In-the-Money Put

“Happy families are all alike; every unhappy family is unhappy in its own way.”

—Tolstoy

“Everyone should feel screwed in a debt rework. Unhappiness makes wise.”

—Uncle Larry

Everything I need to know about Greece I learned from subprime. In stressed debt, shared sacrifice is the signal, all else is noise.

QE and all the monetary shmush don’t really matter that much. What QE and interest rate subsidy gives in debt relief it takes by encouraging even more reckless debt binges. Further, monetary easing only transfers wealth to those with money in financial assets at the expense of everybody else. This helps no one drowning in debt.

Back in the heady summer days of 2005-2006, the music of “Since U Been Gone” and “Sexyback” was played loud. Justin Timberlake has just exposed someone’s boob at the last Superbowl half-time show. People had pretty much given up on network television. I ate many banh mi sandwiches. And there were a lot of people buying houses. My CEO at the time was feeling orgiastic. It was like there was a new unstoppable American economy that had completely dispelled the last fleeting residue of pain that the internet stock bubble had inflicted in all our wallets. This new economy was not based on stupid ideas like pets.com delivering high-end dogfood. It was based on the solid and real family home, fully backed by household income and the value of the real asset it was. These real assets seemed the seeds of a prosperity that could only grow.

Within a few years, the music had changed. Chris Brown was singing “Forever”. People forgot about the boob exposure. My CEO was feeling nauseous. The economy fell face-first into the Great Recession. Everyone’s net worth had experienced disaster. The real and solid family home in some states had lost 50% of its value from the Kelly Clarkson era only a few years ago. Black Mesa Capital wrote its final investor newsletter informing of massive drawdowns and resultant epic, epic fail.

Why? Because of default: multiple, systematic defaults were everywhere, blowing everything financial, social, and psychological up.

You needn’t be a rocket scientist to understand why borrowers “decided” to default. Some had a choice in the matter. They were underwater on their investment and it was a good economic decision to take the pain and move forward leaner and wiser. This choice was possible only because of imprudent lending in the form of high loan-to-value (LTV) lending. In short, borrowers were not asked to collateralize the loan with a sufficient down-payment. Thus the lender/guarantor is short a near-the-money put option. If borrowers were required to put down the historical 20-30% down-payment, the exercise of this option would be out-of-the money and thus rare. What a difference a decent down payment and some basic analysis of income would have made.

Most really did not have a choice at all. They have lost income either through job loss or settling for less pay and can no longer afford the payments. They may or may not have taken out a "unaffordable loan but that is irrelevant if they don’t have enough income or no income at all through job loss and depleted savings. These people deserve sympathy and help, and it is in the interest of a creditor to offer debt relief or some type of forbearance. Creditor, debtor—everyone—knows it is the right thing to do for the creditor to aid "some" at risk homeowners who lost income due to job loss or illness.

There are a lot of “buts” to be attached at this point. But no creditor can afford a bail out and renegotiation of every irresponsible homeowner/lender that borrowed/lent more than he/she could afford. But in all honesty modifying their loan could likely result in another default. But if you renegotiate terms for class of debtor then there is an expectation of renegotiated terms for all debtors.

And thus you have a renegotiation nightmare. There is a need to differentiate classes of debtors. There the people who really want to do the right thing as best they can and took a deal that should never have been offered. There are also scoundrels who knew better and are now trying to take advantage of their creditor. It is not really clear how to make the distinction in hindsight. It’s not like any debtor will every say “Yo dog, I’m a scoundrel.”

There is a need to rework terms, which needs to be done on a case by case basis based on a need for shared sacrifice. Both the debtor and the creditor have to give up something to make it work, not necessarily and not likely in equal share.

There is a need to do all renegotiations behind closed doors, without publicity. Do it any other way and you run the risk of other debtors in stress feeling it is better to stop honoring their obligations. If this takes root, collective action will force the creditor out of business in no time flat. This risk puts creditors in a bind because they can’t afford to rework their entire asset base. So if things get hot with a number of debtors, a creditor will turn from the banker you knew from school to one of the Goodfellas. They have to or they’ll lose everything.

Hey look, it’s Greece. Very little difference to be found. They are a debtor nation loaded with a staggering €300bn of debt. Clearly they were offered ridiculous terms. There is no real way to put a down-payment on sovereign debt. They are deeply underwater, just like a dude that put no money down on a mortgage. It makes sense to walk away. After all, there is no real way to exercise collateral on the debt short of military invasion and occupation. Don’t count this possibility out in a pinch: Russia has absolutely no problem trying this sort of exercise in Ukraine.

The whole “saint-or-scoundrel” dichotomy doesn’t work here either. Every nation is full of both. Not to say groups haven’t tried. Slinging names like “PIIGS”, “deadbeats” and “nation of taxcheats” around is like monkey throwing their crap at each other. What you really have to gauge here is how much the people governed—the polity, using a proper Greek sentiment—are willing to sacrifice and endure to pay their bills. I look at €300bn and I say seriously: that is €25,000 per head on top of the bills they already have to pay. I would be surprised if there is heroic willingness to sacrifice sufficient for this.

So knowing the debt burden has become absurd, there is little to do but to rework the terms published in every publication in Europe and beyond or let Greece default. Greece isn’t making this easy. They show open hostility to everything German, talk trash every chance they get, and show absolutely no indication they will accept anything but their terms, although it is likely that they haven’t thought that far out to consider what these terms actually are. This just makes people think you don’t know what you are doing. You know, a bunch of amateur leftist clowns. So just shut up for a while.

Note to Greece: you are making creditors nervous. They know that all the other debtors are going to be royally pissed off if you get outrageous terms. So when you talk about the EU will implode because of how unfair everything is you guarantee being kicked to the curb. Guaranteed.

It makes sense for everyone involved to cut a deal. Know that Mr. Market is going to treat Greece far more roughly than the Troika ever did: it’s just how Goodfellas work. Troika, you were an idiot for letting this get as far as it has. If you want to recovery anything out of the deal you have to offer better terms. So do it.

QE and all the monetary shmush don’t really matter here. What QE gives in debt relief in interest rate subsidy it takes by encouraging even more reckless debt binges. Further, monetary easing only transfers wealth to those with money in financial assets at the expense of everybody else. I can’t think of a country in any century that exited from QE without tremendous troubles to show for it. I can’t think of a country in our generation that exited from QE at all. Sure seems like heroin: feels great but as time goes on its effect gets smaller and smaller. Until we see what happens when central banks do exit the policy, we do not have an answer.

Debt renegotiation is remarkably the same no matter the scale and politics. As with strategic default, when your income is insufficient to support servicing the debt on your assets, the whole thing has to implode. Austerity may work if it is complemented with a large currency devaluation in which all contracts are rewritten in the devalued currency. In the Greek case, this kind of rework is unlikely without shutting them out of global credit markets for a year or so. This isn’t #winning.

Remember this: Shared sacrifice is the signal, all else is noise.


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