By Adam Fisher
Investors have been following the European debt crisis closely for the last three years, and in the process, have been trying to form a context around which to base an investment thesis and strategy. As the crisis has played out, Europe looks more like one giant collateralized debt obligation than a unified political and monetary body.
Similar to how mortgage securities were frequently assembled before the financial crisis, the European CDO would be organized with multiple traunches, with the most creditworthy countries at the top of the capital structure, and the riskiest countries at the bottom.
The “senior secured” and top level traunche, i.e. first to get paid back, is Germany. It has been the reluctant lender of last resort to the peripheral countries, and with its fiscal prudence and industrious output, it deserves this distinction. With a massive current account surplus and nearly 500 years of financial success, Dutch gilders probably belong in this category as well.
The “senior unsecured” traunche, the next leg down from Germany and the Netherlands, would be France. Despite having one of the most productive private sectors in the world, France’s generous welfare programs have been parasitic in nature, and with the election of a new socialist President, that decades-long trend will likely continue.
Taking the place of the “senior mezzanine” traunche is Italy. Mezzanine debt usually matures in 3 years time – the average duration of the Italian bond market is about 4 years – consistent with the time frame for the European Central Bank’s Long Term Refinancing Option aimed at high debtor countries on the continent’s periphery. While riskier than its northern peers, Italy has a high overall debt level, but often runs a primary surplus. Its deficit consists mainly of debt servicing costs, so its solvency is tied to interest rates. While every debtor theoretically goes broke when an interest rate goes high enough, the LTRO program has kept rates low and southern countries like Italy solvent in the short term. This improves the probability to remain solvent in the longer term, as countries’ balance sheet improve the longer they are allowed to borrow at low rates.
The “junior mezzanine” traunche belongs to Spain. Spain has access to the LTRO just like the others in its precarious state. But with the recent nationalization of Bankia and fear of a possible run on deposits, Spain might soon be downgraded to the equity traunche, the riskiest portion of the European CDO and first to take losses. Currently, Ireland and Portugal would fit the criteria for our CDO equity, and for reality’s sake – and investor safety – Greece is effectively out of the picture.
Given this construct and the constant negative headlines, investors might be wary of buying some of the riskier traunches of this imaginary security. However, investors need not take a completely directional view on eventual outcomes in Europe, nor should they given the daily volatility associated with the EU’s survival. Europe is traditionally self-financing and therefore operates in a closed system. The creditworthiness of one traunche is related to that of the other traunches. As the creditor/debtor debate between countries continues, the push/pull creates havoc – and opportunity – in markets.
Examples of how one might take advantage of this opportunity abound. With properly structured investments, investors can be agnostic to whether or not a country defaults. Sovereign bond markets, sovereign CDS markets, and even European bank debt (which is arguably quasi-sovereign) all reflect market biases and reveal conditional inconsistencies (i.e., conditioned upon one price, the equilibrium price of another cannot remain consistent).
In any case, the construct is dynamic in its parts, but surprisingly robust as a whole. It’s a zero-sum game and while it is difficult to predict what inconsistencies may result from the push/pull debate, the math associated with the subsequent corrections is a warm blanket in otherwise frigid markets.
Adam Fisher is co-founder and chief investment officer of Commonwealth Opportunity Capital, a global macro hedge fund in Los Angeles that manages more than $300 million.