UW European Crisis April

1 Confidential

Will Slaughter

April 2012

European Sovereign Debt Crisis

2 Confidential

Agenda •  Risk free rates?

•  Historic risks facing government bond markets

•  Causes of the European crisis

•  Crisis response

•  Greek debt exchange/ default

•  The way forward

3 Confidential

Risk free rate – Does it really exist? •  Entire edifice of academic finance (fixed income models, asset pricing models etc.) built

on the idea of a risk free rate

•  In practice, this usually means short term government bond yields, bank deposits, or central bank money

•  But government bonds are clearly not “risk free” –  Default risk (repudiation/ restructuring) –  Devaluation/ Redenomination risk (FX) –  Inflation risk –  Taxation/ capital controls

•  Sovereign default is a common and recurrent feature of financial markets –  Rogoff / Reinhart book “This Time Is Different” chronicles long history of sovereign default and its relatively high

baseline frequency –  Default episodes usually accompanied by a rise in inflation, and usually preceded by a big run up in external debt –  Virtually every country in the world (including the US) has “defaulted” in some sense through either currency

debasement or outright default

•  Losses in default/ devaluation episodes usually exceed losses in corporate bankruptcies –  Typical recovery assumption on sovereign CDS contracts is 25% versus 40% for corporates –  Recent default episodes (Argentina, Ecuador, Greece) have imposed losses exceeding 50% in present value

terms

4 Confidential

The long history of sovereign default

•  Four episodes in the last 2 centuries when more than 40% of sovereign issuers in default

Source: Reinhart/Rogoff, April 2008

5 Confidential

Strong association between sovereign distress and inflation

•  Periods of general sovereign distress tend to coincide with periods of high inflation, as governments resort to inflationary policies to liquidate the real burdens of their debts

Source: Reinhart/Rogoff, April 2008

6 Confidential

Is this crisis really about debt and deficits?

•  Difficult to explain how Spain and Ireland have been drawn into crisis when looking only at pre-crisis fiscal positions •  Spain, Portugal, and Ireland all had smaller sovereign debt stocks than either France or Germany in 2007 •  If “It’s Mostly Fiscal” as the IMF likes to say, why aren’t Belgium and Germany in crisis?

7 Confidential

Now it’s clearer…

•  Above all, the current crisis is a balance of payments crisis –  The size of pre-crisis current account deficits and external debt stocks was a much more useful guide to which

countries got in trouble…and which ones didn’t. –  The German position that the crisis is about fiscal indiscipline is transparent, and dangerous, nonsense.

•  Also explains why Japan, with gross sovereign debt/GDP of 160%, can borrow for 10years at 1% –  Japan has a huge, persistent current account surplus and a net foreign investment position of +75% of GDP

8 Confidential

Euro crisis is really about the Balance of Payments, not government debt

•  The size of current account deficits (and negative international investment positions) have been far more predictive of financial crisis than the size of either government debt stocks or budget deficits

•  It is the size of the CA deficit that determines the scale of needed external support (international resource transfer), NOT the size of the budget deficit

•  No surprise that Irish bonds have rallied in the past year, as Ireland has achieved the largest CA adjustment (from deficit of -5% to surplus this year)

•  Peripheral sovereign debt crises will end once the current account is in balance

•  Greece, Portugal, Italy, and Spain all still have substantial adjustments ahead –  Little hope that any of these countries will see a huge rise in exports (although Spain & Portugal doing

surprisingly well on the export front) –  External adjustment will be accomplished primarily through lower imports, and hence a substantial decline in

domestic consumption and investment –  This implies a painful contraction in living standards, but an adjustment no less severe than if these countries

were able to engineer a substantial currency devaluation

9 Confidential

Europe has been here before •  BoP crises quite common in the Europe

–  Breakup of pre-war gold standard during WWI –  Breakup of the interwar gold standard during the 1930s –  Breakup of Bretton Woods in the early 1970s –  Breakup of the “currency snake” system in the late 1970s –  Breakup of the EMS/ ERM 1 system in 1992 (Black Wednesday sterling devaluation) –  Current crisis: Breakup of the euro?

•  Situation is very analogous to recent emerging market crises arising from fixed exchange rates: –  Mexican peso crisis of 1994 –  Asian crisis of 1997/1998 (Thailand/ Korea/ Indonesia) –  Argentina 2001 –  Iceland/ Baltic crises of 2008

•  When external debts cannot be refinanced in private markets, they must either be compromised or bailed out. Options are:

–  Default –  Devaluation –  Official sector loans (IMF/ World Bank/ foreign governments) –  All of the above in some combination

•  Europe resolved past crises mostly through devaluation. Introduction of the euro removes that option this time, forcing Europe to rely on bailouts and default as its primary adjustment tools.

10 Confidential

Outline of the Crisis •  Seeds of crisis built up over a decade, almost from the inception of the euro

–  Persistent and widening current account deficits in peripheral countries –  Buildup of large negative international investment positions in all crisis countries –  Pre-crisis booms sustained by government borrowing in some countries (Greece, Italy)… –  …and by private borrowing in others (Ireland, Portugal, Spain)

•  Imbalances reflected a variety of factors –  Compression of risk premia due to euro adoption (convergence trade from 2000-2008) –  Eagerness of surplus countries (Germany) to recycle savings into higher yielding instruments –  Disinflationary impact of the euro blinded market participants to credit risks –  Divergent labor costs exacerbated imbalances, as restrained German wages drove

competiveness gain vis-à-vis rest of Eurozone

•  US financial crisis of 2008 was the initial catalyst –  Global recession led to fiscal deterioration in all countries (larger borrowing needs in the

peripheral countries) –  Lehman crisis catalyzed financial sector deleveraging in Europe, reducing demand for peripheral

government bonds even as supply expanded –  Intra-Eurozone spreads began widening in 2008, peaked in early 2009, and settled down briefly

until… –  ….Greece!

11 Confidential

Greek 10Y Bond Yields, 1999-2011

•  Greek elections in October 2009 pushed crisis to an acute phase –  Nobody really worried about Greece until Q4 2009 –  Immediately prior to the elections, 5y CDS was only 100 bps –  10Y GGB yields were 4.40%, near pre- Lehman crisis lows and below Greece’s euro era average

•  The Greek elections of 2009 radically altered investor perceptions at a time of maximum balance of payments vulnerability

12 Confidential

Greece sends the crisis nuclear… •  Greek elections of 2009 lit the bomb

–  New government elected (PASOK) which recognized an increasingly hopeless fiscal situation as recession loomed –  PASOK government attempted to blame prior government for the mess it inherited –  The new government disclosed large “hidden debts” and off budget spending in prior years which shattered

already fragile market confidence and alienated European authorities –  Market confidence evaporated in the face of large sovereign refinancing needs and budget deficits, causing

Greece to lose market access and run out of cash by May 2010

•  Greece requests an unprecedented bailout in June 2010 –  120 billion EUR of official financing offered through the EU/IMF and the newly created EFSF –  Original plan was to “fully fund” Greece through March 2013 and rule out default on any Greek sovereign debts –  In exchange for bailout, Greece agrees to a wide variety of budget cuts/ tax increases and structural reforms

•  As default seen possible in the Eurozone, investors dump all peripheral country bonds –  Immediate widening of all small country spreads, as well as Spain and Italy –  Huge flight to German bunds

•  After brief post bailout calm, Ireland reveals larger than expected losses in state controlled banks in the fall of 2010. Ireland loses market access, and requests a bailout program in November 2010.

–  Irish crisis results in another step move higher in peripheral spreads

•  After another brief respite, rising yields cause Portugal to lose market access in the spring of 2011, causing Portugal to request a bailout program in May 2011 and driving spreads wider still

13 Confidential

From convergence to contagion in European interest rates

•  Explosion of Greek risk premium rapidly spread to other European sovereigns, undoing a decade’s worth of interest rate convergence in 18 months

14 Confidential

Broken promises and policy stupidity pave the way for default

•  Ill advised policy tightening from the ECB in early 2011 –  In one of the worst central banking mistakes of all time, the ECB raised policy rates in early 2011 in the face of an

intensifying financial crisis –  The ECB also retreats from market stabilizing asset purchases (SMP), causing markets to question Europe’s real

commitment to supporting all European sovereign bond markets

•  Meanwhile, it become clear that Greece is substantially missing deficit reduction targets, and will need more money

–  Missed targets reflect both a worse than expected recession and poor policy implementation by Greek officials –  The EU/IMF/ECB troika questions Greece’s good faith –  Greek institutional weakness/ administrative incompetence/ and political corruption all real issues

•  During the summer of 2011, Europe breaks its initial promise to Greek debt holders and proposes “Private Sector Involvement” (i.e. default) as a precondition for more loans to Greece

–  Official sector was reluctant to lend any money to Greece to pay out maturing private bonds, wanted to “bail in” all remaining private sector creditors

–  Immediate collapse of what remains of the Greek bond market and contagion to Portugal

•  European frustration with Greek political instability leads to more draconian PSI proposal by late 2011 –  “Haircut” of 50% proposed along with concessional coupon and substantial maturity extensions

•  New Greek bailout agreed by March 2012, incorporating an exchange of more than 200 billion EUR of privately held Greek debt

–  Largest sovereign default in history –  First default by a developed country since World War II

15 Confidential

The Greek Exchange

•  Private holders of all Greek bonds got the same deal, regardless of the maturity or coupon of their existing holdings. For each 100 EUR face of old Greek debt, exchanged for:

–  0.150 of cash (actually short dated EFSF bonds) –  0.315 face of new Greek bonds (2% initial coupon rising to 4.6%, 25 year final maturity amortizing after 10 years) –  0.315 face of “GDP warrants,” which make a contingent payment if Greek GDP exceeds certain future thresholds –  Accrued interest the old bonds was paid in full

•  Holders of Greek law bonds (which represented more than 90% of the total stock) were coerced into the exchange through the retroactive insertion of collective action clauses (CACs) into the old bonds.

–  However, the new bonds were issued under UK law, making it more difficult for Greece to do this in the future. –  Use of CACs was an “event of default,” triggering payout on CDS contracts

•  Substantial losses inflicted on Greek bondholders –  Final notional haircut was 53.5% –  At current prices, recovery package has a value of around 0.25 on the Euro, implying a 75% NPV writedown –  However, current Greek yields of 20%+ are unrealistic….discounted at pre-crisis Greek yields, the value of the

exchange package is 0.45 on the EUR, implying a 55% NPV loss relative to pre-crisis return expectations

•  Greece default sets major negative precedent for all European government bonds due to effective subordination of the private sector to the official sector.

–  Even though private bondholders wrote off half their claims, Greece’s overall debt burden was reduced by only 33% , from 160% to 120% of GDP

–  This is because approximately 135B EUR of troika loans took no losses whatsoever, forcing the burden of default entirely on private markets

–  Effective seniority of ECB/EU/IMF lending implies potential future haircuts on the private sector are larger than overall needed debt reduction, and has already driven negative contagion effects in Portugal

16 Confidential

How Europe has fought the crisis

•  Bailouts/ Loans –  European Financial Stability Fund (EFSF) –  European Stability Mechanism (ESM) –  IMF/ bilateral loans

•  Monetary Policy –  Lower, then higher, then lower again interest rates –  Firing Jean Claude Trichet –  Appointing an Italian to run the ECB –  Securities Market Program (SMP) –  Long Term Refinancing Operations (LTRO) –  Generous, open ended liquidity provision –  Massive central bank balance sheet expansion without quantitative easing (a distinction without a difference)

•  Defaults –  Only Greece and a few junior Irish bank bonds so far

•  “Internal Devaluation” –  Falling relative wages/ price levels in the peripheral countries relative to Germany –  Tolerance of faster inflation in Germany to ease peripheral adjustment

•  Structural reform –  New “fiscal compact” (A plan that makes the Germans happy but which will be ignored by everyone else) –  Austerity programs / privatizations in peripheral countries

17 Confidential

Parting company

•  German bonds (“Bunds”) go their own way –  A GDP weighted basket of all 10Y Eurozone sovereign bonds (including Germany) yields 4.15% –  This contrasts with yields of just 1.72% for German Bunds and 10Y yields of around 2.0% for Treasuries and Gilts –  Euro swaps have followed bunds, with 10Y swaps in Europe trading nearly 200bps through the sovereign basket –  By contrast, US 10Y swap spreads are +10 bps (vs -200bps on the basket in Europe)

18 Confidential

What is the risk free rate in Europe today?

•  Is it the ECB repo rate? Short term bunds? Short term French bonds? –  German bonds trade at record low yields, with 2Y bunds yielding just 10bps as of this week. –  By contrast, 2Y French bonds yield 60 bps, while 2Y swaps are 1.04% –  All rates are substantially lower than one would expect given the ECB’s official target rate is 1.00% for

collateralized lending

19 Confidential

Market currently places huge premium on German collateral for secured lending

•  Effective repo rates on German bunds are currently negative across the curve –  Repo rates for bund collateral on the order of -10 to -15 bps –  Compares with current repo rates for US 2Y notes of around 27 bps –  Market faces an acute shortage of high quality collateral in Europe

20 Confidential

Intra-Eurozone capital flight is flooding Germany with liquidity

•  ECB has been fulfilling the lender of last resort role in Europe with respect to bank assets –  Bank depositors have been fleeing from the PIIGS… –  …to put their money in German banks –  ECB has been only partially effective in recycling this liquidity back to the PIIGS –  This creates considerable divergences in Eurozone interest rates, and divergences from the ECB’s target

21 Confidential

Europe – Could austerity work?

Source: IMF, July 2011

•  PIGS fiscal problems primarily on the revenue side •  Greek government revenue as % of GDP is almost 10% of GDP below core European levels •  Portugal, Ireland Spain tax collections also well below core European averages •  Tax collections at core Europe levels would eliminate Spain, Portugal, and Greece budget deficits overnight •  Substantial scope to increase tax collections in the crisis countries •  Situation is more problematic in Belgium and France, which face large budget deficits but already have high

domestic tax burdens

22 Confidential

Can Austerity Work? – Latvian Lessons

•  Paul Krugman on Latvia: –  “Latvia is the new Argentina” (December 2008) –  “Riga Mortis…[Latvia’s] determination to keep a fixed exchange rate lies behind the catastrophe” (Feb 2010) –  “They have made a desert…[they] have done worse than Iceland” (May 2010)

•  Ken Rogoff on Latvia: –  “In a normal situation, Latvia would already have devalued the lats and defaulted on its debt” (June 2009)

•  Nouriel Roubini on Latvia: –  “Latvia’s currency crisis is a re-run of Argentina’s” (June 2009)

•  Nigel Rendell (RBC) on Latvia: –  “The country is in a mess with the economy expected to contract very sharply this year, while the budget deficit

is horribly high. Devaluation looks very likely as a way of boosting exports and growth.” (June 2009)

As of March 2012, Latvia has neither defaulted nor devalued, and has resumed economic growth after a 25% top to bottom fall in output. After a brutal economic adjustment, taking the current account from a deficit of -20% of GDP to a surplus, Latvia is now able to borrow in the international bond market at 5% (despite Latvian CDS at one point trading at 1200 bps in 2009).

23 Confidential

How bad will peripheral recessions get? Use Latvian, Irish experience to calibrate expectations

•  Proposition: Key to ending the crisis is external adjustment to CA surplus –  Latvia, Ireland the relevant comparators as both pegged to euro, have already experienced major swings from

external deficit to surplus –  Latvia: CA adjustment from -13% deficit in 2008 to +4% surplus in 2010 –  Latvian adjustment accompanied by a 25% top to bottom drop in nominal GDP –  Ireland : CA adjustment from -6% deficit in 2008 to +1% surplus in 2011 –  Irish adjustment accompanied by top to bottom decline in nominal GDP of 17% (now complete)

•  Significant contractions still ahead for Greece, Portugal, and probably Spain –  Greece and Portugal still have to close a CA deficit of 8% of GDP –  Total adjustment Greece will transit is from external deficit of 14.5% in 2007 to needed surplus –  That is a Latvian level adjustment and suggest that Greece will ultimately see a 25% top to bottom drop in

nominal GDP as a worst case –  Greek nominal GDP has already declined about 10% from the peak, another 15% to go in worst case –  Portugal adjustment from -12.6% deficit in 2008 to needed surplus is almost as steep –  Suggest Portugal also likely to see a top to bottom decline in nominal GDP of around 20% as a worst case –  Recessions will be milder to the degree CA deficits do not fully correct

•  Need to calibrate Greek, Portuguese debt sustainability expecting a 20% drop in nominal GDP –  This is a considerably more pessimistic scenario than official IMF, EU estimates –  But market prices assume an even more pessimistic scenario

24 Confidential

Mathematics of sovereign solvency – How much debt is “sustainable”?

•  Simple approach to sovereign solvency analysis –  Supportable debt burden = PV of future primary surpluses discounted at the sovereign’s average borrowing

rate –  As long as GDP growth rate exceeds borrowing rate, arbitrarily large debt burdens are sustainable –  Framework assumes it is institutionally possible to run a primary surplus –  Debt burdens are bounded when interest rate exceeds the growth rate –  Assuming a 2% primary surplus, framework suggests that 200%+ debt to GDP is sustainable for the US or

Japan/ but only 50-60% for Italy or Spain –  Sustainability calculations are highly sensitive to future growth and interest rate forecasts –  A combination of inflation and repressed real interest rates can make any debt burden sustainable

25 Confidential

Assessing Portuguese debt sustainability

•  Portugal is on the edge of sustainability even confronting a worst case economic outcome –  Using fairly draconian assumptions (a 20% further decline in nominal GDP through 2015, no primary surplus

until 2015, and long term nominal GDP growth of only 3%), Portugal debt dynamics are just on the edge of sustainability without a restructuring

–  Non explosive debt dynamics require the average interest rate on Portugal’s debt stock be no higher than 5%, versus a current average interest rate of 4.2%

–  Market yields (currently 12% +) are much higher, but are irrelevant as long as concessional official financing remains available

–  With good luck, quite possible that Portugal avoids a restructuring even in the face of a severe recession

26 Confidential

Some parting thoughts – Europe can work

•  The present crisis does not pose any new problems that Europe has not faced before

•  I think it is likely the Euro holds together in its current form, as exit costs are prohibitively high for both core and peripheral countries

•  Europe has the means to adjust outside of dramatic currency devaluations

•  Successful adjustment will require a continued willingness of the official sector to make very large loans to refinance troubled countries – a failure of political will is the main risk

•  I do not believe further sovereign defaults are likely nor necessary

•  Continued easy monetary policy and higher inflation in Germany will play a key role in the continent’s recovery

•  I am very optimistic that Germany can become a demand locomotive which pulls the periphery out of recession

–  German economy is currently booming –  Exports to emerging markets up 85% in the last 5 years –  German unemployment rate is at a 2 decade low –  German construction activity is nearing 2 decade highs and real estate prices are rising –  German wage settlements coming in at 2x the Eurozone inflation rate –  Current financial conditions are far too easy for German conditions, setting the stage for a sustained beneficial

inflation.

27 Confidential

Current IMF projections for various Eurozone sovereigns

Source: IMF, various Article IV reports, July 2011

28 Confidential

Important Information CONFIDENTIAL – Not for public distribution. This information is confidential and proprietary to Stark Investments and may not be reproduced in whole or in part or used for any other purpose except as authorized by Stark Investments. By accepting delivery of this information, the recipient agrees that it will treat this information as strictly confidential and will not distribute or provide this information to any person outside its organization. By accepting delivery of this information, the recipient also agrees to destroy this information upon request by Stark Investments.

The views expressed in this commentary are solely those of Stark Investments as of the date of this commentary, are subject to change without notice, and may not reflect the criteria employed by any fund managed by Stark Investments to evaluate investments or investment strategies. The information contained in this commentary is presented solely with respect to the date of this commentary, or as of such earlier date specified in the commentary, and may be changed or updated at any time without notice to any of the recipients of this commentary (whether or not some other recipients receive changes or updates to the information in this commentary).

This commentary includes statements that are not purely historical in nature but are “forward-looking statements.” These statements may include, among other things, projections, forecasts, estimates, and specific trade ideas and investment strategies. These forward-looking statements are based upon certain assumptions and are necessarily speculative in nature. The assumptions upon which forward-looking statements are based may not be stated in this commentary. Actual events are difficult to predict, are beyond Stark Investments’ control, and may differ from those assumed. All forward-looking statements included are based on information available on the date of this commentary, are subject to change without notice, and Stark Investments does not assume any duty to update any forward-looking statement.

This commentary is provided to you for informational purposes only. This commentary does not and is not intended to constitute investment advice, nor does it constitute an offer to sell or a solicitation of an offer to buy any security, investment product, or service. Offers to sell, and solicitations of offers to buy, the securities issued by funds managed by Stark Investments will be made exclusively by the private offering memorandum relating to such securities. Potential investors should refer to the private offering memorandum for such fund for important information related to the fund’s and its investment manager’s and/or general partner’s organization, investment strategies, and history, as well as detailed risks of investing in such fund.

This commentary is not intended to be used as the primary basis for investment decisions, nor should it be construed as advice designed to meet the particular needs of an individual investor. This commentary does not take into account any particular investor’s investment objectives or tolerance for risk. Any trade ideas or investment strategies presented in this commentary represent potential trades based solely upon the views and information expressed in this commentary, do not necessarily present any actual trades that have been, are, or will be undertaken by any fund managed by Stark Investments, and do not constitute a recommendation to engage in such trade by any investor or other person.

An investment in any fund managed by Stark Investments is speculative and involves a high degree of risk. Past performance is not an indication of future performance, and there can be no assurance that a fund’s investment objectives can or will be achieved. An investor should not invest in any such fund unless it is prepared to lose all or a substantial portion of its investment. Such fund may employ leverage, which, among other investment techniques, can make investment performance volatile and lead to higher risk. Opportunities for redemptions and transferability of interests in such funds are restricted so investors may not have access to their capital if and when it is needed. There is no secondary market for an investor’s interest in such funds, and none is expected to develop. A substantial portion of the trades executed for such funds may take place on foreign exchanges.

No assurances can be made that any aims, assumptions, expectations, and/or objectives described in this commentary would be realized or that the investment strategies described in this commentary would meet the objectives described. The information, opinions and analysis contained herein are based on sources believed to be reliable, but no representation, expressed or implied, is made as to its accuracy, completeness or correctness, and none of Stark Investments, the funds it manages, its affiliates, or any of the shareholders, partners, members, managers, directors, principals, personnel, trustees, or agents of the foregoing shall be liable for any errors in the information, beliefs, and/or opinions included in this commentary, or for the consequences of relying on such information, beliefs, or opinions.

© 2009 Stark & Roth, Inc.