When I read about Paulson’s bet back in April of this year, I thought it was very risky. In fact, I thought it was so risky that it prompted me to do an entire analysis of his bet. At the time of my analysis, the 5-year German bund CDS was trading at $87.98. Today, it trades at $32.85. That translates to a crushing loss for Paulson. It might be instructive to review my previous analysis, which I have posted below.
Will John Paulson's Big Bet Pay Off?
by Nicholas Kwasny
On April 17th, the Financial Times reported that billionaire hedge fund manager John Paulson shorted German government bonds, in a bet that the eurozone crisis would significantly deepen in the coming months. Paulson told his investors over a conference call that he was specifically betting against the creditworthiness of Germany because he saw the problems affecting the eurozone deteriorating severely. Paulson initiated his position several months ago.
Although the specific details of Paulson’s position are unknown, through news reports we know his holdings include credit default swaps written on German debt.
Paulson’s trade leaves many questions unanswered. Is this a short-term bet, or a long-term bet? Is Paulson shorting actual German bunds, or is he mainly buying credit default swaps? Further, what makes him think that Germany’s credit rating will deteriorate in the coming months, or years, even if there is deterioration in other eurozone countries?
I find Paulson’s trade fascinating, mostly because it isn't apparent to me that Germany is a good candidate for a short. Because I am interested in how Paulson’s position will fare, I have conducted an analysis on Germany’s fiscal prospects, which you will find below. In addition, I have analyzed Paulson’s trade overall, and which economic variables could work in his favor, and which could work to his detriment.
Paulson's Performance So Far
Before analyzing the full prospects of Paulson’s trade, where does his position stand as of now?
Without knowing exactly when Paulson entered his trade, it’s impossible to know his exact performance. But assuming he entered his trade around the beginning of the year, he might already be significantly underwater.
Yields on German bunds have fallen, with the 10-year government bond yield having declined from approximately 1.9% at the start of the year to 1.51% as of today. The price of the 5-year CDS on the 10-year German bund has declined from approximately $102 at the start of the year to $87.98 as of today.
|CDS Price 5-Year German Bund|
As an aside, I found it interesting that CDS prices aren’t necessarily correlated with bond yields. Upon careful thought, one should understand why this is so, since there are other factors affecting bond yields other than credit ratings; for example, inflation, or investors in a flight away from safety can cause moves in yields that wouldn’t necessarily correlate to moves in CDS prices. The correlation can also move in the other direction, with yields falling and the CDS price climbing. Consider, April 2011 marked the top of rising yields on the 10-year German government bond. Yields topped out at approximately 3.46%, before declining to around 1.64% in late September as investors bought up German bunds in a flight to safety. However, during this time, 5-year CDS prices on the 10-year German government bond skyrocketed from approximately $37.50 to approximately $106. CDS prices spiking for an asset that was considered the safest in Europe? Of course, this might be explained by two different types of investors entering into bunds and credit default swaps. But the evidence shows the very real possibility of yields falling and CDS prices climbing.
|10-Year German Bund Yield|
Will Germany's Credit Rating Deteriorate?
According to the FT report, Paulson is putting on the trade because he believes that Germany’s credit rating will deteriorate, prompting a rise in yields and in the prices of credit default swaps on German bunds.
But Germany isn’t in terrible fiscal shape at the moment, at least not when compared to its European neighbors. Total government debt as a percentage of GDP stands at approximately 82%. This compares with 165.3% for Greece, 120.9% for Italy, 108.5% for Portugal, and 108.4% for Ireland. Germany’s debt-to-GDP ratio is even lower than that of the United States, which is at 104%.
Another indicator of note is Germany’s deficit-to-GDP ratio, which stood at 1% in 2011. This is well under the limit permitted for countries that use the euro. For comparison, in 2009, Greece reported a ratio of 15.6%, Ireland 14.1%, Portugal 8.7%, and Spain 8.5%. The ratio of the United States in 2010 was 10%. The deficit-to-GDP ratio is an interesting statistic because it shows the flexibility with which governments can cut deficits through either spending cuts or tax hikes, or a combination of both. Obviously, the higher the ratio, the harder it is for the governments to control the deficit. Further, since spending cuts are rarely popular, the deficit-to-GDP ratio, in some cases, can be viewed as the amount by which the government must raise taxes (as a percentage of GDP) in order to close any budget gap. The ratio can then be compared with a country’s tax revenues as a percentage of GDP, to see how much room is available for raising taxes.
Germany has one of the highest tax rates in the world, with revenues at 40.6% of GDP. France is at 44.6%, and Italy at 42.6%. Zimbabwe, one of the worst economies in the world, taxes 49.3% of its output every year. Clearly, there is very little room for Germany to raise taxes (outside of targeted hikes on the rich), and so it must rely on a combination of spending cuts and GDP growth.
But what about the outlook for Germany? Are there any factors on the horizon that could negatively impact Germany’s credit rating?
Looking at projections from the Federal Ministry of Finance in Germany, it appears that the government is expecting to borrow an additional €85 billion by 2015. Given that Germany’s national debt is approximately €2 trillion, this additional borrowing should not have a major impact on its fiscal position. Of course, whether the government can keep borrowing at such a low figure is another matter.
What should be of concern to Germany is its exposure to rising interest rates. Germany spends close to 12.5%, or €38.3 billion servicing its Federal debt. If interest rates rise in the future (and it’s an almost absolute certainty that they will) Germany could face significantly higher borrowing costs.
The key to determining how exposed Germany is to rising interest rates is to understand the structure of the government’s debt. What I mean by structure is what percentage of the government’s debt is reaching maturity in the short-term, and which portion is reaching maturity in the long-term. If a large portion is maturing in the short-term, we can expect rising interest rates to have an immediate and significant effect on the amount of interest. A longer maturity profile means that a country isn’t as affected by interest rates in the short-term.
In April 2010, the average residual maturity for Germany was just over 6 years. It was reported that in 2010 Germany had 28.1% of its securities maturing in less than one year, 35.5% in 1 to 5 years, and 36.5% in over 5 years. As you can see from the statistics, close to two-thirds of Germany’s debt matures in less than 5 years. Assuming this debt structure has maintained itself into 2012, it means that Germany’s debt will have to be refinanced soon at potentially higher interest rates, which could put pressure on the country’s deficit.
|Germany's Historical Interest Rates|
Using some crude math, if interest rates climb to 4%, the level they were at pre-crisis, Germany could be paying €52 billion in interest payments, which is €14 billion more than what is being paid now. Assuming interest rates spike to 6%, Germany could face a debt service of around €80 billion in 5 years, €40 billion more than what it is currently paying.
While Germany’s fiscal position at present seems relatively sound in comparison to its European neighbors, and to the United States, there is the presence of what might be called ‘shadow’ credit risk.
In December 2011, bond market strategists at Goldman Sachs identified a short bet on Bunds as one of their top trades of 2012. In their note, Goldman’s analysts argued that Germany, along with France, would be increasingly exposed to the debt of their European neighbors, and might be forced into some sort of debt mutualization agreement. Goldman’s analysts wrote, “The ‘shadow’ credit risk of core countries is already rising, and at an increasingly rapid pace.”
The key to quantifying the amount of shadow credit risk in Germany is to look closely at the amount of sovereign debt from PIIGS countries that German banks own. However, this data is very difficult to find. In most reports on Germany’s exposure to the PIIGS, the figure cited is the total external debt, which is the sum of all public and private debt. Looking at external debt can be misleading because, as stated, it includes private debt in addition to public debt. Although the private debt owed to Germany comes from the troubled PIIGS, it’s almost impossible gauge the percentage of private debt that might fall into default. What we’re interested in here, again, is the total sovereign debt from PIIGS countries owned by German banks.
Olaf Storbeck, an international economics correspondent with Handelsblatt (Germany’s business daily) compiled some data on the amount of public debt owned by German banks from PIIGS countries shortly after the EU stress test results were published in late 2011. Storbeck’s data is interesting because it shows that the amount of public debt that German banks are exposed to is significantly less than the total amount of external debt from PIIGS countries they are exposed to. For example, the amount of Greek external debt that German banks are exposed to is approximately €28 billion. But the amount of Greek sovereign debt owned by German banks is approximately €8.8 billion (the Bundesbank puts exposure at €7.9 billion). According to Storbeck’s table, Germany’s twelve largest banks own approximately €68 billion worth of public debt from the PIIGS. Ireland (€1 billion), Italy ($36 billion), Portugal (€3.5 billion), and Spain (€18.6 billion).
Looking at the data above, it doesn’t appear that German banks would be in trouble if any, or all of the PIIGS countries defaulted or forced its creditors into some sort of haircut arrangement. In addition, even if German banks were somehow crippled by numerous defaults or haircuts, the German government would certainly have the financial ability to offer assistance. After all, during the 2008 crisis, the German government guaranteed €174 billion of the German banking sector's liabilities, and injected another €29 billion in capital.
However, there is some concern from German regulators that Germany might be exposed to banks in neighboring EU countries which do hold significant amounts of PIIGS public debt. The concern is that there might be a potential chain reaction, which could envelop Germany. But as a top German regulator commented, there isn’t any way to reliably calculate the amount German banks would be on the line for. Germany’s total external debt figure might be useful here (approximately US$700 billion), but coming to a precise number is obviously very difficult given the number of variables that would have to be considered.
The Future of Germany and the PIIGS
What does the future hold for Germany and the PIIGS? One clear trend is the complete opposition of European voters to austerity measures. In France, voters elected Francois Hollande, who will be the first socialist president in 17 years. He’s promised the French people a war on the finance industry, and increases in taxes on top earners to a rate of 75%. Hollande’s agenda also includes focusing on government growth measures rather than on fiscal austerity.
The story is no different in Greece, where PASOK, the governing center-left party, and New Democracy, the center-right party, saw their support slashed in half due to their pro-austerity stances.
Europeans want their governments to increase spending, while cutting taxes. The only way for these countries to finance such spending is by borrowing even more money.
The European Central Bank has been supporting EZ government debt via it Long-Term Refinancing Operation (LTRO). As of March 2012, the ECB has lent over €1 trillion to European banks through its LTRO I and II. The money being printed by the ECB is reducing pressure on the bond yields of the PIIGS countries, allowing them to finance their deficits and continue spending. For example, the yield on the Italian 10-year government bond has fallen from over 7% during the height of the crisis, to 5.5% where it stands today.
|Italy 10-Year Government Bond|
For now, the ECB has allowed the PIIGS countries to avoid default. But the ECB can’t print forever. At some point, inflation will start to heat up, thereby limiting the ECB’s ability to lower yields for the PIIGS. Thus, the ECB is simply buying time for PIIGS countries to clean up their financies. If the PIIGS can’t get their fiscal positions in order, the chances of a default are very likely.
Whether Germany would step in again in the event of such a default is a complete unknown. Given Germany’s insistence on fiscal austerity, it seems unlikely that Germany would continue to support countries whose governments have made no attempt to abide by the first bailout agreement.
Another scenario that could play out is the dissolution of the European Union. Countries on the euro have obviously experienced the pain associated with not being able to monetize their debt via their own central banks. If they dropped the euro and returned to their former currencies, they would be able to print and finance their borrowing.
How John Paulson’s investment thesis will turn out is pretty difficult to determine. Paulson is betting that Germany will somehow get caught up in a worsening eurozone situation, leading to a deterioration of its credit rating.
But it isn’t clear if Germany would be affected by a worsening of the debt troubles of its neighbors. German banks are probably exposed in some manner to banks in other European countries, but to what extent is unknown. The sovereign debt that German banks own from the PIIGS countries should be of concern, but it is relatively low and isn’t something that would be able to be contained by the German government. Further, if the PIIGS countries do find themselves in trouble once again, it’s unlikely that Germany would be willing to fund even more bailouts, especially if its austerity demands aren’t being met.
Germany’s fiscal position, although not the best in the world, is sound enough to ward off any concern of default in the future, even when factoring in interest rate increases down the road. It’s possible Germany’s finances could worsen in the coming years and lead to a default, but that would be a very long-term development, and something not entirely predictable now. There might also be the risk of declines in German GDP, although monetary stimulus from the ECB should ensure positive growth down the line.
While Paulson’s investment thesis may have its holes, his trade just might end up working out anyway. German yields are trading at historic lows because investors believe that its bonds are the safest investment in Europe at the moment. But if investors’ risk appetite increases, a flight away from German bunds and into other eurozone debt and equities would lead to rising German yields. In addition, any printing by the ECB might lead to inflationary pressures, which would lead to rising yields. If Paulson has shorted German bunds directly, his position would benefit from the price drop of the bunds.
On the other hand, whether his CDS position appreciates in price is another matter. As stated previously, credit defaults swaps usually reflect the ability of the creditor to pay back a loan. If Germany’s fiscal position remains reasonably sound, it’s unlikely that CDS prices on German bunds would appreciate quickly. Further, buying credit default swaps comes with its own set of risks, namely counterparty risk. If a eurozone collapse is what Paulson is betting on, how can he be so sure the credit default swaps will actually pay off?
Overall, Paulson is entering an incredibly complex trade, the performance of which depends on numerous variables, some of which are predictable, and some of which are not. However, Paulson just might profit on the trade due to a reversal from a flight to safety, or alternatively from acceleration of inflation factors if the ECB decides to fund the PIIGS, rather than for the reasons he has given for putting on the positions. It's unlikely he will see a significant decline in the creditworthiness of the German government, thus, it is difficult to understand how Paulson's trade will show profit from this event.
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