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Stasis (3): Fair market value

01 July 2015
Richard Kemmish

So far we’ve established that the ECB has lots of Greek covered bonds, and that they are probably pretty worried about that. They are quite likely to get their money back – or at least the haircut value – as long as capital controls aren’t imposed for too long a time period and the swaps were sufficiently robustly drafted to cope with a redenomination of the assets.

But what does the market think?

Well obviously we can’t ask. I’m guessing that no market maker is currently quoting on the one publically issued Greek covered bond and the covered bonds pledged at the ECB are probably ‘bespoke’ structures that differ from normal ‘for sale to the private sector’ securities in many ways. For example I’m guessing that they are conditional pass through structures.

How can we think about market value?

There is an observable market value for Greek risk for other securities and/or credit default swaps. This could be taken as a basis then adjusted for the specifics of covered bonds.

For example, assume that Moody’s rate both a Greek covered bond and a Greek unsecured bond and give them a rating difference of four notches (for arguments sake). Looking at Moody’s idealised expected loss curve you could translate that four notches into a different level of expected loss. Then simply apply the ratio of the expected losses to the discount to par of the senior bond (or that implied by the credit default swap market) to get an implied discount to par for the covered bond.
Theoretical, and suggests a lot of confidence in the rating agencies, but better than nothing.
Then we can look at market value in other stress cases. Obviously everything has been fine – no covered bond has ever defaulted remember, equally obviously every failure is different. But some comfort can be derived from other cases. Northern Rock covered bonds hardly traded below 90% of face value (although that was an idiosyncratic failure in a AAA rated country), National Bank of Greece which largely traded in the low 70s in the 2011 crisis when the government bonds traded in the mid20s cash price and the Icelandic banks which performed perfectly and were bid accordingly when the market eventually reopened.

Again not ideal, better than nothing.

Then as a final triangulation point, you could undertake a scenario analysis. Lots of investment bank research tells you the probability of each of the possible outcomes of the Greek situation. Combined with a simple cashflow model this can give a probability weighted value.

None of these methods is perfect, but the aggregation of them comes up with a value more reliable than any of them in isolation.

I’ve done some ‘back of an envelope’ sums on the basis of the above and the different methods come up with a broadly similar value. But in order to avoid the ever present risk of looking stupid, I’m hardly going to tell you what it is now am I?

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