«Portugal needs a National Salvation Pact with a short mandate to restructure the sovereign debt» — David Salanic, Tortus Capital
A conversation with David Salanic, Chief Executive Officer and Founder of Tortus Capital Management LLC, New York
Interview by Jorge Nascimento Rodrigues, editor of Janelanaweb.com and contributor for Expresso weekly newspaper, Portugal
Extended English Version of an interview for the Economic Section of Expresso weekly newspaper in Portugal
Also published at Macropolis.gr.
« In order to service its debt, Portugal would need to be able to generate cash flow before interest expense (called a primary budget surplus) of €7.2 billion a year or whatever amount the interest will have grown to in the future. This will never happen. This would imply a primary budget surplus of 4.3% of GDP. Portugal would need to improve its annual primary budget balance by €10 billion. Any attempt by the Portuguese government to extract an additional €10 billion annually from the economy, would destroy the economy and the social fabric of the country.»
«The President’s call for a National Salvation Pact was in our opinion the right approach but the PS had little incentive to agree to it. A new National Salvation Pact with a one-year mandate to restructure the sovereign debt and directly followed by new elections, would in our view be a politically judicious and stabilizing decision.»
«Countries that are on the verge of a sovereign restructuring tend to maximize their debt issuances and cash levels before they restructure. We have actually increased our net short position in the Portuguese sovereign since the bond issue was announced.»
«Notably, €4.6 billion of bonds mature on June 16, 2014 and another €6.2 billion of bonds mature on October 15, 2014. A PSI should aim to restructure these bonds. Working backwards, sovereigns generally need three months to restructure their debts through an exchange offer. Portugal should therefore start working on a PSI in the next month or two for it to be effective by the middle of June.»
«We believe that a second bailout would not be needed if a PSI takes place. A precautionary credit line would provide the necessary financing backstop while not requiring the harsh conditionality of a full bailout. It is therefore a better way forward.»
«Our belief is that rating agencies are concerned about Portuguese debt sustainability and even more concerned that Portugal would decide to follow Ireland’s path and fully rely on financing itself in markets, without any additional official support program.»
«There is a significant search for yield due to extraordinarily low interest rates around the world, which makes investors care about returns much more than risks. In our opinion, these have accounted for most of the improvement in sovereign bond yields, even though Portugal has indeed made some progress, especially regarding its current account balance.»
«By the middle of 2014, we expect additional elements of the 2014 budget to be found unconstitutional and as the deficit target clearly become unattainable again, it will be difficult for the IMF to pretend that that the program is being implemented in full and on time and that the sovereign debt is sustainable.»
Interview by Jorge Nascimento Rodrigues, conducted January 15, 2014. Published January 18
Founded in October 2011, Tortus Capital pursues an opportunistic investment strategy across the capital structure, focusing on sovereign credit, corporate credit, equities, and special situations.
Based in New York Midtown, on Madison Avenue, the hedge fund decided in the week that Portugal returned to capital markets with a bond syndicated tap to create a specific website http://rehabilitatingportugal.com/ explaining its bearish position on Portuguese bonds.
The site became viral among Portuguese specialists after Tyler Durden from Zero Hedge website referred the 64 page slideshow “Rehabilitating Portugal” precisely the day of the market operation (January 9). Also at Alphaville blog of Financial Times, Dan McCrum, the same day, announced that “those rascal short sellers are at it again” referring to Tortus presentation proposing a PSI for Portuguese sovereign.
Prior to founding Tortus, David Salanic was a director at Fir Tree Partners, a multi-strategy hedge fund with $10 billion under management. Prior to Fir Tree, he was an associate in the mergers and acquisitions group of Lazard Frères & Co. He obtained an M.B.A from Harvard Business School in 2007 and a Bachelor of Commerce with high distinction from McGill University in June 2001. Regarding the interview below, David stated Tortus Capital Master Fund LP is short certain Portuguese sovereign bonds and the answers should not be construed as investment advice.
The name Tortus meant to symbolize the Tortoise. “We like certain symbols of the tortoise such as longevity and the protection that the shell provides,” says David.
Going directly to your proposal of an urgent PSI as the way for a “Rehabilitation Plan” for the Portuguese debt, you mean after the end of the bail out in May 17 and after the European Parliament Elections of end of May?
From a timing standpoint, the longer Portugal waits to restructure its debt, the higher the debt levels and the lower the debt servicing capacity. Postponing a PSI by a year or two would result in higher haircuts to bondholders but lower debt relief to the country – or a lose/lose situation. As a result, we believe that addressing the overleverage problem earlier is better. Notably, €4.6 billion of bonds mature on June 16, 2014 and another €6.2 billion of bonds mature on October 15, 2014. A PSI should aim to restructure these bonds. Working backwards, sovereigns generally need three months to restructure their debts through an exchange offer. Portugal should therefore start working on a PSI in the next month or two for it to be effective by the middle of June.
You mean a PSI plus a one-year/two-year precautionary line? Or a PSI included in a framework of a second bail out like in Greece in 2012?
A PSI would drastically reduce the financing needs of the country and we believe that a second bailout would not be needed if a PSI takes place. A precautionary credit line would provide the necessary financing backstop while not requiring the harsh conditionality of a full bailout. It is therefore a better way forward.
Troika reviews, and particularly the IMF DSA (debt sustainability analysis), although considering that the debt overhang is highly vulnerable, concluded for its sustainability. You refer that the main arguments for that conclusion are misconceptions. Can you summarize the main reasons why the Portuguese debt is not sustainable?
A sovereign, just like a corporation or an individual, needs to be able to service its debt at some point in the future. Today, servicing Portugal’s debt costs €7.2 billion in interest payments a year and this number will grow every year. In order to service its debt, Portugal would need to be able to generate cash flow before interest expense (called a primary budget surplus) of €7.2 billion a year or whatever amount the interest will have grown to in the future.
It will be possible?
That will never happen. This would imply a primary budget surplus of 4.3% of GDP. Portugal has had a negative primary budget balance for over 15 consecutive years. The highest primary budget surplus ever realized over the past 36 years for which we have data is 3% of GDP. Portugal’s current primary budget balance is negative 1.6% of GDP. In order to get to a 4.3% primary budget surplus, Portugal would need to improve its annual primary budget balance by €10 billion. Any attempt by the Portuguese government to extract an additional €10 billion annually from the economy, would destroy the economy and the social fabric of the country.
Portugal does qualify for an OMT from ECB, or that is also a myth?
Mr. Draghi and the ECB have clearly indicated that OMTs do not apply to countries that are under a full adjustment program until full and complete market access has been restored, including an issuance calendar, high issuance volume, and a widespread investor base. So right now, I don’t believe that anyone can argue that Portugal qualifies for OMTs.
Could Portugal qualify in the future?
Perhaps. But our impression is that the ECB is already satiated with Portuguese paper. It already owns 23% of Portugal’s bonded debt, via €21,8 billions still outstanding in SMP Bond purchases from Jean-Claude Trichet, former ECB chairman. The ECB has been incredibly accommodative already with Portugal, whether one looks at Portugal’s Target2 balance (€70 billion) or Portuguese banks’ reliance on LTRO (€44 billion).
The European partners are politically sensitive to a PSI for Portugal after considering that the PSI for Greece was “unique”. Do you think the new European Parliament after May and the new European Commission could be more sensitive to a proposal like that?
At the time of the Greek PSI, there was no mechanism to avoid contagion to Italy and Spain such as the OMT program. Things are different today. Contagion risks are better contained. Banks are stronger. Markets have recovered. This is the right time for political leaders to address the problems that are still weighing on the European recovery. We believe that the European Parliament and the European Commission are increasingly against the idea of using taxpayer money to bailout private investors.
The IMF recognized the error of delaying the Greek PSI for almost two years. But regarding Portugal it never mentioned a PSI scenario. Do you think the IMF can change its position after May?
In Ernest Hemingway’s novel “The Sun Also Rises,” Bill asks Mike “how did you go bankrupt?” to which Mike answers: “Two ways: gradually and then suddenly.” This reminds us of the IMF and Greece. In the third quarterly review, Greek sovereign debt was found to be “sustainable.” A few months later, in the fifth quarterly review, the IMF stated that Greek sovereign debt was “clearly unsustainable” due to “more conservative assumptions.” In Portugal, through the third review, Portuguese sovereign debt was found to be “sustainable…assuming full and timely program implementation.” Since the fourth review, the IMF has added the statement that “debt sustainability cannot be asserted with high probability.”
And in the near future?
By the middle of 2014, we expect additional elements of the 2014 budget to be found unconstitutional and as the deficit target (4% of GDP) clearly become unattainable again, it will be difficult for the IMF to pretend that that the program is being implemented in full and on time and that the sovereign debt is sustainable.
You propose for Portugal a non-elected transitory government like in Italy or Greece in the recent past with a one year task (the PSI) supported by a great majority in the Parliament. But is it politically feasible? Is not better a new government legitimated by new elections after May including the PSI in its roadmap?
We do not mean to delegitimize democratic elections – far from it. However, it takes significant political courage to put a PSI at the heart of a political campaign. Not everyone understands that, given the great majority of Portuguese debt is governed by local law, a sovereign restructuring can take place smoothly, without payment default, without runs on banks, without a sudden shock to the economy. Moreover, the history of sovereign debt restructuring shows that political leaders, especially finance ministers, resign after a PSI. It is often viewed as preferable to have a new face for the country’s finances in order to once and for all break with the past. The President’s call for a National Salvation Pact was in our opinion the right approach but the PS had little incentive to agree to it. A new National Salvation Pact with a one-year mandate to restructure the sovereign debt and directly followed by new elections, would in our view be a politically judicious and stabilizing decision.
That proposal for a PSI means restructuring 45% of outstanding debt (excepting troika loans and bonds owned by ECB via SMP), including some of the retail debt and some of the international/soe debt. That will be around 95 billion. You mean a framework similar to Greece regarding the hair cut, the new interest and the extension of maturities?
Portugal has too much debt in aggregate, too great of a short term financing need, and an interest bill that is too high. All three issues need to be addressed. Our proposal is to exchange old bonds for new bonds with a principal haircut of 40%-50%. The new bonds would pay 2%-3% interest rates and mature in 10-25 years. This would be a comprehensive sovereign debt restructuring, which would bring Portugal’s sovereign debt clearly into sustainable territory. To incentivize bondholders to participate, we recommend offering bondholders some warrants to participate in the recovery of the economy. And to avoid holdouts in the local law bonds, we recommend introducing a retroactive collective action clause. Our plan is a simple proposal but adding some consideration options as part of the bond exchange would likely be beneficial.
For example, debt holders may be given an opportunity to exchange their old bonds for new bonds without incurring any principal haircut, as long as they accept an interest rate close to zero and a maturity extension of approximately 25 years. Banks may be especially interested in such an option as it would likely allow them to avoid marking down their bond holdings.
You add also a kind of a soft OSI [official sector involvement] regarding the European bailout funds. You mentioned the «shadow» OSI already done (savings of 31 billion in interest subsidies over 20 years). What would be the new reprofiling of the European bailout funds?
It is unlikely that the official sector would agree to haircutting the principal amount of their loans to Portugal. These loans were rescue loans and just like in most corporate debt restructurings, rescue loans are senior (debtor in possession loans). However, there may be an argument to be made that in the name of solidarity, the EFSF and the EFSM do not need to charge an interest rate on these loans.
But if that is not legally possible?
If it violates certain treaties however, the EFSF and the EFSM could defer the interest payment on their loans until the loans mature, thereby further reducing the net present value of these liabilities for Portugal.
One popular argument against the PSI was a catastrophic scenario for Greece after the restructuring in April 2012. The 52-week return on Greek sovereigns bonds is the highest in the Euro zone, so far. More than 45%. The dynamics of the decline of yields in the secondary market after the restructuring and particularly after Draghi’s OMT is the highest in the peripheral countries. Why the Greek PSI was “diabolized?”
Markets tend to focus on headlines, not on facts.
You refer that Tortus is short Portugal. What you mean when you say short “certain” bonds?
We have borrowed and shorted specific Portuguese sovereign bonds – namely OT (Obrigações do Tesouro — Treasury Bonds). These bonds are governed by local law and offer in our opinion virtually no creditor protection. OT bondholders fully rely on the generosity of the Portuguese state to get paid interest and principal; and their legal recourses are minimal or none if Portugal decides not to pay. However, all bonds are not created equal. For example, bonds governed by foreign law, such as English law bonds offer significantly better covenants and legal protection. Also bond indentures governing Portuguese bonds issued before Portugal’s accession to the Euro offer greater legal protection because investors required it.
You maintain the short position even after last week (January 9) syndicated tap of a bond line due in 2019, considered a success by market analysts?
The syndicated bond issue had no impact on our view or positioning in the Portuguese sovereign. The state only gained two months of liquidity with this bond issue. Moreover, countries that are on the verge of a sovereign restructuring tend to maximize their debt issuances and cash levels before they restructure. We have actually increased our net short position in the Portuguese sovereign since the bond issue was announced.
Moody’s was supposed to do a rating action about Portugal last Friday (January 10), just after the syndicated tap. Moody’s postponed any action until May 9, just one week before the end of the bail out. What do you think about that non-action last week?
Our belief is that rating agencies are concerned about Portuguese debt sustainability and even more concerned that Portugal would decide to follow Ireland’s path and fully rely on financing itself in markets, without any additional official support program.
The Portuguese yields in the 10y benchmark are at around 5% and the CDS price below 300 basis points. Are they artificially low as you mentioned? Is it only the «Draghi effect»? Domestic “fundamentals” perception do not count?
Mr. Draghi’s “whatever it takes” speech helped the European peripheral sovereign bond market tremendously. Moreover, there is a significant search for yield due to extraordinarily low interest rates around the world, which makes investors care about returns much more than risks. In our opinion, these have accounted for most of the improvement in sovereign bond yields, even though Portugal has indeed made some progress, especially regarding its current account balance.
Are we living in a quasi-bubble regarding the present new year rally on the peripheral sovereigns? It will be short as you mentioned that the capital market window is temporarily opened? It depends on what contingencies?
We do not believe that peripheral European sovereigns can be painted with the same brush. Portugal is in a uniquely precarious position. A number of factors outside of Portugal’s control can lock it out of primary market access including monetary policy tightening (taper from the Federal Reserve), slower EU or worldwide growth, higher oil prices, political instability, or, donor fatigue such as a negative ruling on OMTs from the German Constitutional Court. Domestically, issues range from missing deficit or growth targets, bank recapitalization needs (AQR—Asset Quality Review), contingent liabilities being added to the public debt, new off-market swaps being uncovered, increased austerity fatigue (strikes), political instability, further rejections of fiscal consolidation by the Portuguese Constitutional Court, rating downgrades, and negative debt sustainability assessment in a Troika review to name just a few…
In the public discussions there are three variables that are always forgotten: the negative output gap (from 3.7% in 2012 to 4,4% in 2013), the negative Net International Investment Position (from 115.4% of GDP in the 4th quarter of 2012 to 118.1% at the 3rd quarter of 2013, the most recent data so far) and the effective interest rate that is projected to grow from 3.5% in 2013 to 3.8 in 2018. Is it important to “call” these aspects to the analysis?
The output gap hints that employment and inflation will remain low in the foreseeable future. The negative international investment position is particularly interesting. It is the worst in the Eurozone. Political leaders love to point to the fact that Portugal’s current account is now positive, which is a significant achievement, but at this rate, it would take 128 years to bring the net international investment position into balance. As for the effective interest rate, it is indeed going to grow every year. The issue here is that unless the nominal growth rate of the economy can grow above 3.5% this year, and 3.8% next year etc., Debt-to-GDP will continuously go up, assuming a primary budget balance. In our view, Portugal’s debt/GDP is headed to infinity.
PORTUGAL SELECTED ECONOMIC FUNDAMENTALS
(Projections from IMF 8th/9th Review October 2013; Last data from Bank of Portugal, IGCP, Pordata, DataMarket, Bloomberg, Investing.com and Eurostat)
# Real GDP growth 2013 (negative): -1.8%
# Recession from 2011-2013 (year-on-year percent change cumulated): contraction of 6.3%
# Nominal GDP 2013: €165.3 billion
# GDP (PPP) per capita (2012): USD 23,047 (45th in the IMF World Ranking); €15,302.8
# GDP per capita contraction (2007-2012): – 4,6%
# GDP per capita worst year during the crisis: 2012
# Output gap 2013 (negative): -4.4% of potential
# Unemployment November 2013: 15.5% (Euroarea average: 12.1%) — 5th in the black club
# Current account 2013: superavit of 1% of GDP
# Annual Inflation december 2013: 0.2% (Euroarea average: 0.8%)
# Primary balance 2013: deficit of -1.6% of GDP
# Public Debt at face value end of 2013: €211.4 billion; 127.8% of GDP (historical peak; last peak at 124% in fiscal year of 1892/1893)
# Government debt — outstanding, end of December 2013: 204.25 billion
# Fixed rate Treasury Bonds — outstanding, end of December 2013: 92.7 billion
# Debt average residual term, end of December 2013: 7.5 years
# External Debt 2013: €227.4 billion
# Treasury Bonds due 2014: €10.7 bilion
# Effective Interest Rate 2013: 3.5%
# Net International Investment Position 3rd quarter of 2013 (negative): -118.1% of GDP
# Net External Debt: -104.1% of GDP
# Government 10y bond rate (close January 17): 5.06%
# 52Y return of sovereign bonds (January 17): 12.84% (second after Greece, with 43.89%)
# CDS 5y (close January 17): 268.64 basis points
# Bail out from troika (EU/ECB/IMF): MoU signed May 17, 2011; package of €78 billion from 2011 until June 2014
# Last debt restructuring: Concluded in 1902 after the June 1892 default; global reduction of 38% in the debt value; debt change for new bonds due in 2001, with an interest of 3%; hair cuts from 44% to 50%; reduction of 50% on the annual debt service (Source: “1560 to 1902: The Ark of Portuguese Defaults”)
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