From Peter Tchir of TF Mar­ket Advisors

The ECB's Scary Carry Trade

Accord­ing to the WSJ, the “ECB is will­ing to forego prof­its on their Greek bonds”.

That state­ment strikes me as one of the scari­est things that a cen­tral banker could say (and there is some tough com­pe­ti­tion for that one).

Forego prof­its?   Here is the chart of a typ­i­cal Greek bond over the past 2 years.  The ECB started buy­ing Greek bonds in May 2010, and stopped some­time in 2011.

How do they pos­si­bly have “prof­its” to give up?

They have “prof­its” because they live in an accrual account­ing world.  They buy bonds, don’t mark them, and accrue the inter­est.  The accrued inter­est counts as “profit”.  That is the carry trade.  That is what every­one is so excited about for the banks.  Banks can buy bonds, not mark them, and book the inter­est accrual (and pay­ments) as profit.

The prob­lem with accrual account­ing is when a sale is forced.  What­ever the rea­son for the sale (in this case, a restructuring/default by Greece), the accrual account­ing game is over and you have real profit or loss.  The “profit” is the total pro­ceeds received for the sale, ver­sus total pur­chase price, plus any coupon pay­ments received, minus costs of car­ry­ing the position.

Some entity is tak­ing the real world loss.  These bonds were bought at prices far above their cur­rent value.  Since most Greek bonds only pay inter­est annu­ally, there may be a lot of accrued, but unpaid inter­est that will also be lost.

It strikes me as very scary that the cen­tral bankers seem more com­fort­able in an accrual account­ing world.  It is also scary that all future poli­cies seem to be based on an attempt to show that all prior poli­cies worked whether or not they did in real­ity.  It also explains why they are so com­fort­able with plans out to 2020 when Greece just missed their pro­jec­tions for Jan­u­ary by €1 billion.

Can’t wait to see the details of this plan, but can’t imag­ine that we won’t be dis­cussing a sec­ond round of restruc­tur­ing or default before long.

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