Monday, September 12, 2011

Is Greece another Lehman?


For now, it's all about Greece. 2-yr Greek government yields are now just shy of 70%, and the bonds are trading at just under 40 cents on the dollar. In sharp contrast, 2-yr Irish government yields are only 9.5%, and the bonds are trading at 94.6 cents on the dollar—thanks to a credible austerity plan which involves real spending cuts. If Greece doesn't default or restructure its debt in a major way, Greek bonds would be one of the world's most fabulous investments. But with prices so low, the market is essentially saying a major Greek default is a done deal, and the only piece of the puzzle that is missing is exactly how big the default/restructuring will be.

Watching Greek yields rise this year has been like a watching a slow motion train wreck. A default seemed to me like a slam-dunk last April, so I'm surprised that it hasn't happened yet, and that the world is still trying to adjust to the reality of a looming default. How much worse can things get?

Well, with Treasury yields at historically low levels, with T-bills yielding zero, with gold trading at $1800, with Eurozone bank stocks cratering, with the Italian stock market down 42% since February, and down 70% since its 2007 high, the market is pricing in lots more bad news—something like an end-of-the-world-as-we-know-it scenario. A Greek default leads to a Portuguese default, which drags down Ireland and eventually Italy and perhaps Spain, and along the way the cumulative defaults wipe out the capital of the entire Eurozone banking system, which in turn sparks a global financial and economic collapse.

So the question is: will a Greek default precipitate another meltdown of the world's financial markets and send the global economy into another tailspin? Are we on the cusp of another Great Recession or even a Global Depression? Is Greece the catalyst, as was the Lehman default?

I think there are some huge differences between a Eurozone default today and the bursting of the U.S. housing market bubble, which was the proximate cause of the Lehman default and the financial panic of 2008.

The financial crisis of 2008 was triggered by a decline in U.S. housing prices and a consequent rise in mortgage defaults. Mortgage default rates rose from 1% in 2006 to over 4% in 2008, and peaked at 5.6% in 2009. Cumulative defaults ended up being well over $1 trillion, but at the depths of the crisis I recall that many securities were priced to default rates as high as 50%.  Millions of homeowners were defaulting; millions of mortgages were at risk; thousands of mortgage-backed securities were involved; many hundreds of banks and financial institutions around the world had significant exposure to the collapse of the U.S. housing market. The huge losses and the fears of much more to come triggered panic selling, which resulted in downgrades, which forced more panic selling.

The Eurozone sovereign debt crisis involves only a handful of borrowers: Portugal, Ireland, Italy, Greece, and Spain. Together they owe $3.9 trillion, with Italy accounting for 56% of the total. To judge by prices in the credit default swap market, the real risk of default is concentrated mainly in Greece (1850), Portugal (1220), and Ireland (910), which together owe $820 billion. Italian CDS are priced at 430 bps, which equates to the upper range of high-yield bonds, where default rates are measured in the single digits and recovery values are well over 50%. A couple of dozen of Eurozone banks hold the lion's share of the debt that is subject to default.

The 2008 crisis was acutely aggravated by the fact that it was literally impossible for anyone to fully understand the default risk of mortgage securities that were comprised of millions of mortgages issued under all manner of conditions (e.g., fixed rate, variable rate, interest only, 95% LTV, 100% LTV), based on homes in hundreds of different regions, and securitized into thousands of vehicles, that in turn were split up into dozens of derivatives, which were owned by many hundreds of banks and financial institutions around the world. The risks inherent in the mortgage market were far too complex to understand, much less quantify, and the uncertainty itself was a major factor driving down prices, forcing defaults, and shutting down commerce. By the time the dust had settled a few years later, securities that were priced to death and destruction ended up paying handsome returns. In short, the uncertainty meant that at one point the market was expecting an order of magnitude more losses than ended up occuring.

In contrast, the sovereign debt crisis is very easy to understand and quantify: a handful of borrowers, no securitization, no complex derivatives, and only a few dozen lenders at risk. None of the PIIGS face the risk of deflation, which would be akin to the price declines that undermined the U.S. mortgage market. A PIIGS default, if one occurs, is all about politics: can the country adopt the necessary fiscal discipline to convince markets that its debt will be repaid? Or perhaps as the news today suggests—that China may be willing to buy a big chunk of Italian bonds—other countries may be willing to shoulder a significant portion of the PIIGS debt burden. Just a few decisions here and there could make all the difference in the world.

Consequently, I would argue that the Eurozone sovereign debt crisis is amazingly transparent, whereas the 2008 mortgage market implosion was a blizzard of obscurity. That difference alone should make the outcome much less serious than what the world faced and feared in late 2008, and that's why I think the market is too pessimistic.

13 comments:

Frozen in the North said...

Ireland is the one "PIGGS" that has a chance of making it, the reason, its structural deficit is actually small, had the government not decided to bail out the banks -- the structural deficit for ireland would have been somwehat manageble. of course the consequence for Irish account holders may also have been traumatic.

However, yes the problems with the PIIGS is transparent, what is not so transparent is who are the ultimate holder of the debt. Whereas most of the banks seem to be in reasonable shape, the insurance industry seem to be in more trouble -- the CDS market hid the real risk holders: Real instruments of mass destruction

septizoniom said...

the same issues prevail: uncertainty. the issue is who holds the bad debt, and who holds the liabilities of those who hold the bad debt, and etc. classic cough up situation.

Benjamin said...

When debts are heavy and inflation is low, then it is time for a stimulative monetary policy.

Some say the Fed tightening in 2008 precipitated the housing bust--and that the ECB is making same mistake now.

Public Library said...

What is transparent is governments printed money/issued debt to purchase assets of entities/other govt's that are not solvent on a standalone basis.

The vol might be less this time around, but the need to fully realize the losses is unch.

Something akin to Japan comes to mind.

Benjamin said...

This is a fascinating story. China has already emerged as the dominant force in the Far East, and very active in Africa.

Now they will have real influence in Italy.

We will have the Seventh Fleet eating money, but buying very little influence.



Italy turns to China for help in debt crisis

By Guy Dinmore in Rome

Italy’s centre-right government is turning to cash-rich China in the hope that Beijing will help rescue it from financial crisis by making “significant” purchases of Italian bonds and investments in strategic companies.
According to Italian officials, Lou Jiwei, chairman of China Investment Corp, one of the world’s largest sovereign wealth funds, led a delegation to Rome last week for talks with Giulio Tremonti, finance minister, and Italy’s Cassa Depositi e Prestiti, a state-controlled entity that has established an Italian Strategic Fund open to foreign investors.

Public-

Japan is the role model to hell. Would you like your real estate and stock portfolios to sink by 80 percent in the next 20 years? That is what chronically tight money has done to Japan. The yen is very strong--but to what end?

Is preserving the value of currency in monetary formaldehyde the purpose of an economic policy?

Benjamin said...

I just hope the Greeks can sell bonds to China too.

狂猪 said...

Hi,

I have a question.

For the European banks, how important is solvency if there is no liquidity crisis?

The reason I ask is this. During the Lehman episode, liquidity dried up because of a lack of transparency as to which bank is holding the toxic assets (is therefore insolvent). The first order of business for the central banks is to provide liquidity for the banks. However, it took time for the central banks to ram up their liquidity operation and for the market to unfreeze. In the mean time, the lack of liquidity caused huge damage to the global economy. I vaguely remember a news story of container ships unable to set sail with their goods because the trip cannot be financed.

Today, the European bank stress test failed to address the health of European banks because it did not properly account for the possibility of solvent debt default.

However, and I think this is important, ECB's liquidity operation is fully operational. In fact, it even accepts Greek bonds as collateral!

I suspect, though not sure, the world will not have a repeat of a liquidity crisis.

Furthermore, given the liquidity support from ECB (e.g. no pan-europe bank run), why can't the European banks muddle through? Many Japanese banks, after Japan's bubble burst in the late 80s, were insolvent (value of real estate back asset has collapsed). However, liquidity was not an issue. The Japanese banks muddled through for a decade. Granted the Japan's lost decade was bad. However, there was no massive economic collapse.

The Japanese economy didn't collapse and I am not sure why today Europe's economy (and the world) has to collapse.

Any flaw in all this?

Jeffrey said...

Scott, is the difference that European banks are much more leveraged than the US banks were/are? Thanks for the post.

Antonio said...

Mr. market also prices that the eventual solution to the Eurozone debt woes has to come from a bunch of European politicians unable to tell the people our welfare state is unsustainable under current situation. A clear lack of leadership, inherent to the UE system, makes things worse, even if the problem is more transparent than the subprime crisis.

elegantstroke said...

Scott,

if what you say is really true, why are "forecasters" such as BofA analysts, JP Morgan economists and National Association of Business Economics are becoming more pessimistic?

May be they know who's holding the bad debt that would bring the global economy down?

http://blogs.wsj.com/economics/2011/09/12/economic-forecasters-become-more-pessimistic/

John said...

Barrons is reporting that Gerald Hassell, CEO of Bank of NY Mellon invested $1 million in the bank's common stock last week. Two other officers of BNY Mellon have made purchases recently: CFO Thomas Gibbons invested ~$500,000 and vice Chairman Curtis Arledge $1 million.

They are obviously in Scott's camp on the issue, and are taking advantage of the opportunity presented by short sellers and panicing market participants.

Scott Grannis said...

Re pessimistic forecasters: Surveys of market economists and forecasters are likely to produce sentiments that closely track the market in general. As i've noted, my read of market price signals suggests the market is extremely pessimistic.

狂猪 said...

Hi,

I have a question.

For the European banks, how important is solvency if there is no liquidity crisis?

The reason I ask is this. During the Lehman episode, liquidity dried up because of a lack of transparency as to which bank is holding the toxic assets (is therefore insolvent). The first order of business for the central banks is to provide liquidity for the banks. However, it took time for the central banks to ram up their liquidity operation and for the market to unfreeze. In the mean time, the lack of liquidity caused huge damage to the global economy. I vaguely remember a news story of container ships unable to set sail with their goods because the trip cannot be financed.

Today, the European bank stress test failed to address the health of European banks because it did not properly account for the possibility of solvent debt default.

However, and I think this is important, ECB's liquidity operation is fully operational. In fact, it even accepts Greek bonds as collateral!

I suspect, though not sure, the world will not have a repeat of a liquidity crisis.

Furthermore, given the liquidity support from ECB (e.g. no pan-europe bank run), why can the European banks muddle through? Many Japanese banks, after Japan's bubble burst in the late 80s, were insolvent. However, liquidity was not an issue. The Japanese banks muddled through for a decade. Granted the Japan's lost decade was bad. However, there was no massive economic collapse.

The Japanese economy didn't collapse and I am not sure why today Europe's economy (and the world) has to collapse.

Any flaw in all this?