Monday, December 12, 2011

The PIIGS crisis is fading in importance

Even as the likelihood of major Eurozone sovereign defaults continues to rise, there are signs that the the denouement of the Eurozone sovereign debt crisis may not be nearly as bad as everyone has been led to believe. This is a theme I've been developing since last July ("Carmageddon, free markets and the PIIGS crisis"), and have updated several times since (Panic exhaustion?, Eurozone panic update, Panic exhaustion revisited). The idea is simple: when markets are given ample time and warning, they are very good at making the necessary adjustments to accommodate the arrival of bad news. As I discuss below, markets have already written off $1 trillion of PIIGS debt, and the sky has not fallen, nor have markets or global economic activity collapsed. In fact, economic life goes on, the U.S. and many other economies continue to grow, and many equity markets have moved substantially higher in recent months. We've had so much "panic" for so long that it's simply fading away.


The PIIGS debt crisis first surfaced in April of last year, which means that markets have now had about 20 months to adjust. That is completely different from the situation surrounding the Lehman bankruptcy and the subsequent financial meltdown of late 2008, because back then there was almost no advance warning of what was coming; the news sparked a classic rush for the exits, in which panic selling drove prices to absurdly low levels, thus making the panic and confusion even worse. The subprime mortgage collapse was also completely different from the PIIGS crisis, because back then the market found it almost impossible to value the thousands of often obscure and arcane mortgage-backed securities that were tied to many millions of homes whose prices were tumbling at different rates all over the country. With the PIIGS crisis, we are dealing with only a handful of borrowers who have issued fairly straightforward debt securities.


This chart shows the price of the current Greek 2-yr bond, which has fallen from almost 100 at the beginning of last year to a mere 26.625 today. The $470 billion of outstanding Greek debt is now trading at about 20-25 cents on the dollar, which means that the market has effectively written off about $350 billion of Greek debt. In other words, if Greece tomorrow were to restructure its debt and impose a 75% haircut on its creditors, nothing much would happen because markets have already priced in that eventuality.


After Greece, where a major default is almost a certainty, the next-most-likely-to-default country is Portugal, with about $220 billion of outstanding debt. The chart above shows the price of the current Portuguese 2-yr bond, which has fallen from 110 early last year to 85.2 today. Portuguese government bonds are now trading at 50-60 cents on the dollar on average, which means that the market has already written off some $100 billion.


Continuing with Ireland, 2-yr Irish bonds have fallen from 106 to 96, and the $150 outstanding of Irish debt is trading at about 80-85 cents on the dollar, for a write-down of  roughly $25 billion. 


Continuing with Italy, 2-yr Italian bonds have fallen from 100 to 94, while the value of the $2.1 trillion of outstanding Italian debt is trading at 85-90 cents on the dollar, for a write-down of roughly $260 billion.

Finally, the $870 billion outstanding value of Spanish debt is trading at about 95 cents on the dollar, for a write down of roughly $40 billion.

Now let's look at what has happened while global bond markets have been busy shaving $1 trillion off the value of sovereign PIIGS debt.


The S&P 500 index is up 10% from the end of 2009, and about as much since the peak of the sovereign debt crisis and double-dip recession fears of early October. 


The Vix index (a good proxy for the market's degree of fear) is still at levels which indicate serious concern, but we see in this chart that the market has weathered two storms of volatility (in the 2nd quarter of last year, and in the past several months) and panic "exhaustion" appears to be setting in, with the Vix trading at 27 today after hitting a peak of 48 last August. Even though a major Greek default has never been more likely nor as large as it is today.


The VIX/10-yr ratio is a good proxy for the market's level of fear and despair. While still extremely elevated from an historical perspective, it has declined from near-Lehman levels to 13.5 today. This chart also reminds us that periods of fear, panic, and despair occur every so often, but eventually they fade away and economic life goes on.


This chart shows how strongly the equity market has been influenced by fear in recent years. But as markets adjust to expectations of PIIGS defaults, fear subsides, and equity prices rise. 


This chart compares the level of 2-yr swap spreads—a good proxy for systemic risk and financial market health—in the U.S. and the Eurozone. The message here is that although the Eurozone banking system is still in the grips of a very serious crisis of confidence (the likelihood of bank failures and thus counterparty risk is very high), the U.S. banking system has gradually decoupled from the problems in Europe over the past few years. Systemic risk in the U.S. is a little elevated, but not seriously by any means. This suggests that even though the Eurozone may yet experience some wrenching bank defaults, and the fallout may well be very economically disruptive to the Eurozone economies, it shouldn't prove too unsettling for the U.S.

As I mentioned in a post last month ("Putting PIIGS debt into context"), the value of liquid, global debt and equity markets is about $110 trillion, and this total can vary up and down by trillions of dollars every day. So the loss of $1 trillion in PIIGS debt is not a big deal from a macro perspective, and I think the charts I've shown here reinforce the point that the reality of a major PIIGS default—should it occur—is likely to be much less catastrophic than the headlines would have you believe. Meanwhile, there is still no reason to give up hope that the PIIGS countries (save, perhaps, Greece) will eventually realize that the best solution to their problems (e.g., fostering more private sector growth by shrinking the size of their governments and lowering and flattening their tax structures) is also the easiest. Major defaults, restructurings, and/or devaluations all have devastating and lasting consequences, but reversing the trend to ever-more-burdensome government is a great solution for the majority of the population.

17 comments:

Benjamin said...

Wow, what an excellent round-up of Euro events. Whether you agree with Scott Grannis or not, you have to admire this presentation.

My take-away is no sovereign nation should ever lose control of its currency printing press.

An 80 percent haircut on Greek debt? If the Greeks could print money, and inflate, I am sure Greek bondholders would lose something to inflation. But 80 percent?

Greek bondholders would also have the option of spending their drachmas in Greece, where the losses of currency exchange would be eliminated.

I suspect the Eurozone is a zombie. The southern rim needs out, and needs to be kicked out.

The north can freeze their economies through tight money policies, and the south can inflate away. But together you have an even worse disaster. You have sovereign defaults.

Sovereign defaults--then why should any IOU mean anything?

Monetary austerity does not work for the Eurozone--they are getting sovereign defaults. A catastrophe.

Marcus Nunes, an excellent Brazilian monetary blogger, is calling for "austere expansionism"--that is, monetary expansionism and fiscal tightness. Worth considering.

PerformanceSpeaksForItself said...

I'm not sure why you think there was no advance warning before Lehman. Housing prices dropped quickly starting in 2006, the credit bubble burst in August '07 and Bear went down in March '08. It was pretty obvious to alot of people what was happening.
Also, do you mean to say that the "market" has written off $1 trillion, or that banks have taken mark-to-market losses of $1 trillion through write-downs? I interpreted what you said as the former, and if so, just because the market has accounted for it, doesn't mean an institution pretending to hold to maturity has.
Finally, as far as knowing the securities held by shadow/banks, how can you be sure who's solvent anymore when its as easy to hide leverage now as it was when Lehman collapsed?
I wish I could be as optimistic as you, lol. I guess I'm just a worrier. That's why my friends call me whiskers.

Scott Grannis said...

Performance: Faced with the uncertainties you cite (e.g., have the actual market losses been marked to market by all those holding PIIGS debt, and if not, is the market ignoring this?), I think the best approach is to trust the market. The market embodies the collective wisdom of hundreds of millions of individuals all trying to answer the same question.

Topher said...

What are the significant roll dates for PIIGS debt? Thank you for the great posts!

Hans said...

The Gyro Zone banks have no liquidity to cover these loses..

There are no reserve requirement for "sovereign debt" in Europe; so what happens when the banks begin to close their doors?

Benjamin said...

Hans:

The Euros have to print more money, and give it to the banks.

A long time ago Greece should have been doing QE, and retiring debt by printing money.

Yes, yes they would be better off never running up debts, but that is like saying you would be better off not pregnant.

The question is what you do now.

They are going default on sovereign debt.

brodero said...

Did you know half of the Italian debt is held by domestic investors??? I suspect as this number will be higher going into
the future with the ECB being a
major holder also....

Frozen in the North said...

Scott one of the problem you glance over is the leverage of the European financial system, while Lehman did with a stated leverage of 30x right now French and German banks are looking at 50x and 60x respectively. So much borrowed funds -- moreover, your assumption that European investors have taken the hit by marking to market is incorrect, aside from Unicredit no European bank has taken any hit on its holding of PIIGS debt instrument -- never mind 20%, and Greece and Portugal should be around 75%.

The problem in Europe is overleveraged financial institution, the risk to American banks is the derivatives market -- what happens if their counterparts are European and the fail (or at the very least nationalized)...

Jon S. said...

Frozen in the North captures it very nicely. Scott's post is well argued as far as it goes, but I think it misses the huge problem of hypothecation/re-hypothecation. As a solvency problem, the Eurozone only has bad choices ahead, leading to collapse of the euro, big bank failures, and economies throughout the zone on the hook to try and bail them out. Economic growth and sovereign bond ratings are heading south in Europe.

Hans said...

Ben Jamin, you are correct, the Gyro will default...

They have exceed the debt limit, in the EU Constitution, which of course is not being enforced..

The other problem is, that the Bank of Europe, does not have either the power or authority to print Euros at will...

Hans said...

Mr Grannis, a very fine essay, indeed...It is good to keep things in prospective and not become an alarmist...

I also agree with your correct assessment, that the markets will work this mess out - in due time..

My only concern, is that you mixed the equity market with the bond market, which distorts the numbers you cite with authority...

I suspect, the global bond market is a faction of the total of the $110 trillion dollar figure...

Hans said...

This thread has certainly been instructional!

I had no idea, that the world bond market was this large...

It has doubled in size, over the past decade. WOW!

http://www.ftkmc.com/newsletter/Vol2-19-july25-2011.pdf

Dr William J McKibbin said...

The PIIGS crisis in Europe will result in economic depression across the southern flank of Europe, and recession in northern Europe -- such developments will also result in the US entering recession at best, and depression should Federalism handle California the same way the EU is handling the PIIGS crisis -- in summary, the PIIGS problem is synonymous in so many ways with what is about to happen in California, at least politically -- once California's public sector begins to strike and riot, the US will be confronted with many of the same problems that the Eurozone and ECB are confronted with in southern Europe today -- ownership of high quality equities will be the only path to wealth preservation as sovereign bonds and dollars collapse in value right before our eyes...

Scott Grannis said...

Re: size of the global market. I detailed these numbers in a previous post. The global bond market is approximately $63 trillion in size.

http://scottgrannis.blogspot.com/2011/11/putting-piigs-debt-into-context.html

Scott Grannis said...

Re: leverage and re-hypothecation. This is the latest thing people have found to worry about, and it's still mysterious and difficult for anyone to quantify. I am taking the position that anyone that had too much leverage has probably been wiped out by now (e.g., MF Global). I also believe that markets are most likely making an allowance for losses that have not yet been marked to market by some banks.

Hans said...

OPEC's leading indicates are all heading south!

http://dailycapitalist.com/2011/12/12/latest-oecd-leading-indicators-negative/#more-16618

ali kara said...
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