naked capitalism

The Financial Times indicator is looking more and more reliable: when the pink paper starts playing at the top of its form, the wheels are about to come off.

The most troubling aspect of the Standard & Poors downgrade of Greece to junk and Portugal’s downgrade came in its release. It isn’t just that Greece looks increasingly likely to default. As we have said, it seems like a certainty; the fiscal cuts required by its austerity program are arguably the deepest in modern times.

The real problem is that the losses on default are likely to be far steeper than is typical for sovereign borrowers. From S&P’s press release:

The outlook is negative. At the same time, we assigned a recovery rating of ‘4′ to Greece’s debt issues, indicating our expectation of “average” (30%-50%) recovery for debtholders in the event of a debt restructuring or payment default”

Yves here. Those who called Greece a subprime borrower were more correct than they knew. One of the factors that made subprime losses so devastating has been the high loss severities.

The real risk here is to Eurobanks. They ran with even higher leverage ratios than US banks, they are believed to have recognized less of the losses thus far on their books than their US peers. Even worse, readers report that the major dealers (and the Eurobanks were part of this cohort) are carrying toxic assets at prices that are vastly above likely long-term value. Eurobank exposure to Greece is over $190 billion, and total periphery country exposure is roughly $900 billion.

In the subprime crisis, many pundits and the Fed itself thought the losses would be contained, unaware that for every $1 in BBB subprime bonds, another $10 in CDS had been written, and that many of these exposures sat with highly levered firms, namely insurers and dealers, who were not able to take much in the way of losses. The gross level of exposures looks much worse here and the banks most at risk have not done much (save take government handouts) to rebuild their balance sheets.

So the whole idea that the financial crisis was over is being called into doubt. Recall that the Great Depression nadir was the sovereign debt default phase. And the EU’s erratic responses (obvious hesitancy followed by finesses rather than decisive responses) is going to prove even more detrimental as the Club Med crisis grinds on.

The VIX posted its biggest one-day increase since 2008 but its level of 22 is positively tepid compared to crisis norms. Portugal, whose total debt to GDP is higher than Greece’s, is under pressure as bond spreads continue to widen. Hungary’s premier-in-waiting stated that the country, which was bailed out last year, will not be able to meet IMF fiscal targets and should widen its deficit even more to stoke growth. Traders went into risk-aversion mode, with emerging market and junk bonds also suffering. And as we mentioned, quite a few people in London expect a significant devaluation of the pound after their elections.

A further source of trouble is political. If the euro continues on its expected slide and the pound is devalued, the dollar’s strength will put a major dent in the US ambitions to increase exports. Moreover, the rise in the greenback relative to other currencies will no doubt make China much more reluctant to revalue the renminbi against the dollar.

Japanese markets are down over 2% at this hour, with the rest of Asia faring better.

Update 1:30 AM, 4/27: I somehow missed the article by Ambrose Evans-Pritchard of the Telegraph, who argues that the ECB will have to use the nuclear option of market intervention to buy up government bonds.