Cross-posted from Credit Writedowns
Edward here. Yves is away so I have a few guest posts up the next few days. Here’s one on Greece.
I will be on CNBC at 1:30ET to talk about Greece. The situation has evolved since I last talked about the sovereign debt crisis on CNBC in May. Greece is now getting a second bailout and the Greek government is attempting to get the austerity measures upon which the bailout is conditioned passed through its legislature. I think largely the same issues still apply though.
Here are the bullet points from the piece I wrote after the last CNBC appearance.
- Greece needs a strategic plan. At a minimum, a soft restructuring – that is to say, a voluntary reduction of interest rates and an extension of maturities – will happen sooner than later under the EFSF facility. While this is necessary, it will certainly not be enough. Eventually, principal reduction will occur.
- Bank capital must be protected from immediate losses. Principal reduction has to be done with timing and in a way that considers the stress to Greek and foreign bank balance sheets. The problem with an involuntary default is that it would trigger immediate losses and panic. Europe’s banks are still undercapitalised; so such a default must be avoided at all costs.
- It is unclear whether the move to principal reduction will be messy. An involuntary default would clearly be messy. I don’t see this scenario as likely, and it certainly won’t happen in 2011. Instead, I anticipate a soft restructuring followed by a certain amount of political dithering, which will create contagion that forces a hard restructuring (aka ‘soft default’) down the line. This will be “somewhat messy”.
- Neither Marc [Chandler] nor I mentioned a euro zone break-up. My view is still that some combination of monetisation and a voluntary default, hard restructuring package is the most likely scenario for Europe. When I handicapped scenarios after the Irish stress tests in late March, I felt this way. I still do now. This means that when you look at the three options for the euro zone, monetisation, default, or break-up, I see break-up as by far the least likely. Again, a hard restructuring/soft default is much more likely.
- Credit default swaps triggers can be avoided. My view is that a restructuring that involves maturity extension, interest rate and principal reduction via an exchange of bonds or a roll off of maturing issues does not necessarily have to involve a technical default that triggers credit default swap payments. If a strategic plan is properly conceived via bond exchanges, investors will lose money but actual default can be avoided. Obviously, a reduction of principal is still a loss of money for investors. But, it is key that this loss take place with as little unwanted negative consequences for other euro zone debtors and the banking system.
The last two bullets are where I have more doubts now than in May. But mostly this is about politics. If the Europeans wanted to, they could end the liquidity crisis immediately by buying back Greek debt and promising to issue eurobonds going forward. Yields would plummet since the ECB has an unlimited supply of liquidity to deal with short-term liquidity issues and Eurobonds would halt any medium–term liquidity issues.
Eurobonds are a political non-starter though. Here’s how I framed the likelihood of an escalating crisis in May 2010 when Greece got the first bailout:
As you know, the ECB has hit the panic button and used the so-called ‘nuclear option’ of buying up sovereign debt on the secondary market. However, after reading a post from John Hussman yesterday, it occurred to me that the nuclear option may not be enough if, as seems to be the case, foreigners start refusing to buy Greek and Portuguese bonds at auction.
Yes, EU banks might consider buying at auction and then dumping the bonds onto the ECB – at what kind of collateral discount, I don’t know. But this seems a risky strategy to get a yield pickup. As problems with the austerity commitments develop, we might witness an unwillingness by funders of Greek debt to purchase rollovers as default becomes a certainty. And we know that PIMCO has gone on a Greek strike and that the Chinese have become alarmed at Euro debt as well. In my view, unless the Europeans look to the structural issues of the Eurozone immediately, this crisis is going to escalate…
So here is what I see happening; despite the denial by Olli Rehn about Eurobonds, this possibility as a measure to deal with future crises is now being discussed in policy making circles in the EU…
The Germans would not accept Euro Bonds or direct purchases of EU member sovereign debt by the ECB. These are complete non-starters politically. And any attempts to move in that direction would mean the end of the Eurozone.
Now that the second bailout is upon us, the politics have deteriorated even more. Eurobonds and ECB liquidity are dreaded by the core and the ECB. And austerity is dreaded by the Greek populace. To my mind, this speaks to restructuring or default as inevitable. When and how this occurs will determine future political paths and therefore largely determine the outcome.
As an investor, this is a situation you want to avoid. When politics determine the outlook for an investment, look elsewhere. Greece, Ireland and Portugal will all be deeply affected. Likely Spain, Italy and Belgium will be dragged into the undertow. If the Europeans can kick the can down the road a bit, punters might want to have a go at debt in Italy, Spain or Belgium to ride the momentum from a deal. But, crisis will come again until we get a resolution via hard restructurings and defaults.
Contingency planning is going on in private right now to plan for that eventuality. The solution proposed by Evans and Allen looks ever more necessary to keep the euro ship from sinking.