The Bennett Newsletter
In myth, Sisyphus, an uppity Greek King is condemned by the gods to roll a huge boulder to the top of a hill. Sisyphus often gets near the top but the boulder crashes to the bottom of the hill. The latest Greek Government has a Sisyphean task in reducing its debt.
We should fear this crisis. Greece’s debt is about the size of the Lehman Brothers in 2008. There was complacency when Lehman’s were collapsing, but it almost took down the whole financial system. This column will contradict the usual understanding of the crisis: that European banks will suffer. My point is that European banks are insured and it is the American banking and insurance industry that is more dangerously exposed to a PIG default.
The risk is high because it seems unlikely that Greece can meet its present obligations. This raises the possibility of some kind of default, and a default will reverberate not only among bond-holders, but will spread to banks world-wide through credit default swaps (CDS) and higher interest rates. Any funding crisis might have ramifications for NZ banks which continually have to roll over funding.
Greek plight
Greece has already made huge cuts to its budget deficit to appease its bond-holders. Taxes have increased, pensions, wages and benefits have been cut. Unemployment has soared to 16% and likely to increase as demand has crashed and membership of the Eurozone precludes devaluation to stimulate exports and tourism.
The population deeply resents its position of bond-slave subordination to the European commission and the IMF: 80% oppose more concessions on austerity and privatisations which the Eurozone demands for more credit. The government accepts austerity to fund its €340 bn. debt, It now seeks mercy as the electorate revolts against additional conditions.
Bonds and CDS
Greece cannot afford to borrow on the open market because the market has priced in a possible default. Its 2-year bond yielded 30% on June 16. The market would demand similar rates of interest on new debt. Alan Greenspan regards a default as “almost certain”.
A default would have unfathomable consequences. Obviously the initial impact will be on other sovereign bonds, Greek commercial markets and the CDS market. The 2008 post-Lehman crash was caused by a malfunction in the CDS market: what Greece threatens is a crash in the CDS market and in sovereign bond markets.
CDS are a contract to insure against bond default. The premium depends on credit risk. A contract on Greek debt on June 17 was 2,189 basis points ( b.p.) or 21.9%. CDS measure the market’s view of likely default. Similarly it is becoming very expensive to insure against a Portuguese or Irish default.
Should Greece default, bondholders would expect their contract to be honoured. Matters can then get very interesting. Typically banks offer CDS and any investor can buy and then trade them. No one knows exactly who owns the CDS and no one is certain who offered them.
In 2008 this uncertainty spilled over into other markets, notably funding. Normally bank A will approach bank B for short-term funds and a deal is quickly made. But bank funding dried up in 2008 because bank B suspected that bank A had too many toxic assets including (say) CDS on Lehman bonds. The Bank A’s in 2008 were saved by rapid action by central banks in making funds available.
The Greek crisis is already taking its toll. The Telegraph reports that British banks have radically reduced the amount of lending they are prepared to make to European banks. This is because the British fear that European banks would take a hit on defaulted sovereign bonds and CDS. Standard Chartered, has withdrawn “tens of billions of pounds” form the inter-bank lending market.
The funding risk is now increasing focussed on the ECB. Many European banks are already unable to secure market funding. Spanish banks are a useful example: they borrowed €44 bn in April from the ECB and increased this to €51bn in May.
Other banks are being put on credit watch because they hold Greek bonds. Moody’s have put French banks on watch because of their Greek portfolio and threatened to cut Italy’s credit ratings because of possible rises in interest rates: The ECB’s present rate is 1.25% but it has signalled a rise in July. Moody’s has doubts about how Italy can handle the rise given its poor economic growth. The ECB has also questioned banks quality of capital following the severe fall in real estate prices, especially in places like Spain and Portugal.
Readers will now get a glimpse of a potential storm: rising interest rates, decline of credit for funds, possible sovereign default and a crash in CDS. Such a storm would be worse than 2008. Now to some detail that is not found in other newspapers.
BIS data
I have looked at Bank of international Settlements (BIS) statistics on exposures to PIG debt. Portugal, Ireland and Greece bond holdings owned by foreigners were valued at about US$1,180bn at the end of 2010. Most of these are held by European banks. Bonds are “direct holdings”, but what about the CDS and other “indirect’ derivatives based on those bonds?
BIS calculates that bonds are 70% of assets in question and the indirect assets are 30%. The interesting point is that US banks and insurance companies hold 56% of the CDS. If the CDS system works in a default, the European banks would get considerable compensation for their bond holdings. So a default crisis would leave European banks with an insurance payout. Most media have stressed that European banks are in the gun; they have not found who will really be holding the bag. BIS shows the US has 82% of exposure to Greek default. A cynic might expect the US to work hard to prevent a default.
http://bis.org/publ/qtrpdf/r_qa1106.pdf
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