Pear Shaped…….?

Watching the on-going saga in Europe with Greece on the edge of the cliff I can’t help but think of September/October 2008.  The similarities between the situations, while very different, are at the same time incredible!

If you throw your mind back to the week-end of 13^th/14^th September Lehman Brothers was on the edge – the stock had fallen from $16/share to $3.65 over the course of the week – rumours about them were abundant – it was the no 1 story on CNBC and so on. Much like Greece right now.

Similar to what has been going on in Europe over the last 12 months; Bear Stearns had failed, but had received a bail-out orchestrated by the Fed and the Treasury. Guarantees were issued to JP Morgan, which made the takeover possible, and no creditor incurred a loss. While Lehman’s stock price was tanking, the market (me included) still believed that some sort of solution would be found. The NY Fed even called banks on Friday afternoon to tell them that a solution would be found over the weekend. Risk assets had a moderate recovery into the close.

Now we have politicians and central bankers telling the market that no euro-zone member will ever default and that everything will be fine, while every astute market commentator will argue that Greece will default – it’s just a question of time as the debt levels are simply too high to be sustained, let alone repaid.

Bond holders are being asked to roll over their maturing Greek government bonds (GGBs), but not at market yields, so while their very short term bonds will be redeemed at par the holders are being asked to buy new issues with a coupon much lower than secondary market yields, which range form the high 20’ies to the mid-teens depending on the place on the yield curve. Credit agencies say this will constitute a default, which the politicians and the ECB are desperate to avoid. Holders of Greek CDS may, or may not be compensated, which in itself may become a huge problem for certain investors who thought they had purchased insurance against their bond holdings.

It is of course ironic that we live in a world where banks can book gains when the value of the banks own debt falls in value, but at the same time can carry e.g. Greek government bonds at cost (i.e. no mark to market) so some of the most profitable banks at the moment could be Greek and Portuguese banks as the value of their own liabilities are reflecting the assets they hold, but these assets are not being marked down in these banks financial statements!

So what will happen? The most likely is probably that Greece will be funded by the euro zone and the IMF until a time when a restructuring can happen with the vast majority of the debt in the hands of the ECB, EMSF, IMF etc and the need to recapitalize French and German banks will be much smaller and hopefully everything will be much better then and of course it will be someone else’s problem……this is a typical politician’s vision: Things will be better in the future. But what if they are not, or what if we don’t even get to the future? I think this is not as un-likely as the market has been believing!

Further Greek assistance is dependent on further austerity measures being introduced and these are certainly not popular, judging by the protests in the streets in Athens. Nor is further assistance popular with many of the voters in the countries, which are meant to foot the bill. Can this balance be achieved? Maybe, maybe not. There are a lot of variables that have to be observed:

• ·      Austerity measures have to be passed by the Greek parliament. The main opposition party have indicated that they will vote against these;
• ·      Politicians/voters in Germany, Holland and Finland have to be placated so the austerity measures cannot be watered down;
• ·      The next tranche of the IMF support package cannot be released if there isn’t a clear 12 month funding plan;
• ·      Private investors have to be strong-armed into rolling their maturing bonds over into new ones with sub-market coupons and yields. This will result in instantaneous losses of approximately 50% (depending a bit on maturity);
• ·      Default is to be avoided or GGBs will no longer be eligible as collateral with the ECB and the result would be that Greek banks would be illiquid and another bank run would ensue;
• ·      ISDA would need to accept this so a credit event is not declared;
• ·      Losses incurred by holders of GGBs would not be covered by CDS so they would presumably lose twice i.e. the GGB loss + the premium on the CDS, which in itself might prove worthless;

There are probably a few more things I haven’t thought about, but all this is not easy to accomplish.

Is the market ready for a default? Probably not!

What will happen? Greek banks will be instantly bankrupt and will need to be recapitalized/nationalized. Greece will of course have to leave the Euro and reintroduce the drachma.

Some French and German banks may need to be re-capitalized. The inter-bank market, which hasn’t recovered from the events of 2008/09, will freeze. The pressure on Portugal and Ireland, which is already intense as their 10 year government spreads are at EMU-time highs, will become much worse, closely followed by the ones which are too big to bail-out; Spain and Italy. This is of course why everyone who has political capital invested in this is afraid of ‘contagion’.

Then it may be all over – the euro zone experiment may have ended 12 ½ years after it begun.

So while the politicians and central bankers thought a solution would be found for Lehman over that fatal weekend in September 2008 it wasn’t. Greece may have a little more time than Lehman did, but if a solution hasn’t been hammered out by early July it may truly be all over!