Greece Continues to Pose a Major Risk

by: Acting Man

The notion that the EU was "keeping up pressure on Athens" was the judgment of the media when it turned out yesterday that the euro-group would delay disbursement of the next loan tranche to Greece "until the Greek government has voted on implementing new austerity measures."

The German news magazine Der Spiegel put it this way:

Observers had been expecting that the ministers would at least approve the next tranche of aid, worth €12 billion ($17 billion), from the current €110 billion package that was agreed on by the EU and International Monetary Fund in May 2010. Greece needs the money by mid-July at the latest to avoid a national default.

But the euro-zone partners want to wait until the last minute before giving the green light. In a statement, the euro group said that the Greek parliament would first have to approve the latest round of austerity measures and a €50 billion privatization program before the next tranche was disbursed.

The motive behind the finance ministers' tactic is obvious: They want to keep up the pressure on the Greek government – not to mention the recalcitrant opposition. On Tuesday, Prime Minister George Papandreou will face a confidence vote in parliament, which will also vote on the austerity package next week. The euro-zone ministers explicitly appealed to all political parties in Athens to support the austerity measures. "Given the length, magnitude and nature of required reforms in Greece, national unity is a prerequisite for success," the statement read.

(our emphasis)

This not only keeps up the pressure on Greek politicians as it were – it also keeps up pressure on the financial markets. However, as we have noted before, when stock markets are as oversold as they are at present and bearish sentiment has become extremely thick, the high probability expectation is normally that the markets will seize on even the tiniest scrap of good news as an excuse to bounce.

However, playing these bounces is dangerous: the euro-group has maneuvered itself into a corner now. What happens if the Papandreou government falls tonight? If the disbursement of the next loan tranche indeed hinges on approval of the new austerity measures by Greece's parliament, then a fall of the government would surely pave the way for a default.

There are also signs that short term bounces in "risk assets" are leading to a much too fast unwinding of bearish sentiment – people are evidently eager to "catch the low." To wit, see yesterday's large one day decline of the CBOE equity put-call ratio from its recent high.

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The CBOE equity put-call ratio plunges from a recent fear spike as the market manages a small bounce.

Nevertheless, it must be noted that the bearishness recently exhibited by the smallest option traders (10 contracts or less per trade) argues that the market could be ripe for a bigger bounce.

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The ROBO options data, via This suggests that there is a fair amount of fear now among the smallest option traders.

We want to reiterate though that the current "oversold" conditions can in rare instances resolve into an outright panic. This would very likely happen if Greece ends up defaulting.

We would also argue that the delay in disbursing the next loan tranche to Greece is not only about "keeping up the pressure" on Greek politicians. There is also the still simmering issue of how to get private sector creditors to chip in without a default being declared by the credit rating agencies. As we have been saying for some time now, this amounts to an attempt to square the circle. The rating agencies have once again confirmed this view yesterday. Both Fitch and S&P yesterday reiterated their stance on this issue.

According to Reuters:

Standard & Poor's reaffirmed a voluntary debt restructuring for Greece as currently foreseen by euro zone governments would likely be deemed a default, its head of European sovereign ratings told a German newspaper.

"Past experiences show that restructuring the debt of a country, whose creditworthiness is rated at CCC like Greece is currently, tend not to be voluntary and investors must sustain losses," Moritz Kraemer told Die Welt in an article due to be published on Tuesday. Euro-zone officials have told Reuters a second bailout plan for Greece is expected to fund Athens into late 2014 and feature up to 30 billion euros in aid from a voluntary private sector participation on the basis of the so-called "Vienna Initiative." S&P's Kraemer said whether extending a bond's maturity voluntarily or not is of lesser importance.

"What's decisive is how does it compare to what was promised to creditors when they first invested their money," he said.

(our emphasis)

Concurrently CTV news reported on the stance espoused by Fitch:

Fitch Ratings warned it would treat a voluntary rollover of Greece’s sovereign bonds in any rescue package as a default and would cut the credit rating, keeping pressure on European policy makers who intend to outline a new plan by mid-July. Fractious euro zone finance ministers are trying to patch together a second aid package for Greece, with more official loans and, for the first time, a contribution by private investors of Greek government bonds.

"The essence of the problem … is that Greece needs new money," Andrew Colquhoun, head of Asia-Pacific sovereign ratings with Fitch, said at a conference in Singapore.

"Fitch would regard such a debt exchange or voluntary debt rollover as a default event and would lead to the assignment of a default rating to Greece," he said.

(our emphasis)

It couldn't be any clearer. There is no longer any possibility to avoid a default rating for Greek government debt if private creditors take a haircut or agree to a debt rollover that involves a lengthening of maturities. It doesn't matter whether it is called "voluntary." The circle can not be squared, period.

Alas, this means the ECB has painted itself into a corner as well, since it continues to vehemently insist that once Greek government bonds are rated as being in default, it will no longer accept them as collateral. ECB funding for the Greek banks would then have to end and that would mean instant insolvency for Greece's biggest banks.

We would suggest that the ministers of the euro group were grappling with this problem as well and have thus far failed to resolve it. No wonder – it appears intractable.

In summary: whether Greece defaults or not now hinges on two things:

1. The Papandreou government must survive the vote of confidence tonight, and

2. If the euro-group really wishes to kick the can down the road one more time while avoiding an official default of Greece, Germany and others must abandon their plan to involve private creditors in the Greek rescue. The "no bondholder left behind" farce must in other words continue, or else.

We would suggest that market participants should keep their celebratory impulses in check for now. If everything "works out," then there could be a large, playable relief rally. If only one small thing goes wrong, the stock market could very well suffer a waterfall decline.

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The Athens General Index resumed its decline yesterday after a one day bounce on Friday.

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The most recent update on Greece's looming debt rollovers, via Der Spiegel.

As he prepares to face the upcoming vote of confidence, prime minister Papandreou received some verbal support yesterday from European Council president Herman van Rompuy. This may well cost him a few votes tonight, on the general principle that nobody likes van Rompuy.

After meeting with Papandreou, European Council President Herman van Rompuy expressed his "strong support" for the Greek prime minister's economic reforms and said he had underlined the need for further efforts. But Van Rompuy noted that "national consensus" was needed for the package to succeed, "given the length, magnitude and nature of required reforms.

Even if Papandreou's government gets the required majority and survives, the problem of how to deal with the private sector haircut/debt rollover will remain hanging over the proceedings.

Exposure to Greece in Unlikely Places

It is interesting in this context that the latest FOMC policy statement will be released tomorrow – right after the world will be appraised of the Greek government's fate. Ben Bernanke and his minions are on record that they will not engage in "QE3" for now, as they officially all expect a "second half recovery" in the U.S. economy – for reasons that are not quite clear. Perhaps the tooth fairy will descend from fairyland and deliver her blessings. If not, then the U.S. economy looks to be on the verge of sliding into another outright "official" recession (in the bigger picture, the economic situation remains one of secular contraction anyway).

Paul Krugman now opines that all those not predicting a "lost decade" for the U.S. economy are burdened with the 'onus of proof' to show why it shouldn't be so. He curiously neglects to mention how it comes that he can now confidently predict such an economic calamity after the government and the central bank have implemented precisely the policies – namely massive deficit spending and even more massive money printing – that he, Krugman, sotto voce recommended as the only surefire way to avoid precisely the economic malaise he is now forecasting. Could it be that interventionism is failing? If so, why is it failing? Krugman remain so far silent on the subject. However, if we were to guess, he will likely eventually argue that 'they didn't spend and print enough', as hollow as such an argument will sound. After all, this remains the standard excuse for "explaining" the failure of Keynesian policy prescriptions.

As it were, the Fed may well find itself faced with yet another run on U.S. money market funds in the not-too-distant future, which makes the timing of the FOMC meeting so piquant. The fate of U.S. money market funds seems intimately intertwined with that of the euro area's biggest banks.

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Via Credit Suisse: borrowing by European banks from U.S. money market funds.

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The share of French banks in U.S. money market fund borrowings.

As can be seen from the charts above, U.S. money market funds are the among the largest providers of dollar funding to euro area banks at the moment. Ironically, the biggest borrowers are the French banks – which happen to have the by far biggest exposure to Greek government debt among all European banks. You couldn't make this up.

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The widening FRA-OIS swap and the (inverted on this chart) Euribor basis show that stresses in European interbank funding are increasing.

As we have noted previously, there are a great many ways in which the Greek debt crisis can redound on the global financial system. Obviously there is little reason for complacency – U.S. markets will be just as roiled as European ones if push were to come to shove.

Meanwhile, the markets appear to have taken notice of the growing risk to Eastern Europe as well – CDS spreads on the debt various Eastern European countries have lately begun to jump higher as well, as contagion from Greece is beginning to spread.

The Charts

1. CDS (prices in basis points, color coded)

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5 year CDS spreads on Portugal, Italy, Greece and Spain – at 2341 basis points, Greek CDS have just hit a new high (it now costs $2.341 million annually to insure $10 million of Greek government debt over five years), with Portugal, Spain and Italy down just a tad from their recent highs.

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5 year CDS spreads on Ireland, France, Belgium and Japan – all trending higher, but with the exception of France slightly dipping from the most recent high.

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5 year CDS spreads on the Czech Republic, Hungary, Croatia and Bulgaria. All jumping higher, but with the exception of Croatia still well below their late 2010 highs. Bulgaria is especially exposed to Greece as Greek bank subsidiaries hold some 27.5% of all bank credit claims in the country.

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5 year CDS spreads on Austria, Estonia, Latvia and Poland. Note that Estonia has currently the euro-area's lowest public debt to GDP ratio at a mere 6%. Nevertheless even CDS on the Baltics have now turned up, while those on Poland seem close to breaking out to new high ground.

2. Other Charts

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The Greek two year note yield sits just below a record high.

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Spain's 10 year yield is so far holding its recent break-out and climbs to 5.588%. This remains quite possibly the most important chart in the world right now. Yesterday Spain's government auctioned € 3 billion in three and six month bills at the "higher end of the targeted range." If this breakout is sustained, then the troubles of Greece may soon be relegated to the backburner as far bigger troubles come to the fore.

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The one year euro basis swap – still tame, but far from a "normal" level and once again dipping.

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5 year euro basis swap.

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The gold-silver ratio – this might rally back to the trendline that was broken on account of silver's scorching rally earlier this year. If so, it would indicate more trouble for "risk assets" is in store, as the gold-silver ratio is akin to a credit spread.

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5 year CDS spreads on four Middle Eastern countries – Egypt, Saudi Arabia, Qatar and Bahrain. After a recent correction, they too seem to be trending higher once again. Note that there is still an ongoing war in Libya, and massive civil unrest in Syria and Yemen.

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The euro has held up quite well vs. the dollar this time around, contrary to what happened during the first iteration of the sovereign debt crisis in 2010. As we have explained yesterday, this has likely to do with the ECB's relatively tight policy aa compared to the Fed's. There was an interesting article in the WSJ yesterday discussing the euro's recent strength.

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Against the Swiss Franc, the euro hasn't fared so well. CHF has risen by about 35% against the euro since mid 2008.

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Exposure to Greek debt by country – as can be seen here, France has the most to lose from a Greek debt default. As mentioned above, French banks are the biggest borrowers from U.S. money market funds, so this could turn "interesting" on several levels, in the Chinese curse sense.

Charts by: Bloomberg,, Der Spiegel, BIS Quarterly Review,, Crédit Suisse.