On Friday, Germany’s representative on the European Central Bank, Jurgen Stark, abruptly quit in apparent protest over the ECB’s recent bond buying program in Spain and Italy. Germans have continually been loathe to back bailouts, starting with Greece and continuing to other PIIG countries. Considering that Germany has the strongest export economy, employment and debt metrics, using their balance sheet is probably the only way to bail out their weaker southern European neighbors. But eventually this house of cards has to fall. Even Germany, the best of Euroland, is running at 74% Debt to GDP, which is on the high side. And when looking at Greece’s financial condition, the term "hopelessly insolvent" best applies. The question is, what is the likely outcome of a Greek default? And how should you be positioned?
Insolvent
Last week, Greek GDP came in at an astonishingly bad level; an annualized decline of 7.3% in Q2. The July bailout requires that the Greeks implement austerity measures, and the next bailout tranche of €8BB is looking shaky given falling GDP numbers. The problem is that with lower GDP, it gets that much harder to lower current year deficits and reach reduction targets. This year deficits will likely be over 8% of GDP. In fact austerity measures require Deficits/GDP of under 3% in 2014. Not gonna happen.
In 2010, Greek deficits were 10.5% of GDP, but when GDP is falling, the Greek government is forced to cut more jobs and more wages just to keep deficit levels flat (as measured against GDP). Well this naturally reduces GDP even more, and leads to a vicious cycle downward. Riots over the weekend in Greece are erupting as the government just announced 10,000 immediate government job cuts, with that number potentially reaching 120,000 reductions. Ouch.
When your Debt/GDP is running at 152%, and likely to hit 160-170% next year, there really is little hope in paying back that debt. With Greek bonds trading around 40 cents on the dollar, the markets attribute little hope in receiving their money back either. Now, if only there wasn’t the problem of Italy and Spain, the European financial system would probably be ok.
By the way here is a snapshot of Greek yields, clearly bailouts are not the answer, and have done little really to stop the bleeding in their bonds.
Greek Losses
On the whole, a default by Greece would mean significant losses for European banks. Let’s just assume that 40c is fair value for Greek debt.
In total, Greece has roughly €330BB of outstanding sovereign debt. About 40% is owned by international holders, around €150BB. The other €200BB of debt is held internally by Greek banks and investors. But the €150BB of international holdings is held mostly by big banks in Europe. In fact, French banks own €57BB of Greek debt, and German banks own €34BB of this debt. This is a problem when your banking system doesn’t require mark to market accounting, and also when there is a default. In cases of default, banks are required to mark losses as other than temporary. That is, take a write down on these defaulted securities. In all, EU officials have reported that 80% of Greek holdings by banks have not been marked to market. Incredible.
What does that mean? Well, losses of say 60% of €150BB spread across European banks equates to about €90BB of losses, and €80BB of losses to bank equity (assuming a smattering of banks have marked to market). Given the leverage among European banks, they would need to raise that much in capital or generate that much in profit to offset this.
To give one example, French bank Credit Agricole was down 8% on Friday. It owns €22BB of Greek debt, mostly through its Greek bank subsidiary, Emporiki Bank. A 60% hit to their Greek debt implies losses of €13BB, a big hit to tangible book value of €71BB. In fact, that is a 19% hit to BV. That would be fine if the bank wasn’t already levered 21 times. But a hit like this might force them to raise outside capital. And raising €13BB isn’t easy in this environment.
Now, given that the EFSF (European Financial Stability Facility) is €440BB in size, it seems that €90BB of losses from a Greek default is absorbable. After all, the housing crisis in the US caused over $1.2 Trillion of losses in worldwide, and the banking system survived. So why all the fuss over only €90BB of losses?
Contagion
What everyone fears is the contagion of Spain and Italy. When the ECB announced its bond buying program for Spanish and Italian bonds, it quelled some of the fear in the market, brought yields down a little, and so far has kept yields below 6% on both. You can see below where ECB intervention above 6% yields stabilized Spanish bond prices.
But when you look at the size of Spain and Italy, it seems unlikely to me that the ECB, as just a monetary body and not a fiscal authority, can print enough Euros to save them. Take a look at these numbers.
Country Public Debt (BBs) Debt/GDP | ||
Belgium | € 330 | 100% |
Portugal | € 200 | 83% |
Ireland | € 100 | 100% |
Italy | € 1,900 | 120% |
Greece | € 330 | 152% |
Spain | € 650 | 70% |
Total | € 3,510 | |
If Spain and Italy face solvency issues, then it gets quite scary. Indeed, if €1.9TT of Italian debt became worth 50 cents on the dollar, then that is nearly a €1 Trillion hit. According to the European Banking Authority, Europe’s 90 largest banks hold €326BB of Italian debt. Fortunately US banking exposure is light, around €14BB. But the European rescue fund and the Greek bailouts are, in reality, nothing more than bailouts of the entire European banking system. The EFSF fund is not a selfless act of helping thy neighbor. It’s helping avoid a Lehman Brothers event for banks in their own countries.
Interestingly, 75% of Germans (in a ZDF TV poll) oppose broadening the size and scope of the EFSF fund. But when it comes to a parliamentary vote at the end of September, the Germans will pass it. They have to in order to save their Deutsche Banks and their entire export economy. But their resistance bodes ill for the time when even more capital is required of them to save the Euro and the financial system.
Conclusion
The EFSF fund isn’t big enough currently to save the Euro, by a long shot. I would suggest a meaningful percentage of the total public debt listed above, perhaps €1-1.5TT is needed to rescue Europe from the brink. But I am not sure that number is attainable. Perhaps they raise the rescue fund to €800BB, but still larger losses will await as deficits continue.
In fact, if deficits simply average 5% of the above (close to where they are now), then the €3.5TTB in PIIG (plus Belgium) debt will likely grow by €150-200BB, every single year! The proverbial can getting kicked down the road will eventually reach a cliff. More debt isn’t going to solve a debt crisis, sovereign debt has to eventually be restructured. And to avoid a financial panic, sovereign losses need to be realized sooner rather than later, with banks recapitalized before recoveries get worse.
Trading
Avoiding financials here and in Europe is paramount. Banks will need to raise more capital, either from the EFSF or from outside investors, and will certainly mean further dilution. Sovereign risk is either too risky to own among PIIG-land, or too low yield to be worth the risk. Specifically, German bunds are yielding a mere 1.77%. I suspect that if only 20% of Greek debt has been marked to market by European banks, then likely 10% or less of the losses on other PIIG debt has been marked down. It’s a disaster waiting to happen.
I think a Euro style rescue a la TARP in the US will eventually come to pass. But I don’t know when, and with German resistance I am not sure how ugly it has to get to force their compliance. Either way, owning European risk seems like a bad idea. Shorting and hedging European stocks seems wise. I have owned EPV, a double short ETF on European stocks in the past.
Chain of Events
I wish I could also guess the exact chain of events that will lead us to through the coming crisis. I suspect eventually the Greeks default, or in pre-arranged fashion will swap into say 50 year zero coupon bonds (which is a defacto default). The ECB will monetize debt as well. Clearly they have bumped up the size of their balance sheet to purchase Italian and Spanish bonds lately. That is the same as printing Euros, as they haven’t offset bond buys with sales of other assets.
The EFSF will also get bigger to fund losses and provide liquidity, and ultimately a backstop by the IMF may be necessary. Last Friday, the G-7 countries met and declared that they would “provide a coordinated response” to the global slowdown, but nothing in the way of a real fiscal or monetary response to Europe. Perhaps a Eurobond is the answer, and clearly monetization is unavoidable. But with a country as large as Italy creeping toward insolvency, markets will remain jittery. It won’t matter that stocks are already cheap in Europe now.
Worst Case
An unwinding of the Euro is the disaster case, and honestly I would say it’s 50/50 that it happens. Given the Greeks' high debt levels and liquidity issues, default there seems pretty likely. They could bow out of the Euro’s painful austerity measures, and issue Drachmas. Italian debt could then sell off so quickly that they are unable to refinance, or roll upcoming maturities. Another default, and Italian deposits get transitioned to new Lira. Spain, same thing. Remember Pesetas?
The IMF and ECB would likely together back a plan to provide liquidity to the banking system in Europe generally, so that banks get recapitalized quickly. But stock markets take a beating and bank equities get diluted to heck.
Not a rosy scenario, I know. That is why I am posting this article. Perhaps someone could provide a viable solution to the European debt crisis that doesn’t involve tremendous pain to risk assets. In the meantime, caution is warranted in the stock markets.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in EPV over the next 72 hours.
