Stay Out Of Stocks: The Greek Election Is Irrelevant, Europe's Woes Will Persist

Jun.17.12 | About: SPDR S&P (SPY)

Here's something everyone watching the Greek elections should know. In regards to the demise of the European Union, the results of the election do not matter at all. The first reason the elections do not matter is that while a victory by the Syriza party will indeed cause more turmoil in the short term-- as exemplified by the juxtaposition of the party's promise to renegotiate the terms of the Greek bailout 'immediately' and German Chancellor Angela Merkel's foreboding assurance that the terms of the bailout will absolutely not be renegotiated-- the long term result will ultimately be the same: sooner or later, Greece will default.

When the EU and the mass media talk about Greece's debt load, they typically only include sovereign debt. Despite what the headlines say, Greece has a total debt load (counting sovereign debt, sovereign guaranteed bank, corporate, and regional debt, derivatives, and other obligations) of $1.3 trillion--that's trillion with a "t". To put that in perspective, that equates to a debt-to-GDP ratio of 453%. In short, this debt will likely never be paid-off in full. The effects of the inevitable default will be far-reaching, and will bring about substantial systemic risk.

The second reason the Greek elections are largely irrelevant, is that a far larger problem lies to the northwest, in Spain. As I noted in a previous article, the bailout of Spain's banking sector had multiple deleterious side effects. First, the lack of punitive terms caused Ireland to seek a renegotiation of its own bailout and set a dangerous precedent regarding the structuring of future bailouts.

Second, the bailout will likely come from the ESM, which enjoys 'preferred creditor' status. This means all other bondholders are subordinated: their claims are secondary to the EU's in the event of a default. This undermines investors' already weak demand for Spanish debt.

Third, (and here's where the dominoes begin to fall), because the money could not be directly injected into the banks, it had to go on Spain's balance sheet. As such, the 100 billion euros in new debt added 10% to the country's debt-to-GDP ratio, which-- in addition to jeopardizing future economic growth-- triggered a downgrade by ratings agency Moody's. This could prove fatal for the country's struggling banks. Once all three ratings agencies have Spain at BBB+ or below (which, after the Moody's cut, is now the reality), the country moves into the 'Step 3' collateral bucket with the ECB, requiring a 5% haircut on all maturities of Spanish government bonds, which, in turn, triggers margin calls for the banks which pledged the debt as collateral.

Here we see the circular relationship between Spain, its banks, and the ECB coming back to haunt the banks. The ECB should never have accepted the Spanish sovereign debt as collateral for LTRO loans. The country's debt was souring fast and the central bank knew that if the situation in Spain continued to deteriorate, the country's already weak banks would be exposed to margin calls if the ratings agencies downgraded the sovereign. Spain's bank bailout then, is entirely self-defeating.

The ECB accepted Spanish government debt from Spanish banks as collateral for LTRO loans. When those banks ran into trouble, the ECB helped orchestrate a 100 billion euro bailout which went on Spain's books. That money (which was designed to save the banks), may-- because of the ECB's own rules-- end up being their undoing, as its addition to Spain's balance sheet ultimately caused the country's credit to deteriorate, triggering downgrades and, in the absence of a rule change, margin calls for the banking sector.

This inextricable relationship between the banks and the sovereign ultimately caused Sean Egan (president of independent ratings agency Egan-Jones) to predict that Spain and Italy will ultimately have to seek full bailouts, as

...the 100 billion euro figure is not even close to adequate given the fact that, because the fortunes of Spain and its banks have become so inextricably intertwined, to be successful, any bailout must address not only the struggling financial sector, but the sovereign as well, for they are essentially one and the same. In other words, it is Spain that needs to be bailed out, not just its banking sector.

The idea that Spain is nearing the point of no return was reinforced last Thursday when the yield on Spain's 10-year bonds rose above 7%, the level at which other struggling countries were forced to seek international bailouts. If Spain and Italy end up having to seek bailouts, the cost would be in the trillions.

Last week, the spread between Spanish and German debt (traditionally a measure of risk appetite) hit 542 basis points. While this is worrisome in and of itself, the Wall Street Journal notes that even German bunds aren't considered as safe as they used to be as investors (presumably worried that despite their objections, the Germans will ultimately end up on the hook for more EU bailouts) are now flocking to the safest safe-haven of all: Swiss debt. Incredibly, the spread between German bunds and Swiss debt has risen from 9 to 43 basis points in under a month, and Swiss debt maturing in 5 years or less is now essentially repaying itself as yields have turned negative amid rising tensions.

So ultimately, Sunday's election in Greece is of no consequence. Greece will probably default regardless of the character and proclivities of its leaders. Additionally, the bailout of the Spanish banking sector was a disaster by every conceivable measure and, in an irony of ironies, it may be the very event that spells the end for Spain's banks.

Ultimately, the consensus is that Spain and Italy will eventually seek international bailouts, this is supported by the behavior of the bond markets towards those countries' debt last week. While Spain's borrowing costs officially crossed the 'unsustainable' threshold, an auction of 4.5 billion euros of Italian 3,7,and 8 year debt saw borrowing costs skyrocket, betraying investors' unease. The bottom line is this: when the bond market moves in one direction and the stock market in the other (as is the case currently), the bond market is usually correct. The bond market is saying 'risk-off'. Investors would be wise to listen. Short S&P 500 (NYSEARCA:SPY), long volatility, short European equities.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in SPY over the next 72 hours.