Europe on the Brink

Econintersect:  Greek interest rates soared last week to tie the steepest climb in history.  The 10-year Greek bond closed the week with a yield of 20.55%, a rise of 2.27% in seven days.  This tied the one week record rise set just two weeks ago.  The week in between (week starting Sunday, August 25)  saw the 10-year rate stay more stable in the 17.5% to 18.5% yield range as investors mistakenly thought that a resolution to the Greek sovereign debt crisis might be worked out.  But that hope evaporated in the past week and the coming week holds forth the prospect that financial Armageddon may be at hand for Europe.The following graph shows the six-month history for the Greek ten-year bond:

Click here for interactive chart at Bloomberg.com.

Substantial default on Greek sovereign debt is quite likely in the opinion of the bond market.  A week ago the following was written by the GEI Managing Editor and posted at Seeking Alpha:

The interest rates Monday were little changed from those quoted above. A Seeking Alpha news story Monday from the Associated Press said that the Greek ten-year bond had risen above 18%, up slightly from the yield quoted earlier for last Friday. That means the market has priced the principal value of the bond at maturity well below zero. The yield, without compounding, would accumulate to 180% of face value in ten years. The market is saying that the expectation is that

1. no principal will be recovered after the scheduled maturity; and
2. it is likely that less than half of the coupon will ever be paid.

A clarification of that quote would be that it covers just one of the possible scenarios.  It also turns out that the statement “less than half the coupon” should correctly state “a little more than half the coupon”.

Back of the Envelope Assessments

The following discussion is abstracted from a comment left by the author on the Seeking Alpha article a week ago.

The pricing of the Greek bond is compared to the corresponding German bund.   For the German instrument yield is around 1.8% and the Greek yield around 18%.  Let’s take a hypothetical Greek ten-year auction at that yield. That means the implied return at maturity is principal plus 180% (ignoring compounding / reinvestment effects).

If no principal is repaid then 100% of the 180% can be applied to recovering principal and the remaining accumulated coupon payments are now 80%.  (The spread to the 10-year bund accumulates to about 62% over ten years.) The two investments end up equivalent if the two ultimately return the same amount. That means that to recover 1,180 euro accumulated by the bund including return of principal, the Greek bond uses the first 1,000 euro to replace principal and the next 180 is the first year coupon. The remaining 620 euro in coupons is a return above the break-even point with the bund.  The Greek bond will break even with the German bund if there is total default on the principal and 6 ½ years of coupons are paid.  Any additional coupon payments are a return greater than the bund, or any return of principal in addition to 6 ½ years of coupons is an excess return.  That is the risk premium that the bond market has assigned.

The 50% probability situation is to break even with the “risk-free” bund.  One 50% probability point is the one described above with total default on principal and 6 ½ of coupon payments.

What if the ultimate haircut on principal is 50%?  Then the accumulated 1,800 euro (for 1,000 face value and investment) is applied 500 euro to replace lost principal and 1,300 euro for interest payments. This means that the Greek bonds will exceed the return of the equivalent bund by 1,120 euro (1,300 – 180) if all coupons are paid. Equivalence of return is achieved when 3.8 years of Greek coupons are received (500 principal repayment + 500 replaced principal from coupon payments + 180 additional coupons). The needed coupon payments to reach equivalence is 680 euro. That is 680 / 180 = 3.8 years of coupon payments.  Payment of any of the additional 6.2 years of coupons is the risk premium for a 50% haircut.

If the market had priced the Greek 10-year correctly at the Sept. 2 yield, the haircut for exact equivalence to the bund is more than 100% for the Greek bond. That is the reduction of principal repaid at maturity if all 10 years of coupons are paid at 18%. The math: 2,800 – 1,180 = 1,620 which is the amount applied to replace haircut.  That amount is greater than the 1,000 euro principal, so the bond market is applying a haircut greater that 100%, meaning that bond traders have priced in complete default and 620 euro less than the full schedule of coupon payments as a bottom line.

The above are back of the envelope numbers and will be modified somewhat if reinvestment/compounding are included.

But Things Have Gotten Worse

The bond market has had another huge negative jump since the 18% yield discussed above.  Bond traders now are pricing that bond at a level that would return more than double the purchase price in coupons plus the principal as well.  That drives the default probability numbers further into the ground, at least as much as the opinion of bond traders counts.

Meanwhile, European governments, the ECB (European Central Bank) and banks throughout the world are scrambling to prepare for Greek insolvency.  From Spiegel Online:

German Finance Minister Wolfgang Schäuble, who is reportedly doubtful that the country can be saved from bankruptcy, is preparing for the possibility of Greek insolvency. Officials in his ministry are currently reviewing scenarios for handling such a situation, exploring what it might mean for the rest of the euro zone. Under the first scenario for a Greek bankruptcy, the country would remain in the euro zone. Under the other, Athens would abandon the common currency and reintroduce the drachma.

The European bailout mechanism, the European Financial Stability Facility (EFSF), is playing a key role in those considerations. Soon the EFSF is expected to be given new powers agreed to by European leaders at a special euro crisis summit in late July. Two instruments at the EFSF’s disposal are at the forefront of the Finance Ministry’s scenarios.

Ambrose Evans-Pritchard, International Business Editor of The Telegraph writes:

First we learn from planted leaks that Germany is activating “Plan B”, telling banks and insurance companies to prepare for 50pc haircuts on Greek debt; then that Germany is “studying” options that include Greece’s return to the drachma.

German finance minister Wolfgang Schauble has chosen to do this at a moment when the global economy is already flirting with double-dip recession, bank shares are crashing, and global credit strains are testing Lehman levels. The recklessness is breath-taking.

If it is a pressure tactic to force Greece to submit to EU-IMF demands of yet further austerity, it may instead bring mutual assured destruction.

“Whoever thinks that Greece is an easy scapegoat, will find that this eventually turns against them, against the hard core of the eurozone,” said Greek finance minister Evangelos Venizelos.

Greece can, if provoked, pull the pin on the European banking system and inflict huge damage on Germany itself, and Greece has certainly been provoked.

Based on the calculations reviewed earlier and the degradation of prices since, the bond market is pricing in a lot more than a 50% probability of 50% default on principal.  The German “Plan B” (50% haircut) may be way too optimistic, according to bond market prices.

There is much unceratinty just how banks will be impacted by by recognition of losses on Greek debt and how far the contagion could spread to other European countries.  Investment managers have been trying to reassure investors.  From USA Today:

Many U.S. investors are incorrectly assuming European policymakers are powerless to stem a Greek default if it occurs, says Samy Muaddi of T. Rowe Price. “The ECB has a fairly big tool kit that’s not being used at the moment,” he says.

Greece dismissed rumors of a default Friday, saying it’s committed to its July agreement to obtain a second bailout package from the European Union and the International Monetary Fund. Given the uncertainty, it’s understandable how investors might worry that the situation starting with Greece could infect other countries such as Italy and Spain, says Scott Mather of investment firm Pimco. “Most European banks are in pretty good shape. If just Greece and Portugal default, most banks will do pretty well in Europe. The real problem is that people extrapolate from there to Italy and Spain,” he says. “The market is in a ‘show me’ state of mind. It needs to see the actions rather than the words.”

In the meantime the Greek government is battling to find a way to stay afloat in the EU while battling civil unrest on their streets, as discussed in the following short video:

(Click on image to play video)

Early Monday trading in Asian markets is showing a string of big losses , from 1% to more than 3% as the world awaits for European markets to open.  The only bright spot in Asia is Shanghai, which is only down very slightly (almost even).  Data is from Yahoo Finance at 12:00 am 9/12/2011, New York time.

There is some sentiment that stock markets will rebound as soon as there is more clarity.  But what if the clarity is of a picture worse than has been discounted to this point.  It appears likely that the eventual outcome could be worse than the “Plan B” that involves 50% haircuts on Greek debt.  At the end of August a settlement had presumably been reached that involved 21% haircuts.  In less than two weeks the attempt has now deteriorated to 50% writedowns.  Bond traders are now betting it will be closer to 100% than to 50%.

Sources:  Seeking Alpha, Spiegel Online, The Telegraph, USA Today and Yahoo Finance