Euro Toast: Euro to Test Lows as Greece, PIIGS Default or Restructure

April 29th, 2010 | Posted by tips

A Summary Of Likely Outcomes For Greece, The Piigs, And The Euro

Background

Throughout last week, CDS spreads on Greek and other PIIGS bonds were already continuing their rise.

Then came what may be seen as the catalyst for the latest and perhaps final death spiral of the PIIGS.

On Thursday, April 22^nd, Eurostat, the EU statistics branch, released a shocking message that the Greek deficit for 2009 was now the highest in Europe, at 13.6% of GDP, and even this figure could be raised again, being clouded by currency swaps they were still deconstructing.

Eurostat also indicated the estimated total Greek public debt which was thought to be at 115% of GDP would rise by 5 to 7 percent. The Greek debt and credit markets couldn’t take any more of the bad news and uncertainty and capitulated (source: Chris Damas). Greek and other PIIGS bond rates began to accelerate their climb.

Greece officially requested the EU aid package be activated. This was somehow seen as a bullish step to resolution by most asset markets. However, bond markets understood this move now brought new uncertainties about whether Greece would actually get the funding. Germany, more focused on appeasing its voters before its May 9^th elections, fanned these fears with its now familiar backtracking.

Wave of Sovereign Default Or Restructure: A Question of When, Not If – PIIGS Stand Alone

The EU has shown itself incapable of providing the decisive backstop to Greece needed to calm bond markets and get Greek bond yields low enough to keep it from testing the inadequate EU debt package

Greece Too Expensive To Save – So Why Even Start Throwing Good Money After Bad?

As Felix Salmon of Reuter’s notes:

As far as the financial markets are concerned, if any bailout comes now, it’ll be too late: no country can sustain Greece’s combination of funding costs and debt-to-GDP ratio, no matter how much German money it burns through. Plug 13% yields into my Greek debt calculator, and the results aren’t pretty, even if they don’t have any effect at all on all the other optimistic assumptions.

03 apr 28, click to enlarge

This is the problem with the way in which the EU insisted that Greece reach a point of desperation, exhausting all other funding opportunities, before it turned to Europe for help. At that point, it might be too late. And it’s going to be really hard to persuade Germany and the rest of Europe that lending new money at low rates to a country in this kind of fiscal situation makes any sense at all.

Similarly, why should the IMF’s prime funders like the US?

Don’t Believe Me-Believe Goldman Sachs

At least regarding this.

Goldman Sachs (GS) has been advising clients to buy CDSs on Portuguese, Spanish, and Italian banks. In other words, GS is betting that Greece will default, and that the contagion will spread, so they’re taking bets early on the next stage of the crisis while prices are still low relative to those of Greek bonds and banks. No doubt other large savvy players have done so as well, giving them incentive to keep pushing up PIIGS bond yields. There are now active players quite literally willing to burn down the house in order to light their cigars.

So far their bet is looking good. On Monday there was the barely covered Italian Treasury bill auction which received only 9.78 Billion in bids versus 9.5 Billion offered. With 7 times more debt than Greece and as one of the Big Three economies in Europe, Italy presents a much larger problem to the euro-zone than all of the other Southern European economies combined.

That’s why events over the next several weeks could prove critical to the EUR/USD. If the Greek bailout package does not pacify the markets and spreads continue to come under pressure 1.3000 will fall by the wayside and 1.2500 could come into view as risk of fragmentation rises.

The affects on CDS spreads are not limited to the weaker countries. The CDS market has seen an uptick in the number of contracts on UK debt suggesting that traders are becoming increasingly concerned about the state of the country’s finances. It is no accident that US President Obama has in recent days suddenly expressed concern over US deficits.

EU Safety Net Proven A Sham- Here’s Why

Too little, too late, and even that may not arrive given that Greece is beyond saving with its current debt load.

Greece Aid Package Already Insufficient– All The More So For The Rest of PIIGS

Rising PIIGS bonds yields last week were sent higher still Tuesday on new German demands on Greece for getting German aid. Along with the S&P downgrade of Greek credit ratings to junk status and 2 notch reduction of Portuguese bonds from A+ to A-. They can no longer afford to access bond markets due to exploding yields.

Even if Greece can actually get the EU aid package (not clear given latest German conditions) of some 45 billion euros (39 billion pounds) from the EU and IMF, at best that will stave off default for 12 to 36 months. Estimates as high as €80 bln have been heard by ECB member Weber, but who really knows?

This plan does not even consider what Portugal or others will need, as all PIIGS are rapidly losing access to the bond markets. Note the chart below, click to enlarge, courtesy of CMAvision.com

02 apr 28

Note how rapidly credit default spreads are widening. Greece’s CPD (Cumulative Probability of Default) is already conservatively estimated at close to 50%, and it would spark a wave of sovereign defaults as all PIIGS get cut off from bond markets. Remember, fear rises geometrically, so these rates will soar faster still.

If Greek Rescue Solves Nothing –Why Bother At All?

In sum, the Greek situation has panicked bond markets and pushed up borrowing costs for all the weaker economies to the point that they are collectively too big to bail out.

Why should the EU and IMF even bother with the current rescue plan, with Italy and Spain requiring 10 times whatever Greece alone will ultimately cost (over € 30 bln in the coming months alone). Why should already debt laden countries throw more money at a situation that has no affordable final price tag?

This is the question that may be truly holding up Germany and others from committing funds to Greece at this stage. Will the IMF even provide the stopgap funding for May 20^th? Time is running out.

Worst Case Scenario: Greek Default

Consequences are so bad that even the very painful alternatives are much better. About 70 percent of Greek debt is estimated to be held by foreigners, most of them within the euro zone, notably German and French financial institutions. European Union officials will try to avoid an outright default. Here are the consequences of default that will keep everyone focused on avoiding it.

Markets have thus minimized the chance, but sheer inability of relevant leaders to agree may force it.

Consequences of Greek Default

Consequences include:

• Global Market Crash: An ensuing wave of PIIGS defaults would likely at minimum crash the banking systems of the EU and rest of Europe at least (Scandanavia, Balkans, etc) as big banks throughout Europe hold lots of PIIGS and other EU debt. These will demand a massive bailout of at least the largest banks in each country, and that scale of money printing would send the EUR into a deep decline similar to that seen by the USD after US bailouts. A repeat of Sept 08 or March 09 lows in asset markets is likely. Things may get worse, as states are now less able to offer additional mountains of stimulus and bailout cash, fearing that they eventually become the next Greece.

• Euro Trashed: The euro would probably drop below parity against the dollar.

• Credit Freeze- Great Recession Part II: Intra euro zone bond yield spreads would blow out, with the bond market for other countries facing fiscal challenges drying up, leaving only triple-A rated countries able to issue debt. That in turn leads to a global credit freeze-up and crashes economies once again. This time there is less bailout money and already an army of existing unemployed in addition to the new one.

• An outright default by Greece and the other PIIGS that follow would mean exclusion from capital markets. Argentina defaulted in 2001, and has not issued any euro or dollar-denominated debt since then as it has yet to come to an agreement with international creditors. Not an attractive option.

Best Case and Likelier Scenario-Debt Restructure, Euro Toasted But May Save Global Financial System

Despite EU comments yesterday that restructure was out of the question, we take these remarks as seriously as we did those a month earlier about no IMF involvement and no threat of default.

Some hope remains, though there may not be enough time left for the negotiations involved in restructuring. There will certainly be additional efforts to avoid outright default given the consequences of a Greek default and resulting contagion of PIIGS defaults.

Thus there will be attempts to minimize the damage via debt restructurings of various kinds as a last ditch attempt to avoid default. Probably the most likely outcome is an agreement to restructure Greek and probably other PIIG debt (unless PIIG bond yields can be gotten way down).

Consequences include:

• Investors take a loss but world may avoid another market crash or at least minimize it.
• Spreads on other highly-indebted countries in the euro zone and elsewhere would widen sharply while German bunds and US T-Bonds would benefit from flight to quality

• The euro could fall to test lows at $1.15, levels last seen in 2005, USD benefits given its counter-nature to the euro.

Other Outcomes – Less Likely But Possible

The EU Agrees To ECB Loans: Loans to help Greece meet its obligations, buying Greek bonds or relaxing its collateral rules yet further to accept any bonds as collateral irrespective of their ratings.

Unlikely Because:

1. This would require political or policy decisions that analysts say would be very difficult to achieve. We can’t see the Germans accepting this.
2. Many investors have bet on a default through credit default swaps and thus have a vested interest in forcing such an outcome.

Greece leaves the EU: After enough austerity and humiliation, despite enormous legal and logistical obstacles, Athens might elect to leave the euro zone and European Union.

Probability: Market consensus is that leaving the currency union would make it even more costly for any fiscally weaker country to borrow because of the addition of an exchange risk premium to the sovereign risk premium.

Consequences: The euro would be hit even harder as markets would, as a knee-jerk reaction, price in a greater risk of eurozone disintegration. Spreads of higher-yielding eurozone countries would blow out even further versus German benchmarks, sending them to the same fate as Greece – debt restructure, exit, or default.

Either way, the euro will be toast by a combination of loss of credibility or money printing.

How To Profit:

Risk assets in general will suffer and safe-havens will benefit. Obvious bets include:

Forex: Short the EUR and CHF (moves with the EUR) vs. the USD and JPY, or short ETFs FXE, FXF, or go long UUP and FXY.

Commodities: Oil should pull in – short USO or crude futures, or CFDs

Stocks: Short leading global indices.

CDS: Long CDSs on vulnerable PIIGS block banks – good enough for Goldman Sachs!

Financial Advisor