The Greek economy is the thread hanging off of Europe’s sweater, and if it gets pulled, the entire Eurozone could unravel.
But do you understand what’s going on?
RBS has produced an excellent Q&A to get you up to speed.
RBS: EU authorities and/or the ECB are only days away from making comments to help stabilise EGB debt markets if events threaten a disorderly contagion and a possible flight by foreign investors in Euro paper. Greece does not have a sudden stop risk for funding but we are concerned by the impact of repo collateral for Greek bank funding. The concern regarding debt dynamics will continue to plague GGB valuations for several years. We expect a series of rolling crises.
According to the statistics released by the debt management office, in 2005- 2009 the largest concentration of GGB was domestically allocated, accounting for about 29% of the outstanding government debt stock. The most exposed foreign countries are the UK and Ireland, jointly accounting for about 23% of the total outstanding amount of GGB in the market. In the eurozone, the most exposed country is France (11%), followed by Italy (6%) and Benelux (6%).
Germany, Switzerland and Austria account for about 9%. The amount of GGB allocated in Asia is very tiny, about 2% of the total amount of GGB, and 3% are allocated in the US.
Looking at the allocation of GGB by sector over the same period, about 45% are held by banks and Trusts, Fund Managers hold about 19% of the total allocation, followed by Pension and Insurance Funds (14%), Asset Managers (10%), Central Banks/Sovereign (5%), Hedge Funds (5%).
According to the Eurosystem's statistics, domestic MFI hold 11% of the Eur297.9bn of outstanding amount of public debt (September 09).
The information below are an extract of the latest Financial Stability re:
(i) Domestic Economy
Assumptions: GDP - 3% over two year; unemployment rate up by 4 percentage points and bank lending rates up by 400 basis points.
Results: NPL ratio up from 5% end 2008 to 12.7% by December 2010.
(ii) Eastern European countries exposure
Assumptions: NPL ratio at the end of the two-year period assumed to be 20% for high-risk countries, 15% for medium-risk countries and 12.7% for low-risk countries, the same as that assumed for Greece.
Results: average NPL ratio for loans to these countries would almost quadruple in comparison with end-2008; in certain cases it would even rise tenfold.
(iii) Financial market shock
Assumptions: parallel upward shift in the yield curve by 300 basis-points, a 30% depreciation of the euro vis-à-vis the other major currencies, a 40% drop in the stock market and an increase of 450 bps in the 10 year spread over Bund. Profits before taxes and provisions would fall by 15% in 2009, before rising by 10% in 2010.
Results: weighted average of the Tier I ratio would remain above 8%
(iv) Liquidity risk:
Assumptions: withdrawal of 10% of customer deposits and the non-renewal of 50% of wholesale funding.
Results: none of the banks in the sample would face liquidity difficulties; the few banks whose liquid asset ratio would fall to a relatively low level would still remain capable of fulfilling their obligations, albeit by a close margin. The Bank of Greece will continue to conduct stress tests in the future, compare their results with actual outcomes and take corrective action whenever it deems it appropriate to do so.
6. How reliant is the Greek banking sector on wholesale funding and what measures to support the banking sector have been put in place?
At an aggregate level, the Greek banking sector does not come up with a high funding gap (about EUR 12.7bn as of October 2009), thanks to the large deposit base (deposits / GDP of about 100%), however this number does not capture funding of foreign operations.
E.g. the cumulative gap for the four biggest banks is about EUR 4.6bn for the Greek business thanks to large surplus at National Bank of Greece (EUR 7.7bn), however on consolidated basis (including foreign operations in the Balkan states and Turkey) the gap is EUR 27bn.
The Central Bank of Greece stress test conducted above suggest that the banking sector as a whole does not seem to be over exposed should the banking sector lose access to wholesale funding. Also, the Greek authorities like other countries implemented support measures last year including a recapitalisation scheme, a wholesale funding guarantee scheme and a bond loan scheme; all of which helped the banking sector navigate through the crisis. However, most of these measures are due to expire at the end of this year. In its latest note on the Greek banking sector (dated December 7th), S&P notes the increased reliance of ECB financing and some players' high proportion of short term debt in their wholesale funding structures.
If Greek banks are tasked to finance their bond holdings by means other than the ECB facilities, then they may find this difficult.
The market has moved fairly quickly to price in the implied correlation risk in repoing Greek bonds from Greek banks, and with risk appetite already waning for Greek repo (funding spreads a minimum of 25bp wider on the week), we see few street names willing to finance Greece from Greece.
Other European bond repo markets enjoy central counterparty netting arrangements, with the exception of Greece and Spain (although Spain are working on a solution for Q4 2010) - the lack of a CCP in Greece means that there is no way to mitigate counterparty risk in Greek repo, which handicaps Greek banks' ability to repo out their domestic holdings.
In addition we feel a downgrade to BBB by all agencies will trigger Greek bonds being removed from counterparty collateral schedules, which typically only extend down to A rating - this removes the ability to finance Greece in securities lending / financing programmes i.e. it removes another funding avenue.
In the extreme scenario, which we do not envisage at this stage, of a funding issue, we would envisage a solution similar to the one we had considered at the start of the year when Ireland and Greece were seen as most exposed to the financial turmoil.
Euro area institutions have no appetite for the IMF to step in.
The most likely course of event would thus be a crisis management handled by the core countries like Germany and France with the backing of the European Commission and the ECB.
This would take the form of a bilateral bridge loan from core countries or a consortium of banks (which would not be interpreted as a bail out). These loans would have some stringent conditionality attached (a la IMF) with the EC likely to conduct the surveillance work given its expertise on public finances.
What does a default look like? At its simplest this involves a missed payment by the sovereign of the outstanding debt as in previous episodes of defaulting countries. If that were to happen, we do not think that Greece would leave the Euro.
That is, a default by Greece is likely to occur inside the Euro area with even here no mechanism to force Greece out of EMU. One could argue that payment of debt in any new Greek currency would significantly alleviate the burden on the state but this ignores the fact that any recovery process of funds for investors would very likely be measured in Euros and the costs of new currency bonds would be astronomically high.
For CDS, a Greek bond default would constitute a trigger event, given that it does not involve a G7 currency. We have more details of the implications in CDS of default in Giles Gale's CDS Primer, and in this document see pages 31-37, which also covers some of the broader issues around the mechanics of the recovery process.
We have been saying since the new debt numbers came to light that Greece should ultimately be downgraded to BBB status and Greek budget dynamics are a slow motion train wreck. Where we were wrong was the judgement that the downgrades to a BBB handle would take 2-4 years given some shelter of EU and EMU membership.
The speed at which rating agencies have since moved has important implications that serve only to consolidate our medium term bearish GGB view.
First of all, ECB collateral eligibility is a useful stick with which to encourage the Greek government to enact austerity measures but any measure to leave Greek institutions without access to the ECB lender-of-last-resort function could have self-fulfilling consequences and that in turn means that ultimately we do not expect the ECB to refuse GGBs, when the normal ratings threshold reverts back to A-.
The danger is instead located in a potential breakdown of social cohesion if the Greek government - and in perhaps our most damning comment of all - if any Greek government attempts a solid austerity budget. That means aggressive intervention in Greece's affairs has dangers regarding social cohesion that embeds a rolling crisis until the population itself is sufficiently attuned to the need for more sustainable government finances.
Our concerns are heighted by the significant rise in old-age expenditures (health/pensions/long-term care offset by lower unemployment benefits/education) that begin to bite from 2012 much harder in Greece than any other EMU country. For example, a EC study suggests the rise in expenditure for Greece between 2007 and 2035 is 9.1% GDP, compared to the EMU average of 3.2%. (For the other PIIGS, this is Portugal = 1.1%, Italy = 2.0%; Ireland = 3.7%, Spain = 4.3%).
All this is effectively a recipe for rolling crises which then see spreads ratchet still higher. In our report outlining why we thought GGBs were a slow-motion train wreck, our failure to see near term rating cuts (despite our BBB ratings view) and an excessive focus on rather easy Q1-10 GGB funding led us to advocate GGB steepeners. That trade has been quickly stopped for the largest loss in our macro portfolio this year (-35 bp). The GGB and Greek CDS curve tends to flatten and then invert on jump-to-default risk (see below).
Contagion risk to other EGB spreads is likely to prove high in the coming weeks partly on speculation of EMU break-up and of course illiquid conditions. The idea of EMU break-up should however be given little traction as any true contagion to periphery will in all likelihood see official comment that Germany/France and perhaps even the ECB stands behind EMU integrity for the fiscally responsible countries. There is simply no sense in policymakers being passive as risk aversion rises here just as we saw in Q1-09.
The market will however still look to see 'who is the next Greece risk event' and while the scatter gun will initially and primarily hit all the other members of the PIIGS, we expect only Portugal to be truly in a similar mould as Greece. Consider here that Portugal has a weak minority government and more remarkably has had even weaker primary budget balances than the revised Greek budget data that effectively triggered the most recent GGB crisis.
Fitch has already moved to cut Greece ratings to BBB+ with a negative outlook, while S&P is on ratings negative watch which it expects to resolve in 2-months, which in turn would coincide with results of the Greek budget amendments following discussion with the European Commission as part of the Excessive Deficit Procedure (EDP). Moody's rating is A1 but with a negative outlook, and we think the results of the Greek budget amendments (under the EDP) will be key here too such that any ratings follow through is likely on a similar timeframe to S&P. Note that Moody's current rating (= A+ in the language of S&P/Fitch) is expected to be moved a maximum of one-notch to A2 (= 'A').
We said after the revelation of new Greek deficit and debt numbers in October that Greece is a BBB handle sovereign risk but had expected the rating agencies to take much longer to come to this view. The hyper activity from the rating agencies means that further downgrades could come within months but we expect Moody's to remain the laggard. In CDS, Greece is already priced above many BBB+ and even BBB countries.
As a credit becomes distressed, market rationale shifts from a carry approach to a recovery approach: for sub-par bonds pulling to par, the short-dated paper carries a higher cash price than the longer dated bonds, and therefore a larger potential loss-to-recovery as all bonds should recover the same notional amount. As a result, the negative impact on the short-end is more pronounced than the long-end (either from outright selling of the bonds, or match-dated buying of protection).
Further, distressed situations are typically expected to resolve over a relatively short time-frame. Accordingly, investors want to match their CDS exposure to the projected time-frame: buying 10 year CDS might be the cheapest in spread terms but the binary nature of default/survival could leave an expensive residual position if no default occurs.
Finally, existing market positioning can exacerbate inversion: for example jump- to-default hedging from holders of DV01-neutral curve steepeneres who are long notional risk.
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