In his latest letter, John Hussman addresses the Greek bailout and tries to anticipate how things will play down the road. This is good. Everyone is talking about how the can’s been kicked down the road, so we should try to guess what things will look like when we get further down the road to where the can stops.
Hussman uses game theory to propose a very plausible explanation of what’s going to happen. Basically, as things get near the danger zone again, you’ll liquidate your holdings until the point of max pain:
Put yourself in the position of a holder of Greek government debt a few years out, just prior to a probable default. Anticipating a default, you would liquidate the bonds to a level that reflects the likelihood of incomplete recovery. Working backward, and given the anticipated recovery projected by a variety of ratings services and economists, one would require an estimated annual coupon approaching 20% in order to accept the default risk. For European governments and the IMF to accept a yield of only 5% is to implicitly provide the remainder as a non-recourse subsidy. Even then, investors are unlikely to be willing to roll over existing debt when it matures – the May 19th roll-over is the first date Europe hopes to get past using bailout funds. In the event Greece fails to bring its budget significantly into balance, ongoing membership as one of the euro-zone countries implies ongoing subsidies from other countries, many of which are also running substantial deficits. This would eventually be intolerable. If investors are at all forward looking, the window of relief about Greece (and the euro more generally) is likely to be much shorter than 18 months.