BAML is out with a monster report today detailing a couple different scenarios for how a Greek exit from the euro will likely shake out as well as a comprehensive look at the effect it will have across asset classes given different policy responses to such an event.
Greece’s Ominous Fiscal Situation — Next Two Months
Here is the best case, based on BAML estimates, which provides a good baseline for measuring more likely (and significantly worse) outcomes:
Given the developing political situation, however, the above scenario seems more unlikely with each passing hour. A more likely outcome, according to BAML, is that Greece might be able to collect half of these estimated revenues, putting them flush out of cash “sometime in June.”
If that happens, BAML thinks it likely that “Greek authorities may decide to meet payments only for salaries, pensions and debt servicing.” This will have a negative feedback effect on revenue collection and will probably lead to some serious torches and pitchforks in the streets of Athens.
The Likely ECB Response to a Greek Exit
Here is BAML’s take:
The ECB is exposed to Greece through two channels, repo operations of various maturities and emergency liquidity assistance (ELA). The respective amounts are €109bn and ca. €60bn. Should Greece default, we think it is highly likely that the ECB would terminate the repo operations. And, the ECB could veto the ELA, which would cause the Greek banks to run out of liquidity.
We have reported all week on the bank run on Greek deposits that is already under way. To state the obvious, the banking system’s exposure to its sovereign, combined with mounting deposit flight and the likelihood that the ECB cuts off liquidity, means the end of Greek banks as they are currently constituted.
Spillover Effects into the Eurozone Banking System
The greater eurozone banking system has been effectively shut out of funding markets for some time now, and the ECB’s LTRO policy responses have only worsened the situation as banks have pledged what’s left of the quality paper in Europe in exchange for ECB loans.
Ergo, BAML says “funding markets are likely to be completely shut, even for the strongest euro zone banks.”
The real risk, though, is deposits. They’ve evaporated already in Greece this week. Bankia in Spain has seen 1.3bn euro withdrawn already this week. SocGen this morning sees a 20-30% deposit outflow in Spain and Italy as a result of a Greek exit.
BAML on the deposit risks to the periphery:
In our view the main risk is to deposits as this accounts for some 50% of euro zone banks’ funded balance sheets. As can be seen in Table 2 below, to date the deposit outflows have been relatively limited with the exception of Greece with a 30% reduction since December 2009, and Ireland with a 12.4% drop. However, should Greece leave the euro, there is a risk that this could spread to other countries as depositors fear redenomination at unknown terms.
And here is the table on deposit outflows from the report:
Finally, BAML sees the shock to confidence in the real eurozone economy “at least as high as that of fallout from the Lehman Brothers collapse,” and further, they see at least a 4% GDP contraction in the eurozone resulting from the Greek exit scenario described in this piece. And all of this in against a far worse economic and fiscal backdrop than in 2008.
How to Play a Greek Exit in Various Asset Classes
The main idea from BAML here is that the short-term response to a Greek exit from the eurozone will be risk-off, with 10-year Bunds perhaps dropping below 1%, and heavy liquidation flows sending gold and other commodities down sharply along with equities and non-IG credit.
What follows depends on whether a) the ECB steps in strong (perhaps coordinated with other central banks) or b) the central bank response is not seen as adequate by investors.
In scenario a), BAML sees a “powerful short squeeze” in peripheral sovereign yields, financial stocks and credits, and the euro given the current extreme underweight positioning in these classes. Further, gold will have “scope to trade > 2000/oz.”
On the other hand, if the ECB’s response is seen as inadequate, expect a totally disastrous risk-off move as investors run for the hills toward conventional safe haven assets. BAML notes, for example, that “the euro zone banking sector is already back towards its credit crisis lows in Price-to-Book terms at about 0.4x,” but even these valuations are nothing compared to the 0.15x P/B Korean bank stocks traded down to in the wake of the 1997-98 Asian crisis or the 0.25x P/B of the Scandinavian banks in the early 1990s.
Bottom line: the ECB is going to have its work cut out for it in the weeks ahead, regardless of what unfolds.
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