Virtually every financial market is watching the outcome of the Greek negotiations very carefully – after all, global equities, bonds, gold, currencies, etc. have been dealing with various degrees of volatility, hand-wringing and general unease as a result of Greece’s predicament for the better part of a year now. Indeed, one of the major reasons why both the U.S. dollar and the Treasury market have been strong through the end of QE2 has been their safe-haven status away from the Euro, a currency that looks increasingly fragile under the weight of several concurrent member-nation debt crises.
Regardless of one’s beliefs about the immediate solutions available to Greece, the strategic outlook for the Euro is a real mess. A hard-line approach, favored by the Germans, is to force Greece to restructure its debt and thus its bondholders the pain. The problem there, however, is the Byzantine cross-holdings of that debt and its optionbit derivatives – Greek banks would be hammered, as would German, French and British ones. Moreover, a large number of U.S. financial institutions own swap contracts against that debt, which would be executed upon any default. Greece may seem like a local problem on the nightly news, but it is most assuredly a global one in terms of balance sheets.
While attractive in theory, the German approach risks another worldwide elliottwave of capital markdowns in a financial industry barely off life support from the last one. Any restructuring of maturities – the favored option at the moment – would undoubtedly be treated as a default by capital markets, and very few within the financial system have sufficient incentive to push for such a move. A default, even one of a technical nature that modifies payment schedules & maturity dates, would kill Greek banks, accelerate payment clauses in derivative contracts and swiftly impact the investment ratings of more than a few global financial institutions. Indeed, while the German solution is the most correct one from the perspective of market theory and the “too-big-to-fail” syndrome, practically speaking, it is not the most likely one. If it is one thing we have learned in the markets, it is that fear is usually more powerful than greed, and rarely does the “greater good” come at the expense of profits and/or losses.
And issues of moral hazard abound in this discussion. The private sector was more than willing to cash in double-digit yields on Greek debt for years while the country was dragged along to prosperity through its inclusion in the Euro, and it should be the private sector that also pays the price of any default. However, as we saw ad nauseum during the U.S. financial crisis, even the bastion of free markets is not above bailing out an entire industry or three if the private sector is going to get it right between the eyes. But the alternative is equally unpalatable (and unpolitical), as the riots in Athens last week amply showed.
Ultimately, we think Greece will be bailed out. There is virtually no other choice. It will be horrendously expensive, very messy and, because of the involvement of the EU, the IMF, the World Bank, the Fed and the ECB, will take much, much longer than would be the case were financial markets driving the bus. Furthermore, the precedence value is huge – other European nations in the same boat as Greece (and also members of the Euro) such as Portugal and Spain are going to watch what happens very carefully, as are global bond investors.
One of the interesting ironies of all this is that historically, half-measures like bailouts and provisional measures usually don’t work. They merely delay the inevitable. Eventually, it is highly likely Greece defaults anyway, making any taxpayer-fed bailouts a waste of both money and time, two things of which Europe as whole has little to spare. Theoretically, Greece needs to devalue its currency and reissue new debt, but this avenue is unavailable so long as the country remains tied to the Euro. So, like any cash-strapped business trying to make a bank payment, the country is looking to sell assets, in its case airports and train lines to raise cash. To say the European Central Bank is in uncharted territory due to this mess is an understatement; one only has to look at Spanish and Portuguese bond spreads over German bunds to see how the global financial market views the situation.
Either way, the Greek vote of confidence today will be remembered as a departure point. If Papandreou survives, Greece will be the test case for a national bailout. If he doesn’t, it becomes highly likely that Greece will eventually be ejected from the Euro currency (which incidentally would result in a massive rally in the European currency). In either case, Greece is now a guinea pig in global finance, a position we do not envy. It’s no wonder, when one looks at the overall situation, why gold, silver and other hard assets have soared.
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