Why a Greek default won’t ever be priced in

By Felix Salmon
June 17, 2011
skeptical that Greek bonds were pricing in a massive default, despite the fact that the likes of Martin Feldstein were saying that they were.

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Back on May 26, I was skeptical that Greek bonds were pricing in a massive default, despite the fact that the likes of Martin Feldstein were saying that they were. But even if they weren’t back then, we’re getting closer now. The numbers, courtesy of Peter Rudegair: Greek CDS spreads were 1,400bp on May 26; now they’re more like 1,900bp. Greek 10-year bonds were yielding 16.4% back then; they closed today at 18.3%, with prices at about 50 cents on the dollar. European stocks have lost 5% of their collective value since May 26, and the Thomson Reuters default-probability calculation is now over 90% for Greece.

Which means it’s time for an article saying that default is not priced in yet at all:

Today’s rising bond yields, stratospheric insurance costs and heavily pressured stock prices may only be a taste of what could come if euro zone leaders fail to halt Greece’s decline and ring-fence it from others.

In short, a lot of markets and bond holders have not priced in some of the worst outcomes…

“The main case that people are assuming is that when push comes to shove Europe and the IMF will step up,” said John Stopford, head of fixed income at Investec Asset Management…

Stopford says asset price moves actually only reflect caution.

“The market is taking risk off rather than necessarily pricing in catastrophe,” he said.

There are three factors at work here. The first is that no one has any idea what would actually happen in the event of a Greek default. In order for markets to be pricing in a default, traders would have to be buying debt now on the expectation that if Greece defaults the price of its debt would not fall further. I don’t think anybody’s doing that yet — as Stopford says, they might be taking risk off, but they’re not expecting catastrophe. If Greece were actually to default, I’m pretty sure that markets would fall further.

The second factor is the short-termism of market reporting. Journalists have a tendency to look at moves rather than levels when it comes to markets, since it’s the move which is the news of the day, rather than the level at which assets are trading. The conceit of market reports is that if an asset price moves, then it’s likely to have done so for a reason, probably related to some news or other. Meanwhile, if an asset price doesn’t move, then there’s a good chance that there was no news of interest at all. Neither of these things are true. But the result is that pundits are much more likely to think that the market is pricing in catastrophe after a big fall in bond prices from say 90 cents to 70 cents on the dollar than they are after a rise from 45 cents to 55 cents.

Finally, the markets are bad at pricing in catastrophic events even after they happen. Lehman collapsed in September 2008; it was another six months before the market reached its bottom. If Greece defaulted tomorrow and the bonds didn’t move very much, that wouldn’t mean a default was priced in, so much as that the market was paralyzed and didn’t yet know what the consequences of Greece’s actions were going to be. Look at Greek bond prices three or four months after a default: that will give you a much better indication of what the effects of the default were on markets.

In general, the market is much better at pricing in small events from Mediocristan than it is big events from Extremistan. A company releases quarterly earnings of 17 cents per share, or the monthly payrolls number comes in at 210,000 — these things can be priced in. Lehman goes bankrupt, Russia defaults, the House fails to pass the TARP bill — these things you just need to live through in order to know how markets will react. So long as the Eurocrats are all still unanimous that a Greek default is unthinkable, you can be sure that markets will fall if and when such a thing happens.

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