Europe’s lethal uncertainty

By Felix Salmon
September 6, 2011
John Lanchester is a great place to turn for such things:

" data-share-img="" data-share="twitter,facebook,linkedin,reddit,google" data-share-count="true">

As markets plunge again today, ostensibly on existential worries about the eurozone, you might want a plain-English explanation of what the root of the problem is. And John Lanchester is a great place to turn for such things:

On 16 August, Nicolas Sarkozy and Angela Merkel had an emergency meeting to decide what to do about the Eurozone crisis. After it, they gave a press conference at which they spoke in platitudes about the need for Europe to improve its ‘economic governance’, avoiding all specifics. They precisely and explicitly ruled out the only two things which would have helped: the creation of ‘eurobonds’, i.e. debts backed by the full economic weight of all the countries inside the eurozone; and the extension of the €440 billion European Financial Stability Facility. It’s easy to see why they did this, and their reasons are entirely to do with the domestic unpopularity of giving more aid to the indebted and severely struggling ‘Club Med’ countries of Southern Europe. Unfortunately, Merkel and Sarkozy’s inaction is a recipe for certain disaster. Everybody and his cat knows that the eurobond is the only way out of the crisis for the eurozone in the medium term; as for the necessary size of the short-term bailout facility, Gordon Brown’s guesstimate was €2 trillion. That ‘could have convinced the markets that Europe meant business’. Huge, sustained and manifestly undeflectable government intervention on that scale is the only thing which will cause the speculators and hedge-funders and ‘hot money’ types to back off. Instead, nothing.

Lanchester’s full essay is well worth reading, and helps to put today’s news in perspective. When Mario Draghi says that Europe needs to “make a quantum step up in economic and political integration,” he’s basically agreeing with Christine Lagarde that Europe’s nations need to stand together. And when elected leaders signally fail to say the same thing, markets fall.

Meanwhile, amazingly, the Greek bond exchange is still far from a done deal, and Landon Thomas does his best to try to explain how Europe’s banks are being pushed to accept it:

This week, bankers representing the Greek government — Deutsche Bank, BNP Paribas and HSBC — have been explaining to investors why it is in their interest to trade in their decimated Greek bonds, take a 21 percent loss and accept a new package of longer-dated securities with AAA backing…

With the price of Greek debt trading in some cases at 50 cents on the dollar — even lower than when the bailout deal was announced in July — the 21 percent haircut seems to be quite a bargain.

As a bonus, the new bonds would be governed by international law, rather than Greek law. That is a significant alteration of lending terms that would strengthen the negotiating hand of the bondholders if Greece eventually concluded it had no alternative but to default — even after this latest bailout.

The math isn’t quite as simply as Thomas implies — if you take a 21% haircut on a bond, the new instrument is not automagically going to be worth 79 cents, even if it does have “AAA backing”. That backing will be in the form of long-dated zero-coupon collateral which is hard for bondholders to extract, and the new debt will still have a low credit rating and a large amount of default risk baked in.

But the governing-law part of the deal is important. Thomas cites (but doesn’t link to) Lee Buchheit’s important paper on that topic. Basically, current Greek debt is in many ways worthless to bondholders: if and when Greece defaults, they have no legal recourse. But if the exchange goes through, then the new Greek debt will give bondholders real teeth in the event of default.

There’s still a lot of weirdness going on in Greece’s debt, especially at the short end of the yield curve. Consider this, for instance: the Greek bond maturing on January 11 is trading at par — the market expects it to be paid in full, and the yield on the bond is in single digits. But the Greek bond maturing on March 20 is trading at about 63 cents on the dollar, for a yield well into triple digits. Meanwhile, the bond maturing on May 15 is trading in the low 80s, for a yield of around 30%.

There might be a good explanation for why short-dated Greek debt is trading so oddly, or it might just be an artifact of illiquidity. But the general chaos and uncertainty that’s reining in Europe right now is very reminiscent of the height of the financial crisis. Crises of confidence are always self-fulfilling, and the longer governments take to react to them, the worse they get. Europe, by its nature, moves slowly. And that’s bad news for global markets.

More From Felix Salmon
Post Felix
The Piketty pessimist
The most expensive lottery ticket in the world
The problems of HFT, Joe Stiglitz edition
Private equity math, Nuveen edition
Five explanations for Greece’s bond yield
Comments
8 comments so far

Meanwhile back here in the US, we continue to watch the deficit hawks (who didn’t seem to mind spending for the Iraq/Afghan military efforts) continue to drag down the economy. The fact is the stimulus helped cushion the blow of the financial crisis. One need look at the current budget shortfalls of many states. The deficit reduction crowd don’t seem to get that the states are hurting badly, and the consequences of not acting will be felt mostly by those already suffering from long term unemployment. To see how another round of stimulus might help, see this chart which sizes the budget shortfall & stimulus grants per capita (in a few critical states):

http://www.verisi.com/resources/decision 2012.htm#s5

Posted by datascientist | Report as abusive

There might be quotes for the very short term bonds that are printing in the high 90′s but I don’t see any recent trades.

Posted by random_trader | Report as abusive

datascientist, so an expenditure of around a trillion over a decade is the same as a DEFICIT of over a trillion in one year?

Posted by Danny_Black | Report as abusive

“the Greek bond maturing on January 11 is trading at par — the market expects it to be paid in full, and the yield on the bond is in single digits. But the Greek bond maturing on March 20 is trading at about 63 cents on the dollar, for a yield well into triple digits. Meanwhile, the bond maturing on May 15 is trading in the low 80s, for a yield of around 30%.”

Fairly simple to explain that barbell. random_trader noted half of it: not exactly a liquid, trading market.

The other half is the Good Story issue: you can meander through Q4 with Euro extensions and the like, but by mid-to-late–but not necessarily early–January, the flows for the year will be clear.

By March, there will be need for another bailout. Expecting to be paid then is a mug’s game. Once the queue forms, you might not get paid for months. Many months. Treat a 3/2012 maturity as a 9/2013 or 3/2014 zero and the yield drops into line.

By May, Something will have happened, and a 30% yield is barely enough protection for the (implicit) currency risk of UnEuroBundled Greece.

Posted by klhoughton | Report as abusive

@Danny_Black: “so an expenditure of around a trillion over a decade is the same as a DEFICIT of over a trillion in one year?”

That’s not what ‘datascientist’ wrote, nor what he meant, and you know both of those facts, which is unfortunate because you normally add value around here. Less trollish next time?

Posted by SteveHamlin | Report as abusive

The problem with Eurobonds is that they would create a defacto dictatorship. They would create a new country, “Europe”, that does not answer to any electorate.

Breakup seems like rough sailing but it would force real solutions. Why do Greeks still get to retire so much earlier than Germans? Isn’t Germany’s ‘success’ partly a fiction due to lending to uncreditworthy countries who then buy its stuff? Doesn’t this give the same fake success that we saw during years of the US housing bubble?

Breakup would probably be seen as the cause of a huge recession, but in reality it would not be the cause. Similarly, Lehman was not the root cause of the recession. The cause was the bad lending and poor asset allocation during the bubble. If Lehman didn’t trigger things, something else would have.

Perhaps when Europe is in a full-blown recession anyway the polical difficulty of breakup will be less.

Posted by DanHess | Report as abusive

Felix, hardly a plunge. The DAX fell 1%, the BE 500 0.7% and the STOXX was down 1.29%. Seven European indexes actually went up so why use an emotive word such as ‘plunge’?

It does seem popular to invent Euro bashing stories at the moment. If the Euro really was so weak, why is it within 10% of its lifetime high against the USD? Why is it 66% higher than its weakest ever value against the USD? Doesn’t that say more about the USD being the sick man here? The European politicians may be slow to move, but the US politicians are in horrendously self-destructive opposition to each other.

If the US doesn’t sort itself out and start working together I can see a future with the US being broken up as the only solution to politicians that only seek to undermine the other party, even at great cost to the Nation. As the parties are predominantly regional (blue coasts and red middle) a split along those lines could be the outcome.

@DanHess actually Europe does have elected politicians that are directly elected to the European Parliament.

Posted by FifthDecade | Report as abusive

Felix,

I don’t see how these two sentences fit togeather:

“even if it does have “AAA backing”. That backing will be in the form of long-dated zero-coupon collateral which is hard for bondholders to extract, and the new debt will still have a low credit rating and a large amount of default risk ”

How can the new bonds have both AAA collateral backing and default risk? How is this not different from having FDIC insured deposits in the 100 weakest banks in the country. Sure there are some forms to fill out and you might not get your check until next Thursday but you know you’ll get your principal and interest.

If you can buy some Greek bonds at 50c swap them for 79c worth of new Euro backed bonds you’ve made what looks like a pretty safe profit. It will be interesting to see if Bill Gross is doing this in size.

Posted by y2kurtus | Report as abusive
Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/