Europe’s lethal uncertainty

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

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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.

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