Get Ready: Another 2008-Style Crisis Coming

Well, my hat is off to the global central planners for averting the next stage of the unfolding financial crisis for as long as they have. I guess there’s some solace in having had a nice break between the events of 2008/09 and today, which afforded us all the opportunity to attend to our various preparations and enjoy our lives.

Alas, all good things come to an end, and a crisis rooted in ‘too much debt’ with a nice undercurrent of ‘persistently high and rising energy costs’ was never going to be solved by providing cheap liquidity to the largest and most reckless financial institutions. And it has not.

Forestalled is Not Foregone

The same sorts of signals that we had in 2008 are once again traipsing across my market monitors. Not precisely the same, of course, but with enough similarities that they rhyme loudly. Whereas in 2008 we saw breakdowns in the credit spreads of major financial institutions, this time we are seeing the same dynamic in the sovereign debt of the weaker European nation states.

Greece, as expected and predicted here, is a right proper mess and will have to leave the euro monetary system if it is to have any chance at recovery going forward. Yes, all those endless meetings and rumors and final agreements painfully hammered out by eurocrats over the past year are almost certainly going to be tossed, and additional losses are going to be foisted upon the hapless holders of Greek debt. My prediction is that within a year Greece will be back on the drachma, perhaps by the end of this year (2012).

Greek default spectre turns material

The weekend Greek revolt against the austerity measures imposed on its economy in return for eurozone funding has elevated the prospect of a Greek default on its debts or a chaotic exit from the eurozone.

The collapse in support for the mainstream parties that had reluctantly accepted the austerity program and the vehement opposition to the measures by the radical left party that finished the runner up in the weekend’s elections has made it almost impossible for a coalition to be formed that would persevere with the program.

It is likely new elections will have to be held next month but given the degree to which Greeks have protested against the harsh eurozone prescriptions – and the 20 per cent shrinkage in GDP and 20 per cent-plus unemployment that has accompanied them – it is improbable that Greece will continue with the reforms it agreed in return for the next $300 billion tranche of eurozone funding.

If it does walk away from that commitment there will be chaos in Greece and, to a lesser extent, elsewhere. Greece would inevitably default on its debts and could be forced to quit the eurozone.

(Source)

There really is no choice for Greece but to leave the euro, and the sooner, the better. Even then, there is a lot of hardship coming their way. But in my estimation, that’s better than the imposed austerity that is a guaranteed torture chamber. The institutions that avoided taking losses on their Greek debt on the first pass through, due to their preferred status in the process (the ECB among them), are almost certainly going to eat big losses this time, perhaps a full 100% of them.

Leaving the euro is going to be quite a process, and the ripple effects are going to be large and somewhat unpredictable. I found this description of what will happen within Greece and its banking system to be well on the mark:

The instant before Greece exits it (somehow) introduces a new currency (the New Drachma or ND, say). Assume for simplicity that at the moment of its introduction the exchange rate between the ND and the euro is 1 for 1. This currency then immediately depreciates sharply vis-à-vis the euro (by 40 percent seems a reasonable point estimate). All pre-existing financial instruments and contracts under Greek law are redenominated into ND at the 1 for 1 exchange rate.

What this means is that, as soon as the possibility of a Greek exit becomes known, there will be a bank run in Greece and denial of further funding to any and all entities, private or public, through instruments and contracts under Greek law. Holders of existing euro-denominated contracts under Greek law want to avoid their conversion into ND and the subsequent sharp depreciation of the ND. The Greek banking system would be destroyed even before Greece had left the euro area.

There would remain many contracts and financial instruments involving Greek private and public entities denominated in euro (or other currencies, like the US dollar) that are not under Greek law. […] Widespread defaults seem certain.

Euro area membership is a two-sided commitment. If Greece fails to keep that commitment and exits, the remaining members also and equally fail to keep their commitment. This is not just a morality tale. It has highly practical implications. When Greece can exit, any country can exit.

As soon as Greece has exited, we expect the markets will focus on the country or countries most likely to exit next from the euro area. Any non-captive/financially sophisticated owner of a deposit account in that country (or in those countries) will withdraw his deposits from banks in countries deemed at risk – even a small risk – of exit.

Any non-captive depositor who fears a non-zero risk of the future introduction of a New Escudo, a New Punt, a New Peseta or a New Lira (to name but the most obvious candidates) would withdraw his deposits from the countries involved at the drop of a hat and deposit them in the handful of countries likely to remain in the euro area no matter what – Germany, Luxembourg, the Netherlands, Austria and Finland.

The ‘broad periphery’ and ‘soft core’ countries deemed at any risk of exit could of course start issuing deposits under English or New York law in an attempt to stop a deposit run, but even that might not be sufficient. Who wants to have their deposit tied up in litigation for months or years?

(Source)

The Greek banking system will be destroyed immediately upon Greece’s exit from the euro, but the banking system there is already all but dead anyway. Best just to sweep the floor clean and start over. The idea is easy enough to understand; if your bank is about to go under, it is best to get your money out before that happens.

The only mystery to me is why so many people have left their money in the Greek banks this long. I suppose they were waiting for a clearer signal? Well, it would seem that the signal has now been sent and received:

Greek Depositors Withdrew $898 Million From Banks Monday

Greek depositors withdrew €700 million ($898 million) from the country’s banks on Monday, fueling fears of a bank run amid the growing political disarray.

With deposits falling, Greek banks become even more dependent on the European Central Bank to meet their funding needs, exposing the central bank to potentially huge losses if Greece leaves the euro area.

Monday’s deposit withdrawal far outpaced Greek banks’ steady decline in deposits since the start of the country’s debt crisis in 2009, as depositors withdraw cash and transfer funds overseas. In the past two years, deposit outflows have generally averaged between €2 billion and €3 billion a month, though in January they topped €5 billion.

The latest data from the Greece’s central bank show that total deposits held by domestic residents and companies stood at €165.36 billion in March.

(Source)

Again, the real mystery to me is who still has 165 billion euros in Greek banks at this stage of the game? Also a mystery is why Greece has not yet imposed a withdrawal moratorium and capital controls? It is only a matter of time, perhaps days, before they do.

Of course, it is the contagion effect that most worries the market, because the same dynamic of utter insolvency leading to the intractable nature of Greece’s dilemma applies to Spain, Portugal, and Italy.

Indeed, the market is already adjusting to this possibility, as evidenced by the spikes in the yields of those country’s bonds:

Contagion Fears Hit Markets

LONDON – Investors battered European stocks, dumped the bonds of Spain and Italy, and bid the euro down against the dollar Monday after the collapse of weekend coalition talks in Greece edged that country closer to an exit from the euro zone.

The sweeping market action dealt a blow to hopes that the damage of a Greek exit, should it occur, could be comfortably contained.

In the market carnage, Greek stocks fell to two-decade lows, and Spanish bond yields leapt to levels not seen since the panic of last November. Shares of a big Spanish lender dropped 8.9% on the Madrid bourse, pulling the benchmark index down 2.7%. The Italian market also fell 2.7%, and the euro slid to $1.2845 late Monday in London, its lowest level in four months.

(Source)

The worry and the carnage are both running deep. And they should. Everything is now interlinked to such a degree that there is no possible way for a run on Greek banks or continued declines in the value of sovereign debt to be anything other than exceptionally destructive.

Everybody owes everybody, and there’s not enough productive economy to mask the insolvency of the system any longer.

We saw this as Spain’s sovereign yields vaulted, Spanish bank shares plunged, a not-so-happy linkage courtesy of the LTRO funding which enabled (and encouraged) Spanish banks to load up on Spanish debt. A virtuous circle morphed into a vicious spiral, each element weakening the other all the way down.

That the US stock market is only down less than 5% from recent highs is a testament to the power of the liquidity that the Fed and US banking system have directed at keeping things elevated. However, this cannot last, at least not without another big quantitative-easing (QE) injection from the Fed. Without such an infusion, I am calling for another 2008-2009-style market rout of at least -30% but possibly as much as -50%.

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