It Should Be Obvious To Many That The Risk Of Defaulting Sovereign Bonds Can Spark A European Bankings Crisis

I’m fresh back from my trip to Amsterdam where I lectured ING clients and staff on this very same topic. Below are a few clips from the first of two lectures.

Now that the mainstream media has been reporting what BoomBustBloggers knew as fact as far back as two years ago. Today, the FT printed an article titled “Greek debt hit by restructuring fears“, whose pertinent points are as follows:

The euro tumbled on Thursday and premiums charged on Greek debt over Germany’s hit euro-era highs after the countries’ respective finance ministers talked of Greece needing more time and raised the prospect of debt restructuring.

In an interview with the Financial Times, George Papaconstantinou said Greece needed more time to convince international investors of its commitment to reform its finances.

Separately, Wolfgang Schauble, Germany’s finance minister, told Die Welt newspaper that, if a study already under way showed Greece’s debt levels were unsustainable, “further measures” would have to be taken.

When asked what those could be, he ruled out any involuntary restructuring before 2013, but warned investors could face losses after that point…  Yields on Greek two-year bonds jumped nearly a full percentage point to 17.884 per cent.

… “Greek bonds are getting crushed today due to the comments from the German finance minister and the Greek equivalent,” said Gary Jenkins, head of fixed income at Evolution Securities. “The European Stability Mechanism allows a roadmap towards restructuring, indeed it insists upon it if debt cannot be restored to a sustainable path.”

Investors… flight left yields on equivalent Greek debt 24bp higher at 13.162 per cent while Portuguese 10-year notes yielded 8.88 per cent, up 14bp. Mr Jenkins said investors expected that any restructuring would start with Greece trying to extend repayment deadlines on existing debt, or asking investors to “forgive” interest on the loans. But he warned it could take more than that. “Ultimately we believe that if the idea is to get the debt back to a sustainable level then the target will be the Maastricht treaty limit of debt-to-GDP of 60 per cent. In order to reach that level bonds will have to take a haircut of some 62 per cent,” he said.

Professional and institutional subscribers should feel free to look at a variety of haircut scenarios via out proprietary sensitivity analysis for the Greek head grooming. If you remember last year when  illustrated How Greece Killed Its Own Banks!, you realize the main reason why the EU has been using the kids gloves with the Greeks. To make a long story short, let’s employ the old adage “A picture is worth a 1,000 words”…

Insolvency! The gorging on quickly to be devalued debt was the absolutely last thing the Greek banks needed as they were suffering from a classic run on the bank due to deposits being pulled out at a record pace. So assuming the aforementioned drain on liquidity from a bank run (mitigated in part or in full by support from the ECB), imagine what happens when a very significant portion of your bond portfolio performs as follows (please note that these numbers were drawn before the bond market route of the 27th)…

The same hypothetical leveraged positions expressed as a percentage gain or loss…

When I first started writing this post this morning, the only other bond markets getting hit were Portugal’s. After the aforementioned downgraded, I would assume we can expect significantly more activity. As you can, those holding these bonds on a leveraged basis (basically any bank that holds the bonds) has gotten literally toasted. We have discovered several entities that are flushed with sovereign debt and I am turning significantly more bearish against them. Subscribers, please reference the following:

• Leveraged European Entities from a Sovereign Risk Perspective – retail
• Leveraged European Entities from a Sovereign Risk Perspective – professional

If you think those charts look painful, imagine if the Maastricht treaty was actually respected. Our models haven’t pushed passed 80% debt to GDP, but if you were to put the treaty’s debt ceiling in you would see the very definition of contagion. The following chart represents the first order consequences of a 62% haircut on Greek debt…

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