Is Europe another Lehman?

In retrospect, the failure of Jon Corzine’s MF Global may be the first domino to fall in response to Eurozone troubles. Corzine’s fund had bought billions of Eurozone debt on the assumption that bondholders would either be protected or bailed out. In the end, the firm’s rapid decline came on the heels of a larger-than-expected quarterly loss and a downgrade by major credit rating agencies. As the firm revealed more details about its exposure to sovereign debt from Ireland, Italy, Belgium, Portugal, and Spain – counterparty concerns only grew, along with demands for more collateral.

Many other financial institutions may not be far behind. Eurozone sovereign debt is held by numerous financial institutions. Many other firms don’t have much direct exposure to Greece, but are intimately connected with firms that do. Just as the systemic consequences of subprime mortgage default ultimately proved highly destructive to the global financial system in 2008, the consequences of Europe’s inability to finance government debt may have comparably devastating consequences. Here’s a brief rundown of recent e21 commentary on the ongoing Eurozone crisis.

On future Greek solvency

Consider Greece today. Even if Greece managed to keep cutting spending, wrote down its debt by 50%, kept its banks solvent somehow, and managed to fund its continuing huge deficit without leaving the eurozone, Greece would still face a daunting real exchange rate over-valuation problem (currently estimated at between 40 and 50 percent relative to Germany). Without devaluation, it will take Greece many years of deflation and recession to eliminate that over-valuation. Furthermore, deep reforms in labor laws and other economic rules would also have to occur immediately to restore competitive productivity growth, or else Greece will continue to experience further slippage relative to the North…

If the answer for the South is not just debt write downs, bank bailouts, and austerity, then what is it? Either the departure of some countries from the eurozone to permit growth, or a gamble to preserve the currency union through higher inflation, engineered by the European Central Bank (ECB) to encourage southern reforms. In my view, the first option is the better one; I doubt that a credible deal can be agreed to trade deep reforms in the South for higher inflation, and once higher inflation becomes entrenched, it will be costly to bring it down.

On the decision to restructure Greek debt in the form of voluntary haircuts

The oxymoronic decision to force private sector creditors to accept voluntary haircuts on Greek sovereign debt is likely to doom the sovereign credit default swaps (CDS) market. CDS are insurance-like financial contracts that allow investors to buy protection from default risk. The new 50% write down on Greek government debt is tantamount to default, but structured in such a way so as to avoid triggering CDS default payments. This is like watching a house burn down while simultaneously learning that fire is not a risk covered in the homeowner’s insurance policy. Why would anyone rationally decide to throw money away on insurance premiums in the future?

The problem for the euro zone is that the potential “buyer’s strike” will extend not only to CDS protection, but also to sovereign bonds themselves. CDS are used to reduce net exposure to credit risk. If an investor has $100 million of gross exposure to Italian sovereign debt, for example, she can cut her net exposure to $50 million by buying $50 million of notional protection in the CDS market. However, if the investor later discovers that the CDS protection does not work, the only way she can reduce her net exposure to $50 million is by selling $50 million of her Italian government debt portfolio.

On the implications of Greek default on US markets

The U.S. would likely feel immediate financial repercussions from the Greek default in two ways. First, as explained previously, data from the Bank for International Settlements (BIS) suggest that U.S. banks may have large residual exposure to Greece through credit derivatives. Secondly, the U.S. money market mutual fund (MMMF) industry basically provides the dollar funding for European banks today. Both exposures could be significant and pose an enormous risk to the continued functioning of the U.S. financial system.

According to BIS, European banks hold about $8 trillion in dollar-denominated assets. To avoid currency risk, they have to either finance these holdings through dollar liabilities or through currency swap arrangements. The cheapest way to finance these positions is through issuing commercial paper to U.S.-based money market funds. MMMFs are eager to provide this low cost funding because the interest rates European banks pay are actually higher than the rates paid by U.S.-based commercial paper issuers (called the “Yankee premium”). While this seems like a match made in heaven as both sides get better deals than available from other market participants, the effect is to import European financial fragility to the U.S.

John Makin, resident scholar at the AEI, has also recently delivered an extensive Congressional testimony that details the European problem and how American markets are interconnected:

Americans are exposed to the European debt crisis through money market funds, among other channels. The rapid slowdown of US economic growth, along with the elevated uncertainty tied to July’s debt-ceiling fiasco, caused many households to sell stocks during August. Typically, investors move such funds into “cash equivalents” or money market funds, which pay virtually no interest but are meant to be highly liquid should households need to reinvest the funds or to purchase goods and services. As Europe’s debt crisis intensified during the summer, US money market funds were, in effect, lending heavily to European banks that in turn were significantly exposed to shaky sovereign-debt issuers like Greece, Portugal, Spain, and Italy. The result was that Americans who wanted to avoid more risk by exiting stocks and entering money market funds were effectively lending to Greece and Portugal. This discovery led money market funds to sharply reduce their exposure to European sovereign debt as depositors began to exit for fear that the funds would be vulnerable to a Greek default and other European sovereign-debt problems…

The systemic mess the United States and Europe—and eventually, the rest of the world—are facing in the fall of 2011 is greater than the sum of its parts. The US economy slowed down even after substantial monetary and fiscal stimulus had been applied. The slowdown was surprising and also disconcerting to policymakers who had to entertain the notion that the policy levers they were pulling were no longer effective. Just as these disquieting realizations were arising in the United States, the European debt crisis reintensified as Greece teetered on the edge of default and the crisis environment spread to the rest of southern Europe.

The situation is quite worrying for Europe; but is no less troublesome for America. The nature of modern interconnected financial markets means that European troubles will not be contained, as we learned during the subprime mortgage crisis. Unfortunately, policymakers have not been spending the last several years taking the lessons of 2008 to heart and helping to build a resilient financial system. Rather, we have a financial system just as brittle; one that may be headed to collapse again in face of new European problems.