The euro began weakening sharply at 2pm EDT yesterday when Greece’s Prime Minister Papandreou announced his intention to seek another vote of confidence late this week and then hold a national referendum on Europe’s deal with Greece (130 billion euros in new aid and a 50% debt haircut in return for austerity measures.) The Dow lost 150 point from 2pm to the market close.
- The vote of confidence is a risk in itself, though it should be resolved late this week. Papandreou’s majority is tenuous, maybe three seats. Austerity is unpopular. The legislature is reluctant to downsize (see the Saturday New York Times article about the perks of Greek legislators including free Mercedes, payments for attending meetings, riding coach and nutritionists on staff.)
- A Greek referendum is a more open-ended risk and an even harder sell. Our piece this morning pointed out that Greece’s pension funds hold Greek debt and will be hurt by a haircut, making it politically unpopular. Much of the new aid to Greece is in the form of non-rescheduleable loans from the IMF and other sources. The ECB is providing various forms of assistance to Greek banks and the Bank of Greece (Greece’s central bank) that will presumably end up as non-rescheduleable Greek debt.
- A referendum would create a date in the future when bad news might come out. It gives time for the deal to be examined and criticized. If the referendum occurs and is rejected, it would probably be interpreted as a public renunciation of Greece’s national debt (and of Papandreou, of course). The ECB might be unable to continue its behind-the-scenes support for Greek banks and the Bank of Greece, leading to a shortage of euros in Greece and the risk of a Greek exit from the euro. As discussed in our previous pieces, we think any country departing the euro (resorting to scrip or local currency issuance) would cause a severe contagion to euro deposits in other weak euro-zone countries. While many are advocating a breakup of the euro, we think it would be a very deep global negative while it occurs and a longer-term negative due to the resulting devaluations and implications for borders, population mobility and trade barriers.
Separately, other factors may add to pressure on European sovereigns, banks and bank assets:
- MF Global was reportedly long Italian debt. In bankruptcy, it might be a seller of those and other assets. Markets like to sell first.
- European banks may want to sell similar assets in order to reduce leverage and meet new capitalization requirements.
- Rules applying mark-to-market to European banks were intensified in October. We think this will heighten volatility and may reduce liquidity for a range of bank assets as potential market makers renegotiate with the asset holders. We wrote extensively in late 2008 and in 2009 about pro-cyclicity -- the harmful interplay between arbitrary bank regulatory capital standards, mark-to-market applied to thin markets, momentum-based bond ratings, and naked CDS. We think the bottom in bank stocks didn’t occur until Congress’s March 12, 2009 instruction to FASB to stop feeding the contagion.
- The value of CDS as a hedge for sovereign exposure is at risk. The determination by ISDA that the proposed 50% haircut on Greek debt is voluntary and does not trigger CDS contracts change the ability of sovereign bond-holders to hedge their exposure. For example, a French bank that is long Italian debt hedged by CDS is now more exposed than it thought. It may want to sell due to MF Global, capitalization requirements, mark-to-market and uncertainty about hedging.
- There’s also direct contagion in that a 50% haircut for Greece makes debt issues by other weak euro countries less saleable (because sovereign debt can now be reduced by large haircuts); and reduces the incentive for structural reforms like Italy’s commitment to increase the retirement age to 67 (because structural reforms are now used as a bargaining chip for debt forgiveness and new EU aid.)