Europe’s Dangerous Bonds

The chart below, which comes from the Calculated Risk blog, shows how the bond yield spreads of Europe’s peripheral markets have widened again, after a brief respite earlier this summer.

The EU/IMF bailout of Greece in May helped the country’s 10-year bond yield spread over German bonds to halve from a peak of over 1000 basis points.  However, spreads have steadily increased since then, and are now almost back up to those May highs.

The introduction of Europe’s financial stability fund (EFSF) in June, a month after the Greek bailout, in an attempt to stop the contagion spreading elsewhere within the eurozone, has also had limited success, if one looks at the widening spreads of Ireland, Spain, Portugal and Italy over recent weeks.

Remember that the EFSF is a kind of CDO structure that uses overcollateralisation to try and enhance its overall creditworthiness:  the collective guarantees of the 19 participants are designed to add up to 20% more than the amount insured by the fund.

The problem with the structure – as with CDOs – is that all the apples in a basket tend to go bad at once.

As derivatives expert Satyajit Das calculates, “if 16.7 per cent of guarantors (20 per cent divided by 120 per cent) are unable to fund the EFSF, lenders to the structure will be exposed to losses. Coincidentally, Greece, Portugal, Spain and Ireland happen to represent around this proportion of the guaranteed amount. If a larger eurozone member, such as Italy, also encountered financial problems, then the viability of the EFSF would be in serious jeopardy.”

The Irish government, which earlier this year was being lauded – by contrast with those lackadaisical Greeks – for taking the harsh medicine of austerity, is now right back in trouble.

As an article in today’s Economist points out, the cost of Ireland’s bank bailout has soared, raising concerns that public debt is out of control.  Ireland faces a classic debt trap, with nominal GDP having shrunk by nearly 20% since the 2007 peak, causing the real debt burden to compound at an accelerated rate.

In Greece, servicing debt at double-digit interest rates while economic activity contracts by 4% this year, then 2.6% next, would be impossible were it not for the EU/IMF backstop.  Meanwhile, top-end property prices have already fallen by half.

If the credibility of that backstop is beginning to be questioned – and market developments suggest that it is coming under increased pressure – then European government bonds are heading for another crisis, with the euro likely to take the strain as well.

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