As far as Greece is concerned, it’s now merely a matter of when a default occurs and by how much bondholders’ hair will be cut.
John Hussman’s latest weekly market commentary gives us a chart that links three variables, derived from current Greek bond yields: the likelihood of default, expressed as a percentage; the time from now to the default event; and the recovery rate (a 95 percent recovery rate equates to a 5 percent “haircut”, 60 percent recovery is the same as a 40 percent haircut, and so on.)
What investors are collectively telling us, Hussman’s chart makes clear, is that default is almost certain, and it’s only a matter of by how much and when. Whether you assume that 5 percent, 20 percent or 40 percent is taken off the net present value of Greek government debt, a default by 2013 is priced in completely. Even a massive 95 percent wipe-out of Greek debt value is given as having a four in five chance in ten years’ time.
But, though Greece is important, it’s a sideshow when compared with the battle over potential writedowns in the debt of European banks.
According to Morgan Kelly, writing in May in the Irish Times, late last year during bailout negotiations Ireland’s government had reached a notional agreement with the IMF to impose losses of up to two thirds on holders of senior debt in the country’s banks. Remember that it was Ireland’s decision in September 2008 to backstop bank obligations that eventually led to an unsustainable burden for taxpayers. The country’s politicians realised by 2010 that they had made a mistake (to their credit, one might think), and sought to reverse the policy.
However, the proposal to impose “haircuts” on holders of those senior Irish bank bonds was vetoed from an unexpected direction—by US Treasury Secretary Tim Geithner, according to Kelly. Geithner’s position of refusing to contemplate losses for senior debt holders was apparently shared by the European Central Bank.
One cause of policymakers’ hypersensitivity over the idea of senior debt holders actually bearing the risks they signed up for is the prospect of renewed bank runs. In many countries senior bank debt ranks pari passu (equally) with bank deposits, meaning that if bondholders face losses, so do depositors. And since the financial crisis, with the single exception of Iceland, the notion of allowing Europe’s bank depositors to take a hit when an institution fails has been excluded from polite debate.
But things may be changing. Irish officials have in the last week again flagged the prospect of imposing losses on senior bondholders, causing the ECB to issue an immediate slapdown. While the ECB’s response indicates that such a policy remains taboo at EU level, a precedent has in fact been set in February (in Denmark) for burdensharing to be imposed on owners of senior debt, as Tracy Alloway of FT Alphaville covered at the time.
And, in a little-publicised case, British financial authorities last week announced that a small bank (with an unfortunate name, given financial history, “Southsea”) would enter insolvency proceedings, but that depositors in the bank would be protected only up to the £85,000 limit for the UK’s deposit insurance scheme. If you had more than that in the failed bank—and some individuals did—then you’ll have to enter your claim in court as a creditor, and face the prospect of receiving only pennies in the pound on the amount you’d deposited in the bank over and above the insured limit.
Compare the way the authorities have treated Southsea with the blanket bailout of all depositors in Northern Rock (and in the UK branches and subsidiaries of failed Icelandic banks) only three years ago, and you’ll sense that a tectonic shift may be taking place, at least at the individual country level in Europe.
So far, broad measures of European banking sector credit risk, such as the Markit iTraxx Europe Senior and Subordinated financials indices (which measure an average of 25 credit default swap spreads on the senior and subordinated debt, respectively, of European financial institutions) are registering concern, rather than panic. See the chart below.
Complicating things further (when you look the CDS market) are attempts by some overindebted issuers to try and restructure obligations in ways that avoid “triggering” default clauses in related credit derivatives. According to Tamara Burnell of fund manager M&G, this has also now become a political issue (and an international one), given potential cross-border exposures and risks of contagion.
Playing with fire is a mild way of describing such attempts to wriggle out of CDS-related obligations, since the potential gains for some institutions if payouts can be avoided are likely to be overwhelmed by a much bigger market shock if investors worldwide find that the contracts they had bought to hedge bond risks turn out to be unenforceable.
These CDS-specific caveats aside, it’s not Greece that investors should now be focusing their attention on. For equity investors as well as for the fixed income markets, how the stand-off over bank debt burdensharing is resolved seems the most crucial question of all.