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Tuesday April 27, 2010 - 18:38:08 GMT
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When Does a Sovereign Debt Crisis Become a Bank Crisis?

Written and sent today before S&P and Moody’s downgrades.


When Does a Sovereign Debt Crisis Become a Bank Crisis?


For some in the market the Greek debt crisis has always been about the European banking system…collateralized by “risk-free” sovereign paper from some less than “risk-free” sovereign credits.  Tons of debt issued by Greece, Spain, Portugal (not too different from AAA rates subprime MBS) and yes Italy support the banking system in the Euro Zone as collateral for borrowing from the ECB and from other banks, as well as a place to capture yield.  Well when markets discern that “risk-free” sovereign debt is not really “risk-free” the inevitable run on weak credits starts.  And like the subprime-driven run on banks in 2008, officials only add to downside risk as they assume the problem is contained. 


Surely not even a major election in the state of NRW May 09 would get in the way of Germany’s capacity at cauterizing Greece’s (and now Portugal’s) fiscal crisis if officials there truly grasped the scale of the problem unfolding in this part of the world. 


The bailout cost is growing by the minute like some rigged meter in a NYC taxi cab or the US debt clock in Union Square.  Markets ignored the bazooka in the pocket of the Eurogroup, the bazooka out of the pocket of the Eurogroup and the same for the IMF’s 50 caliber machine gun now on display for all to see. 


Short of guaranteeing Club Med debt, which is an option that politically is impossible to make happen, the only other option to get the likes of Greece back on some normal path for growth is to give creditors a major haircut on debt…not unlike what US banks have to do on underwater mortgages and many HELOCs….write down principal. 


Anyone who thinks deflation is an answer for macroeconomic adjustment is running low on any sense of economic history and common sense.  Greece has two choices (and probably Portugal and maybe Spain in a few weeks)…leave EMU and devalue a resurrected national currency or enter into some debt restructuring program with creditors.


Markets sense the no-good-options nature of this crisis and hence are betting on a partial failure in EMU…amputation or force the exit of the weakest.  Meanwhile the banks in Europe that own or hold Club Med debt are rushing to hedge this exposure and buying CDS at any price. Keep in mind that the Club Med debt in the banking system in Europe is like a Warren Buffett derivative…no collateral posted in better times. Shorting Greek government debt is not an option for many as the supply of it can’t handle the demand.  European banks will at some point, in theory, mark to market distressed Club Med exposure and if this contagion drags Spain and Italy into the gutter of distressed sovereign debt, and then the solvency of the European banking system will be seriously challenged requiring fresh recapitalization. 


We know the ECB is keeping the Greek banks afloat (deposits have been depleted as Greeks move cash into non-Greek banks) as they are cut off from the interbank lending market.  How long before the ECB is keeping Portuguese banks on liquidity life support?  And how long before Spanish banks are registered with ECB’s methadone program?   And how long before ROW banks treat all Euro Zone banks with a large dose of Lehman-like counterparty suspicion?   


This points to huge potential liability for the European taxpayer.  One has to ask is this tenable?  Is the great single currency experiment worth it?  As one official at G20 observed last week…when the Titanic sank the First Class passengers suffered the same fate as the steerage class.   


A strong recovery would give the Euro Zone a means for avoiding the iceberg and sinking ahead…strong growth is an elixir for many ills, especially indebtedness. Yet Europe is lagging in this global recovery and countries with large imbalances like Greece (and Portugal) can’t do what is natural in this environment…devalue its currency.  Imposing deflation to address imbalances is destructive medicine.  EUR devaluation would be the next best thing…and yet officials in healthy Europe are not likely to take this path. 


So we are stuck with watching a sovereign debt crisis morph into a banking crisis and testing the very essence of EMU.  And it will reverberate across continents and assets classes demanding taxpayer funded bailouts.  This is not a market that favors risk assets.  I am also confident that reserve managers engaging in diversifying from USD to EUR can’t keep it going indefinitely. 


It takes many cuts of a saw to fell a giant sequoia redwood…EMU is a few pulls of the saw from toppling and asset prices and the EUR have a long way to run (lower) to reflect this ever nearer event.


David Gilmore



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