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ECB debt contagion fears continue to rise

This chart helps to put the European debt crisis—which is focused on the debt of Portugal, Ireland, Italy, Greece and Spain—into perspective, since the yield on 2-yr government bonds is a good proxy for the market's guess as to the likelihood and magnitude of default. The real risk of default is concentrated in Greece, Portugal, and Ireland.

An investor today can choose between buying Greek bonds that are highly likely to default in some fashion, or he can buy rock-solid German bonds. An efficient market would leave the investor indifferent to the choice. Assuming that Greek bonds will lose 40% of their value in a restructuring tomorrow, then buying them today at a yield of 31% would produce a total return comparable to what could be had by buying a 2-yr German bond today. Here's the math: 0.6 * (1.31)^2 = 1.03, which is slightly more than the 2.53% total expected return on German 20-yr bonds. So one could argue that Greek bonds are priced to an almost certain and immediate default (or "haircut") of 40%. The same math suggests that Portuguese and Irish bonds, with yields of around 17%, are priced to an almost certain and immediate default of about 25%. (There are other ways of calculating the likelihood of default, but this is the simplest.)

Although the rise in yields on 2-yr Spanish and Italian debt is making headlines today, they are still far from likely to default, since their yields are only a few percentage points higher than comparable German yields. If there is a risk of "contagion" from a Greek default, the market is saying that it will most likely be limited to Portugal and Ireland.

I would emphasize that a significant default or restructuring of the bonds of Greece, Portugal and Ireland has in effect already been priced in by the market. Greek 2-yr bonds are currently trading at about 66 cents on the dollar, and Irish 2-yr bonds are trading at about 82 cents on the dollar. The market has known for months that big losses are inevitable, and losses have been taken by the holders of those bonds. The only unknown at this point is the exact amount of the eventual losses. If they are more than 40% in the case of Greek bonds, then there is more pain to come; if they are less than 40%, then that will be good news.

As the above chart of 2-yr swap spreads suggests, the level of systemic risk (using 2-yr swap spreads as a proxy for systemic risk) is still quite low in the U.S., and in Europe it is no more elevated today than it was when the ECB sovereign debt crisis first erupted in May of last year. And as the top chart reminds us, the likelihood of default was much lower last year than it is now. This looks consistent with the following conclusion: a significant default or restructuring of the debt of Greece, Portugal and Ireland is highly likely, but the risk of further contagion is likely to be low. Moreover, the risk that European sovereign debt defaults will prove destabilizing to the Eurozone economy is only moderate, while the risk that all this will have a significant or deleterious impact on the U.S. is very low. I suspect the headlines and the pundits may be exaggerating the dimensions of the problem.

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