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Once burned, twice shy?

Several weeks ago I speculated that the PIIGS crisis might prove similar to Los Angeles' Carmeggedon. Carmeggedon was so named because the planned, 2-day closure of a key section of the 405 freeway was widely predicted to unleash total chaos on the streets of Los Angeles. As it turned out, nothing happened. At all.

Might the widely-anticipated, much-feared default of one or more of the PIIGS turn out to be a non-event? Since markets have had over a year to prepare for this eventuality, might it already be priced in? Might the consequences of an actual default prove far less catastrophic than is currently feared?

As the top chart shows, the market has already priced in a high probability of a substantial default or restructuring of Greek government debt. At a yield of 32.5%, Greek 2-yr bonds are trading at 66 cents on the dollar. A default of Portuguese or Irish debt is much less likely, with 2-yr Irish debt currently trading at 89 cents on the dollar. Although a potential Italian default has been making headlines of late, 2-yr Italian debt is currently priced at 96 cents on the dollar—thus making a significant Italian default (and by extension a Spanish default) not very likely.

As best I can tell, what most concerns the market is that should a PIIGS default occur, it could be contagious; for example, a Greek default might lead to an Italian default. And should both occur, then there are a dozen or so large European banks with substantial exposure to PIIGS debt on their balance sheet that could be brought down, and this in turn could bring down the entire European banking system and wreak havoc in the European economy. The second chart of swap spreads shows that Euro swap spreads have widened out significantly in recent days, reflecting precisely this concern: with 2-yr swap spreads at 90+ bps, the market is saying that systemic risk in Europe has reached significant levels. Not quite as high as last year's panic, however, but high enough to suggest that something distinctly unpleasant is likely to happen. Fortunately for us, U.S. swap spreads are still trading at perfectly normal levels, suggesting the spillover effects of any European default on the U.S. economy and financial market are likely to be quite small.

Whether the risk of a debt contagion that is sufficient to significantly and negatively impact the financial viability of the European banking system is a real and present danger—and by extension serious enough to negatively impact the global economy, or whether the rise in swap spreads is the knee-jerk response of a market still skittish and hyper-sensitive to the financial crisis of late 2008, is the issue at hand. I can't pretend to know the answer, but I am suggesting here that there is a decent chance that the financial panic we are witnessing is an overreaction, and that the reality of an eventual Greek default could be less painful and more contained than the market fears.

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