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Is Greece another Lehman?




For now, it's all about Greece. 2-yr Greek government yields are now just shy of 70%, and the bonds are trading at just under 40 cents on the dollar. In sharp contrast, 2-yr Irish government yields are only 9.5%, and the bonds are trading at 94.6 cents on the dollar—thanks to a credible austerity plan which involves real spending cuts. If Greece doesn't default or restructure its debt in a major way, Greek bonds would be one of the world's most fabulous investments. But with prices so low, the market is essentially saying a major Greek default is a done deal, and the only piece of the puzzle that is missing is exactly how big the default/restructuring will be.

Watching Greek yields rise this year has been like a watching a slow motion train wreck. A default seemed to me like a slam-dunk last April, so I'm surprised that it hasn't happened yet, and that the world is still trying to adjust to the reality of a looming default. How much worse can things get?

Well, with Treasury yields at historically low levels, with T-bills yielding zero, with gold trading at $1800, with Eurozone bank stocks cratering, with the Italian stock market down 42% since February, and down 70% since its 2007 high, the market is pricing in lots more bad news—something like an end-of-the-world-as-we-know-it scenario. A Greek default leads to a Portuguese default, which drags down Ireland and eventually Italy and perhaps Spain, and along the way the cumulative defaults wipe out the capital of the entire Eurozone banking system, which in turn sparks a global financial and economic collapse.

So the question is: will a Greek default precipitate another meltdown of the world's financial markets and send the global economy into another tailspin? Are we on the cusp of another Great Recession or even a Global Depression? Is Greece the catalyst, as was the Lehman default?

I think there are some huge differences between a Eurozone default today and the bursting of the U.S. housing market bubble, which was the proximate cause of the Lehman default and the financial panic of 2008.

The financial crisis of 2008 was triggered by a decline in U.S. housing prices and a consequent rise in mortgage defaults. Mortgage default rates rose from 1% in 2006 to over 4% in 2008, and peaked at 5.6% in 2009. Cumulative defaults ended up being well over $1 trillion, but at the depths of the crisis I recall that many securities were priced to default rates as high as 50%.  Millions of homeowners were defaulting; millions of mortgages were at risk; thousands of mortgage-backed securities were involved; many hundreds of banks and financial institutions around the world had significant exposure to the collapse of the U.S. housing market. The huge losses and the fears of much more to come triggered panic selling, which resulted in downgrades, which forced more panic selling.

The Eurozone sovereign debt crisis involves only a handful of borrowers: Portugal, Ireland, Italy, Greece, and Spain. Together they owe $3.9 trillion, with Italy accounting for 56% of the total. To judge by prices in the credit default swap market, the real risk of default is concentrated mainly in Greece (1850), Portugal (1220), and Ireland (910), which together owe $820 billion. Italian CDS are priced at 430 bps, which equates to the upper range of high-yield bonds, where default rates are measured in the single digits and recovery values are well over 50%. A couple of dozen of Eurozone banks hold the lion's share of the debt that is subject to default.

The 2008 crisis was acutely aggravated by the fact that it was literally impossible for anyone to fully understand the default risk of mortgage securities that were comprised of millions of mortgages issued under all manner of conditions (e.g., fixed rate, variable rate, interest only, 95% LTV, 100% LTV), based on homes in hundreds of different regions, and securitized into thousands of vehicles, that in turn were split up into dozens of derivatives, which were owned by many hundreds of banks and financial institutions around the world. The risks inherent in the mortgage market were far too complex to understand, much less quantify, and the uncertainty itself was a major factor driving down prices, forcing defaults, and shutting down commerce. By the time the dust had settled a few years later, securities that were priced to death and destruction ended up paying handsome returns. In short, the uncertainty meant that at one point the market was expecting an order of magnitude more losses than ended up occuring.

In contrast, the sovereign debt crisis is very easy to understand and quantify: a handful of borrowers, no securitization, no complex derivatives, and only a few dozen lenders at risk. None of the PIIGS face the risk of deflation, which would be akin to the price declines that undermined the U.S. mortgage market. A PIIGS default, if one occurs, is all about politics: can the country adopt the necessary fiscal discipline to convince markets that its debt will be repaid? Or perhaps as the news today suggests—that China may be willing to buy a big chunk of Italian bonds—other countries may be willing to shoulder a significant portion of the PIIGS debt burden. Just a few decisions here and there could make all the difference in the world.

Consequently, I would argue that the Eurozone sovereign debt crisis is amazingly transparent, whereas the 2008 mortgage market implosion was a blizzard of obscurity. That difference alone should make the outcome much less serious than what the world faced and feared in late 2008, and that's why I think the market is too pessimistic.

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