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The PIIGS crisis is fading in importance



Even as the likelihood of major Eurozone sovereign defaults continues to rise, there are signs that the the denouement of the Eurozone sovereign debt crisis may not be nearly as bad as everyone has been led to believe. This is a theme I've been developing since last July ("Carmageddon, free markets and the PIIGS crisis"), and have updated several times since (Panic exhaustion?, Eurozone panic update, Panic exhaustion revisited). The idea is simple: when markets are given ample time and warning, they are very good at making the necessary adjustments to accommodate the arrival of bad news. As I discuss below, markets have already written off $1 trillion of PIIGS debt, and the sky has not fallen, nor have markets or global economic activity collapsed. In fact, economic life goes on, the U.S. and many other economies continue to grow, and many equity markets have moved substantially higher in recent months. We've had so much "panic" for so long that it's simply fading away.


The PIIGS debt crisis first surfaced in April of last year, which means that markets have now had about 20 months to adjust. That is completely different from the situation surrounding the Lehman bankruptcy and the subsequent financial meltdown of late 2008, because back then there was almost no advance warning of what was coming; the news sparked a classic rush for the exits, in which panic selling drove prices to absurdly low levels, thus making the panic and confusion even worse. The subprime mortgage collapse was also completely different from the PIIGS crisis, because back then the market found it almost impossible to value the thousands of often obscure and arcane mortgage-backed securities that were tied to many millions of homes whose prices were tumbling at different rates all over the country. With the PIIGS crisis, we are dealing with only a handful of borrowers who have issued fairly straightforward debt securities.


This chart shows the price of the current Greek 2-yr bond, which has fallen from almost 100 at the beginning of last year to a mere 26.625 today. The $470 billion of outstanding Greek debt is now trading at about 20-25 cents on the dollar, which means that the market has effectively written off about $350 billion of Greek debt. In other words, if Greece tomorrow were to restructure its debt and impose a 75% haircut on its creditors, nothing much would happen because markets have already priced in that eventuality.


After Greece, where a major default is almost a certainty, the next-most-likely-to-default country is Portugal, with about $220 billion of outstanding debt. The chart above shows the price of the current Portuguese 2-yr bond, which has fallen from 110 early last year to 85.2 today. Portuguese government bonds are now trading at 50-60 cents on the dollar on average, which means that the market has already written off some $100 billion.


Continuing with Ireland, 2-yr Irish bonds have fallen from 106 to 96, and the $150 outstanding of Irish debt is trading at about 80-85 cents on the dollar, for a write-down of  roughly $25 billion. 


Continuing with Italy, 2-yr Italian bonds have fallen from 100 to 94, while the value of the $2.1 trillion of outstanding Italian debt is trading at 85-90 cents on the dollar, for a write-down of roughly $260 billion.

Finally, the $870 billion outstanding value of Spanish debt is trading at about 95 cents on the dollar, for a write down of roughly $40 billion.

Now let's look at what has happened while global bond markets have been busy shaving $1 trillion off the value of sovereign PIIGS debt.


The S&P 500 index is up 10% from the end of 2009, and about as much since the peak of the sovereign debt crisis and double-dip recession fears of early October. 


The Vix index (a good proxy for the market's degree of fear) is still at levels which indicate serious concern, but we see in this chart that the market has weathered two storms of volatility (in the 2nd quarter of last year, and in the past several months) and panic "exhaustion" appears to be setting in, with the Vix trading at 27 today after hitting a peak of 48 last August. Even though a major Greek default has never been more likely nor as large as it is today.


The VIX/10-yr ratio is a good proxy for the market's level of fear and despair. While still extremely elevated from an historical perspective, it has declined from near-Lehman levels to 13.5 today. This chart also reminds us that periods of fear, panic, and despair occur every so often, but eventually they fade away and economic life goes on.


This chart shows how strongly the equity market has been influenced by fear in recent years. But as markets adjust to expectations of PIIGS defaults, fear subsides, and equity prices rise. 


This chart compares the level of 2-yr swap spreads—a good proxy for systemic risk and financial market health—in the U.S. and the Eurozone. The message here is that although the Eurozone banking system is still in the grips of a very serious crisis of confidence (the likelihood of bank failures and thus counterparty risk is very high), the U.S. banking system has gradually decoupled from the problems in Europe over the past few years. Systemic risk in the U.S. is a little elevated, but not seriously by any means. This suggests that even though the Eurozone may yet experience some wrenching bank defaults, and the fallout may well be very economically disruptive to the Eurozone economies, it shouldn't prove too unsettling for the U.S.

As I mentioned in a post last month ("Putting PIIGS debt into context"), the value of liquid, global debt and equity markets is about $110 trillion, and this total can vary up and down by trillions of dollars every day. So the loss of $1 trillion in PIIGS debt is not a big deal from a macro perspective, and I think the charts I've shown here reinforce the point that the reality of a major PIIGS default—should it occur—is likely to be much less catastrophic than the headlines would have you believe. Meanwhile, there is still no reason to give up hope that the PIIGS countries (save, perhaps, Greece) will eventually realize that the best solution to their problems (e.g., fostering more private sector growth by shrinking the size of their governments and lowering and flattening their tax structures) is also the easiest. Major defaults, restructurings, and/or devaluations all have devastating and lasting consequences, but reversing the trend to ever-more-burdensome government is a great solution for the majority of the population.

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