Greece will not be 'allowed' to default until policy shores up the Irish bond market

Just look at Tracy Alloway's imagery at FT Alphaville, and you'll know what's expected: an imminent Greek default. I still argue no, although European policy tactics are quite enigmatic and their next move is really anyone's guess. Alas, here's mine.

Assuming that Greece does not secede from the Euro area, I give you three reasons why Greece will not be allowed to default soon (at least the next 12 months, given current market conditions). I say 'allowed' because true to the IMF legacy, EU/Euro area officials very likely see restructuring as a 'gift' for good fiscal behavior.

(1) Moral hazard is an important issue in Europe, and Greece has only begun its austerity program. We'll need confirmation that they are not on track in order to assess the timing of default, in my view.

Ironically, the EU/IMF/Euro area are sticking to the 'exports will grow the Greek economy' story. I say ironically because Greece was exporting a larger share of GDP before the recession, average 22.6% spanning 2005-2007, than it is now, 19.8% in 2010 (average Q1-Q3).

(2) The banking system's not ready. Unless the Germans want to instantly recapitalize the Landesbanks this year, I'd argue that the Euro banking system remains overly exposed to mark-to-market accounting (i.e. holding the assets at fair value not wishful thinking) for all of the crappy debt that it holds on balance.

In fact, the German banks purchased 11bn 1.1bn euro in Greek sovereign bonds in January. That's the most current data available; but I bet they're simply moving debt out of the Greek banks and corporates and into the sovereign as the probability of default rises (see chart below).

(3) This one's critical: policy makers must shore up Ireland and Portugal in order to avoid a quick contagion across the European banking system. They haven't done that yet. In fact, the Finnish election results exposed the tenuous negotiation process overall.

See, the Greek yield curve is inverted - so are the Portuguese and Irish yield curves, albeit to a much lesser degree. The point is, that Portugal and Ireland are very close to the Greek brink.
(read more after the jump!)



Inversion matters. Currently a Greek 10yr bond yields 14.5% with a euro price of 59, while a 2-yr bond yields 21.4% with a euro price of 73. Bond investors are going for the cheapest bond not the highest yield (at the end of the yield curve) as a bet on a binary situation: haircut or no haircut. When a curve is inverted, it's all about price not yield.

Portugal and Ireland are already inverted and close to the Greek brink. If Greece were to restructure without a full-fledged backstop from the Euro area governments, the Portuguese and Irish curves would swiftly turn over. And if European policy makers could stop the contagion there, then that would be a true feat....

Spain, the economic 'line in the sand', would be next. We saw last week how markets view the Spanish sovereign, still risky. Bond yields on the Spanish 10yr broke out of a 4-month trading band, hitting 5.55% on April 18 (latest number is 5.47%).

More on Ireland

I assure you, that it's too early to deem the Irish sovereign as impervious to the Irish banking system's fake asset base. The banking system is living on emergency liquidity assistance (ELA) and the ECB's marginal refinancing operations (currently Irish banks can borrow as much as they want on a short-term basis from the ECB at the current rate, 1.25%).

By my calculations, the Central Bank of Ireland (via the ELA) and the ECB are subsidizing - I say subsidizing because market funding costs are proxied by the sovereign borrowing costs of 10% - 16% of the Irish banking system's balance sheet. As such, profit margins are thin, and mortgage rates are running low at 3-4%. (see CBI website for plenty of data.) These funding costs are not sustainable - not to mention the Irish stress tests assume that they remain fixed at Q4 2010 levels (see exhibit 2 in Appendix C of the stress test documentation). Nonperforming loans will rise.

I leave you with this illustration of possible non-performing loans when mortgage rates rise on the following:

(A) ECB rate hikes - mortgages are tied to 12-month euribor and most Irish mortgages are variable.
(B) the dissipation of record-low bank borrowing costs (this also is another post, but the ECB has yet to release its medium-term funding program for Ireland).

Note: if/when they do default, Kash at the Street Light blog provides an overview of some technical considerations.

Rebecca Wilder