The good news? Following months of tension and uncertainty, Greece successfully completed what its prime minister, Lucas Papademos, described in a television address to his country as “the biggest debt restructuring that has ever taken place”, the transaction in which private sector investors will swap their existing holdings for those with longer maturities and lower interest rates at a loss of more than 50 cents on the dollar.
The bad news? The successful end to the PSI (the name given this bond restructuring, standing for ‘private sector involvement’) was deemed to be a credit event under the terms of credit default swap contracts, triggering payouts to investors who had used CDS contracts to hedge the risk of a Greek debt default. Those payouts have certainly increased the risk of the sovereign debt crisis spreading via contagion to other European nations, although a Greek default – on its own – probably isn’t enough to tip us over the edge. But will it really end here?
Greece has already defaulted. Now that that has happened, the market-implied probability of a Portuguese default rises to more than 60%: in other words, the market is already viewing such an event as more likely than not to occur. In Fathom Consulting’s view, the Greek default makes a kind of domino scenario more likely: one in which defaults by Portugal, Spain, Ireland and Italy become increasingly probable. If we assume that the Greek PSI will be the model used to resolve future such de facto defaults, then banks – and European banks in particular – are sitting on vast, unrecognized losses on their holdings of bonds issued by governments of those nations on Europe’s periphery. Their decision to use cheap funding from the European Central Bank to increase their exposure to these high-yielding but risky securities looks less than clever in light of these probabilities.
The Fathom Sovereign Fragility Index (SFI) has long highlighted the risks associated with fiscal debt – the debt associated with a government’s fiscal balance. This innovative index is constructed by combining the various proxies of a country’s sovereign fragility, such as its debt load, banking sector exposure and its inflation risk, into a single index. (While the IMF constructs a set of component indicators, it hasn’t yet combined them into a similar index; ratings agencies produce summary measures, but don’t reveal how they are computed.) Fathom’s index weights the hard default risk of a government (made up of its net public debt, external government debt, government balance and banking sector exposure, both domestic and foreign, as a percentage of GDP) with its inflation risk. There is a lag of two to three years on average; a build-up in financial sector exposure today translates to increased sovereign fragility tomorrow. A reading of 150 or more on the index indicates danger, while a level of above 250 indicates a sovereign fragility level that is consistent with a “junk” credit rating.
As the charts below show, Greek debt has long been ‘junk’, while the credit worthiness of Portuguese debt continues to deteriorate. The Italian SFI chart shows that its fiscal position has somewhat stabilised in recent months. However, as our conditional probability calculations show, any such improvement would threaten to be overwhelmed should another European nation decide to restructure its debt.
For more in-depth analysis on the Euro Zone crisis, join the Fathom Consulting Group for a live webcast on March 29, 2012
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