How to Watch and Interpret the Greece Story

There was big news today.  As usual, the trading reaction takes the simple approach -- as it should.  There is something bad happening.  It could be contagion.  It could be systemic risk.  There is rioting in the streets.  This cannot possibly be good news, so let's sell.

Why would anyone buy?  Economic data are bad, and who knows when it will change.  [Please note that there is a buyer for every seller, or markets would not clear.]

The question is whether this is an over-reaction or a real threat.  I wrote yesterday that long-term investors must look for opportunities.  I also wrote that they must assess valid risks.

Is the Greek Crisis an opportunity or a serious risk to the financial system?

What to Watch

To answer questions like this you need a dispassionate analysis.  You must do the work to learn the facts.  You must also have an analytical framework.  At times like this, doing some extra work really pays off.  As readers of "A Dash" might expect, I have been watching this closely.

Here is an interim report -- what I am watching, what is significant, and why?

• Will Greece agree to the latest round of austerity measures, required for additional credit facility?  We do not know, and we may not have a final answer until Monday.  The Greeks harbor resentment dating from WWII.  We have different social norms and expectations, but the investor must put this aside.  The question is how the Greeks will respond.  Our answer is not just in the streets, but in the Greek Parliament.
• If Greece plays hardball on the austerity question, how will the Germans respond?  Bailing out Greece affects all European taxpayers.  Some believe that "bankers" should share the pain through a restructuring of debt.
• Restructuring debt seems like a reasonable part of the process, but the European Central Bank is worried.  If debt is extended or modified, is this a "credit event"?  This is important because there is a market in Credit Default Swaps (CDS) in the debt of  Greece, other countries, states, and corporations.  Buying a CDS is like insuring your loan to the issuer.  The problem is that trading in the CDS market permits buyers to take out "insurance" even if they do not own the underlying debt.  You can make a leveraged bet against any entity whether or not you have a prior position.
• If there is a "credit event" this may trigger payments of the CDS holdings.  This means that those who have been paying premiums of a few points may collect 100 cents on the dollar -- a windfall for the buyers and a disaster for the sellers.  The ECB will be on the job -- trying to make sure that any resolution does not trigger a credit event.
• Will there be contagion?  If there is an adjustment in the loan provisions for Greece, others may follow.  This is a crucial question.
• The Lehman Effect.  This was much discussed today.  The concern is that the European impact will create a systemic crisis.  For this to happen, there would have to be big banks with huge holdings in European CDS markets -- and the holdings would need to be unhedged.  No one really knows the answer.

A Good Source

CNBC's Simon Hobbs has done a great job on this story.  I recommend the video summary on tonight's Kudlow and Company.

 

My Provisional Conclusions

This is an important story.  It bears careful watching.  If the situation is resolved, it will be a major buying opportunity.  This is the most probable outcome. 

Here is the key point to understand:

For systemic risk to occur, the entire list of worries must take place.

In case you are new to "A Dash" or missed this piece, I strongly recommend that you read my review  (a big recommendation) of Michael Lewis's book, The Big Short.

It seems that most readers have missed the most important aspect of his work.  The key point is that there was an unknown market in synthetic CDO's, highly sought after by many investors.  This made the overall CDS exposure 6 or 8 times larger than anyone knew, including Bernanke and others when they thought the subprime problem was "contained."

Anyone who does not grasp this point is doomed to see every future problem as another example of 2008.   There is no current evidence that there is a huge secondary market in the CDS holdings of European sovereign debt.  If we know the size, we know the risk.  It is not like the sub-prime market of 2008.

To conclude -- I am watchful and wary, but what I see and read does not translate into a 2008 scenario.  Having said this, the issue will be in play for several days, and it is options expiration week.  The short-term trade may be different from the investment.

Comments

[Mohan]

NYT asks if there is a hidden AIG.
http://www.nytimes.com/2011/06/23/business/global/23swaps.html?_r=1&hpw

[oldprof]

scm0330 -- Reporting in these markets has gotten better. The Depository Trust and Clearing Corporation reported recently that the total notional amount was about $5.8 Billion. There have been a number of academic studies pointing out that this market is about 2% of the cash market.

The key point -- and it would help if everyone would read The Big Short review as I suggested -- is that in 2008 the market was starved for "AAA" debt and Wall Street obliged with synthetics. The situation in Greece is not a good analogy to this.

People who keep repeating "Lehman moment" are missing this.

There are some sources this morning with lists of potential losers -- http://www.businessinsider.com/greece-default-contagion-2011-6#

I hope this helps. This article was supposed to be an aid to people as they watch the story unfold. I will do my own reacting and trading before I have time to write about it.

Jeff

[wsm]

scm0330 is onto something. Namely, when you say "There is no current evidence that there is a huge secondary market in the CDS holdings of European sovereign debt..." you seem to be dismissing the fact that there is also no current evidence that the market is CDS is NOT huge enough to manifest systemically.

Also, when you say "For systemic risk to occur, the entire list of worries must take place..." this seems preposterous. Only a few of the items on the list need to occur in order for significant dominoes to begin falling.

Finally, when you say "If the situation is resolved, it will be a major buying opportunity. This is the most probable outcome..." What is the 'THIS' that you deem as the most probably outcome? That the situation is 'resolved'? I.e. that private haircuts are taken along with the taxpayers? I.e. a 'credit event' that would trigger CDS payouts?

If you deem this a "major buying opportunity", please describe what, exactly, you will be buying.

[scm0330]

Hi Jeff,

Could you elaborate on what you know about the CDS market (e.g., notional size, and dealers) for Greek paper? Presumably, CDS writes would include both sovereign and bank obligations. I was of the understanding that his is an private market and therefore highly opaque, whether it's in primary CDS deals or secondary derivatives on them. Can you point us toward your data sources on this topic?