Guest Post: The Financial System Is Built On Eggshells: Can Spain Avoid Default On Its Own?

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From JM

The Financial System is Built on Eggshells:  Can Spain Avoid Default On Its Own?

The European financial system, like the others, is efficient but is not robust.  It makes the most of what it has and runs on a razor edge between efficiency gains for individual agents and horrendous systemic losses.  It depends crucially on the performance of its sovereign assets.  System survival depends on one hand whether or not counterparties can absorb the necessary haircuts and on the other, whether fundamentals of debtor nations are strong enough to stand on their own.  

Spain and Italy will have to stand on their own, because when Greece goes, Ireland will most likely go, which will in turn set off a critical mass such that the nation who dictates monetary policy (Germany) will be taking care of its own self. 

Data on Servicing

 

Greece

Ireland

Italy

Portugal

Spain

Budget Deficit (% of 2010 GDP)

-10.2

-15.2

-6.3

-8.7

-10.1

Outstanding Debt (%of 2010 GDP)

135

84

119

86

65

Interest Payments to Revenue (% of 2010 GDP)

14 (2011=17)

8

10

8

6

Roll in the Next Twelve Months (% of total)

12

6

24

24

21

External Debt (% of total)

67

82

51

86

42

Domiciled Bank Exposure to Other Periphery (% 2010 GDP)

1

40

3

3

10

CDS Spreads (a few days ago)

1995

782

205

974

310

Source:  Bloomberg, BIS

Macro data

 

Greece

Ireland

Italy

Portugal

Spain

Private Savings (% of GDP)

16

20

18

14

22

Unemployment Rate

13

13

9

10

20

Average Duration

8

7

8

8

7

Source:  BIS, Eurostat   

Nobody knows how flaky these numbers are, but the implications are plain: 

  • There is insufficient growth to avoid serious austerity programs in any of these countries
  • Austerity programs will make growth even less likely
  • With the exception of Spain, most of the sovereign debt is held externally
  • Irish banks hold the equivalent of 40% (probably less now) of Irish GDP in other periphery debt instruments
  • With the exception of Greece and Ireland, a quarter of existing debt has to be refinanced in the next twelve months

Greece is just a situation of the irresponsibility found elsewhere only more so, and a lot of abuse is thrown between Greece and Germany.  Ireland, however, acted like a hedge fund that made a business of collecting tail risks that they didn’t hedge.  Thus, when Greece goes, Ireland—already distressed— goes.  So why is it such a big deal if Ireland goes?

The following table shows you what banks domiciled in the US, France, Germany, and the UK are exposed to in terms of public and private debt, and also derivatives related to these exposures. 

Exposure
in $ billions, Q1 2011

Greece

Ireland

Italy

Portugal

Spain

US

41.5

105

269

47

179

France

65

56

472

32

176

Germany

40

159

216

50

224

UK

19

194

100

29

138

Source:  BIS

These exposures are just so big that they will require Germany, France, and the UK to forget about supporting sovereigns, as they will have to directly support banks domiciled in their countries.  When these banks have to deal with these exposures, it causes even more stress because they are connected to each other in ways far beyond the issues of Greece, Ireland, Spain, Portugal, and Italy.

The payoff and losses here are nonlinear, so nobody knows what will happen.  But it is clear that the US, the UK, France, and Germany are even more interconnected to each other and will suffer losses based on these interconnections.

Exposure
in $ billions, Q1 2011

Greece

Ireland

Italy

Portugal

Spain

US

41.5

105

269

47

179

France

65

56

472

32

176

Germany

40

159

216

50

224

UK

19

194

100

29

138

Source:  BIS

*It is probably not possible to calculate the US-UK exposures, because the BIS requires report only bank exposures greater than 1% of assets, and in this case, probably these small exposure add up to a lot of unreported exposure.

When you think about these exposures, you need to apply a significant haircut here, but there could be short-long exposures that cancel each other out.  But any losses will probably be more than the usual 40% recovery assumption simply because the losses will be correlated and pretty simultaneous.  It is impossible to know the short-long composition of the derivative exposures.  However, the following seems reasonable to infer:

  • If Ireland goes, the UK stands to lose a lot, as will Germany. 
  • If Italy defaults, France will be in deep trouble.  Their fate is tied to Italy with nearly a half trillion in exposure.  Germany and the US and the UK have significant exposure to Italy as well.
  • After Italy, the next biggest in terms of exposure is Spain.

If this is really about minimizing banker losses, policymakers need to address how to keep Ireland from defaulting in the event of a Hellenic default.  Once this plan is in place, let Greece go.  I’m not sure that you can firewall this stuff off in this way.  Probably what is needed is a firewalling of banks by applying an orderly settlement of exposures with steep haircuts. 

This isn’t the end of the world.  This means serious financial losses at issue, and events risk is seriously underpriced.  One more time:  fundamentals do matter.  Good ones allow you to stand on your own.