default

One of the stealthier developments over the past months has been the ever wider creep in Greek CDS, especially in the longer-dated part of the curve. In fact, everything to the right of the 3 Year point is now wider than it was both on the eve of the Greek semi-default, and just after the announcement of the European Stabilization Mechanism (ESM). How is it that with so much firepower, better known as free money, thrown at the problem, have spreads not declined? The CFR provides one interpretation, which speculates that once European banks find a firmer footing, that Greece, with the blessing of Europe proper, will be allowed to finally sever its mutated umbilical cord, and default. The catalyst would be Greece getting its primary deficit under control, at which point ongoing bad debt funding would no longer be necessary. Of course, this hypothesis is based on two very critical assumptions: European banks, especially in the periphery, as the second attached study from Goldman indicates, are still locked out. To think that Europe will be able to get to an equal footing for all countries seems like some wishful thinking at this point, especially if the market does consider the implications of what a Greek default will do to peripheral banking. Additionally, the ramifications to the euro in the case of a default will be dire, although that may be precisely what Europe is after all alone. Regardless, that is how the CFR sees things, rightly or wrongly. Keep an eye on Greek spreads in the coming weeks to see if the theory is validated.

While the merits of its conclusion are at best questionable, and at worst, completely worthless, the IMF study presented earlier provides one statistical curiosity vis-a-vis sovereign defaults. Specifically, in "Default in Today's Advanced Economies: Unnecessary, Undesirable, and Unlikely" the author Carlo Cottarelli presents an observation which could be classified as a "Hindenburg Omen" type of signal for sovereign default. Unlike the real H.O. observation (which incidentally has now been experienced 5 times in the past three weeks) for stocks, the one relevant for sovereign bankruptcy has a much simpler gating threshold: 1,000 bps spread in credit risk. And just like in the Hindenburg Omen, this is a necessary (but not sufficient) condition for a crash: only in this case it is not the market that collapses, but a country's solvency. Cottarelli finds that since the first Brady deals in 1991-92 there are 36 instances in which a country’s spreads rose above 1,000 basis points. "Of those instances, seven eventually resulted in default; in the remaining 29 cases, however, the spreads stayed high for a few months and eventually fell back well below 1,000 basis points, with no default." The 1,000 is logically an inverse gating factor: no single country defaulted with spreads being below the 1,000 threshold. In other words, once a country passes 1,000 bps, it has a one in five chance of defaulting, roughly in line with the crash expectations of the traditional Hindenburg Omen.

Debt/GDP ratios are too backward-looking and considerably underestimate the fiscal challenge faced by advanced economies’ governments. On the basis of current policies, most governments are deep in negative equity. This means governments will impose a loss on some of their stakeholders, in our view. The question is not whether they will renege on their promises, but rather upon which of their promises they will renege, and what form this default will take. So far during the Great Recession, sovereign (and bank) senior unsecured bond holders have been the only constituency fully protected from partaking in this loss. It is overly optimistic to assume that this can continue forever. The conflict that opposes bond holders to other government stakeholders is more intense than ever, and their interests are no longer sufficiently well aligned with those of influential political constituencies....Investors should be prepared to face financial oppression, a credible threat against which current yields provide little protection. - Arnaud Mares, Morgan Stanley

John Taylor was on Bloomberg TV Friday, and in this extended version of his interview, the head of the world's largest currency hedge fund said that the euro will fall, equities could head lower, credit spreads will widen sharply and government bonds will rally.

Of America’s 11 million homeowners with negative equity, a majority live in the four sand states where the real estate bubble was concentrated--California, Florida, Arizona and Nevada. Over three million live in California and Arizona, where a borrower can hand over the keys to the lender and walk away. These are two antideficiency states, where the lender has no recourse beyond the collateral property. So of course it makes sense that wealthy homeowners would default on their mortgage loans. They live where in places home prices were the highest and the fell the steepest, and where the consequences of default are the least onerous. The New York Times overlooked the “where” and “why” of the story. The wealthy are also less dependent on consumer credit. They can buy cars for cash; and charge expenses on their debit cards. So for them, it’s easy to make a fresh start. But the mortgage debt doesn’t go away. It’s simply pushed off to the banks insured by the Federal government. The rest of us pick up the pieces.

It's official. Illinois, the fifth most populous state in the U.S., has overtaken Iceland in the default risk category. Will other U.S. states follow?

Following up on our earlier observations on the Spiegel article about Germany change in posture vis-a-vis the European Stability Fund, here are some additional summary thoughts from Thermidor.

And now the latest joke - the increasingly more incorrectly named "stress" tests being conducted in Europe are now officially confirmed to be anything but. As Market News reports: "Planned stress tests for European banks will cover their resistance to a crisis in the market for European sovereign debt, but not the scenario of a default of a Eurozone state since the EU would not allow such an occurrence, a German newspaper reported Wednesday." Now that is some serious downside stress testing. Of course, by the time the stress tests are found to have been a joke, and the country hosting the bank blows up just becase the bank's assets are 3x the host nation's GDP, and the country is forced to bankrupt, it will be far too late. So let's get this straight - the very issue that is at the heart of the liquidity crisis in Europe, namely the fact that a bankrupt Greece has managed to destroy the interbank funding market in Portugal and Spain, and the other PIIGS, and has pushed EURIBOR and other money market metrics to one year stress highs, and forced the ECB to lend over $1 trillion to various central and commercial banks, will not be tested for? Fair enough - if the ECB wants to treat the CDS vigilantes as a bunch of idiots, only to be hounded in the press with derogatory words as "Wolfpack" and much worse, so be it. But it certainly should not be surprised if this is latest show of idiocy by Trichet's henchmen serves as the springboard for the latest round of spreads blowing up across Europe.

Ironically even with Greek CDS surging by 60 bps to 909 bps this morning, the biggest mover in percentage terms is not the bankrupt Mediterranean country but Europe's "stablest" one -  Germany, whose default risk has spiked by 9.19% according to MarkIt. Without splitting hairs, Europe is a sea of red this morning as the ugly specters of default and complete lack of credibility in the EU administration raise their ugly heads again.

One of the oddest phenomena over the past two years has been the relative outperformance of European bank CDS compared to their transatlantic counterparts. Well, this peculiar relationship has now ended. European banks are finally, on average, riskier than American ones. Investors have finally realized that "regulatory capitalization" in Europe is an even more ephemeral concept than in the US. Furthermore as JPM pointed out yesterday, not only do European banks use more leverage, but the "the larger size of Europe’s banks argue against using simple GDP weights to assess potential risks to global markets.  Due to a buyer’s strike over the last month, European banks now have 3.5x as much debt to issue than U.S. banks over the remainder of the year." Also, as we have been pointing out every single day for the past week, European banks, or at least those that have excess liquidity, have been storing more and more of their euros with the Central Bank, instead of lending it out. Add to this the relentless rise in EUR Libor, and this trade should have been a no-brainer for months.

Poor, poor Europe. Every room one shines a light in, the cockroaches don't even bother to scurry to safety any more. Yet what is glaringly obvious takes a media-reported soundbite to awake people. So is the case with Hungary today. After opening 7 tighter, Hungarian CDS are now 14 bps wider to 277bps. As the attached chart shows, the Hungarian Forint is now in freefall. Yet if investors are concerned about Hungary, they should take a look at some of its less lucky Eastern European neighbors which, just like Hungary, have been considered to be strong for so long.

Libor is now at 0.53%, eurodollars are plunging, new Fed-ECB rescue facilities are rumored to be imminent, Germany is set to introduce a ban on naked shorting of all stocks, and sovereign risk is exploding: it will be a fun day. Spain, Italy and Korea are all more than 20% wider on the day, as the contagion virus is spreading faster and faster toward the heart of Europe.

On the other hand ...

With its CDS at 875, today, Greece is riskier than dictatorical (but Fed Free) Venezuela and perpetually bankrupt Argentina. All the hedge funds who went long Greek bonds with or without protection are getting destroyed. And some very prominent names did. We are waiting for the latest HSBC report to confirm this.

Country         Spread       CPD

• Greece:       874.22      50.66
• Venezuela:   841.28     44.57
• Argentina:    832.50     43.17
• Pakistan:      708.40     38.22
• Ukraine:       601.41     34.24

No, you are not looking at Portugal or Greek CDS. BofA starting to rumble too: CDS hits 163.