Sunday, 28 June 2015

Grexit and the risks of financial contagion

Availability bias. Representativeness heuristics.

When trying to anticipate future events we tend to be over-influenced by what we tend to view as similar (representativeness) recent dramatic events, which are - precisely because of their dramatic character - strongly present (availability) in our memory. We then tend to extrapolate almost linearly the sequence and consequences of the events we are currently faced with from those past, and perceived as similar, events.

This explains why many today think that Grexit will be Eurozone's Lehman moment. They are wrong.

The FED initially downplayed the consequences of defaults on subprime real estate loans and the contagion risks arising from the financial system's high degree of connectivity. The line of though was a simple one: if subprime real estate loans just accounted for 1%-2% of the total banks' balance sheet size, there was no way that a collapse of this market segment could have meaningful adverse consequences on the whole financial and economic system. This proved to be a major error of judgement.

The European authorities, and first and foremost the ECB, have a complete different view about Grexit. They know that the Greek economy may be tinny in the context of the Eurozone but that the risk of contagion via the sovereign bond market is significant. As a result, they have put in place a massive firewall (ESM and ECB's QE programme) that effectively stops at inception any risk of contagion.

There will be in the very short-term (this and next week) turmoil in financial markets following the call for what can be perceived as an In/Out (of the Euro) referendum by the Greek government. Stock markets will fall. Spreads between peripheral and German sovereign bonds will widen. Investors (read hedge funds) that will be betting on a widen of the spreads will make money. As the market moves their way, they will increase their positions. And then, at some point, the ECB will intervene massively and force the spreads to narrow down again. Investors betting on a widening of the spreads will burn their fingers. And stop playing the game. Some of the more savvy investors will not even start to play it as they understand that this is not a pure economic game. It is a game with an overwhelming political dimension. And that commander-in-chief Mario Draghi has de-facto unlimited resources to squeeze any profits out of tentative short-Eurozone players "a la John Paulson".

To put numbers to the story:

- Portugal, the first country at risk of contagion in case of a Grexit, has a total public debt of around Eur 200bn

- Around 45% of it is held by the Troika. This leaves Eur 110bn being held by private investors

- Let's say that 100% of the Portuguese sovereign debt is turned over a 12-month period (a generous assumption given that many of the debt is held by pension funds and retail investors, who don't trade it actively). This would mean less than Eur 10bn of Portuguese public debt being traded each month

- The ECB only has to intervene at the margin to influence the price setting. Let's say that it would have to buy 25% of the average monthly traded volume of Portuguese sovereign bonds to stabilise their price and narrow down sovereign spreads to a pre-determined level. This would amount to interventions of Eur 2.5bn per month. The ECB QE programme alone allows Mr. Dragi to buy up to Eur 60bn of Eurozone sovereign bonds on a monthly basis

- On could always argue that the ECB will need to buy sovereign bonds from other countries as well. Sure. But then again: (i) there would be Eur 57.5bn left (approx. 96% of total available resource) to buy sovereign bond markets of other countries; (ii) if the ECB stops contagion to Portugal (arguably the weakest link in the chain) it will stop contagion from Portugal to other countries. Or are we saying that investors would be asking more yield to buy Spanish and Italian government bonds than Portuguese ones?

Cutting a long story short, with the safety mechanisms that Eurozone's authorities have put in place no country can be forced out of the Euro by financial market forces. Only countries that don't want to stay in the Euro will leave.

And if a Grexit does occur, with the devastating short-term consequences for the Greek economy visible to everyone, there won't be any other country willing to follow Greece out of the Euro.

Dear candidates to become Eurozone's John Paulson, I wish you luck. Dear Alexis Tsipras & Yanis Varoufakis, if your strategy is to put pressure on the Eurogroup via financial contagion of a potential Grexit to reach better deal terms, I wish you luck as well. To all of you: even a lot of luck will not be enough.

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