From the archives ... this isn't a victory lap or anything, just a marker to put down that my views today are at least consistent with what I was saying at the time. If you were one of the three or four dozen subscribers to my PREDICTO list in 2010, this is what I sent out at the time of the first Greek bailout ...
<<** Greece - no meaningful private sector participation in this round
There are two principles at work here. One of which is "Don't fight
the central banks", and the other of which is "A man sitting on an
atomic bomb will usually do his level best to ensure it is not set
off". A lot of this might sound fairly mainstream, but I have two
PREDICTO bits of analysis which I haven't seen elsewhere. Actually,
for that reason, it's probably worth a brief recap of the citation
SOMEWHAT UNUSUAL CITATION POLICY: basically the citation policy is
"use it how you like, but keep my name out of it (and anyone else's
name if I let it slip)". If you want to use something and the only
way you can keep my name out of it is to pretend you came up with it
yourself then I am 100% cool with that. On the other hand, it is
probably best to check with me first because I quite often lift
material and if you're writing in a context where it would be
embarrassing to be accused of plagiarism, probly best to make sure
that the particular bit of Predicto you're interested in wasn't itself
plagiarised by me.
OK, on to the analysis. Basically, we have not one but two central
banks who seriously, seriously don't want Greece to have a default.
The ECB is quite easy to see (although perhaps not the reason why
...). But the interesting one is the Fed. Here goes:
- Why can't the ECB live with a Greek default? Partly because the
ECB owns EUR62bn of Greek debt outright on its own balance sheet
(under the securities market purchase program) and would be seriously
embarrassed if it had to write it down (there are institutional
provisions for recapitalising the ECB if it became economically
insolvent, but one shouldn't underestimate the embarrassment and
inconvenience of doing this, plus situations like this always cause
about a thousand lawyers to spring up causing problems at the worst
possible time). But more fundamentally, even if there wasn't a
writedown event (say, a more-or-less-coercive exchange with no NPV
loss), the ECB still can't live with this. Why? Because in such a
situation, the Greek government would be rated as being in selective
default by the ratings agencies. Which doesn't really matter all that
much in the grand scheme of things, but which would make it very
difficult indeed for the ECB to accept Greek government paper as
collateral in its own operations (because of the unacceptable risk of
a future writedown). And this is a problem.
Basically, the European banking system (ex Greece itself) owns about
EUR40bn of Greek paper. This isn't a big number relative to the
capital of the banking system; they could actually all write it off
tomorrow if they had to without too much hassle. But, it is quite a
big number relative to the ECB's overnight operations - it's about 10%
of the total repo balance. And replacing that EUR40bn in an interbank
market which is not functioning well at all, could be very
embarrassing indeed for a lot of banks, including some household
names. What you would see would be that, to try and reduce the
funding need, a load of banks would try to dump balance sheet assets
at any price. When that happens, nobody else wants to be the buyer
(because they can see the supply building up) and the market goes
offer-only for risk assets. That's the kind of ugly free-fall crash
we had in 2008 - note that, as with our analysis of the UK's NEST
savings scheme in week 23 2010 (massive bull run in FTSE in 2012),
what affects the price is not the amount of the supply or demand, so
much as the fact that it is totally price insensitive.
- Why can't the Fed live with a Greek default? More interesting.
Basically, remember the "shadow banking system" that we all wrote
chin-scratchers about, and which we kind of thought might have been
regulated a bit? Well actually the money-market mutual funds are
still there, and they still have the break-the-buck taboo which makes
them vulnerable to runs just as if they were bank deposits. The only
difference is that they don't invest in asset-backed commercial paper
any more, because there isn't very much ABCP to invest in. What took
its place? Glad you asked. Short term commercial paper and
certificates of deposit issued by .... the European banking system!
By my quick sampling, it is very likely that as much as half of the
invested assets of US money market mutual funds (that's a rough
$1.3trn, certainly no less than a trillion) is held in European banks'
short term securities. There is actually very little of it issued by
Greek, Portuguese, Irish or even Spanish banks (and not that much
Italian either), but big French and German names with big second-round
exposure are funding a fair couple of percentage points of their
balance sheet this way.
And money-market funds are among the flightiest and most risk averse
investors you'll find. Any scare event, like a Greek default, and it
has to be suspected they'll rush for the exits. Not all of them, but
if even 10% of them refused to roll over paper, it would be a nasty
sudden shock in liquidity, and not obvious where funds would come from
to replace it. My guess is that the Euro names would be forced to the
central banks - either the Fed for people with regulated entities over
there, or the ECB (via the ECB/Fed emergency swap line) for the rest.
Those are both quite expensive sources of funding (in both cash and
collateral terms, plus not obvious that the euro names actually have
enough collateral to replace the unsecured MMMF funding), so in order
to economise on its use, you'd expect to see the banks dumping dollar
assets in exactly the same price-insensitive manner described above.
So on my analysis, playing hardball with Greece has the potential to
blow up both the European and American financial systems. I think
heaven and earth will be moved to ensure that nothing is done to
frighten the horses - the ground needs to be prepared much better for
a final default, including, in my opinion, some sort of legal
mechanism to indemnify the ECB against its own losses (ie a
fiscalisation of the ECB's lending to Greece). And we're a way off
that. Fingers crossed.