Crowded Investment Space Kept Greek Interest Rates Unrealistically Low Until the Crowd Realized It Was a Mess

From the moment Greece joined the European Union in 2001, banks around the world lent money to the country, assigning it a risk level very similar to that of other countries with more fiscal discipline, less sovereign debt, and higher productivity, such as Germany. The crowded space kept Greek interest rates at unrealistically low levels, and the Greeks were happy to borrow and fund consumption—until the crowd realized that Greece was a mess.

The Markets Have Been Greeked

A country’s interest rates depend on repayment risk, which in turn depends on total debt, exchange rate risk, and the country’s future prospects. From 2002 to 2007, ten-year Greek debt traded at about the same level as German debt. This didn’t make sense, as Greece’s future payment ability and hopes for disciplined government spending were nowhere near those of Germany.

From when it adopted the Euro in 2001 until 2008, the Greek government spent more than it earned. By 2008, its deficit had run up 9.8% of GDP. Other Euro countries had an average deficit of 2.1%, with Germany and France having deficits of -0.1% and -3.3% respectively. It violated the EU’s fiscal constraint, but was not penalized.

Banks bought Greek debt for the same reason that banks and governments bought Freddie and Fannie’s bonds at a 55 basis-point spread over Treasuries: they were certain that the European Union would bail out Greece. Greek bonds that paid 40 basis points above German bonds were a great deal if the EU would eventually rescue them. Crowd demand kept the spreads unrealistically low.

Then, in October 2009, Prime Minister George Papandreou made a startling announcement: Greece’s 2009 deficit was more than double the amount that had been reported to the public. The deficit was 15.8% of GDP, not 6.7% of GDP. The Greek government had used clever financing and accounting gimmicks to minimize its debt. The markets had been Greeked.

Soon after, bond yields on Greek debt began rising. Within one month of the announcement, 10-year interest rates went from 4.45% to 4.74% as investors began dumping Greek debt. Ratings firms downgraded Greek debt. By July 2011, Greek debt had a CC rating super-junk status. Some runs on Greek banks had already started; depositors withdrew money before the possibility of frozen accounts. By December 2011, Greek 10-year debt traded at 36.37%, while German ten-year bonds traded at 2.23%.

Banks in many countries bought Greek debt, including Germany, France, Italy, Spain, the United Kingdom, Japan, and the United States. German and French exposures are estimated at as much as 34 billion Euros of Greek debt. These were the crowds that rushed in to buy Greek debt, thinking it was as good as gold.

The Future of Greece

The Greeks have three choices. None of them are ideal, but Greece must choose one of them.

Remain a Club Member and Order Finances: On May 6, 2010, Greece agreed to reduce its deficit level to 3% by 2014. It will cut spending by reducing civil service pensions and wages, raising the retirement age and possibly reducing pension amounts, and instituting a civil servant hiring freeze that allows only one new civil servant for every five retirees. With all of Greece’s problems, raising taxes and cutting government spending will lead to a sharp recession and higher unemployment. Reform may be very difficult if people won’t accept it.

Ditch the Club and Keep the Debt: If Greece leaves the Euro zone, it will still have problems. The country must issue its own currency and do everything it can to halt a bank run. As the drachma will most likely trade at a discount to the Euro, many savers would lose when Euros converted to the depreciating drachma. A depression would likely ensue, reducing real wages. Foreign goods would become prohibitively expensive. Bank solvency would depend on how the Greek government handled deposits and assets. Greek interest rates would move higher in the short run, so Greek debt value would decline, hurting Greek banks that own Greek debt and foreign banks, leading to bank insolvency problems in Greece and abroad.

Ditch the Club and Ditch the Debt: In 2010, Greece’s total debt was 321 billion Euros. Foreigners still owned roughly 50% of this debt in 2011. European bank exposure to all of Greece, including government and private sectors, was an estimated 206 billion Euros in 2011. An outright Greek default would pass a large chunk of the problem from Greece to foreign banks and investors. Though devaluing would make Greek goods more affordable, the demand for Greek exports would decrease or stagnate to the extent that other Euro countries suffer. Greece would also find it hard to borrow, bringing government expenditures to a screeching halt and causing a worse recession.

Greece’s best plan may be to accept aid from the IMF and the EU while using austerity measures to get its house in order. A second-best solution is to leave the EU with an accompanying large depreciation, as Argentina did in 2001.

The EU’s Future

Banks are interconnected throughout Europe and the world, so their Greek debt losses would pass through the system. The instability could lead to a run on Italy. At 1,842 billion Euros, Italy’s debt burden is much larger than that of Greece, but Italy’s finances are better. An Italian crisis would cause large-scale problems everywhere.

The EU is probably better without Greece, and Greece is probably better without the Euro. Not even a strong currency manager can solve Greece’s fundamental problems: low growth and a lack of fiscal discipline. Some weakly managed countries joined the EU for disciplined economic management. The Greek crisis and emerging crises in other countries have shown that if a country can borrow on the cheap to temporarily boost its economy, it will.

With recessions in place all over the world, none of the large European countries qualify for EU membership as of December 2011. European banks have sold a total of 178 billion Euros worth of credit default swap protection on the sovereign debt of Greece, Italy, Portugal, Ireland, and Spain. If Greece defaults, these European banks will have huge tabs. The diverse array of banks in the sovereign CDS market means that risks can spread more quickly through the financial system. It’s hard to know how Greek debt problems would ricochet through the interconnected financial system.

If Greece leaves the union, Estonia, Slovakia, and Slovenia could follow, and the situations of deficit-ridden countries such as Turkey may persuade the EU to postpone new memberships for the foreseeable future. European countries have made pre-emptive plans in case the EU does fall apart. As of December 2011, Ireland’s central bank has begun discussions about accessing printing presses, Montenegro is considering its own national currency, and investors are hedging their Euro exposures.

The coming years will be interesting, as the world recession unwinds and Europeans grapple with their ailing club. The decade started with fairytales, promises of new hope, a booming economy, an Internet revolution, and a strong and prosperous Euro. It ended with the 2008 financial crisis and Greek problems that continue into 2012. Do any parts of the fairytale remain?

Ludwig B. Chincarini, CFA, PhD, is an Associate Professor of Finance in the School of Management at the University of San Francisco, and author of The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal and a member of the academic council of IndexIQ, with over fifteen years of experience in the financial industry specializing in portfolio management, quantitative equity management, and derivatives. He was Director of Research at Rydex Global Advisors, where he co-developed the S&P 500 equal-weight index and helped launch the Rydex ETF program. He helped build an internet brokerage firm, FOLIOfn, designing its innovative basket trading and portfolio management platform. He also worked at the Bank for International Settlements (BIS) and Schroders.

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