A financial meltdown took place in last week. The Stock Market went into free fall, collapsing by more than 10 percent, trading had to be halted in its worse plunge since 1987. Bond prices collapsed as investors scrambled for the exit door, pushing yields to an all-time peak of 9 percent. Regretfully, such high yields will make servicing the sovereign debt unaffordable and thereby make the unthinkable, a massive sovereign debt default in Europe, now realistic. If such an event were to occur, it could potentially be the catalyst for a financial crisis that would make the last crisis look like a picnic. As explained in my previous piece, this is where I believe the financial apocalypse event will occur, with a massive sovereign debt default in the peripheral states of the euro bloc.
Basically, if sovereign debt is collateral and used to make more loans throughout the system due to leveraging, when collateral becomes worthless, in the case of a sovereign debt default, the money supply shrinks. Moreover, due to the global inter-connectivity of the system, shock waves are felt and magnified around the globe. There is no need for me to go into the detail regarding the above, as I have already explained in a number of my writings. Perhaps you can get a feel for the potential severity of the problem by looking at it this way. The sub-prim mortgage default in the US caused the last Financial Crisis of 2008, which only involved a relatively small portion of risky mortgage lending to home buyers in the US, who couldn't pay their debts back. The financial and economic impact of that fallout is still with us today. But what happens when a whole nation, interconnected to the financial system, defaults on their debts? Regretfully, it may be a question of mathematics, you take the 2008 Financial Crisis and the severe recession that ensued and magnify the problem many times. If that paints a bleak picture, well that’s because it is.
So why now a financial meltdown in Greece?
Greece has been severely hit by the 2008 financial crisis, its economy has shrunk by a massive 25 percent since then and one in five people have no work. It’s a basket case, resembling the Great Depression experienced by the US in 1929. For the nation to payback its debt, the size of the state has to shrink. An economy that’s shrunk by a quarter in six years, doesn't generate the tax revenue to support its existing public sector. But selling austerity, depleted public health service, diminished public education, transport and public goods is like trying to flog misery to the electorate, which can be political suicide. So the cold reality may be that no politician will do it unless the financial market, through a crisis, forces them to tackle the issue.
The Greek credit line deal to keep the “lights on” has not been concluded in a speedy way that lenders anticipated. As I mentioned last week in a piece it would cause ripples in the market if lenders were to walk away feeling unsatisfied.
The main wrangling issue is Greece's widening budget gap, it’s spending more than it earns. But, the Greek government doesn't have the stomach for more politically unpopular austerity measures, believing that tightening the noose might tip the country into civil unrest.
So the idea is to call an early election, which is causing more political uncertainty. Markets don't like political uncertainty, particularly when the popular political opponent is viewed as a far left Marxist, with unconventional plans to ditch the euro and default on the sovereign debt.
The Greek government needs a super-majority to install a president, which it doesn't have. If it can't elect a president, that might bring forward a general election. The radical Coalition of the Left (Syriza) is leading the polls.
The bond holders are shaking in their boots
An economic meltdown has rapidly turned into a financial crisis that metamorphoses into a political crisis, which typically swings from two extremes (left and right) of the political spectrum.
How are the financial markets reacting, this time around?
The market's respond to uncertainty in a predictable way; it is always negative.
Sovereign bond yields are breaking out of the region they've been in for the past few days, up from 7.2% to beyond 7.75%. The yield on a 10-year bond is a common measure used to show how expensive it is for governments to finance their debt. Yields saw a recent peak just below 9% in October, when the far left anti austerity party Syriza took a polling lead and the government was planning to exit its bailout early.
Deutsche Bank's Jim Reid explains the situation here:
The failure to elect a President by the existing parliament would lead to a national general election within 3-4 weeks, with the current SYRIZA opposition party leading in the polls (according to various opinion polls). Such very large electoral uncertainty and lack of an official financing backstop, ensures a meaningful period of uncertainty ahead for Greece.
Deutsche's George Saravelos also says there's a 60/40 chance of a Greek parliamentary election. With Syriza in the lead, that's a big risk for bondholders. The insurgent party wants Greece's creditors to take a major haircut (dramatically cutting the value of their investment) and for existing bailout programs to be cancelled.
As they say, there is no such thing as a free lunch. If a sovereign bond pays higher than the average, it does so because it’s a riskier investment. It wasn't so long ago when a bandwagon of investors, intoxicated by the central banks funny money QE policy, were falling over each other to pile into Greek bonds yielding 6 percent. The Wall Street expression comes to mind: “picking up nickels in front of a steamroller.”
The problem is that when mistakes are made high up the food chain, the fallout is usually big and it is always felt downstream. This is a serious problem that could easily spread to larger countries in Europe. Italy isn't in that much of a better situation. I see a flight to safety moving forward.
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