Beware of Greeks Bearing Bonds

Phil Diamond, CFA | March, 1, 2010

Okay, this past week we've had another disaster, not the earthquake in Chile, that's a natural disaster, not man-made. Okay, so Greece isn't a new disaster, they just got their debt downgraded by Standard & Poor's. Does that come as a surprise to anyone? Maybe it happened a little quicker than most folks expected, but given the history of credit ratings, at least they didn't wait until after they defaulted to cut it. Any default is at least years in the future according to most folks who supposedly know about these things. Also, a report states that Greece, since its war of independence from the Ottoman Empire in 1832, has spent just about half of their modern history in default on some or all of their foreign debt. A new default would be more in character for Greece than for most European countries.

The issue here is really a slippery-slope kind of deal for the European Union. Once the EU starts bailing-out members we'll get a new, improved definition of moral hazard. Moral hazard today means more or less that society has compelled some group or organization to perform some service or accept some limit on their freedom and thus society has a responsibility to protect the organization against the repercussions of those limits or services. So, once the US decided to make the major US banks the agents of its monetary policy, it felt it had to save them from the repercussions of US monetary policy.

The Europeans are facing a similar problem, once it lets a member state of the EU welch on its bargain to keep government deficits below 3% of GDP or maintain other requirements of membership in the EU, what do they do? If the Greeks can run large deficits, why can’t the Portuguese? Why not the Spaniards? Why not the Germans? If the rules don’t work, how can you enforce the rules? The EU would prefer to save the Greeks, so long as it isn’t too expensive, in order to save the euro. But, if the price is too high, do they kick Greece out of the EU? Does the European Currency Unit (ECU) have to be amended in some major way? Can they continue to grow the Euro-zone? All these questions because Greece broke the rules.

As things stand today, the Greeks can pay their current debts, but they are approaching the limit of how much debt they can shoulder. The point may come where Greece can’t service their debt but they still need to borrow. That day will be real interesting. Any package of EU fixes will be directed at maintaining Greek access to credit markets and postponing the day when the Greek crisis becomes the Greek tragedy!

Also, the EU would like to create a template for how to handle all the other miscreants in the EU with the PIGS moniker -- Portugal, Ireland, Italy, Iceland, and Spain. Whatever they come up with, it had better be flexible, fair, effective and affordable. Yeah, there’s nothing they can do but kick them out.

The new wrinkle in this whole sad affair is the attack on the euro by hedge funds. Because of the Greek tragedy, many people in the hedge fund world think the euro is overvalued and needs to come down. If enough hedge funds sell enough euros, can they make that happen? The euro is a huge market and there is some question as to whether the hedge funds have enough ammunition to take it down. This will at least cause a lot of volatility in the euro (versus other key currencies) over coming weeks and maybe months. It could also mean that many hedge funds are going to have a lot of eggs in the euro basket. If the attack on the euro fails miserably, it could cause a lot of bleeding for a lot of hedge funds. Beware of the Trojan horse!

We would like to thank our colleagues and business partners at FocusPoint Solutions for their contribution to our Commentary. Particular thanks go to Phil Diamond, CFA; Ryan Long, CFA and all within their research staff. We look forward to their on-going Commentary contributions.

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