Friday, February 17, 2012

Do We Really Know Greece's Default Will Be Orderly?

The market seems to be pricing in an orderly Greek default or a successful "firewall" around the potential instability. Are the unknowns really all known?

The equities market is acting like we know Greece's default will be orderly and no threat to financial stability. It is also acting like we know the U.S. economy can grow smartly while Europe contracts in recession. Lastly, the high level of confidence exuded by market participants suggests we know central bank liquidity is endlessly supportive of equities.

What do we really know about the coming default of Greece? Whether we openly call it default or play semantic games with "voluntary haircuts," we know bondholders will absorb tremendous losses that are equivalent to default. We also suspect some bondholders will refuse to play nice and accept their voluntary haircuts. Beyond that, how much do we know about how this unprecedented situation will play out?

It may be a good time to unearth a famous statement about known knowns and unknown unknowns:
Reports that say that something hasn't happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns -- the ones we don't know we don't know. (Donald Rumsfeld)
What we know is that the European Union is a model without easy historical precedent. Any predictions made about Greek default or the many financial and political machinations designed to "firewall" Greek default from the rest of the EU are speculations, as there are no good historical precedents to guide our guesswork. To say we "know the European Central Bank has this under control" is to claim knowledge of the unknowable.

We also know the derivatives market for credit default swaps (CDS) is not transparent, so no one can claim to know the risk levels in this market or the possible spillover effects should an "event" trigger instability.

Here is how frequent contributor Harun I. views the CDS market and Greece's impending default:
My contention regarding Greece has been that they cannot be allowed to default because of a tremendously leverage system. This contention remains unchanged.Below, the excerpt from KWN, indicates the problems confronting the system. Ten years ago Greece defaulting would not have been noticed but today, in a world where the CDS market has gone from $60 billion to over $600 trillion in a decade, and needs another $100 trillion in new debt over the next decade, Greece is a line drawn in the sand, apparently even if they burn it to the ground. 
Note the discussion of hypothecation. He is saying that customer accounts have been used two to three times to serve as collateral. And should their money disappear as it will when things fly apart, it will have been perfectly legal because all of this paper was rated AAA when it was purchased. (This is why you will not see any widespread compliance audits even in the wake of MF Global). At leverage of 500 to 1 all equity is wiped out after a 0.2 percent decline or default.
Here is the link Harun referenced: This is Financial Armaggedon, Lehman X 1,000
One thing that isn’t talked about much, although I did receive a note today from UBS regarding it, is derivates related to bond insurance...There are basically three times the amount of bonds out there, existing in contracts, to insure those bonds. Now you have to remember that a lot of these contracts were signed when all of these bonds were considered AAA rated. People didn’t believe they would default. 
So their is huge exposure in these dangerous contracts. There was one contract I saw that was going to pay 500 to 1 for the loss. These things are incredibly toxic contracts confronting the system right now. We don’t know who the counterparties are, and in many cases it’s hypothecated two or three times and it’s something that’s worldwide. 
We are looking at financial Armageddon. This is just awful, Lehman times 1,000. This is why they are going to all of these crazy extremes and calisthenics to make it seem like Greece is not defaulting so the bond insurance doesn’t kick in.
I have no idea if this is true or not, but the point is neither does anyone else. The possibility that one bondholder refusing to accept the "haircut" demanded by the Eurocrat lackeys of the banking cartel might trigger a contractually valid demand for a CDS to be paid does not seem priced into the equities market.

Under a slightly more lurid headline is another story making the same point: Forget Greece, Traders Are Worried About Something That Could Send Us Back To The Middle Ages.
As of now, most of the public discussion has centered on potential contagion among the banks as most of the Greek sovereign debit is held by the European banking community. 
Traders, however, fear that the real risk is in the area of credit default swaps (CDS). They are insurance policies, individually written, that basically say - if Greece defaults, we’ll pay you what they should have. 
Credit default swaps have grown exponentially over the last decade. Since they are individually written, there is no clear visible record of how many CDS contracts are outstanding. Also unknown is who is involved. The two parties obviously know who the counter-party is but there is no public record that would allow a regulator or a third party to find out who was involved. 
No one knows how much CDS exposure there is on Greek debt but is assumed to be a lot. Banks and others looked at the very high and attractive yields on Greek bonds and began salivating. But, what about that risk - better buy some insurance.
If the CDS written against Greek debt are not allowed to execute, then that calls into question all CDS insurance written against Euro-based debt. After all, if the banking cartel and its Eurocrat lackeys can essentially negate CDS written against Greek debt, why wouldn't they do the same with CDS written against Portuguese, Irish, Spanish or Italian debt? And if they pull that off, why would anyone trust any CDS written against debt anywhere in the global system?

I have no idea what will happen in the next few months, but I think it is fair to say that what may be unleashed is a known unknown. To be supremely confident that a Greek default will be orderly is to claim knowledge of that which cannot be known.

That smacks of hubris.

As for the American economy expanding smartly while the rest of the global economy contracts--is there any precedent for this premise? Since there is no precendent for the financial crisis enveloping Europe (and it can be argued, China), then whether the U.S. can grow while the rest of the world slumps into recession is a known unknown.

What we do know about global central banks flooding the world with liquidity is that this inflates asset bubbles that always pop with devastating consequences.Since this is known, what is the basis for the confidence that global liquidity will drive equities ever higher without negative consequences? Is this a "liquidity driven rally" or a "blow-off top"? Perhaps the difference between the two is purely semantic.

Once again the risk of liquidity-inflated asset bubbles--oops, I mean "rallies"--is a known unknown.

But what about the unknown unknowns? Markets don't seem to be pricing in any of the known unknowns, i.e. the risk of disorderly default, much less the unknown unknowns.

Maybe the U.S. will expand without regard to Europe or China or Japan, and maybe the Eurocrats will successfully "firewall" the Greek collapse. (Never mind the cost to the non-Elite Greek people--what matters is getting all those politically powerful bondholders and hedge funds paid.)

It seems to me that there is ample evidence that the situation very likely holds unknown unknowns--but few seem to have priced that into the equities markets. It often seems like a financial soap opera is playing out on some distant stage, but the money being made and lost is real--if the players cash out of the game before the lights go out. 

Thank you, Bryan S. ($100), for your outrageously generous contribution to this site -- I am greatly honored by your support and readership.Thank you, Mark A. ($50), for your lavishly generous contribution to this site -- I am greatly honored by your support and readership.

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