The Eurozone sovereign debt crisis

The Eurozone sovereign debt crisis is arguably the most telegraphed global financial melt-down in recent history, certainly when compared to the Asian and LTCM / Russian crises, and even compared to the US sub-prime crisis. As we and many others have commented for the better part of the last two years, the problem is not just one of peripheral European countries’ deteriorating fiscal positions. The microeconomic unsustainability of the peripheral countries within the Eurozone, the intractable political disagreement about potential fiscal transfers and bailout costs borne by core European countries, and the lurking risks of a panic on undercapitalized banks throughout Europe all pose large concerns.

Investment managers and hedge funds are lured by the attractive yield on some of the debt in the region, but only if some of the risk can be hedged away. Of course, the risks are priced-in and buying tail protection is an expensive proposition. Greek bonds yield a lot, but a Greek 5yr CDS trades in excess of 2300 basis points per year, Portuguese about 1100. The FTSE Eurofirst300 bank index is trading more than 20% below this year’s highs and is nearly 70% below its pre-subprime crisis high, making it a difficult short. Any hedge fund manager trading in these markets is taking a large risk.

An alternative to buying outright protection against a European catastrophe would be liquid market trades likely to react to adverse events in Europe: short euro, long bunds, long US Treasuries, short S&P500, or short DAX positions are some candidates among many. These trades, however, have performed inconsistently and have proved devilishly hard to time, and they probably have the risk built into their prices as well – although how much is harder to calibrate. So why not back away from all this? This week we read a story that two well-known and respected macro hedge funds are currently three-quarters invested in cash, reflecting the difficulty and lack of opportunities presenting themselves in the “macro” space. To believers in efficient markets – or semi-efficient markets, in our case – this sounds about right. If outright European protection is so expensive, the market is likely to render related substitutes in the liquid market-macro space expensive in their own way. Stubborn resilience and choppiness in developed market equities and the euro persist; richness in US and German bonds, the Swiss franc and gold deter all but the boldest buyers. The difficulty of trading the coming Eurozone crisis theme in liquid markets is a consequence of its near inevitability, not the contrary. Getting the timing correct is critical otherwise the hedges bleed premium.

Our approach to the immediate conundrum that the ‘coming European crisis’ presents is to hang tough. As unappealing as the crisis hedges are priced, they remain the right positions to have. The Hellenic Republic will not pay the entirety of its debt not only because it cannot, but also because its citizens would not allow it. As Portugal, Ireland, Spain and Italy cannot grow quickly in a time of austerity, they will not pay the entirety of their debt either. Policy debate ahead of today’s summit wholly focuses on the risky exercise in dividing up the costs of the Greek restructuring, searching for a magic formula that involves the banks in bearing the costs without triggering a panic. There will be no time for discussions about policies that will ensure that Greece and her peripheral brethren return to growth, allowing the Eurozone to survive. If the can is kicked further down the road without sparking an immediate crisis, we see more difficult trading – and expensive tail hedging – ahead. The alternative, actually owning European risk, however, would be far worse. As time passes, this crisis becomes more and more expensive for everyone. Delaying the conclusion is actually the worst thing the politicians can do.

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