While the sovereign debt crisis has been a concern for more than a year, the markets are becoming increasingly focused on the day-to-day headlines concerning Greece. The first Greek bailout was insufficient to tide the country over to the point that it can access the public markets, and now an additional bailout financing is being negotiated.
While it appears that the eurozone members and the European Central Bank will continue to support Greece in the short run, the country's eventual default will be a surprise to no one, as the bond market is already pricing in a likely default within the next two years. Greece's yield curve is inverted, the 5-year credit default swaps are trading well over +2000, and the 10-year bonds are trading around 54 cents on the dollar. The real test will be whether the ECB has developed contingency plans to mitigate any liquidity issues that may arise from the Greek default and stem any contagion before it starts.
We don't think a default by Greece will cause a widespread financial meltdown. While many Greek banks hold a significant amount of sovereign Greek debt as a percentage of their capital and would probably fail, it appears that most European banks' exposure is manageable. Reportedly, only seven European banks have exposure to Greek debt that is more than 10% of their equity. In addition, since Lehman's failure, financial intermediaries of all types have learned to better monitor, manage, and hedge their credit counterparty risk. Thanks to the credit crisis, bankers and bureaucrats have learned how to keep liquidity from drying up by providing a combination of backstops, guarantees, and liquidity. A Greek default with appropriate measures in place to keep the markets functioning would assuage fears that contagion with Portugal and Ireland would bring the financial system to its knees.
However, while we think it is likely that the ECB has been developing a contingency plan, a default by Greece without such a plan to provide liquidity to the financial system could cause a liquidity crisis that would reverberate throughout Europe and take its toll on the struggling recovery. In this scenario, sovereign credit spreads would widen and drag both international and domestic corporate credit spreads wider as well.
In either scenario, our takeaway is that sovereign credit quality in Europe continues to decline. The European peripheral nations have not begun to dig themselves out of their hole yet and the strongest nations--those funding the bailouts--are weakening their credit profiles by taking on additional debt and guarantees. Considering the complexity of the different sovereign bailout funding mechanisms, the off-balance-sheet nature of entitlement obligations, and the time lag in reporting economic metrics, fixed-income investors are becoming increasingly weary of the inherent risks in investing in sovereign credit as opposed to corporate credit. This supports our longstanding thesis that corporate credit provides investors superior transparency relative to sovereign credit and should lead to better risk-adjusted returns over time.
Possible Moody's Downgrade of Italian Banks Adds to Market Pressure
Late Thursday, Moody's placed 16 Italian banks on review for possible downgrade. The move was based on Moody's June 17 announcement that it was placing the Republic of Italy's bond rating on review for possible downgrade as a result of slowing economic growth and the overall risks faced by European countries with large debt balances. A downgrade of this rating would call into question the Republic of Italy's ability to support Italian banks and diminishes the overall balance sheets of Italian banks, since a large portion of their holdings is in the sovereign debt of Italy. Trading in Italian bank stocks was halted Friday as Intesa Sanpaolo and UniCredit fell more than 7% intraday.
While we acknowledge the serious issues facing Italy and its banks, we think some of the reaction may have been overdone. No investor in Italian banks should have been surprised by a possible downgrade, since the Italian government's high debt/GDP ratio has been known for some time. Ultimately, any investment in Italian banks is a macroeconomic bet on the future of the Italian government, and with a debt/GDP ratio of more than 115%, buyer beware.
James Leonard, CFA is a credit analyst for Morningstar, covering financial institutions.
