Greece: it’s not Lehman

The outcome of the vote should not ever have been in much doubt. After all, the vote concerns the question of who will get the blame for the austerity measures. All legislators can naturally agree that the answer should be “someone other than me,” and Papandreou qualifies. Adding more cynicism to that observation, let me point out that getting someone to take money is rarely the problem in a negotiation. The main problems are usually (1) persuading someone to give the money, and (2) getting the recipient to pay it back. It seems to me that even though Greece has agreed to take the money if it is offered, the hard parts are still ahead of us.

Still, as I pointed out yesterday the equity markets since late last week have clearly been looking for reasons to rally. Delaying the inevitable on Greece seems to be a decent excuse to do so.

How far could such a bounce extend? It should not go very far, since the stock market was not down over the last two months because of fear about Greece but rather because softer economic data collided with a market priced at 22x cyclically-adjusted earnings. The high valuation and soft data have not changed; as a reminder of that, we learned yesterday that Existing Home Sales slumped to 4.81mm units in May and the inventory of unsold homes remains above 3.7mm units.

Now, assessing what bounce is “reasonable” doesn’t always work. Bulls are adept at selecting scapegoats and attributing all of the bad things that are happening at the moment to the single scapegoat. In 2000 it was the “NASDAQ Bubble” even though the S&P was also extremely overvalued. In 2002 it was “governance” after Enron and Worldcom collapsed. It was LTCM. It was program trading. In each case the scapegoat was advanced, dealt with, and then bulls (led by the cheery fools on financial TV) declared that the reason to be bearish was over and the market could rally again.

Can “Greece” be the scapegoat for this market? I don’t think so, if only because scapegoats are most successful at the bottoms of markets and not at the ends of brief corrections of long uptrends. Maybe “European sovereigns” could be the scapegoat, and that’s closer to the truth anyway – but the fact that the problem is far from solved means that it makes a poor scapegoat. So I don’t think the current exuberance is going to last very long unless there comes other good news. The related markets are echoing my skepticism. Treasury yields rose only 2bps, which isn’t much of an unwind of any ‘flight to quality’ bid!

And Greece, vote or no vote, remains a problem – perhaps deferred a couple of months at best if they get the current tranche due from the EU. How a big a problem it is remains a matter of debate.

Because it is recent, the Lehman collapse is often cited as a model for how bad a default by Greece could be. It is a bad comparison. In most ways, a Greek failure would be worse although in one or two ways it compares favorably.

First, let’s think about the ways that Greece is a bigger problem than Lehman. While Lehman had enormous amounts of derivatives outstanding, most of the money lost in the collapse had nothing to do with the derivatives. That is because the derivative positions were mostly hedged – for every long Lehman had, there was an offsetting short also in the book. The two counterparties each did not know who the other was, but it was pretty certain that if Lehman was receiving fixed on $200bln in 10-year swaps in aggregate, they must have been paying fixed on roughly the same amount. Dealers did lose money in search costs, trying to find the other side, and in panicky hedging maneuvers that were ineffective, but the aggregate loss on market positions was small – perhaps a couple of billion (remember also that derivatives positions are subject to a mutual exchange of collateral. The ‘gap risk’ from suddenly losing a hedge turned out to be far more damaging than the credit exposure).

However, Lehman also had in the neighborhood of $100bln in bonds outstanding. That is the only major position that was essentially unhedged – as an issuer, Lehman was “short” its bonds to the world, and they weren’t long anything against that. Most of the money lost on Lehman was lost by equity investors and by lenders who owned Lehman bonds, and that wasn’t generally the other banks/dealers.

Greece, by contrast, has over €340bln, or nearly $500bln, in outstanding bonds. Now, Greece is also not as leveraged as Lehman was, so while Lehman bondholders recovered around 16% [1] of the notional amount of the debts, meaning that they lost some $84bln-ish, a 40% recovery assumption on Greece would imply that the losses by bondholders would be around $300bln, about three-and-a-half times worse than Lehman’s collapse. My point here isn’t to make precise calculations but to illustrate the size of the problem.

On the other hand, whether a Greek default would lead to a seizing up of the credit markets is less certain even though the amounts involved are much larger. What caused the credit markets to seize after Lehman was not the size of the event, which wasn’t actually all that large when you consider banks’ exposures, but the fact that no one knew who was holding the bag. Should I lend unsecured money to Citigroup, or Goldman, or Morgan Stanley, if I don’t know what their derivatives exposure to Lehman was? It is best to husband one’s resources until we know who the zombie banks are. But with Greece, the exposures are conveyed through ownership of the sovereign bonds, and so it is easier to know

where the bodies are buried. If Greece defaults, the regulators will have a very good idea of which banks are in the most trouble. Very quickly, the capital will flow around the dead banks and to the living banks and it will be fairly easy to tell which institutions are in those two sets because regulators will want to cordon off the bad banks. In fact, with the current uncertainty gone, it might actually improve capital market functioning.

Oh, but here’s another way that Greece is different from Lehman. The Federal Reserve did not have meaningful direct exposure to Lehman, while the ECB owns a large slug of Greek bonds that it has bought in misguided price-keeping operations over the last year.[2] I have no idea how the system will function if the ECB is effectively insolvent. I assume that the central bank would take the route out of the problem that only a central bank can, and print itself back to solvency, but the people in charge of the ECB are somewhat crazy – after all, let’s remember that they are tightening policy at the moment, into a sovereign crisis.

One final way that Greece is unlike Lehman is that default doesn’t end the game for Greece. Once Lehman shuttered, there wasn’t much else to do besides prepare for the lawsuits and help counterparties find each other. The entity was finished, kaput. But if Greece defaults, it opens up a whole can of worms with respect to membership in the EU and the euro. Both entities threatened contagion: Lehman to other banks and Greece to other PIIGS. But Greece creates a constitutional crisis in the eurozone as well. There is no mechanism to explain how a country exitsthe EZ, how the egg ‘unscrambles’ as the analogy goes. It is sure to be messy. And in that sense, a Greek default will be just the beginning.

It is a beginning that European politicos don’t want to have to deal with any sooner than they have to, but the day is rapidly approaching when there won’t be a choice.