The Market votes against the Greek Referendum

The Market votes against the Greek Referendum

Why Greek PM Papandreou would call for a referendum on the recent bailout has certainly confused the markets and this author.  One could guess it is to get a better grip on his flagging power base; however, it appears to have already backfired as his fellow lawmakers, including those within his party have blasted him. 

The referendum call puts in jeopardy the next installation of bailout funds by the IMF and the EU and, although no one is able to yet put together thoughts on what may occur, below is a quick sketch of our thoughts on the referendum.

A brief review of Greek Debts

Of the 364B Euro in Greek debt, the holders can be roughly broken down as follows;

• 1/3 Public (IMF, ECB, other governments)
• 1/3 Greek (mostly banks)
• 1/3 Non-Greek Public

From The Economist- October 2011

The total amount isn’t huge- the issue is potential contagion affects.

From Bloomberg:

So, although the timing of the above chart total numbers are different from the last graph; we still have about 25% being held by banks (the majority of the 1/3 we have as Private holders). 

From  a July analysis by Barclays, it appears that the majority of banks are French and, after that, German. 

Referendum

If it goes to referendum as a simple “yes” or “no” on accepting bailouts/austerity, it will likely fail.  If it fails Greece will default, likely either before their mid-November payment which they are supposed to receive or; if they can convince Euro-area members to get it, the tranche will run out in January (roughly when the referendum is rumored to be scheduled).  If the referendum is “yes, accept bailouts/austerity and remain in Euro” or “No, do not accept bailouts and exit the Euro” the outcome is much cloudier, as a solid majority of Greeks want to stay in the Euro. 

Default & Contagion

What happens if a country goes into default?  There is no prescribed path to default.  There is no international bankruptcy court, and a lot of the actual law depends on where the bonds were underwritten.  Most are underwritten in New York and abide by that law and their contracts.  Typically, the country will try to come to a voluntary agreement with the majority of bondholders; however, there are typically holdouts that try to get more than the other bondholders (which can be very lucrative).  Those holdouts can keep the country in litigation for decades.  However, even a victory in a court does not make the bondholder able to collect the assets, as countries can and will hide assets. 

Specific to Greece, if default occurs, not paying the IMF and ECB won’t affect markets, although IMF loans have strict covenants that will make Greece a financial pariah if they choose not to pay those back.  Other governments needing payback is a bit more questionable.  Non-Euro area governments can take the hit fairly easily as the numbers aren’t that big.  Greek banks will likely see some bankruptcies- or at the very minimum significant shareholder dilution to get their Tier 1 capital back up to decent numbers. 

We can’t ascertain what would happen with Greece staying in the Euro, as there are no exit clauses, but they would likely kick Greece out.  Greece could choose to inflate it’s way out of its debts and it would likely go back to being the typical inflationary Mediterranean country it was prior to joining the Euro. 

What would happen to French and German banks becomes more concerning as we look past Greece.  Looking to Italy, their Debt to GDP has been rising and is at 120%.  Their last bond auction went off for 5 year bonds at 4.9%, which is pretty high and seems unsustainable.  If they catch fire, it’s a whole different ballgame- which is what France and Germany are trying to protect against.  Europe’s 90 largest banks own an amount equal of Italian debt equal to all of Greece Debt. 

Banks holding this debt is the issue and the true risk of contagion.  If bondholder’s accepted 25% of their principal back instead of the 50% that has currently been negotiated, this would hurt banks that own other countries’ debts as well.  This would be a serious issue for all. 

An interesting case study can be found in the Argentina default of 2002.  In the early 1990’s, Argentina conquered its hyperinflation issues by tying it’s currency to the dollar.  In doing that, it essentially acted as a common currency area, much like the Euro.  Like Greece, it was unable to print currency to inflate its debt away.  Its default in 2002 caused a localized but very deep depression that the global economy has since been able to grow them out of as the peso revaluation made their exports more competitive internationally. 

Valuation

So, is the market accurately valuing the future volatility we’re sure to experience?  The foreign markets (as measured by the MSCI EAFE) were trading at a Price to Earnings Ratio of 10.68 as of 9/30.  This is equivalent to an earnings yield of 9.3%.  The U.S. market (S&P 500) was trading at a P/E ratio of 12.5, or an earnings yield of 7.9%.  Those are relatively high earnings yields on a historic basis, signaling a fairly “cheap” market compared to it’s earnings.  With the low visibility and high probability of future volatility, it seems reasonable that investors want to be better compensated for these risks.

So, is the valuation compensating us fairly for the risks?  Frankly, we do not believe any investors have the visibility to be able to tell at this point and therefore maintain our neutral stance.  Investors would be well served to maintain diversification  and humility in markets such as these.