Monday, March 12, 2012

The Greek Situation: Financial Markets Do Not Like Surprises...and Vice Versa

Greece had a credit event.  Credit default swaps were triggered.

Markets opened.  Markets functioned.

This morning, the “new” Greek debt was trading at distressed levels…just below 20 percent.  The read of the market, “investors are braced for more distress.” (

Concerns still remain about Greece and the Greek government: “Most investors remain deeply skeptical of Greece and the sustainability of its debt despite Athens shaving off €100bn, or nearly a third, from its debt burden in last week’s successful bond swap.”
Financial markets are going to want to test this.  And this may mean that the “downside” of the pricing of Greek bonds may initially be pushed to see how firm it really is.  Whether or not the downside holds will depend upon what the Greek government does in upcoming weeks and what the eurozone does with respect to its lingering problems.
This concern does extend beyond the Greek situation in that the yield on the 10-year government bonds of Portugal, the country deemed most likely to follow the example of Greece, remains near the high levels reached in the recent unsettled weeks.
This situation, I believe, raises the question as to whether or not the actions taken by Greece are strong enough and will the Greek government actually be able to carry out everything that is needed to resolve the Greek insolvency.
Markets do respond positively to “credible” actions on the part of national governments.  For example, the “technocratic” government put into place in Italy seems, at least for the time being, to have calmed the international investors.  In November 2011, the 10-year bond of Italy was trading to yield around 7.30 percent.  A 7.00 percent yield was declared to be unsustainable for Italy.  Currently, this bond is trading below 5.00 percent, indicating that there is some trust that the present Italian government will achieve what it is attempting to do.
We will, of course, see whether or not these “expectations” play out.
But, as the editorial in the Wall Street Journal suggests, “the world did not end” with the Greek restructuring.
My response here is that markets do not stop trading when events are not surprises.  Markets hate surprises and when they are surprised…trading stops.  In such situations, traders don’t know where to set prices.
We can have policy surprises.  I was at the New York Fed one time when the Federal Reserve decided, for international reasons, to reverse the policy they had been following that had resulted in short term interest rates declining.  The fact that the Fed wanted short term rates to rise and therefore did not intervene when market pressures pushed these rates higher caused the financial markets to pause…trading stopped for a while.  Expectations had been broken and traders had to reset them before trading began once again.
Another example of a “liquidity crisis” is when the Penn Central Company failed.  Here was an example where the market perceived that the Penn Central had top rated credit and expected that the commercial paper issued by this company would be rolled over without any problem.  When the company declared bankruptcy it was a shock to the financial markets because the traders not only had to deal with this new information about the Penn Central itself, but also questions arose about the credit ratings of other highly regarded companies. 
The Federal Reserve had to react to this liquidity crisis by “throwing open the discount window” and other measures to provide market liquidity until traders could feel confident in starting up trading once again.
The recent “unexpected” event that surprised the financial markets and provided the background for the current concern over the creation of another “credit event” was the failure of Lehman Brothers.  Financial markets did not expect the United States government to let Lehman “go under”.  When the government did allow the company to “go under” people were not really prepared for this event…they were “surprised”.  And, systemic risk was released that caused substantial disruption to United States and European financial markets.
Great concern has been expressed in Europe (and elsewhere) that a Greek “credit event” that triggered the payment of credit default swaps could set off systemic effects that would spread from Greece to Portugal and possibly Spain…and Italy…and other countries. 
My feeling is that this concern was excessive.
The Lehman Brothers “event” was not expected.  Since people were not really prepared for the “event” adjustments had to be made, financial positions had to be altered, and, expectations had to be changed.  And, this transition had to take place throughout many, many organizations.
In the current Greek situation, the action taken last week was not un-expected.  Financial markets were prepared for it.  And, the financial markets absorbed the “shock” without much problem.
I believe that financial markets do work and do work well if they are not surprised.  This is why, in my mind, financial markets handled the Greek bond-restructuring program as well as they did. 
I am not convinced that politicians and government officials understand this.
Also, I am not convinced that politicians and government officials understand that their failure to fully resolve issues can create “sure-thing bets” in financial markets.  That is, if the Greek government does not fully execute the restructuring plan and carry out the promises it has made, a lot of people will make a lot more money by continuing to bett against the Greek government.
Just ask George Soros about the British government setting up “sure-thing bets” by trying to maintain the value of the pound in the 1990s.

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