Looking For Black Swans In The Eurozone's Infirmary

I thought that this might be a good time to take a quick look into the eurozone’s ICU to see how the PIIGS are doing. My particular interest is in identifying any countries that look likely to blow up this fall. I will review the PIIGS in the order of their current Moody’s bond rating, from highest to lowest.

(Baa2/Negative Outlook. Barely eligible for investment grade portfolios. Bonds at 5.1% trade as a Baa3.)

Italy is the Big Enchilada of the PIIGS. As a major economy with EUR 2 trillion of debt, it is way too big to be allowed to default. However, refinancing a debt burden on that scale cannot be handled by the EFSF/ESM. It would require the full resources of the ECB, and then some.

Italy’s bond yield has been quite volatile. It was as high as 7.2% last fall. Since the OMT was announced, it has fallen to 5.1%, which is still too high.

Moody’s downgraded Italy from A3 to Baa2 in July, providing the following rationale:
“A key factor underlying Moody's two-notch downgrade was the assessment that the risk of a further sharp increase in Italy's funding costs or the loss of market access has increased due to fragile market confidence, contagion risk emanating from Greece and Spain and signs of an eroding non-domestic investor base. The risk of a Greek exit from the euro has risen, the Spanish banking system will experience greater credit losses than anticipated, and Spain's own funding challenges are greater than previously recognized. In this environment, Italy's high debt levels and significant annual funding needs of EUR 415 billion (25% of GDP) in 2012-13, as well as its diminished overseas investor base, generate an increasing liquidity risk. The second driver of the rating action was the deterioration of Italy's near-term economic outlook, as manifest in both weaker growth and higher unemployment, which creates risk of failure to meet fiscal consolidation targets. Failure to meet fiscal targets in turn could weaken market confidence further, raising the risk of a sudden stop in market funding”.

So far, Monti seems to be hoping that the ECB’s OMT announcement plus further reform at home will bring Italy’s bond yields down further, which I doubt. His fiscal situation will worsen, and his government’s domestic power position will continue to decline. In the end, Monti will have to apply to the troika for assistance, and the ECB will have to move heaven and earth to establish an informal yield ceiling.

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(Rated Baa3, on review for downgrade. Moody’s says that its review will continue through the end of September. Spain is already ineligible for most investment grade portfolios. Trading as a Ba1 at a yield of 5.6%.)

Spain, with EUR 750 billion of debt, is Europe's other big problem. Although Spain’s bond yield has come down since the OMT announcement, it is still high at 5.6%. The Spanish banking system has been steadily losing deposits due to convertibility risk (which is, of course, “unthinkable”). Spain requires help from Europe to pay its maturing debt, recapitalize its banks, and bail out its regions. Rajoy has been slowly going through the stages of grief and is currently moving from denial to bargaining.

Because Spain is too big for the EFSF/ESM to rescue, it ultimately will be up to the ECB to bring Spain’s yields down to a financeable level. The immediate question is the size of the capital hole in the banking system. The longer that Rajoy waits to apply to the Troika for assistance, the more likely Moody’s is to downgrade Spain to below investment grade, which will add to the pressure.

(Rated Ba1/Negative Outlook. Ineligible for investment grade portfolios. Bonds at 8.2% yield trade at their rating level.)

Ireland is the Troika’s poster boy for compliance and success. Ireland has executed its austerity program and is on track for continued fiscal consolidation.

Moody’s says that it “sees a possibility that the end of the current support programme at year-end 2013 will not only prompt a need for further rounds of official financing, but that private sector creditor participation is also to be required as a precondition for such additional official support.”

One can only hope that Moody’s is mistaken in suggesting that the Troika will require a bond default as a precondition for additional assistance, since this would make Ireland a credit like Greece. Europe can’t be that stupid.

As a fully-compliant government, Ireland should be the first in line for bond purchases under the OMT. They don’t even have to apply. It will be interesting to see if the ECB steps up. I can see no reason why they shouldn’t, if they want the program to have any credibility. Let’s see how fast Draghi can bring down Ireland’s yields. What is he waiting for?

(Rated Ba3/Negative Outlook. Ineligible for investment grade portfolios. Bonds yielding 8.1% trade at their rating level.)

Portugal remains in austerity hell. It has no market access, is in permanent depression, and still faces major additional cuts. It is on track but has a long way to go, with no light at the end of the tunnel.

Moody’s assessment is quite pessimistic: “considerable uncertainty over the prospects for institutional reform in the euro area and the increasingly poor macroeconomic outlook across the region will continue to weigh on already fragile market confidence and make it difficult to reverse Portugal's adverse government debt trajectory”. Moody’s adds that a Greek exit would not be helpful for Portugal.

(Rated C, in default; remaining bonds yield 22% in anticipation of a second default.)

Greece, on permanent life support from Europe, is way off track in the implementation of its Troika-designed program. It has done almost nothing to comply, and prefers rioting to reform. Greece is the proof that there is almost nothing that a eurozone government can do to get kicked out of the eurozone. Europe knows that a Greek exit would be another Lehman event and would put intolerable pressures on the other PIIGS. The Greek negotiators know that. I expect that Greece will get its money by once again agreeing to a plan it has no intention of implementing. Greece is impossible to reform and too big to fail.

If you want to gauge these five credits as potential black swans, you’d have to start with Greece, although I am confident that Greece will get bailed out no matter what. Next would be Spain which is playing chicken with Europe on the terms of its bailout, but this is political theater. Spain will have to apply, so the risk of an unanticipated explosion is low. Italy may be the sleeper of the bunch, because most of her plausible scenarios are on the downside, as Moody’s stated. Time is not on Monti’s side, and his credit is likely to worsen.

Because neither Italy nor Spain can be rescued by the ESM, they will ultimately have to be rescued by a display of shock-and-awe by the ECB. By shock-and-awe, I mean massive unsterilized bond buying. That can only occur when Draghi has enough votes. Let’s hope that, when one of these behemoths starts to keel over, Draghi will have the votes to do something.


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