The financial market’s focus remains on Europe. The financial press directed its attention today to the rumored Standard & Poor’s downgrades of European sovereign debt, confirmed late in the day. Most European nations have now been downgraded, and the downgrades have reached Europe’s core with France and Austria losing their prized AAA rating. A few nations, including giant Italy, were dropped two notches. At the most fragile end, Portugal joined Greece, as S&P downgraded Portugal to junk with a negative outlook.
Markets reacted calmly. Since the potential for such downgrades was announced several weeks ago, the markets have apparently had an opportunity to factor them in and adjust.
Perhaps just an interesting coincidence, but a rumor floated this morning on CNBC that the Federal Reserve is seriously considering QE3. That prospect served to remind investors worldwide that governments and central banks remain alert to the problems and stand ready to bend every effort toward avoiding economic downturns that would penalize banks, individuals and other entities that made the mistake of excessive leverage. The Fed stands poised to once again attempt solving problems brought on by too much debt by creating even more debt.
A potentially more important news story emerging this morning was the apparent breakdown of the latest talks regarding the restructuring of Greek debt. Before today, there had arisen some level of confidence that bondholders would accept a negotiated price reduction or–“haircut”–of perhaps 50%, and that Greek debt could be restructured on a “voluntary” basis. If such a reduction of principal value were “voluntary,” no credit default event would be triggered, and the writers of insurance against bond defaults would not have to pay. Of course, to contend that the acceptance of any such “haircut” would be “voluntary” is pure fiction, but such intellectual contortions are necessary to ward off the potentially calamitous repercussions that could flow from a credit default event. The breakdown of today’s talks reduces the likelihood of an orderly Greek default.
While the financial consequences to counterparties who wrote credit default swaps are unknown, according to banking analysts, they are potentially severe. Investors don’t know which financial institutions would be exposed to losses from a disorderly Greek default.
Last weekend, hedge fund pioneer George Soros warned that the current European crisis is more dangerous than the 2008 crisis that, but for the greatest government intervention in history, nearly led to the breakdown of the world financial system. Chinese officials voiced the same alarm a month earlier. Soros indicated that a breakup of the euro, which could follow a disorderly Greek default, could precipitate a collapse of the European Union, which could in turn have “catastrophic consequences” for the global financial system.
Since the next rollover of Greek debt is not until March 20, it is likely that negotiations will continue for several more weeks. Those discussions, however, are no safeguard against investors starting to handicap in advance the odds of a “voluntary” agreement. Spanish and Italian debt was brought to market today relatively successfully. Huge volumes of debt are scheduled to come to market throughout Europe over the next several months. If potential buyers become wary that Greece’s problems will lead to a Eurozone breakup, they may boycott those auctions. Destructive contagion could spread rapidly even in advance of a formal default.
Our markets experienced no violent reaction to today’s negotiations breakdown. Just a few months ago, the morning news from Europe moved U.S. equity markets by hundreds of points day after day. Minor changes in investor confidence could again precipitate such volatility. As we head into a long weekend in the U.S., there is added time for events or rumors of events in Europe to again reach a boiling point.
This is not simply traditional market volatility. Debt is threatening the world financial system. Governments and central banks may again successfully “kick the can down the road,” as long as they can maintain investor confidence. But that can’t be guaranteed. Governor of the Bank of England, Mervyn King recently said: “The crisis in the euro area is one of solvency and not liquidity. And the interconnectedness of major banks means that banking systems, and hence economies, around the world are all affected.” If investors start to focus on solvency–and Greek default could force that–the return of capital will become far more critical than the return on capital.