Sun Setting on Greece and Eurozone?

Prime Minister George Papandreou on Friday lauded his government’s efforts to dig the debt-ridden country out of serious economic problems as a meeting of European Union leaders failed to conclude with the agreement of a comprehensive solution to the crisis in the eurozone.

Speaking at the end of a two-day summit in Brussels, Papandreou said that this week’s gathering and the emergency meeting of eurozone leaders earlier this month both highlighted that Greece is on the right track in tackling its mammoth deficit.

“We made big sacrifices,” he said. “The efforts are today recognized by all European partners. The efforts have delivered results. We need time, but we are committed to put Greece on a new path, on a modern path.”

Papandreou said that EU leaders recognized his government’s efforts by rubber-stamping a deal to extend the repayment period for Greece’s 110-billion-euro emergency loan package with the EU and the International Monetary Fund from three to 7.5 and lower the interest rate to 4.2 from 5.2 percent.

“We were not done any favors,” he told journalists. “The decision was reached after solid bargaining. We took some very difficult decisions so we could make our economy viable again… but now we can look to the future with greater hope. Our strategy has been vindicated.”

Meanwhile, European leaders failed to produce the much-anticipated anti-crisis package and delayed until June a final decision on increasing the 27-member bloc’s temporary bailout facility, the European Financial Stability Facility.

The Brussels summit was clouded by Portugal’s financial troubles. Portuguese Prime Minister Jose Socrates quit on Thursday after the country’s parliament rejected austerity measures aimed at staving off a bailout.

There were also concerns about the state of Irish banks, which prompted new Prime Minister Enda Kenny to put off renegotiating the terms of his country’s 85-billion-euro bailout.

Greece and Ireland were warned by German Chancellor Angela Merkel that they both still had a lot of work ahead of them. “The euro has survived a critical test but there is lots of homework to be done,” she said.

“Member states face many years of work to atone for past sins,” she said.

I wish I can tell you that Greece is rising from the ashes but it's not. The Greek economy is being put through the wringer and all these austerity measures have caused a lot of pain. Austerity measures are going to fail in Greece, they're going to fail in Ireland and they're going to fail spectacularly in the UK. Ireland is probably looking at Iceland and thinking about joining them.

What will additional austerity do? It will create more resentment in the periphery and pretty much kill these economies. After they collapse, growth will be easy. But don't worry, they won't collapse. Someone was asking me if they should buy Greek bonds and the National Bank of Greece. NBG just closed a difficult 2010 and is preparing for a perilous 2011. If you believe this is the bottom for the Greek economy and that Turkey will continue doing well, buy NBG and hold it.

Mike Mutti, Raymond James’ senior credit strategist, keeps a screen with five-year credit default swaps for European sovereign debt open at all times. That’s because more than any other current crisis facing the world – from the devastating earthquake in Japan to the turmoil in Libya and the Middle East – a severe escalation in Europe’s credit crisis has the capacity to cause a repeat of the 2008 meltdown.

Since the Greek debt crisis erupted nearly a year ago, new issues have cropped up in other peripheral countries (commonly, if not politically correctly, referred to as the PIIGS) every few months. You can almost set your watch to it. Though the disaster in Japan and spike in oil prices put the European debt issue on the backburner for a time, it flared up again this week after Portugal’s Parliament rejected an austerity plan, swiftly followed by downgrades to the country’s sovereign debt ratings.

Mutti acknowledges the challenges facing Portugal, Ireland and Greece, the three PIIGS in the most precarious shape, but believes the bailouts of those nations are essentially priced into the market. Fears crop up every few months, “then the fire is put out when European leaders put another hundred billion euros aside,” he says by way of explaining the ebb and flow in credit markets.

We’ve seen this movie before, he adds, pointing to previous surges in the price of insuring against default on European sovereign debt. What’s notable though, is that while previous spikes in credit default swap prices on Greek, Portuguese and Irish debt were accompanied by similar increases in corporate bond yields, thus far in 2011 increases in Greek CDS have not interrupted tightening in spreads of yields on investment grade corporate bonds to U.S. Treasuries. Of course, as Mutti is quick to point out, that all changes in a hurry if the credit plight of Spain or Italy worsens. (See “Europe’s Debt Crisis: Expect More Flare-Ups, But Breakup Unlikely.”)

(Source: Bloomberg, Citi Indexes, Raymond James)

Mutti doesn’t put too much stock into the bond yields at European sovereign debt auctions. For all the talk about this or that threshold that marks the breaking point for a country like Portugal, the CDS market tells the real story. “I’m a credit derivatives guy,” says the longtime Bear Stearns veteran who joined Raymond James in 2009. “It’s a swift market where people express their opinion on the likelihood of default.” Sure, you could surmise how risky a sovereign default is by looking at bond yields, “but CDS actually has ‘default’ right in the name of the product,” Mutti says.

A chart showing 5-year CDS on European debt clearly shows that while the PIIGS are grouped together, the investment community has delineated the fivesome into three distinct leagues. Mutti shared the chart below, which shows the difference in risk traders see in Greek, Irish and Portuguese debt, when compared with that of Italy and Spain.

(Source: Bloomberg, Raymond James)

If Italian or Spanish CDS rise into the 400 basis point neighborhood currently occupied by Ireland and Portugal, it won’t be easily solved by tossing another hundred billion euro at the problem.

To USAA portfolio manager Arnold Espe, who also believes a European sovereign default is the biggest risk facing the global market, government debt is not an enticing place to be. Owning Greek bonds at current yields is “ridiculous,” he says, particularly when he can buy corporate credits with similar yields and less risk, such as senior secured bonds of TXU (now called Energy Future Holdings) at 82 cents on the dollar with a 12% yield. Though the energy giant is struggling under its heavy debt burden, Espe figures he will still get around 100 cents on the dollar in a bankruptcy filing.

Another area he sees opportunity: subordinated debt in financial institutions. Issued by a wide variety of U.S. banks and insurers, as well as other finance-related firms like General Electric and American Express, some of the bonds offer junk-like yields of 6-7% in return for being a bit lower in the capital structure.

Of course, Europe creates a risk there as well. Unlike other situations unfolding around the world – the aforementioned issues in Japan and the Middle East, but also inflation concerns in emerging markets – Europe’s debt crisis could have a profound impact on the banking system that holds the sovereign bonds.

Just like the crisis of 2008, a major European default could result in a flight from stocks, bonds and any other hint of risk , and lead firms to crack down on counterparties. If things were to escalate to that point, Espe suggests the only port in the storm could once again be U.S. Treasuries, a trade that would get crowded awfully quickly.

Are we heading towards a "major European default"? Are macro funds shorting the euro? Is owning Greek debt "ridiculous"? Of course not. Europe isn't going to collapse and if you think it is, you're going to be waiting forever. Europeans drag their feet but they're not dumb enough to let eurozone collapse. As for Greek bonds, some pretty big sovereign wealth funds, like Norway, own Greek bonds and the FT recently reported on EU debt swaps stating that hedge funds have been buyers of Greek debt, rather than CDS, and the widening in spreads was instead attributed to panic protection buying by overexposed banks.

But I know people prefer jumping on the "Eurozone is doomed" bandwagon thinking that Greece and other periphery economies will implode. I'm not buying this drama. Let me end by wishing my fellow Greeks everywhere a Happy Greek Independence Day. There's one thing you should know about us Greeks. We're warriors, it's in our DNA. We simply never give up. So let the speculators bet against Greece. I know that no matter what happens, Greeks will survive and get passed it just like we have countless times in the past.

View the original article here