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“And the giant beside him about to fall, they will try to make you crawl.”

-Sly Stone

There all kinds of risk.  Good risk, medium risk, and bad risk. (Some investment bankers even say no risk.) Bad risk is also the name of a song by the U.S. funk band Sly and the Family Stone.  Growing up in the era of psychedelic drugs and music, it is likely that Sly Stone knew a few things about bad risk.

As Risk Master Brother McCullough is discussing on Bloomberg this morning, we are waking up to some funky news. Suffice it to say, in the world of global investing , potential sovereign debt defaults be some Bad, Bad Risk

Greek credit default swaps have been blowing out for the last few weeks and yesterday the culmination was a downgrade of Greek and Portuguese sovereign debt, the former to junk bond status.  That be bad.

As is often the case in global macro risk management, geopolitics matter.  In 1998, the United States and a few other nations came to the rescue of Mexico in her inability to roll over short term loans.  Sho’nuff, the United States actually made a profit of some $500MM on this bailout.  Ironically, the architect of this bailout was Treasury Secretary Robert Rubin.

Even the most eminent of Perceived Experts, like Brother Rubin, make funk predictions.   As it relates to sovereign debt defaults, we’ve quoted former Secretary Treasury Robert Rubin from a presentation he gave at Yale Law School last year in which he said, “he did not forsee any sovereign debt defaults.”  Now to be fair to Brother Rubin, in the same lecture he indicated that a Greek Philosophy class he took in his freshman year at Haw-havd was the underpinning of his risk management philosophy.  No math, brother?

(We’d just be piling on Goldman if we mentioned that Brother Rubin was also the former CEO of Goldman Sachs and that Goldman had a very substantial long position in Mexican bonds, and thanks to his bailout they got out whole.  But no need to kick a firm when it’s down!)

The simple math associated with Greece suggests that risk is accelerating. This morning the spread between Greek bonds and their German counterparts is 800 basis points (8%!). That be wide!  In addition, and we’ve highlighted this in the chart below, Greek credit default swaps continue to blow out.  By our last measure, they were at 842 basis points.  That would be funky, if it weren’t dang expensive insurance. 

Yesterday, S&P downgraded our Greek Brothers to junk status.  The implications of this go far beyond one country.  This is the first time any nation in the Eurozone has been downgraded to junk since the introduction of the Euro in 1999.  Incidentally, Greek debt is now on par with the economic stalwarts of Azerbajian and Egypt.  According to S&P, in a restructuring Greek debt could be worth as little a 30 percent of face value. Dang!

The question is: When is Germany going to get down with it? It is time to put some stank on it in the Eurozone!

This morning Sister Merkel, also known as the Chancellor of Germany, is going to be giving a statement regarding Greece at 10:45 a.m. eastern.  Mark that one in your Outlook calendar.  This will be a catalyst for the market.  And while it is earnings season . . . at the moment Macro Matters more than the EPS miss of Buffalo Wild Wings. Ain’t that the truth?

While it was an easy decision for the United States to bail out Mexico in 1998 (setting Goldman’s long exposure aside), it is a much more nuanced decision for Sister Merkel in regards to Greece.  As our European Analyst Matt Hedrick wrote yesterday:

“ While we believe Germany’s “contribution” is inevitable, what we’re currently seeing from Merkel is political posturing. On May 9th, Germany’s largest state by population and the industrial heartland, North Rhine-Westphalia (NRW), holds a state election.  Merkel’s Christian Democratic Party (CDU) along with her coalition partners the Free Democrats (FDP) need a win to retain the majority in the Bundesrat (upper house of parliament), which is critical for her party to carry out scheduled reforms, including tax cuts and health care reform. 

Recent polls suggest that Merkel’s opposition, the alliance of the Social Democrats-Greens, has a slight advantage. With government spending a hot topic in the election, Merkel must show that she’s not writing a blank check to the Greeks, and will continue to drive a hard line.”

Like any astute geo-political, analyst Brother Hedrick has ascertained an important point, even in the face of a spiraling economic crisis in the Eurozone, politics still matter. To summarize this in the wise words of Sly Stone: “And the giant him about to fall, they will try to make you crawl.”  Now that’s a groovy realization.

Last month we did an in-depth presentation of sovereign debt and the risks associated with potential defaults.  The conclusions of this historical analysis was simply that defaults or restructurings are rarely one-off issues, and certain nations, not surprisingly Greece, tend to be leading indicators.

Rumors yesterday out of Europe suggested that Europe would convene a “Greek Aid” summit on May 10th.  By that time, Sister Merkel’s elections will be one day behind her.  If that date don’t speak the truth . . .

Keep groovin’

Daryl G. Jones

Managing Director

Bad, Bad Risk - merk