The recent weeks have been extraordinary. After considering that Europe was going to bankrupt and that the economy was in recession, investors and market participants have decided to be optimistic. As always, they disregard the dangers and prefer to believe that the recovery is happening. One of the elements of this euphoria is the bailout of Greece: the impact of a $150-billion haircut for the private sector, which will graciously receive $60 billion in new bonds -- between 25 and 30 percent their face value. In a strange way, this overoptimism could become an opportunity.
The Overoptimism Is Obvious
The non-AAA issuers of sovereign bonds will need $500 billion to refinance their debt, of which $300 billion will be... Italian. The mismanagement of the Greek debt under Berlusconi was abysmal. The result is that the Italian public debt reached $2 trillion. It is four times that of Greece. Greece was a problem, but the collapse of Italy is not manageable. Fifty percent of the Italian debt will mature in the next two years. This is a Damocles sword, and it is not going away any time soon.
The problem does not affect Europe only. According to Business Week, JP Morgan, Citi, Bank of America, Goldman Sachs, and Morgan Stanley hold $19.5 in net derivative exposure on Italy.
Where Is the Opportunity?
Over the past three months, the 10-year bonds of Italy saw their yield decrease from 7.26 percent to 4.8 percent today. This means that Italy has the ability to organize a voluntary exchange of its bonds maturing in 2012 and 2013 into a 5-percent five-year bond issue. It would reduce the undue concentration of its refinancing over the next two years, and the bondholders who would do that exchange would increase their interest rate for a longer maturity. Those bonds would trade at par, and no sacrifice is required of the bondholders. After a $1.3-trillion "gift" to the European banks who are using it to refinance their debt, the European Central Bank has a balance sheet twice as large as the Federal Reserve. It has exhausted its intervention possibilities.
Why Is It Not Happening?
Nobody wants to take the initiative. Europe considers that it has more urgent matters. The bondholders are traumatized by the Greek bailout. Italy does not want to take initiatives that would appear to be desperate. We know by now that the Eurozone leaders are incapable of managing a crisis, and that their inaction on the Greek crisis came with a huge sot for all private lenders.
Si vis pacem para bellum. If you want peace, prepare the war. This Latin adage is pointing in the direction of taking immediately the necessary preemptive measures to avoid unnecessary risks. Today's position is nothing else than a trillion-dollar bet on two years of market (over)optimism. As in-digest as it was, the Greek moussaka was... a piece of cake. An Italian default will bankrupt Europe and seriously shake the entire world. Nobody should take such a huge bet. Didn't we learn our lesson?
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