In the past few weeks a flurry of articles have hit
the popular press regarding the probability of default of Greece. Headlines
like, “Markets predict Greek Default probability 99.99%” or “CDS markets
predict 100% probability of default for Greece” inspired fear to the hearts of
investors and to Greek depositors who rushed to take their money out of Greece.
Most of these stories have originated from the financial press[1]
and from traders who used a well known mathematical formula that computes the
probability of default given the bond Price.
One cannot argue the correctness of this number or the
mathematical involved which have been checked by many practitioners and
academics alike (including me). There is however, great ambiguity and
controversy at applying this mathematical formula and interpreting this number as
the market’s prediction for the probability of default for the Hellenic
Republic. The reason is simple. Many of the underlying assumptions, which
unfortunately are almost never mentioned, are violated in this case.
Market Liquidity and Efficiency
Figure 1. Monthly traded volume of GGB's
The credit spread of any bond whether corporate or
sovereign is comprised of the following components:
a) Risk of Default.
b) Optionality if any.
c) Liquidity Premium
d) Other, like Convexity, Repo specialness, etc.
In the case of almost all Greek bonds the credit
spread is simply (a) and (c). I.e. Risk
of Default plus Liquidity Premium.
So how much is the Liquidity risk or premium embedded
in the spread. Do we know? Can we somehow estimate its value? Most academic
studies have shown that it is significant but unfortunately no satisfactory model
exist (to the best of my knowledge) that can separately price it.
So, how liquid are the Greek bonds and the Greek Bond
market. Greece has about 350 billion of debt. In the form of tradable bonds
around 280billion as the bailout package have so far transformed 60billion into
bilateral loans and there are also around 10billion in short term Tbills. How
many of these bonds are traded on a monthly basis now and how many a year ago.
The graph below (Figure 1) is revealing. From a high of around 45billion in
March 2010 (when the debt crisis erupted) we are down to 1.7billion in March
2011 (Data are from the major providers, HDAT, MTS, Brokertec, BGC, ICAP). This
is an absolute staggering reduction in liquidity to the once vibrant Greek bond
market. Why did it happen? Why are these bonds not traded? Why do investors shy
from them even at extremely low prices and why are scared holders don’t sell
them?
The problem is that as prices dropped, many banks
holding Greek bonds moved them to the banking book (accrual) and marked them at
PAR. By moving them to the banking
book, they also shielded them from the infamous stress tests. Thus, it was
impossible for them to sell them at 70 (say) as it would mean taking a loss
that most European banks could ill afford.
The recent EBA (European Banking Authority) tests imply
that around 85% of the Bonds held by Greek banks were marked at Par (before the
PSI writedown) and 60% of the bonds held by European banks. Then we have the
funds, mutual or pension. The majority of the European funds bought the Greek
bonds on an asset swap basis taking advantage of the credit spread at the time.
The asset swap package is marked at Par and selling the bond not only would
incur a loss on the bond side but also on the swap side. Finally, other
institutional investors like insurances may or may not have taking the mark to
market losses. Anecdotal evidence suggests that not all of them have taken the
losses.
How about the repo market? In principle investors
could find the bonds there. Well, around 85billion are with Greek Financial
institutions, which are locked out of the market (no lines). They can only repo
with the ECB. The ECB owns a further 45billion. Most of the other banks prefer
to repo with the ECB for credit crunch reasons.
So, who remains in the market to determine the price?
a.
Funds and
insurances that own them outright and have real MTM and have redemptions.
b.
Banks that have
them in the trading book.
c.
Private banking
investors who are easily spooked.
These bondholders are a small subset of the market and
they do not represent a good sample anyway. On the buyers side, the problem is
that most Institutional investors are not allowed by their rules to invest in
low quality bonds. True, they are stuck with the Greek ones, but they cannot
add to them no matter how great the opportunity is.
In conclusion, the Greek bond market is a totally
dysfunctional market with separate dynamics from the ones most modellers
assume.
Information
availability and valuation
One of the basic tenets of mathematical pricing
theory, is that all information is available to the market at any point in time
and that market participants have equal access to it. Valuing this information
is the job of the trader who can easily shift through the credible from the
ludicrous. Unfortunately, most market participants have been caught in the dark
here. After 2000 with the introduction of the Euro most investment banks scaled
down their coverage on individual countries (and peripheral) as they shifted
their resources into covering the ECB.
The result was a huge mispricing of the Greek risk (and other
countries), which now the market tries to correct in panic.
Now that we have a malfunctioning bond market,
together with a malfunctioning of the information flow the bond price reflects
mainly the ignorance of the risk of default rather than the true probability of
it.
Conclusion
I am not arguing that Greece does not have a high
probability of default. Their fiscal situation speaks louder than anything
else. I am only saying that unqualified usage of the models is wrong and it
gives totally the wrong message to the easily spooked and impressionable market
participants.
Apart from the sensationalist value of these reports
one should not attach any credence to the numbers obtained. There is
information content in the Price of the Greek bonds, however the interpretation
is far more complex than the naïve and simple Probability of Default.
[1] See for example, 1) http://www.bloomberg.com/news/2011-09-12/greece-s-risk-of-default-increases-to-98-as-european-debt-crisis-deepens.html,
2) http://money.cnn.com/2011/09/19/news/international/greek_default/?source=cnn_bin
