If the Euro Breaks Up – – Scenarios for Greece, PIIGS and Total Collapse
Even a modest breakup of the euro, such as the departure of Greece, would send the S&P 500 down 10 percent and with contagion effects knock 17 percent off the value of a long/short equity portfolio, said Dr. Lance Smith, CEO of TS Imagine.
Banks, asset managers and presumably governments are looking at what a breakup of the euro would mean — from the departure of a single country (Greece), to the departure of several countries or a complete breakup of the euro zone.
TS Imagine, a New York-based provider of real-time portfolio and risk management software, recently completed a paper “Stress Testing Critical to Navigate Looming Eurozone Crisis.”
“This thing is looming,” said Smith. “Once it happens it is too late,” he added, a point echoed by others who have developed stress tests to simulate the impact of a breakup. “It would be very chaotic for quite some time. People want to make sure they survive this. What’s cheap can get cheaper, and no one know how bad it will get.”
Although he refers to TS Imagine’s work as stress tests, they don’t include the usual measure of stress, such as value-at-risk, and they aren’t once-a-year exercises dictated by regulators. With the euro zone in such flux, annual stress tests aren’t much help in preparing for a break.
Both TS Imagine and SunGard APT, a risk management group, are working with scenarios and SunGard expects to provide an update within a few months.
“Scenarios are more and more of what you must do as a risk manager,” said SunGard APT head of research Dr. Laurence Wormald. “Statistical models are never going to help when the distribution is as odd-looking as it is now.”
Wormald, who worked at the European Central Bank before joining SunGard, drew on some of his contacts among the bank’s economists for a reality check as he developed his scenarios. European banks started looking at scenarios shortly after the September-October credit crunch, he added.
“It has taken a few months for people to crystalize their thinking about the order of play. Some talk of Portugal following Greece very fast, then Italy and Ireland. These scenarios follow conversations with our clients. I decided it was worth trying to elaborate slightly on different scenarios, but I can’t comment on timing because that is certainly political.”
Several clients have asked him for more information, including a large asset manager in Boston and a sovereign wealth fund, he said.
“Banks are in better position to watch the markets than conventional investment managers because they have a real-time view of the interbank market. They know whether Libor is real or not. My former colleagues [ECB] were well aware that the published rate was meaningless in 2008. The actual flows in the interbank market are recognized as critical signals from the bank’s point of view.”
Part of euro bust-up planning is looking at key dates on the refinancing calendar for Greek debt issues and the timing and outcome of the French election, which could be a nasty surprise, Wormald said. Discussions in Brussels have been going on for months with little indication that politicians realize how serious the euro zone financial crisis is.
When an executive at ICAP, the world’s leading interdealer broker, mentioned in late November that it was testing trades in the old Greek drachma, his comment cut through the fog of Brussels’s endless bickering. David Rutter, CEO of ICAP Electronic Broking, said the company had built out a euro-Drachma currency pair and tested it. Since then it has developed and tested pairs for all the potential currencies in the euro zone.
“As the source of price discovery in the FX markets, we at ICAP take our responsibilities to prepare for changes in the market very seriously,” said Rutter. “Because we’ve tested the currencies, we are ahead of the market, and the pairs we have tested can be turned on overnight.” The firm expects that in the event of one or more countries leaving the euro zone, they will revert to their old currencies.
ICAP is quick to point out it isn’t predicting the dissolution of the euro, but it is preparing for any foreseeable change.
Andrew Bailey, the FSA’s director of banks and building societies, said in late November that British banks need to be prepared for a disorderly breakup of the euro zone.
Little in the political behavior so far indicates national leaders are ready to undertake strong measures to save the euro. Financial market leaders are therefore preparing for the unknown.
TS Imagine’s Smith thinks the trigger will probably be political, followed by quick financial reaction.
“Maybe spreads will blow out, or maybe a refinancing will come up and they can’t do it at the existing market levels. I think it will happen very quickly, a tipping point for everybody, and that’s when you want to be on the sidelines.”
TS Imagine chose to work with eight factors – the euro, gold, Brent, S&P 500, Eurostoxx 50, EEM, USD 2Y and EUR 10Y and then apply a moderate shock, based on the disorderly withdrawal of Greece from the market, and an extreme shock caused by the breakup of the euro into separate currencies.
“It was clear from the authors’ discussions with banks that the extreme scenario is a true ‘black swan’ event, an event so outside experience that it is almost impossible to visualize in clear detail,” the report says.
“The euro will take a hit and gold will spike; it’s a fairly unsophisticated stress test,” Smith added. After that they worked on the risk to a sector diverse long/short equity portfolio worth $325 million.
The report noted that “The core shocks to the S&P 500 are -10 percent and -30 percent but after taking contagion effects into account the US stocks experience losses of -17 percent in the moderate scenario and -46 percent in the extreme scenario. Swiss stocks were not given a core shock, but despite being only 45 percent net long that portfolio component lost 13 percent and 40 percent of its gross value in the two scenarios.”
Smith said that the US losses were greater in the contagion example because they were compounded by other stresses.
“It is all a global economy.”
SunGard developed five scenarios. In creating the scenarios, SunGard APT drew on a variety of leading recent economics research and focused on the mechanisms by which shocks are transmitted between different asset classes, reviewing the two most recent sovereign debt shocks to markets, in March 2010 and August 2011.
“We want to help professional investors think logically about the potential impact of different Euro breakup scenarios on their portfolios,” said Wormald. “We’re not predicting exact timing, though clearly the next six months have a variety of known critical dates, as well as possible unknown flashpoints. It’s important to realize that this is not a black swan, it’s a widely discussed possible event, and while unprecedented it can’t be classed as very improbable, nor would it be rare. Since 1945, 87 countries have left currency unions.”
His scenarios are:
Greece and Portugal leave, which would result in 15 percent rise in the euro against the dollar, a 20 percent fall in Eurozone yields (i.e. the swap curve), a 15 percent fall in Eurozone equities and a 20 percent increase in credit spreads (ITRAXX Europe).
Greece, Portugal, Ireland, Italy and Spain (PIIGS) leave, leading to a 25 percent rise in the euro against the dollar, a 40 percent drop in the Euro yield curve, a 20 percent drop in euro equities and a 15 percent drop in US equities. In addition EU banking stocks would fall by 25 percent and ITRAXX Financials credit spreads would increase by 100 percent, which would imply downgrades and losses of up to 20 percent in high-grade corporate debt. This scenario also predicts losses of up to 15 percent for global equities with near-doubling of volatility and the VIX over 50.
Total collapse of the euro zone — European equities down 40 percent, US and global equities down 30 percent, euro yields down 75 percent and ITRAXX Europe and ITRAXX Financials credit spreads up 150 percent and 200 percent respectively.
Oil would fall across all scenarios, ranging from 5 percent for a Greece departure to a 50 percent decline in a complete breakup.
“The resulting scenario shocks are no more than very rough estimates,” added Wormald, “but it is understanding the order of magnitude and inter-relationships that is critical for investors. For example a severe recession in the European countries would have real-economy effects, leading to enormous pressure on global equities markets, including exporters such as China and the commodities producing nations.”
He noted that Asian investors have been avoiding the European financial sector and in many cases they are avoiding Europe entirely.
“There’s no reason for Asian investors to take a European equity risk,” he said, since they have plenty of investment opportunities outside Europe.
“Asians were alive to this problem early on. Two years ago at a conference in Hong Kong I was asked about the risk of Greece leaving the euro zone. At the time I thought that question was out of left field, but clearly they were ahead in their thinking.”
While it is an intellectual achievement to develop these scenarios, their results do raise the question of what a bank or asset manager can do.
Smith said that some banks are pulling back from the markets, which tightens credit.
SunGard’s Wormald said clients are in discussions over whether effective hedges are available, or whether they simply place a lot more in cash.
“Some clients are sitting on so much cash that their biggest concern is foreign exchange.” Others are selling futures and some are considering buying puts, but trying to get the timing correct is a challenge.
“People look at the date for Greek repayment and at the French election and ask if they want to stay in the market. Some German fund managers have 30 percent cash and 40 percent German bonds; they are already so hedged there is not much reason to sell futures or buy puts.”
SunGard is not alone in modeling the potential for a eurozone break-up. Finextra reports that firms such as ICAP and industry utilities like CLS, the FX settlement bank, have initiated scenario planning in the event of a major soveriegn default and subsequent euro exit. It also said that banknote printers have reported that central banks have been scouring the market for printing presses capable of running large stocks of once-defunct currencies.
As the song says, breaking up is hard to do.
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