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Market prices for Greek government bonds imply a 100% probability of default. But this does not mean a Greek default is already priced into the global asset markets. Here’s why.
The Greek default is indeed inevitable, but there remain two possible ways the world may learn about it, and financial markets will react very differently depending on which of these two processesfor default occurs.
The first possibility is a “structured default” that would be announced on a Saturday or Sunday, when financial markets are closed. It would involve the simultaneous disclosure of at least three items:
- The terms for restructuring Greek government bonds – i.e. the default.
- A comprehensive plan for recapitalizing systemically important creditors (banks) throughout the euro zone.
- A coordinated program among central banks, the International Monetary Fund (IMF), and sovereign wealth funds worldwide to support the government bond markets of other countries in the European Union (EU). This might not include every country in the EU, so it’s possible that other countries in the EU might restructure their debt as part of this program.
Assuming investors perceive each of these three programs to be credible, a structured default would likely be a positive catalyst for global asset markets. If a coordinated plan for default in Greece is accompanied by a fourth announcement involving credible policies to stimulate economic growth throughout the euro zone, financial markets should recover hard and fast.
The second, more worrisome, possibility is a “messy default.” Such a default could occur at any time, and any number of possible catalysts could trigger it. The tipping point for a messy default is not important. What matters is that any announcement of default will be messy if it isnot immediately accompanied by a plan for restructuring euro zone banks and a program for defending the remaining sovereign debt markets in the EU.
In my opinion, the recent decline in equity markets has already discounted some of the downside risk associated with a messy default, but not all. Another 15%-25% downside in global stock markets is plausible in the event of a messy Greek default.
