One of the stealthier developments over the past months has been the ever wider creep in Greek CDS, especially in the longer-dated part of the curve. In fact, everything to the right of the 3 Year point is now wider than it was both on the eve of the Greek semi-default, and just after the announcement of the European Stabilization Mechanism (ESM). How is it that with so much firepower, better known as free money, thrown at the problem, have spreads not declined? The CFR provides one interpretation, which speculates that once European banks find a firmer footing, that Greece, with the blessing of Europe proper, will be allowed to finally sever its mutated umbilical cord, and default. The catalyst would be Greece getting its primary deficit under control, at which point ongoing bad debt funding would no longer be necessary. Of course, this hypothesis is based on two very critical assumptions: European banks, especially in the periphery, as the second attached study from Goldman indicates, are still locked out. To think that Europe will be able to get to an equal footing for all countries seems like some wishful thinking at this point, especially if the market does consider the implications of what a Greek default will do to peripheral banking. Additionally, the ramifications to the euro in the case of a default will be dire, although that may be precisely what Europe is after all alone. Regardless, that is how the CFR sees things, rightly or wrongly. Keep an eye on Greek spreads in the coming weeks to see if the theory is validated.

From the CFR:

The difference between Greek and German government bond yields can be used to estimate the market’s view of the likelihood of a Greek default. The chart above shows these probabilities over different time frames on three different dates. On April 30th, no European plan was yet in place to address the ballooning Greek debt, and default was considered a real possibility in the short term. On May 11th, just after the European Stabilization Mechanism (ESM) was announced, markets sharply cut their view on the odds of default across all time horizons. However, the market’s analysis of the ESM has become much more nuanced since then. On September 1st, the market’s view of the probability of default within two years was lower than before the ESM was announced, but higher over longer time frames.



Greece will happily borrow from the ESM to avoid having to close its primary deficit (that is, excluding interest payments) too rapidly. Yet if Greece is successful in eliminating its primary deficit, its temptation to default will actually grow, as it can wipe out huge amounts of accumulated debt without any longer needing the financial markets to fund current expenditures. If faced with the choice between paying Greek debts and letting Greece default, its northern neighbors may, once their banks are on more solid footing, find it more attractive simply to let Greece default. This is the story line that the markets are now pricing into government bond spreads.

And for those seeking an update on European funding, here is Goldman with: "ECB’s bank liquidity stays on max, periphery needs it most."