Is Greece Riskier Than Egypt?

If you believe the credit default swap market, the answer to that question is "absolutely!" On Monday evening, insuring $10 million of notional Greek government debt against default cost $835,000 a year -- nearly twice the rate on Egyptian debt ($440,000). The CDS market isn't infallible, though. Is it really possible that a Eurozone member poses a greater credit risk than a poor North African country in the midst of a popular uprising?

Two numbers that equal real trouble
Not only is it possible, but it is looks highly likely. Two numbers are all it takes to show the gravity of the Greek sovereign's insolvency predicament:

Source: International Monetary Fund.

With a debt-to-GDP ratio of 130% (and rising), Greece's fiscal position is untenable. There is no hope that the country will grow itself out of this impasse. As far as the possibility of plugging the hole through increased tax collection and belt-tightening, here's what Citigroup's Chief Economist Willem Buiter wrote in an 84-page report released in early January (emphasis mine):

Greece needs to run a (permanent) general government primary surplus of around 6% of GDP just to stabilise its general government gross debt-to-GDP ratio at the level of around 150% of GDP expected at the end of 2012... This means that additional tightening equal to 10% of GDP is needed over the next [few] years to just stop the gross general government debt-to-GDP ratio from rising in Greece.

If you believe the Greek government and people are capable of this, can I interest you in a luxury condo on top of the Acropolis?

What the technocrats are missing
Back in August 2010, I commented that it was "a near certainty that Greece will default on its debt, whether on a unilateral or negotiated basis." I have seen nothing since then that would lead me to change my opinion. The stratospheric cost of insuring Greek government debt suggests this may also be the market's consensus view -- if not that of the technocrats in Brussels, Frankfurt, or Athens.

However, one institutional investor manifestly shares that view, and it's getting ahead of the problem. Last week, Vienna Insurance Group took an unusual but wise step in writing down the value of its Greek government debt holdings by 25%. The writedown is immaterial to its results; its exposure to the five peripheral Eurozone sovereigns represents less than 1% of its investment portfolio. However, the news must have sent chills down the backs of French and German bankers, the largest foreign holders of Greek public debt.

Shares offered at a 72% discount!
For more evidence of investor concern, take the equity-raising that Greece's fourth-largest lender, Piraeus Bank, completed on Monday. Yes, the issue was ultimately oversubscribed, but the bank had to offer shares at a whopping 43% discount to the theoretical ex-rights price, which accounts for share dilution. The discount to the closing share price prior to the announcement of the issue was 72%. That's what it takes to convince international investors to own the common shares of a Greek bank these days.

Finally, the depressed book value multiples of major Greek, German and French banks suggest that the market is already pricing in a haircut on some of their assets:

*As of Jan. 31, 2011. Source: Capital IQ, a division of Standard & Poor's.

Compare those numbers to the multiples of leading Swedish and Swiss banks, which have relatively little exposure to Eurozone periphery sovereigns, and are indeed headquartered outside the Eurozone:

*As of Jan. 31, 2011. Source: Capital IQ, a division of Standard & Poor's.

With major French, German, and Greek banks already trading at depressed valuations, it's not at all clear that their shares represent a "short" opportunity, even with the expectation of a Greek default. My inclination is that the long side may -- may -- now be more attractive; one would need to take a hard look at the potential impact of a Greek default on bank balance sheets, then decide whether or not current prices offer a sufficient margin of safety.

If the bank stress tests are more stressful...
The repercussions for shares could play out on an accelerated calendar if the second round of European bank stress tests, scheduled for the first half of the year, includes a realistic scenario of a Eurozone government default. If it does -- and I'm not holding my breath -- you can expect dilutive share offerings from banks in Greece and elsewhere to follow.

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