Monday, May 30, 2011

Danger of Greek Contagion Climbs

Danger of Greek Contagion Climbs

By TOM LAURICELLA

As European leaders wrangle over Greece's debt crisis, investors are scrambling to assess the damage any imminent restructuring would have on the rest of the region.

Investors have long expected Greece to default on its debts, but most were anticipating it would happen sometime next year. Now, skirmishes among European leaders last week have raised the prospect that a default could come as early as mid-July—not enough time for Europe's other debt-ridden economies to right themselves.

That scenario would make contagion more likely and dangerous, sending bond yields in affected countries soaring and hurting investors.

"In an ideal world, from the [European Union]'s perspective, you would [restructure] further down the track and give the likes of Portugal, Ireland and Spain time to put their fiscal consolidation in order," says Huw Worthington, European interest-rate strategist at Barclays Capital in London.

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.Greek bond prices indicate investors are anticipating a restructuring, such as a deal in which bondholders suffer immediate losses or their interest payments are extended, which is still considered a default. Greek two-year debt traded Monday at a yield of nearly 25%, about 23 percentage points more than comparable two-year German bonds and roughly double the level of two months ago, according to TradeWeb.

After relative calm earlier this year, some other European countries also have had their borrowing costs rise. Investors don't appear to have factored in the impact of a more-immediate Greek default on such countries as Portugal, Ireland and Spain, or how such an event would affect European banks and the European Central Bank, which hold Greek debt.

Spain this week will test demand as it seeks to raise €3.5 billion ($5 billion) from the sale of in three- and four-year bonds. Italy on Monday paid lower yields than a month ago to sell debt amid relatively strong investor demand.

Following last year's rescue by the International Monetary Fund and the European Union, Greece wasn't supposed to need to borrow money from the markets until 2012. And until recently, European officials dismissed any talk of restructuring until an EU-wide framework for sovereign default comes into place in 2013.

But Greece warned early last week that it could default if the IMF doesn't come through with an expected $17 billion payment at the end of June. And on Thursday, financial markets were rattled by comments from a top euro-zone official, Jean-Claude Juncker, the Luxembourg premier who heads the group of 17 European finance ministers. Mr. Juncker said that IMF payment might not be forthcoming.

European officials are struggling to hash out some kind of a short-term agreement over more aid to Greece before it runs out of cash, which would happen in mid-July. The fix would be designed to ensure IMF support for the country.

"It's hard to see how Greece gets out of this without some restructuring," says Peter Fisher, head of fixed-income portfolio management at BlackRock Inc. "Is it possible to stave it off until 2013? The Europeans, the IMF and the ECB have to come up with the resources, and that has to do with political will.

"A lesson of history is you want to anticipate a default and prepare for the consequences," he says.

In Greece's case, that would mean having a clearer picture of the value that European banks have placed on any Greek debt that is on their books and strengthening Europe's banking system with more capital.

"Right now, that's not in evidence," Mr. Fisher says.

Another concern is that Portugal and Ireland are vulnerable to a credit-rating downgrade, says Frances Hudson, a strategist for Standard Life Investments' Global Absolute Return Strategies, of the U.K. Both Ireland and Portugal are rated one level above "junk" status by Moody's Investors Service.

Last week, Moody's warned about the potential for a Greek default to hurt the ratings of other countries.

"The full impact [of a Greek default] on Europe's capital markets would be hard to predict and harder still to control," Moody's analysts wrote. "The fallout would have implications for the creditworthiness and hence the ratings of issuers across Europe."

Should those ratings get cut further, that could force selling by money managers whose guidelines prohibit holding junk-rated debt and result in those countries being deleted from investment-grade bond indexes tracked by many managers.

"It would take them out of the investable universe for a lot of managers," Ms. Hudson says. Portugal and Ireland "are on the cusp of a massive problem."

Mohamed El-Erian, co-chief investment officer at Pacific Investment Management Co., expects that ultimately holders of Greek debt will suffer losses of 40% to 60% of their original investments.

In the wake of such a move, both government- and corporate-bond markets in Ireland and Portugal would come under further, sustained pressure "as both countries are already in the…intensive financial care unit," Mr. El-Erian said.

Spain, too, would likely suffer, he said, though it may be more resilient, assuming it continues to shore up its financial system.

For now, prices on those countries' debt are well above those of Greece. Spain's two-year debt traded Monday at a yield of 3.52%, Portugal's at 10.9% and Ireland's at 11.8%, according to TradeWeb. Yields and prices move in opposite directions.

The ECB, meanwhile, will take a hit through both the Greek bonds it has bought and those it has acquired from European banks through financing operations.

—Stephen Fidler
and Emese Bartha
contributed to this article.
Write to Tom Lauricella at tom.lauricella@wsj.com

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