Greece's Obese Tail

Posted on July 1, 2011 by David Laidlaw

Statistics is a dry subject and tends to be explained with painfully boring language including terms such as mean, median, and normal distribution.  However, some of the subject’s topics are described using more colorful language, which paints a picture of the phenomenon being depicted.  One of those more evocative terms is “fat tail,” which describes risk. 

When thinking about how the world works, most people think in terms of averages.  For example, the average tennis player probably hits his or her serve at about 70 mph.  Given this average, one would be correct in estimating that the vast majority of tennis players serve between 50 and 90 mph.  However, one would be completely incorrect in hypothesizing that it was impossible to serve over 110 mph.   At Wimbledon’s Tennis Tournament this past week, most of the contenders consistently served above this level.  Therefore, a statistician would view service speeds as having a normal distribution with “fat tails” or an unexpectedly high number of people that can serve much faster than would be expected given the average. 
 
In finance, fat tails denote high levels of risk within markets.  For example, there are fat tail risks in the returns of common stocks which usually produce gains between 0 and 20%, but sometimes decrease a frightening 40% as they did in 2008.  The NASDAQ market’s incredible return of almost 90% in 1999 represents a fat tail event in statistical terms, but financial professionals are usually only referring to negative outcomes when discussing the likelihood of a fat tail event. 
 
Greece’s debt problems represent the type of risk that could have dire consequences to the world’s financial markets.  Greece has about $240 billion in debt outstanding backed by its government excluding any private sector debt.  Ireland and Portugal, the other financially precarious Western European governments, have an additional $54 billion and $117 billion in debt respectively.  Greece’s debt is roughly 1.5 times the size of its total economy.  Since Greece’s businesses are not competitive with the rest of the world’s companies and its economy is shrinking , the country does not have the ability to pay its obligations.  Ireland and Portugal are not quite as unstable as Greece, but they too cannot repay the debt they have incurred as it comes due. 
 
Let’s assume that Greece, Ireland and Portugal only have the ability to repay about one-half of their total obligations.  This number was not arrived at scientifically, but is probably as accurate as most guesstimates.  Europe’s current bailout plans call for the other nations to contribute and provide resources to Greece as its bonds come due.  However, since the total debt load is not being reduced, these countries will eventually have to default and restructure what they owe.  When the restructuring comes to pass, roughly $200 billion (50% of $400+ billion debt of the three countries) of assets will disappear.  It should be noted that the architects of the current bailouts would argue that the support provided by the European Central Bank and the International Monetary Fund will buy Greece enough time to be able to fund its own needs at some point in the future.   
 
Europe’s banks own quite a large portion of the sovereign debt of Greece, Ireland and Portugal since Europe’s banking rules incentivized banks to hold these bonds as assets, similar to the manner that our banks were encouraged to hold Fannie Mae’s preferred stocks.  For arguments sake, let’s assume that European banks hold 75% of the value of this debt that is going to disappear.  This number is larger than what we have read, but our initial estimate of debt excluded all of the private sector bonds that are in circulation.  Given these assumptions, Europe’s banks would lose $150 billion in assets whenever these sovereigns restructure. 
 
We researched how much capital is held at Europe’s banks.  The top 11 banks hold about $600 billion in capital on their balance sheets.  Europe’s banking sector is top heavy with a handful of very large banks that hold most of the assets/capital in the banking system.  Assuming the write-off above, Europe’s banks would lose 25% of their capital.  Since the sovereign debt is not held evenly some of these large banks would probably fail if this occurred and explains Europe’s reluctance to deal with its problems in a more forthright manner. 
 
As we saw in 2008, all banks are intricately connected so that such an event could have major impacts throughout the world’s financial system and cause another major credit event.  On June 27th, the Wall Street Journal pointed out in an Op-Ed piece that Fitch’s Rating Service reported that “half the assets in the U.S. prime money market funds were invested in European banks as of the end of May.”  If a systematically important European bank failed, then a number of money market funds here would probably not be worth $1 per unit as expected.  Again, this could cause multiple problems. 
 
The above analysis also does not involve other countries with very risky finances.  Spain carries $482 billion in debt with 20% unemployment and poor prospects for growth.  Though a much bigger country, Italy holds almost $2 trillion in debt.  If the contagion spread to either of these countries, the results would be catastrophic. 
 
Unlike Nouriel Roubini (the economist who correctly predicted the financial crisis of 2007/2008 and goes by the moniker of Dr. Doom), we are not predicting that the world is poised for collapse due to a “perfect storm” of negative trends.  The stronger economies in Europe, including Germany, France and Finland, have the ability to support their ailing neighbors for the foreseeable future and prevent the realization of a fat tail event.  However, their populations may not have the patience to continue the cash payments as long as is necessary.