The equities market is acting like we know Greece's default will be orderly and no threat to financial stability. It is also acting like we know the U.S. economy can grow smartly while Europe contracts in recession. Lastly, the high level of confidence exuded by market participants suggests we know central bank liquidity is endlessly supportive of equities.
What do we really know about the coming default of Greece? Whether we openly call it default or play semantic games with "voluntary haircuts," we know bondholders will absorb tremendous losses that are equivalent to default. We also suspect some bondholders will refuse to play nice and accept their voluntary haircuts. Beyond that, how much do we know about how this unprecedented situation will play out?......
What we know is that the European Union is a model without easy historical precedent. Any predictions made about Greek default or the many financial and political machinations designed to "firewall" Greek default from the rest of the EU are speculations, as there are no good historical precedents to guide our guesswork. To say we "know the European Central Bank has this under control" is to claim knowledge of the unknowable.
We also know the derivatives market for credit default swaps (CDS) is not transparent, so no one can claim to know the risk levels in this market or the possible spillover effects should an "event" trigger instability.
Here is how frequent contributor Harun I. views the CDS market and Greece's impending default:
My contention regarding Greece has been that they cannot be allowed to default because of a tremendously leverage system. This contention remains unchanged......... At leverage of 500 to 1 all equity is wiped out after a 0.2 percent decline or default.
[Smith]Here is the link Harun referenced: This is Financial Armaggedon, Lehman X 1,000
One thing that isn’t talked about much, although I did receive a note today from UBS regarding it, is derivates related to bond insurance.........
We are looking at financial Armageddon. This is just awful, Lehman times 1,000. This is why they are going to all of these crazy extremes and calisthenics to make it seem like Greece is not defaulting so the bond insurance doesn’t kick in.
[Smith]I have no idea if this is true or not, but the point is neither does anyone else. The possibility that one bondholder refusing to accept the "haircut" demanded by the Eurocrat lackeys of the banking cartel might trigger a contractually valid demand for a CDS to be paid does not seem priced into the equities market.
Under a slightly more lurid headline is another story making the same point: Forget Greece, Traders Are Worried About Something That Could Send Us Back To The Middle Ages.......
Credit default swaps have grown exponentially over the last decade. Since they are individually written, there is no clear visible record of how many CDS contracts are outstanding. Also unknown is who is involved. The two parties obviously know who the counter-party is but there is no public record that would allow a regulator or a third party to find out who was involved.....
[Smith]If the CDS written against Greek debt are not allowed to execute, then that calls into question all CDS insurance written against Euro-based debt. After all, if the banking cartel and its Eurocrat lackeys can essentially negate CDS written against Greek debt, why wouldn't they do the same with CDS written against Portuguese, Irish, Spanish or Italian debt? And if they pull that off, why would anyone trust any CDS written against debt anywhere in the global system?
I have no idea what will happen in the next few months, but I think it is fair to say that what may be unleashed is a known unknown. To be supremely confident that a Greek default will be orderly is to claim knowledge of that which cannot be known.....
As for the American economy expanding smartly while the rest of the global economy contracts--is there any precedent for this premise? Since there is no precendent for the financial crisis enveloping Europe (and it can be argued, China), then whether the U.S. can grow while the rest of the world slumps into recession is a known unknown.
What we do know about global central banks flooding the world with liquidity is that this inflates asset bubbles that always pop with devastating consequences. Since this is known, what is the basis for the confidence that global liquidity will drive equities ever higher without negative consequences? Is this a "liquidity driven rally" or a "blow-off top"? Perhaps the difference between the two is purely semantic.
Once again the risk of liquidity-inflated asset bubbles--oops, I mean "rallies"--is a known unknown.
But what about the unknown unknowns [i.e. factors which we don't even know exist, let alone have any information about]? Markets don't seem to be pricing in any of the known unknowns, i.e. the risk of disorderly default, much less the unknown unknowns.