November 15, 2011

Political Changes Don't Fix Europe's Debt Problem

Mario Monti, an economist, is the new Prime Minister of Italy, but will it make any difference to the future of Italy given their staggering debt load? No.

The arithmetic on Italy’s likelihood of default is interesting (regardless of who their Prime Minister is). The five-year Credit Default Swap on Italy is around 560. The assumption that Italy defaults in ten quarters (half-way through the term) produces a future value of about $14.3 for the writer of the CDS. 

If Italy was to write down its debt to 80%, the debt-to-GDP ratio would be slightly less than 100 (120x/8). If that was the magic number, it implies a recovery rate of about 80% or a 20% payout on the CDS—i.e., better than 70% chance of default.

So if Italy has an implied probability of 70% of defaulting, what about Greece with their 5-year CDS of 5,277? Pretty close to 100%.

The 10-year yields are also telling.

Greece, of course, has the highest 10-year yield with 25.39%, followed by Portugal at 10.74%. Italy is “only” at 6.59%. Compare these yields to Switzerland with a 10-year yield of 0.894% and Germany with their 1.80% yield.

Clearly, there is an enormous imbalance between the debt prospects of the European core (which is starting to look like Germany all by itself) and the periphery (Italy, Spain, Portugal, Greece) at 5.90% or above.

Throw in Hungary (8.56%) and Poland (5.78%), and we are looking at spreads over German sovereign debt of 400-basis-points or more for seven European countries.

Europe has a spending, debt, and entitlement problem. As the periphery continues to falter, Germany is becoming the lone remaining safe haven in Europe, and may well get dragged down by others.

You can read more of Professor Sanders' comments on this issue at his blog Confounded Interest