Preparing for the worst...

Risk.net comments on the latest measures by banks to protect themselves from a potential escalating debt crisis in Europe.

With markets anticipating a Greek debt restructuring, bank traders and risk managers are preparing for a wider crisis that could drag in northern European countries, tip the euro into a tailspin or even threaten the eurozone’s integrity.
Banks are shorting the euro, along with German and French government bonds, as a hedge against an escalation of the Greek debt crisis. Their fear is that a Greek restructuring is inevitable and will scare investors away from other vulnerable members of the eurozone. One obvious consequence would be a weakening of the single currency, but banks have entertained a variety of other, wilder scenarios as they seek to immunise their books against a possible Europe-wide crisis.

"The big question for us, though, is how bad the contagion will be into northern Europe, the UK and the US." The problem for banks is the potential range of outcomes. An agreement by the International Monetary Fund (IMF) and European Union (EU) on April 11 to provide a €45 billion standby aid package initially seemed to ease pressure on Greek assets. It quickly proved to be a false dawn. Yesterday, as Standard & Poor's downgraded Greek debt three notches to junk territory, and a German government official suggested Greece might need to exit the eurozone, the cost of five-year credit default swap (CDS) protection on Hellenic Republic debt hit a new high of 710 basis point, roughly twice the level seen in mid-April.

Commentators are still split on whether a restructuring will happen sooner or later - but banks should, by now, be protected, says the London-based market risk head at a large UK bank: "If Greece defaults tomorrow and some bank stands up and says ‘I've lost a billion dollars on Greece', they should fire everybody. Greece is a very old story. What we're trying to figure out is what happens next. Is it Portugal? Italy? Spain?"

Or something even nastier. Some analysts have suggested that if the capital markets close to other eurozone countries, forcing them to go cap-in-hand to the EU, it could test the commitment of countries like Germany to economic union - richer nations could choose to go it alone, or they might just boot out the weaker countries. The consequences for European assets would be enormous.

"Germany pulling out of the eurozone would be great for Germany and terrible for everybody else," says one European bank's market risk head. "But it doesn't have to be that. You can imagine some statement from the EU saying the enlargement project is on hold, so the Czech Republic, Poland, and Hungary get caned. You really have to look at anything related to the EU including potential break-up. There's a pretty much unlimited set of scenarios."

Based on CDS spreads, the market sees contagion to other, weaker countries as the next likely step. Spreads on Portugal and Spain have more or less doubled in recent weeks. Portugal was trading at 157bp as recently as April 13 and hit 315bp on April 27 as it too was downgraded. Spain has leapt from 93bp to 188bp in roughly the same period.