The comparison between Iceland’s banking crisis and Europe’s debt version has been made before — most notably by Paul Krugman, and regarding Ireland specifically.
Iceland, the theory goes, declared a swift bankruptcy and devalued the krona. Ireland, locked into the eurozone union, has been unable to do the same.
That was Iceland vs Ireland.
We want you now to think of Greece, where spreads on government bond yields are reaching records reportedly on fears of haircuts. And we want you to glance at the below from William Porter and Helen Haworth at Credit Suisse’s credit team:
… The chart shows how suddenly the Icelandic crisis evolved and eased (in sovereign credit terms). In contrast, Greece has been trading at current levels for nearly a year. We think the differences are very illustrative. They also show why we were recommending longs in Iceland at the time, but not in Greece now. The first difference is that Iceland was a direct, relatively isolated banking crisis. (Iceland is a relatively independent, in the sense of uncorrelated, entity, whereas Greece clearly is not.) Greece is one sovereign aspect of a broader European situation that we see as generally a banking crisis. Nevertheless, applying the counterfactual that Greece had managed to build its current balance sheet in the context of Iceland, not in the context of its position in the euro area (and just to consider how implausible this counterfactual is highlights the differences) then we venture that it would have defaulted in about May 2010. Clearly, it has not done so, largely because of the euro 110 bio package, which has now started to disburse in earnest with the recent approval of the next euro 15 bio disbursement. The resources available to maintain the Icelandic “par pretence” were nothing like as big, so the costs were immediately externalised through the banking system. Greece’s costs have not been fully recognised yet, in our view, and the mechanism for externalizing them is very different and much more subtle.
Greece is a correlated part of the euro area, and of the EU more generally. The correlation structure keeps, in our view, the overall risk of default constant while moving it around Europe’s capital structure. Abandoning our counter-factual, Greece has built up its balance sheet within that structure and could not have done so outside. (We occasionally hear fairness arguments deployed as a reason why Greece should not be allowed to buy back debt at a discount. But it takes two to tango and it is not clear that pushing all the costs onto the periphery is fair or indeed sustainable.) Some part of its default risk is transferred to that of its peer sovereigns, whose balance sheet is deteriorated by the rescue on uneconomic terms.
Clearly, high levels of default correlation widen spreads on the higher quality parts of the capital structure, narrowing the lower quality parts. At current spreads, traditionally seen as unsustainable, the market seems to be telling us that eventually correlation will break down. This is ultimately a political call, and as we have said since October, the market needs to get used to thinking about this on a political timeframe …
Now, what was that Groucho Marx politics quote?