Analysts see various scenarios playing out for the U.S. municipal bond market should Greece exit the euro currency and default on its remaining debt.
Concerns over Greece defaulting on its debt and its consequences on the world economy have been affecting the muni market for at least a year. Seeking a safe haven, investors have poured money into U.S. Treasuries and munis, pushing down yields.
“We’ve seen Treasury yields fall in the past few weeks in reaction to bad news out of Europe including the possible exit of Greece from the euro zone,” said Rob Williams, director of fixed income at Charles Schwab. “Falling yields for Treasuries have transferred through to the municipal market as well.”
In late February and early March, Greece managed to gain a deal shrinking its privately held debt by $132 billion, which an international group declared a default. The default affected the U.S. bond insurer Assured Guaranty, which had to pay $189 million to fulfill a guaranty.
But what if Greece were to end its use of the euro currency, return to the drachma, and halt payments on its remaining $341 billion in debt?
Money might flow into munis in a flight to quality, said Natalie Cohen, managing director of Wells Fargo Securities. Money would initially go into Treasuries, said Howard Mackey, president of the broker-dealer division of Rice Financial. Only if the flight to quality lasted for more than a few days would munis be significantly affected, he said.
Chris Mauro, director of municipal bond research at RBC Capital Markets, agreed that munis would follow Treasuries.
A Greek euro exit would lead to widening spreads of yields between strong and weak munis, according to David Manges, managing director of municipal trading at BNY Mellon Capital Markets.
A Greek default would lead to increasing financial problems for European banks and investors, Manges said. Some would sell taxable U.S. munis to raise cash, which would pressure the bonds’ prices.
Several analysts said a Greek default would push Europe into a recession. That would lower exports from the United States to Europe, said Paul Christopher, chief international strategist at Wells Fargo Advisors.
It would ultimately lead to lower tax receipts for state and local governments, wrote Bart Mosley, co-president of Trident Municipal Research.
Wells Fargo in October released a study of state exposure to a European recession. The states where European exports as a percent of state gross domestic product were highest were Utah (5.6%), South Carolina (4.1%), West Virginia (3.9%), Louisiana (3.5%), and Kentucky (3.1%).
The largest U.S. banks have substantial exposure to Europe in various ways. For example, as of the end of 2011, Bank of America had about $116 billion in exposure to Europe. U.S. banks hold bonds issued by European banks, Christopher noted.
U.S. bank exposure to European sovereign debt is considerably smaller. However, as of the end of 2011, Bank of America held $6.4 billion in debt from Great Britain’s public sector.
As of the end of March, Citigroup had net current-funded exposure to sovereign governments, financial institutions, and corporations in Greece, Ireland, Italy, Portugal and Spain of $9.1 billion.
The U.S. banks with large European exposure are Citigroup, Bank of America, JPMorgan Chase, Goldman, Sachs & Co., and Morgan Stanley, said Richard Bove, vice president of research at Rochdale Securities.
In Argentina’s 2001 default on its $132 billion of sovereign debt, Citigroup lost an estimated $2.2 billion.
U.S. bank exposure to Greek sovereign debt is minimal, according to Bove. “The real question is whether Greece will bring down the whole system,” he said.
For this to come about, one has to make at least two assumptions. First, Greece defaults on its remaining debt and withdraws from the euro zone. Second, in the difficult times that follow, the European Central Bank would not support European banks.
If some large Spanish banks collapsed, that could be dangerous for Latin American as well as European banks — and utimately, it could pose a danger to U.S. banks. Bove, however, made clear he thought that outcome was unlikely.
Quite apart from a bankruptcy of a major U.S. bank, the muni market could be harmed by U.S. banking problems due to credit downgrades on the banks. For example, a large portion of variable-rate demand bonds are dependent on the letters of credit from major banks.
A Greek exit from the euro would affect investor sentiment and could lead to a sell-off of higher-risk bonds, Christopher said.
“It is not even necessary to reach the last act in the Greek Tragedy for serious consequences to be felt throughout the capital markets,” Mosley wrote in an email. As Greece’s situation appears to worsen, investors will increasingly question the ability of the European Central Bank to handle the problem, he wrote.
Worsening of the European debt drama would have two other negative impacts on U.S. municipal debt, according to Mosley. It would reduce “banks’ ability to provide liquidity and credit support to municipal issuers,” he said.
There would also be pressure on “global capital markets leading to continued underperformance of pension investments … which would exacerbate the long-term structural difficulties facing public pension funds.”
Further Greek problems could lead to financial contagion in Europe, Mosley wrote.
A contagion in Spain or Italy, which owe much larger amounts of money, is a possibility, Manges noted. “If there’s a contagion to other countries, you’re throwing the deck of cards up in the air and I don’t know where they will fall,” he said.
On Thursday Guy Lebas, chief fixed-income strategist at Janney Capital Markets, took a more moderate view of the Greek situation.
Assets in the Greek banking system are just 1.4% of the assets across all euro-area banks. Greece’s GDP is modest. “On the basis of either economic or banking system impact, it’s hard to imagine a Greece euro exit causing irrevocable harm,” Lebas said
While a Greek exit from the euro is now probable and could lead to contagion elsewhere in Europe, the only other country with a high risk for leaving the euro is Portugal, he wrote. Spain and Italy are more stable.
“We believe the risk factors are largely limited to capital markets froth, and not meaningful economic or financial damage,” LeBas wrote.
A Greek default would lead to money flows into U.S. Treasuries and out of risky assets. However, since the actual risk is lower than what is widely perceived, that would be a good time for buying riskier high-yield credits.
