-- On Wall Street, event risk means an unforeseen development that sends markets reeling. The markets were full of event risk Tuesday.
The event: Greek Prime Minister George Papandreou announced Monday night that he would call a national vote on the European bailout package agreed to last week. Polls show the vote would be unlikely to pass. "This would undo all the progress made to date," says Alec Young, global equity strategist for S&P Capital IQ.
The move raised the possibility of a full-blown Greek default that could topple the finances of other countries, unravel the eurozone, and send the world into recession.
Then again: Perhaps not, if Greece and its European partners can cobble together a solution to the Greek debt crisis. But it could be a long, nail-biting process.
"We're going to continue to see really shaky markets, constantly torn between hope and despair," says Scott Mather, managing director at Pimco.
Despair ruled the day Tuesday. The Dow Jones industrial average dropped 297 points, or 2.5%, closing at 11,658. The German DAX index tumbled 5%, and Britain's FTSE plunged 6.8%. The value of the euro fell on international currency markets, and investors desperate for safety pushed down the yield on the benchmark 10-year U.S. Treasury note to 1.96%.
The market's violent reaction to the news is based on "legitimate concerns," says Tim Anderson, chief fixed-income strategist at Riverfront Investment Group. How those concerns evolved:
•Greece, racked by recession and plagued by overzealous spending and underzealous tax collection, asked for a European Union and International Monetary fund bailout in April 2010.
•In June this year, rioting broke out in Athens as the government announced new cutbacks to allow the next batch of rescue loans.
•Last month, tensions again arose as the possibility of a Greek default loomed again. Eurozone leaders and the IMF crafted a package that would allow Greece to pay 50 cents on the dollar on some of its debt. The agreement also proposed a 1 trillion euro fund to shore up Greek and other troubled eurozone countries, such as Italy, Spain and Portugal. And European banks would be forced to raise capital — the money they use to cushion losses.
Stock markets in Europe and the U.S. soared on the news. But investors became increasingly concerned that the plan raises more questions than it answers and that further reforms would be needed, Anderson says. Among those questions: Where, exactly, would that 1 trillion euros come from? "They were going to have to go hat in hand to the Japanese and Chinese," Young says.
Papandreou's surprise call for a Greek national referendum put the entire deal on hold and sent shudders throughout the financial markets. It's unlikely, after all, that anyone would contribute to the proposed 1 trillion stabilization fund if Greece defaults.
More important, a hard Greek default — where the country doesn't pay any of its debts — could have catastrophic consequences. Not only could some large holders of Greek debt go under, but confidence in all the troubled eurozone countries would be shaken.
Greece could be kicked out of the eurozone — or could leave it voluntarily, which would allow the country to pay its debts with newly minted drachmas, which would be heavily discounted on the world currency markets.
It would be years before creditors lent money to Greece again, and legal squabbling between Greece and the eurozone could continue for years. "If this had happened 100 years ago, they would have just gone to war," says Pat Socci, dean of the Frank G. Zarb School of Business at Hofstra University.
In Italy, for example, government bond yields soared to 6.2%, a sign that nervous investors were demanding higher interest because of higher risk. "It's like the collapse of Lehman Bros. on a national scale," Socci says.
"We are all scared by this unexpected news," says Ansgar Belke, professor of Macroeconomics at the University of Duisburg-Essen in Germany.
So why the referendum?
"He's a politician, and politicians like to stay in office," Socci says.
Austerity plans are never popular. "You don't stay in office with messages of years of sacrifice," he says. Winston Churchill was booted out of office at the end of World War II for sending exactly that message, Socci says.
By throwing the vote to the Greek people, Socci says, Papandreou can sidestep blame for the deeply unpopular austerity programs. "It's a bold gamble by Papandreou," says Art Steinmetz, chief investment officer for the OppenheimerFunds. If the referendum wins — and Steinmetz thinks it would — Papandreou could simply say the unpopular cuts are the will of the people.
Papandreou also runs the risk that he'd lose his majority in the Greek parliament, which he holds by a narrow margin.
"It's unlikely that the next prime minister would be any more amenable to a deal," Socci says.
Announcing the referendum on the eve of the meeting of G-20 nations in Cannes, France, gave Papandreou's news added sting. The G-20 are a group of the 20 largest nations, which were brought together by the 1998 Asian currency crisis.
Investors are increasingly sure that if Europe isn't in recession already, it will be, says Riverfront's Anderson. What investors are trying to deal with is determining the odds that the downturn could turn into something worse than a recession. "The markets can handle a recession (in Europe), but they want to know it's not developing into something worse," he says.
A few cracks are already showing. On Monday, MF Global, run by former New Jersey governor and senator Jon Corzine, became the first U.S. casualty of the crisis when it filed for bankruptcy-court protection after its big bets on European sovereign debt led to sharp cuts in its credit ratings. U.S. banks, money market funds and corporations are beginning to reduce European operations, hedging their bets against more bad news to come.
European unemployment has hit the highest levels since the euro was launched in 1999. The Europe-based Organization for Economic Co-operation and Development reported Monday that in the eurozone, "A marked slowdown with patches of mild negative growth is likely." The outlook would be "gloomier" if the latest rescue plan fails to restore confidence, leading to a "disorderly" sovereign debt situation.
And even if the Greek referendum does go through, austerity programs in Europe don't have a great track record, says Pimco's Mather. "Either they fail or the government fails," he says.
For investors, the best bet now is to be broadly diversified, says S&P Capital IQ's Young.
"The markets are increasingly headline-driven," He says. Making a big bet on any one market is "kind of a fool's errand."