By forcing the EU to explicitly detail support for Greece, markets are showing they will no longer tolerate fuzzy “implied guarantees” to underwrite the creditworthiness of troubled borrowers.
Since the formation of the euro, Greece, Spain and other fringe euro economies have been borrowing at lower interest rates on the market assumption that they were effectively backed up by richer core euro zone states such as Germany.
But for months, EU and Greek policymakers have been refusing to publicly discuss what support might actually be there, fearing that to do so would take the pressure off Greece itself to push through painful reforms and cuts.
Repeatedly pushed both on and off the record by journalists, they simply clammed up, saying such matters should never be discussed.
Meanwhile, Greece came under greater and greater market pressure, pushing its borrowing costs to unsustainable levels, in part because investors struggled to price in accurately the prospect of a bailout.
But investors continued to treat Greece more leniently than non-euro troubled countries, believing the colossal potential fallout from Greek default or currency breakup would ultimately force the EU's hand.
The cost of insuring Greek debt in the default swaps market was less than half that for Ukraine, where it still costs investors around $1 million a year to protect $10 million of five-year debt.
On Thursday, after days of hints, EU President Herman Van Rompuy said euro zone officials had reached a deal to help Greece -- although an EU diplomat said the methodology was still being worked out.
The spread between Greek debt and benchmark German bunds narrowed to the tightest in two weeks on the news.
The greater the support, the riskier bunds will be priced against US, Japanese or other non-euro zone debt as markets reprice the risk from Greece to Germany.
Similar market alarm over Ireland in 2009 was eased when the then-German finance minister Peer Steinbrueck brought calm by saying that all the euro zone countries would help “if it came to a serious situation” -- seen as an effective guarantee.
With the current Greek crisis, Steinbrueck was out of office and other policymakers offered much more mixed signals. In any case, this time markets wanted more.
The crisis has been gradually testing to destruction a whole host of assumptions, with the greatest market shocks coming when expected support failed to materialize.
Not all implied guarantees have failed. US mortgage giants Fannie Mae and Freddie Mac traded for years with the tacit backing of the US government -- and when needed in 2008, a bailout was there.
Then the US government tried to restore moral hazard by letting Lehman Brothers fail, upending market expectations.
Middle East investors were similarly dismayed when they discovered late last year that their two key assumptions -- that Dubai would back state companies such as Dubai World, and that oil-rich Abu Dhabi would back Dubai -- were at best over simplistic.
What support Abu Dhabi will offer remains unclear, leaving Dubai effectively frozen out of international borrowing.
Investors in emerging markets have increasingly grown skeptical of the “implied sovereign guarantees” for a host of “quasi-sovereign” companies whose links to the state are complex or murky and where government support has not been explicitly guaranteed.
Ukraine's state gas firm Naftogaz was seen as enjoying just such an implied guarantee, but in September the firm failed to repay a $500 million Eurobond. The deal was restructured -- but this time investors demanded a cast-iron sovereign guarantee written into the contract.
When British bank Northern Rock was collapsing in 2007, the government tried to reassure savers their money was safe but customers were quick to note there was an upper limit on government deposit protection.
They raced to withdraw savings, the bank run ending only when Chancellor Alistair Darling guaranteed 100% of retail deposits.
The lesson for the EU and Greece seems clear. To price Greek risk accurately, markets want much clearer guidance on support and conditions attached.
Then, everything will depend on Greece's political ability to push through reforms even in the face of social unrest and strikes.
Pricing that purely political risk should still offer a challenge, not to mention market rewards for those who call it right. (Reuters)