Alas, Alack… The Greek Debt Crisis is Back!

June 30th, 2011
by Jonathan Leidy

Prologue

Despite the most recent vote by its leaders to rein in spending, Greece really has little choice but to permanently restructure its debt. According to the major credit rating agencies, restructuring (or “reprofiling” as it has been euphemistically branded) will likely constitute a technical default. Compounding matters, the civil unrest resulting from continued spending cuts is gouging deeply into Greece’s number one source of income, tourism.

So how significant is the credit worthiness of one tiny, sun-soaked nation in Southern Europe?  In short… very. Admittedly, Greece is far from an economic Orion. Its 2010 GDP was just 2.9% of the European Union’s (EU) and a mere .44% of the world’s as a whole. However, its debt crisis stands as a monument to our ever-increasing global interconnectedness. Greece’s fate is now the fate of Western Europe and perhaps for many, more distant, economically-developed nations as well.

Episode

A Greek default has many undesirable consequences, some of them much more latent and far reaching than others.

Act I:  Blood, Sweat, and Teargas

Most obviously, Greece’s financial woes are bad for Greece. The country’s latest debt restructuring is conditioned on the continued adoption of austerity measures by its parliament. The move is part of the original €110B bailout approved in May of 2010. This latest injection of €8.7B (part of the €110B) serves as a momentary reprieve. Come fall, however, it is estimated that an additional €80-90B could be required to keep the ailing country afloat.

Bailouts also come with negative carry-on effects for Greece. Assistance is conditioned upon Greek cutbacks. Cutbacks lead to rioting, which leads to fewer tour buses idling outside the Acropolis, which inevitably leads to further cutbacks. Thus bailouts themselves are antagonists in this ill-fated drama.

Act II: Something is Rotten… in Athens to Denmark

Regionally, Greece has become the poster child for a host of similarly debt-laden European sovereignties. Portugal, Ireland, Spain and Italy are all anxiously waiting in the proverbial wings to see what sort of precedent is set by their Hellenic neighbors. If Greece receives clemency, why shouldn’t the rest? And if the rest of the troubled Eurozone is allowed to sidestep its financial indebtedness, the euro will be in an all-out sprint with the US dollar, vying for the dubious title of World’s Most Defamed Currency.

Greek default would also spell disaster for the reserve capital of many European banks. In particular, four French banks (BNP Paribas, Credit Agricole, Societe Generale, and Natixis) hold ~€38B of Greek debt. Germany holds ~€24B of the perilous paper, the UK holds ~€9B, and beleaguered Portugal holds ~€7B. Add to those figures the fact that the European Central Bank (ECB) is sitting on roughly €80B of previously absorbed Greek debt, and you can see that the bell doth toll for Europe en masse.

The debt itself is only the beginning. Whenever a portion of a bank’s reserve capital is diminished, it must mark the debt to market and adjust its lending ratios accordingly. Assuming a lending reserve requirement of 10%, a total Greek default could translate into a €780B decline in liquidity… a huge move in what is an already fragile economic recovery. What’s more, the ECB would be precluded from absorbing any more Greek debt, should default occur.

Act III: When Greece Sneezes…

The interdependency of today’s global economy makes the tragedy in Greece even more harrowing. Gone are the days of isolationism and contagion containment. Now even the smallest fiscal sickness can cause the entire world to catch a cold.

Globally, Eurozone bailouts mean fewer euros available for imported goods. Declines in import/export numbers portend a similar move in global employment. Hence a Greek default could indirectly lead to additional job losses throughout the US, the UK, and Japan.

Restructuring Greek debt seems like the only viable solution. However, that may carry consequences of truly epic proportions. For although US banks hold very little Greek debt, they have taken the lead role when it comes to insuring it. American banks, the same troupe that took center stage in the recently reviled production known as “The Great Recession,” have written roughly $35B in credit default swaps (CDSs) on Greek debt.

Ratings agencies Fitch, Moody’s, and Standard & Poor’s have all so much as said that any restructuring of Greek debt involving significant concessions on the part of current bond holders would constitute a technical default. And default, technical or otherwise, will mean that not only will European banks need to be recapitalized, but US banks will be forced to cover. Making matters worse, US banks also hold $54B in CDSs on Ireland and another $41.2B on Portugal. Even the sanctity of money market funds may be in question, with ~44% of all US deposits invested in European bank instruments.

Exode

“Monetary union without political union is increasingly untenable and leaves global financial authorities with one hand tied behind their back.”  Michael Lewitt, The Credit Strategist

Developed financial markets in Europe and around the world are staring directly into the abyss. On one hand, it is plain to see that the only long-term solution to the decades of financial profligacy in Greece (and beyond) is to restructure. On the other hand, there is very little political will to do so. Moreover, restructuring could lead to wide-spread default among Europe’s worst credits, which could in turn lead to the complete undoing of any economic recovery we have experienced over the last 2 years.

So is Greece the next Lehman Bros.? It’s certainly not out of the question. If we could only convince those pesky ratings agencies to revert to their pre-2008 ways, all of this default nonsense might magically disappear.

After all, what’s a tragedy without a bit of good, old-fashioned irony added to the mix?

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