Financial Tsunami right ahead: The Fall of Greece

Financial Tsunami Coming right ahead

The Fall of Greece

After three years of struggle and receiving billions of euros as bailout package the Greek sovereign has worsened. Greece is at the edge of the biggest sovereign default and policy makers are worried about global shock waves of an insolvency by a government with 353 billion euros ($483 billion) of debt -- five times the size of Argentina’s $95 billion default in 2001.

There is a monstrously large amount of uncertainty and a massive range of possibilities. A macroeconomic disaster could be averted but only by aggressive policy action by central banks and governments.

After two international-bailout deals, three years of recession and budget-cutting votes that almost cost him his job, Greek Prime Minister George Papandreou says throwing in the towel now would be a “catastrophe.” Potential consequences of a national bankruptcy include the failure of the country’s banking system, an even deeper economic contraction and government collapse.

The fallout may echo the days following the 2008 implosion of Lehman Brothers Holdings Inc. when credit markets froze and the global economy sank into recession, this time with the prospect that the 17-nation euro zone splinters before reaching its teens. The International Monetary Fund, whose annual meetings start in Washington on September 24, reckons the debt crisis has generated as much as 300 billion euros in credit risk for European banks.

Default Risk

Greek two-year yields surged above 70 percent and credit-insurance prices on Greece indicate the chance of default at more than 90 percent. Investors can expect losses on Greek debt of as much as 100 percent.

People, justifiably, think the crisis is what we’re living now: cuts in wages, pensions and incomes, fewer prospects for the young. Unfortunately this isn’t the crisis. This is an attempt, a difficult attempt, to protect Greek and avert a crisis. Because the crisis in Argentina: the complete collapse of the economy, institutions, the social fabric and the productive base of the country.

Even if Greece receives its next aid payment, due next month, default beckons in December when 5.23 billion euros of bonds mature.

 Too Late

It’s too late for Greece, Howard Davies, The Greek situation is tumbling out of hand and Greece will not be able to avoid a substantial default. The introduction of the euro and global financial connections mean previous Greek defaults in the 19th and 20th century, most recently in 1932, don’t provide a decent precedent for a failure to satisfy lenders now.

Contagion will be violent as the price of the two-year Greek note tumbles below 30 cents per euro. The European Central Bank would be the first responders through purchases of government debt.

Greek Banks

The country’s banks, of which National Bank of Greece SA (ETE) is the largest, would be the next dominoes. They hold most of the 137 billion euros of Greek government bonds in domestic hands, a third of the total and three times their level of capital and reserves, says JPMorgan Chase. As those bonds are written down and equity wiped out, banks would lose the collateral needed to borrow from the ECB and suffer a rush of withdrawals that likely triggers nationalizations. No banking system in the world would survive such a bank run.

A hollowed-out banking sector wouldn’t be the only danger to an economy that the IMF says will contract for a fourth year in 2012. Greece will shrink 5 percent this year and 2 percent next year, reversing a forecast of a return to growth in 2012. Unemployment is set to rise to 16.5 percent this year, and to 18.5 percent next year, the highest in the European Union after Spain and dry kindling for potential social unrest. Even after saving 14 billion euros in debt repayments, much depends on what deal Greece could strike with its creditors.

 Large Haircuts

The losses from Greece-related exposures in isolation look manageable, even in a disorderly default scenario with large haircuts, though the ECB would probably require fresh capital from euro-area governments. A debt exchange that was part of the second Greek bailout approved by European leaders in July would impose losses of as little as 5 percent on bondholders. The risk is that the rot spreads beyond Greece as investors begin dumping the debt of other cash-strapped European nations. Portugal and Ireland have already been bailed out, while speculators have also tested Italy and Spain. Italy, the world’s eighth-largest economy, has a debt of almost 1.6 trillion euros, while Spain, the 12th biggest economy, owes 656 billion euros.

Grand Solution

The possible ripple effects explain why policy makers won’t let Greece default. Policy makers would only allow a Greek default if they think they can contain the fallout, which is a dangerous presumption. If Greece, Ireland, Portugal and Spain all impose haircuts, European banks could lose as much as $543 billion with those in Germany and France suffering the most.

Even those figures don’t tell the full story because they omit indirect exposure via derivatives such as credit-default swaps. U.K. and U.S. banks hold such insurance on Greek debt totaling 25 billion euros and 3.7 billion euros respectively. Extend that metric to the whole European periphery and U.S. banks have a 193 billion euro exposure.

Even Worse

Such linkages threaten an “even worse crisis” than the folding of Lehman Brothers, The amount of outstanding debt is more than with Lehman and we don’t know the amount of derivative exposure.

Governments must create a fund to inject capital into banks as the U.S. did with its $700 billion Troubled Asset Relief Program.

If banks fail, or if they fear big losses, they will stop lending. As things stand today, a credit crunch will corset euroland and a depression will ensue when Greece fails and takes out euroland’s banking system.

G-20 Signals

Signaling efforts to contain the crisis, European officials including French Finance Minister Francois Baroin yesterday said they may be willing to use leverage to boost the firepower of their 440 billion-euro bailout fund. Group of 20 finance chiefs said after talks in Washington late yesterday that European authorities are willing to “maximize” the fund’s impact by the time the group next meets Oct. 14-15.

The ECB may also intensify its own attempts to support growth and ease financial market tensions as early as next month. Potential measures include the reintroduction of 12-month loans to banks. A disorderly Greek default with spillover into Spain and Italy could mean the euro-area contracts 1.3 percent in 2012, using the Lehman Brothers episode as a benchmark.

Rebounds

After shrinking 10.9 percent in 2002 following its decision to default and devalue, Argentina’s economy grew eight years straight, exceeding 8 percent in every year aside from 2008 and 2009. Russia was growing in double digit just two years after defaulting on $40 billion of local debt in 1998.

In contrast, facing only hard choices, EU officials have taken half-measures in the hope that the situation would somehow turn around. What they have done so far is a patchwork approach, Now things are much worse. It’s becoming more expensive not only in economic terms but also in social terms for Greek citizens because now there will be redundancies, now there will be more taxes there will be less jobs and things will get worse.

If Greek defaults the contagion will soon spread to other Euro zone countries and the systemic risk will be beyond measures.  It’s certain that Greek has to default and it will default soon. If central banks and government fail to manage the ripple effect it would be impossible to survive the financial tsunami coming ahead.