Greece is the bad penny that keeps cropping up at inconvenient moments. We’d desperately like to forget Greece. Farr has been writing about it for 18 months with all of these depressing comments, and it seems to be among the things blamed for market down days. Each time that Greek economic news roils, regulators affect worried looks and promise to give the whole mess the most serious consideration tomorrow, or next week, or next month. But time may be about up. Whether or not European officials can delay dealing with Greek insolvency much longer, we think it’s worth reviewing what a default may mean.
If you will hearken back to the days of Lehman Brothers’ failure, you will remember that it was not only Lehman Brothers that suffered but all of the counter-parties to Lehman collateral transactions and holders of Lehman debt. We all became familiar with the term “counter-party risk.” What our banks suffered in holding each others obligations will next be felt by those countries and banks that hold Greek debt. It is unique to be concerned about the counter-party risk of sovereign debt, but that’s where we are. And it may spread from Greece to Ireland, Portugal and Spain.
But let’s stick with Greece. As Greece struggles to pay its debts, it is scrambling to borrow money to stay current on current debt. Think of this as taking a big high interest loan to make the minimum payment on your staggering credit card bill. It may keep the wolves away for a while but ultimately just covers you in gravy for when the hungry wolves actually show up.
While European banks and governments hold most of the actual Greek bonds, brilliant US bankers have insured Greek bonds against default by writing – you guessed it – credit default swaps. Estimates for the dollar liability of US banks exceed $100 billion. This odd situation not only cries to heaven, but, as our friend John Mauldin points out, pits the interests of EU bankers against US bankers. If there is a slow, work-out solution, European banks will suffer and US banks won’t have to pay for defaults. On the other hand if Greece defaults, US banks will be on the hook for making many of the EU banks almost whole.
The other curious thing about sovereign debt held by EU banks is that it is not marked-to-market. Why bother? It is a sovereign debt. But if you bought the Hellenic Republic Government bond 6.25% maturing June 2020 at the face amount of $1,000 per bond and continue to hold them today at $530 per bond, the value of your holding has fallen by almost half. If you’re a bank and used those $1,000 bonds as collateral for other monies you’ve borrowed, you’ve watched your collateral fall by half, and your ability to borrow more has been impaired by your newly diminished reserves.
It is tough to tell how a Greek default will ripple through world markets, but it will not be good. It is clear that, once started, this type of contagion can quickly spread to the other European economies we discussed earlier. It is confounding that US banks may soon again seriously suffer from ill-considered risk taking.
As I wrote last week, it is imperative that culpability be reconnected to consequence. The banker that decided to write the credit default swap on Greek bonds should be fired in a very public way. The banks that endorsed these swaps should be held accountable by their shareholders. We don’t need government stress tests; we need sensible people to begin doing responsible things. This is getting ridiculous!