Fresh signs of a possible default in Greece have revived a contentious debate between politicians and major banks in the European Union over what to do about the Greek debt crisis.
Yesterday (Wednesday) Greek Prime Minister George Papandreou had no success convincing opposition party leaders to support new austerity measures needed to comply with bailout terms set by the International Monetary Fund (IMF) and other European Union countries.
Without those measures, Greece will not receive the bailout money it needs to avert default. Default would destroy the country's credit for a decade, maybe longer.
Meanwhile, Bank of France Governor Christian Noyer, a member of the European Central Bank, spoke out against recommendations by Germany and other EU governments that Greek debt be restructured, calling it a "horror scenario."
Restructuring the debt would entail delaying or reducing payments to the bondholders, primarily large banks. Since any restructuring would be regarded as a default, those banks would have to report the altered bonds as a loss. That could raise questions about the solvency of any institutions heavily exposed to the debt.
The big EU banks prefer that the wealthier EU countries offer Greece more aid on top of last year's $163 billion (110 billion euros) bailout, but the governments of those countries fear a pattern of bailouts — not just for Greece but other debt-burdened European nations such as Portugal, Ireland, Italy and Spain (PIIGS).
Of course, if Greece restructures its debt, the other PIIGS nations would likely follow, putting the entire European banking system at risk.
"It's going to be one, then another," said Money Morning Contributing Editor Shah Gilani. "One domino falls, then the other dominoes will fall."
The governments in wealthier EU nations such as Germany also are worried about the political fallout of more bailouts, Gilani added. Many citizens in those countries view the bailouts as a potential threat to their own financial well being that could, for example, result in higher taxes.
Gilani said even politicians realize the disaster that would result from letting Greece – or any PIIGS country – default, but are reluctant to be honest with the public about what needs to be done.
"The politicians can't say how dire it is," Gilani said. "There would be panic."
Gilani says he's worried about how all of Europe's financial institutions are over-exposed to each other's sovereign debt. Add in the austerity measures required by the bailout programs, and you get a recipe for what he terms "a hot summer in Europe."
"By hot I mean Europe is going to reach its boiling point and there's going to be civil unrest, strikes, and a default, maybe a couple of defaults," Gilani said. "If they're not termed 'defaults' they'll be called restructurings. Same thing."
Banks Stuck with Debt
The European banks that hold most of the Greek debt have grown increasingly anxious about the possibility of default, as they have virtually no way to dispose of it.
No one wants to buy it – the 10-year bond trades at 51 cents on the euro – and hedge strategies via credit default swaps (CDS) have grown too expensive. It now costs $2.09 million (1.48 million euros) to protect $14.09 million (10 million euros) of five-year Greek bonds against default.
"CDS are beyond the level where you even bother to hedge," one analyst told Reuters. "It's easier in a way just to take the hit."
What seemed like a good investment in 2004 when the spread between Greek and German 10-year bonds was only 20 basis points has evolved into a financial quagmire. The spread on Greek bonds now has ballooned to 1,400 basis points.
"For a lot of banks, their worst nightmare seems to be coming true," an investment banker who advises financial institutions on the continent told Reuters. "We now know that the Greek smoke was indeed fire and a lot of people have now found themselves heavily exposed."
Greek banks hold about $70.5 billion (50 billion euros) of the sovereign debt; German banks hold $26.8 billion (19 billion euros) worth and French banks $21.1 billion (15 billion euros). The European Central Bank itself is also exposed.
"The vast majority of these banks have just been unable to do anything," one European banker who has advised dozens of such banks told Reuters. "Protection is too expensive, and markets for these bonds are illiquid, so many are riding out the problem. Right now, all they can do is shut their eyes and hope."
The best strategy for the banks is to delay restructuring, allowing at least some of the shorter-term notes to mature. But the money for that would have to come from the very type of government bailouts that Germany and other wealthy EU countries find objectionable.
"We are never going to be in a position where the restructuring of Greek debt doesn't have a market impact, it's just about minimizing that impact," Roberto Henriques, head of financial institutions credit research at JPMorgan Chase & Co. (NYSE: JPM), told Reuters. "It's about buying time for the other European sovereigns, and buying time for the European banking system."
News and Related Story Links:
- Money Morning:
Resurgent Greek Debt Crisis Stokes Concern, Causes S&P to Lower Rating
- Money Morning:
The Future of the Euro: Why Europe's Key Currency is Doomed
- Spiegel Online:
Greece Says Debt Haircut Would Be 'a Huge Mistake'
- Bloomberg Businessweek:
Main Greek opposition rejects deal with government
Greece's 100 billion-euro shadow over banks