A Greek default is inevitable.
After years of piling up bailout loans on an already severely debt-ridden Greece, the Eurozone finds itself in the situation it is in now. Each maturity or rollover date on Greece's debt is another financial news headline.
And with each looming repayment deadline, there's a discussion over whether that one is the one Greece won't have the cash to pay back.
It has yet to miss one of these deadlines since the Syriza party stepped into power in January. But the 7.2 billion euros ($8 billion) of bailout money Greece has been trying to tap won't be disbursed until the country shows its creditors it's making meaningful reforms to cut its budget.
And for all the pledges to privatize public assets and crackdown on tax evasion, Greece hasn't made any true efforts to address pension and labor costs - what its creditors really want to see. Even worse, just last week, Greece rehired thousands of civil sector workers who were let go under prior international agreements, effectively defying creditors on previously agreed-upon bailout conditions.
The Greek Syriza party wants access to bailout money - but it also doesn't want to risk alienating the voters who swept Syriza into power on a populist, far-left mandate.
And this is why there's no way to solve the Greek debt crisis without a Greek default.
Either Greece will be forced to negotiate a major write-down, if not an all-out default, or exit the euro altogether, reissue the drachma, and then renegotiate its debt still outstanding in euros.
In every case, a Greek default is the end result. "Extend and pretend" can only continue for so long before Greece, the IMF, and the major Eurozone creditor nations tire of the brinkmanship inherent to conditional bailouts - especially when Greek left-wingers continue to defy those bailout terms.
But it's not the more than 324 billion euros ($362 billion) in Greek debt that's the biggest problem here.
Author Satyajit Das wrote in 2010 in his book on derivatives called Traders, Guns and Money that every $1 of real capital is supporting another $20 to $30 of leverage. It's hard to believe that even in the event of Greece defaulting on all 300 billion or so euros of its debt, that it will be confined to just 300 billion euros of asset destruction.
"They've all cross-collateralized in Europe," Money Morning Chief Investment Strategist Keith Fitz-Gerald said. "So, Greece's debt is spun out to France, banks in Germany, banks in Italy - Europe is this huge spider web of cross holdings."
And that's where the real peril of a Greek default comes to light...
How a Greek Default Could Devastate the Eurozone Financial System
It's hard to pin down an exact number, but the global derivatives market has been estimated to be worth somewhere between $500 trillion and $1.5 quadrillion.
Now that figure may seem terrifying, but a good chunk of that is harmless. Just think of put and call options, commodity futures, and the like. These particular investments won't take down a big bank or precipitate some kind of financial crisis.
Where the real danger lies is in derivative instruments tied to the performance of Greek debt.
Derivatives trading is a zero-sum, mark-to-market game. Two traders on opposite ends of the trade will make leveraged bets on the performance of an asset. At the end of each day, their accounts have to reflect some percentage of the value of the asset underlying their contract.
Here's a quick example. Say two traders are betting on the performance of a contract worth $10,000, and the broker requires both of them to put up 10% of the value in what's called a margin account. There's a long buyer betting on an increase, and a short seller betting on a decrease.
At the end of each day, the long buyer's account will have to reflect the 10% maintenance margin. So if it goes up to to $11,000, the short seller will have to pay $100 to bring the long buyer's margin up to $1,100. If it goes down to $9,000, the long buyer will be debited $100 which will be credited to the short seller.
Now here's where a Greek default could be ruinous to derivatives traders.
One particular danger could come from any derivatives trader using Greek debt as collateral in their margin account.
Margin accounts will allow for traders to post bonds as collateral, not just cash. So any Greek default or restructuring that pushes down the face value of Greek debt could force traders to post even more collateral to make up for the loss of value in their margin accounts.
A big enough markdown in Greek debt could be devastating to any trader that is highly leveraged on Greek debt when it comes time for a margin call. If a big European bank happens to be on the wrong side of the trade, it could topple a large financial institution and Europe would be reliving the Lehman Brothers nightmare.
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Another issue comes from credit default swaps (CDS). Credit default swaps guarantee the payment of a debt. If a trader buys a debt and is worried that the borrower will not pay back at maturity, they can find an insurer to pay them the principal of the debt in the event of a default. They'll pay the insurer periodic premiums.
"Wall Street wants you to believe CDS are insurance, but they're really not," Money Morning's Fitz-Gerald said. "They're a massive leveraged bet made on a specific set of economic circumstances that may or may not have a basis in reality."
There's a lot of schadenfreude in the derivatives market. There are huge profits to be made in breaking the bank and demolishing a counterparty's margin account. And at the same time, CDS trades don't have to be made by a holder of the debt. Meaning in this insurance scheme, a third-party has financial interest in economic devastation.
But, in many ways there's even more incentive to see a Greek default beyond just the payouts from CDS and other derivatives tied to Greek debt.
A Greek default enhances the possibility that another debt-ridden Eurozone member, say Portugal, Spain, or Italy, decides they too want to stiff their creditors. Protection sellers will be happy because higher demand for protection on these debts will widen the spreads and make for bigger profits collecting premiums.
And the CDS buyers will be happy to feed this demand, convinced that a Greek default will just be the first in a line of Eurozone defaults.
What makes this even worse is that in a market as unregulated as derivatives, nobody knows just what could happen, making any precautionary measures to defuse this derivatives time bomb that much harder.
Jim Bach is an Associate Editor at Money Morning. You can follow him on Twitter @JimBach22.
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