A Guide to What Happens When Greece Defaults
What scares everyone about a possible Greek debt default is that it would cause a lot of other institutions -- even other nations -- to join Greece in default. Remember 2008 when AIG hit the fan? It's like that, only much, much, much bigger.
How likely is this to happen? The Magic 8 Ball and the markets say: Very. On Monday, Greek 1-year bonds were trading at 111 percent. Germany has already announced it is putting up as many financial moats and dikes as it can.
The nations and institutions holding the most Greek debt are:
- Greek banks: $62.5 billion
- European Central Bank: $40 billion
- Germany: $22.6 billion
- France: $14.96 billion
- UK: $3.4 billion
- Italy: $2.35 billion
We have asked the banks to essentially do stress tests and ask, looking at all their positions, all their hedges, what would the effect on their capital be if -- if Greece defaulted. The answer is that the effects are very small.It is true the U.S. government and banks don't have much direct exposure to Greek debt. Unfortunately, Fitch Ratings says as much as 50 percent of U.S. money market funds are tied up in commercial paper from European banks.
For example, Vanguard Prime, a $110.6 billion fund, has 21 percent of its holdings in European bank debt. In the past six months, Vanguard increased its European investment by 4 percent because it could get better returns in Europe. (Now we know why.)
The risk here isn't the direct impact but the fallout. Institutions that found themselves suddenly holding worthless bonds would suddenly get calls from their bondholders asking for money. Other dominoes would then follow.
So here's an itinerary for a trip we really don't want to take.
Start: The running of the banks »
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The running of the banks
Because Greek banks are so heavily exposed, default would force many of them to look for new capital in an attempt to make up for the losses. Good luck. This would likely trigger a run on banks by Greek depositors. The Greek government (or whatever is left of it) would be forced to declare a "bank holiday" to stop the run. The most exposed Greek banks would have to be nationalized.
Similar scenarios would play out in neighboring nations like Romania and Bulgaria, which are heavily exposed to Greece even though their total dollar figure isn't large enough to get them on the previous list.
Greece may then get booted or leave the EU. If that happens it will re-create its old currency, the drachma, in new form. These New Drachmas (or whatever) will devalue a lot. Let's say 50 percent, though it could be more.
This would effectively discount all Greek euro-denominated debts by 50 percent or more. There may be little reason to think Greek can pay off 50 percent any better than it can 100 percent and a lot of people know that.
Next: The world's capital goes crunch »
The world's capital goes crunch
Most of those who bought Greek debt probably bought insurance in the form of credit default swaps.
So the institutions that issued the CDSes would need to pay the face value of the bonds immediately. This too could domino. This is where the U.S. money market exposure would get very problematic.
As we saw in the wake of Lehman Brothers' collapse, every institution will be (justifiably) very nervous about the financial stability of every other institution. Global credit markets could easily seize up should banks hesitate to extend credit to each other out of fear about exposures. Counter-parties may be asked to hand over additional collateral, forcing asset sales. The price of these assets would drop in turn, creating a new death spiral as more institutions try to sell more assets.
Next: Default starts looking more attractive »
Other nations start eyeing the default option
You know all those homeowners who walked away from their mortgages because they owed more than the house is worth? Ireland and Portugal are now those guys. They see Greece has just cut the amount it owes by 50 percent, so what do they have to lose by defaulting? They can't get more bankrupt.
The likelihood of default is significantly higher if there is massive public unrest in Greece. Dublin and Lisbon will want to avoid that particular piece of chaos.
But hey, what are the chances that Greeks would riot?
Next: The European Central Bank shudders »
The ECB goes under -- for a bit
If Ireland and Portugal do default, it will cause a number of French and German banks to "make sufficient losses that they no longer meet regulatory capital adequacy requirements." That's how you say insolvent in bureaucratic. The European Central Bank will follow because it also holds a lot of Irish banking sector debt.
The EU governments who can still pass for solvent -- likely France and Germany -- would then have to decide what the ECB should do to get back in business. The top options would be
- Recapitalize the ECB (with help from non-EU nations?), or
- Let the ECB print money to restore its solvency.
Because the ECB has relatively little foreign currency-denominated exposure, it could in principle print its way out, but this is forbidden by its founding charter. On the other hand, the EU Treaty explicitly, and in terms, forbids the form of bailouts used for Greece, Portugal and Ireland, but a little thing like their being blatantly illegal hasn't prevented that from happening, so it's not intrinsically obvious that its being illegal for the ECB to print its way out will prove much of a hurdle.(By the way, at some point in all this Spain's bonds will come under heavy pressure and if they go under then things will get even worse.)
Next: Double-dip city »
Double dips are for ice cream, not economies
Here in the States, whatever remains of consumer confidence would vanish instantly. You know how after World War II they had to rename what was known as The Great War because WWII was so much worse? Expect the Great Recession to be treated similarly.
Whatever they call it, it will hit China hard as world demand for products slows to a crawl. Who knows what happens to internal Chinese politics then. More's the pity, because Beijing is currently doing a pretty good job of guiding the Chinese economy to a soft landing.
Now, before you go and cash out your IRAs to buy canned goods (which, take note, should remain highly fungible), please keep the following in mind.
Next: Your mileage may vary »
Your mileage may vary
These predictions are based on so many different assumptions that you'd be foolish to believe in them all. At several different points, someone might throw a monkey wrench in the works and set us all on different path.
After all, I have been picking the Cubs to win the World Series every year since 1967.
