Crisis In Greece: Why This Is Your Problem, Too

By Sara Glakas Friday, April 30, 2010

The Economist's cover story this week is titled, "Acropolis Now: Europe's debt crisis spins out of control."

Kudos to whoever wrote that headline. It sums up the urgency and importance of what could be the catalyst for the next global financial shock.

Sovereign debt is not the sexiest field in finance. What could be more boring than analyzing bonds issued by governments to finance economic development, governmental operations and programs for citizens?

But here’s a little Wall Street secret: the big money is in bonds. The always eloquent James Carville declared, “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”

The global bond market is worth over $82 trillion. That's over twice as large as the global stock market, which as of October 2008 was valued at around $36.6 trillion. Bonds are big money. And some of the biggest money of all is in Sovereign debt.

Unfortunately, when a country borrows too much and/or doesn't collect enough tax revenue to repay its lenders, then we see turmoil in the debt markets. And that can easily spill over into the larger global economy, impacting investors around the world.

Small Country With Big Problems
The turmoil in the debt market today has been caused by the looming threat of a default by the Greek government. Default is simply the term bankers use for failing to pay your debts.

To summarize its situation, Greece needs to pay back almost $16 billion in bonds coming due in 2010. But it also needs to borrow an additional $22 billion to cover its budget shortfall. Then it needs $45.6 billion next year, $39.1 billion in 2012 and $30.3 billion in 2013.

Last year, Greece's GDP growth was negative. Its citizens aren't very good about paying their taxes. And Greek officials have admitted that they've been lying to the EU about their budget deficits for years and years.

Naturally, global markets are wondering how in the name of Zeus Greece is ever going to be able to pay back $153 billion. They have expressed their concern by ratcheting up interest rates.

So when it comes down to it, Greece really only has 3 choices at this point:

Choice A: Borrow $37.5 billion today at market rates that have shot up to 8-10% annually. That is unbelievably high for sovereign debt (the U.K. can currently borrow for 2 years at just over 1%). To make interest payments at the much higher rate, Greece would have to cut the government budget to the bone, increase taxes on its citizens and hope that the people don't spill into the streets and light the place on fire.

Choice B: Default. Greece could call it a day and just stop paying everyone.  The IMF would step in and try to prevent mass chaos, but investors and citizens would most likely pull their money out of local banks and flee. The Greek economy would be ruined.

Choice C: Take the bailout that has been cobbled together by the EU. The EU (and its largest member, Germany) have offered a 110 billion euro ($143 billion) rescue package that the German Parliment is expected to approve on Friday. The loan will be at below-market rates for a period of at least two years. It comes with tight strings attached -- the austerity measures have already sent protesting Greeks into the streets.

No Good Choices
Choice A, borrowing at market rates, is more or less off the table. But if it happend, the consequences will largely be on Greece alone. The situation would be similar to a homeowner continuing to pay an adjustable rate mortgage when his house is already underwater and he just lost his job.

The increased percentage of GDP that Greece would have to pay to foreigners in the form of interest payments would cripple the economy. Greece would probably slip into a depression.

In any event, Greece would only be able to borrow for the short-term, and we'd go through this whole exercise again in few months. However, if Greece is really lucky, and if the global economic recovery is real, it could benefit from an increase in confidence and more stable debt markets in the future.

Under normal global economic circumstances, Choice B, defaulting on the debt, might not be that big of a deal. Bondholders would take some lumps but would theoretically be able to absorb the losses.

In this environment, though, a Greek default could be disastrous. A point not often mentioned by pundits is that a huge percentage of Greek bonds are owned by European banks. And by some accounts, European banks are in even worse shape than their American counterparts.

According to Niall Ferguson, Harvard Business School professor and noted historian, European banks were allowed to operate with astronomical levels of leverage. He points out that pre-Lehman, the average ratio of assets to capital for U.S. banks was 12 to 1, for British banks was 24 to 1, for Belgian banks was 33 to 1, and for German banks was 52 to 1.  That means for every 52 euros in loans, the owners of German banks provided 1 euro in equity. That's similar to a 1.9% down payment on a house.

This is important because if Greece defaults, Greek bonds are worth little to nothing. Banks that own the bonds would have to recalculate their assets, and if the overall value of the portfolio falls enough, the bank would be insolvent. Another wave of financial chaos, this time originating in Europe, could ripple through the global economy. The international bankers and politicians know this, though they don't talk about it.

Since it looks like Europe can't afford to see Greece default, they've moved forward with Choice C. German politicians are expected to approve the bailout this weekend in the face of heavy opposition from German citizens. Under the terms of the deal, Greece will need to continue cutting its budget, but it will lock in the financing it needs for the next two to three years at fairly favorable interest rates. That doesn't sound so bad for the rest of the world, right?

Fallout from Subprime Sovereign Debt
Remember when Fed Chairman Ben Bernanke said that the subprime mortgage crisis would be contained? Unfortunately, one financial crisis spilled over into another, and before long a domino-effect roiled global markets.

If Greece is offered and accepts a bailout, the EU and IMF will be praying to the gods that the global economy rockets forward. Because just down the street from Greece live their bigger, badder cousins: Spain, Portugal, Italy and Ireland. These four would be next in line for a bailout, but with a super-sized price tag: $576 billion for 2010 alone, $1.8 trillion for 2010-2013.

If EU countries and the IMF are required to provide bailouts to all the countries that need them, the global economy will certainly experience another slowdown. The EU is the world's largest economy, responsible for 29% of global economic output. A Europe-led recession could be contagious.

And if the EU sets a precedent for bailouts, it's essentially commited to shoveling dirt into a hole without knowing how deep the hole is. Who knows how long it will be before they can stop filling holes from the past and instead start building roads to the future. The worst part is that with European banks in the state they're in, default is not a better option.