How the European Debt Crisis will play out

(2 pm. – promoted by ek hornbeck)

  Too often commentary on the European debt crisis has been like handicapping a horse race (“this country is leading the race to default, but this other nation is catching”).

  While interesting, it is useless in trying to figure out how this relates to the average person.

 The first thing you have to understand is who the players are and how they are connected.

Greece has defaulted.

  Well, not technically. The stock markets are still pricing in some hope of yet another European bailout, but the credit markets have already given up on Greece.

  The yield on 2 year Greek bonds is now over 60 percent.  The yield on 1 year Greek bonds is now over 110 percent.  Basically, world debt markets now fully expect that Greece will default.

 Let’s face it: the debt markets have a better historical record at predicting the future than the stock market does. Lately the stock market has moved up and down based on nothing but rumors of bailouts. Thus, once reality fully sinks in, expect the stock market to plunge again.

  But what if the bailout actually happens? Nothing much will change, that’s what.

 It is elementary school arithmetic. The Greek debt-to-GDP is currently at 140%. It will be close to 180% by year’s end (assuming someone gives them the money). The deficit is north of 15%. They simply cannot afford to make the interest payments. True market (not Eurozone-subsidized) interest rates on Greek short-term debt are close to 100%, as I read the press. Their long-term debt simply cannot be refinanced without Eurozone bailouts.

 Even with another bailout Greece will still be unable to access the private debt markets. So unless the bailouts are permanent (something that countries such as Germany, Finland, Holland, and Austria are not going to do), Greece’s only recourse is to default.

 Besides, the ECB is hardly in a position to be offering large bailouts these days.

 “Should the ECB see its assets fall by just 4.23pc in value . . . its entire capital base would be wiped out.”

 So what does a Greek default mean and when will it happen?

The answer to the second question, barring another temporary bailout, is easy: next month at the latest.

  That’s when the Greek finance minister says that Greece will run out of cash.

Of course that doesn’t mean a default won’t happen sooner, and it certainly doesn’t mean that the markets won’t react and anticipate the default beforehand.

 As for what it means, that’s a little harder to say because there is so much politics involved, most of it local. And as we learned from 2008, there are complicated, opaque financing behind every door, so it is impossible to map out every counter-party risk beforehand.

  However, there are “known known’s”.

 One thing we can be sure of is that the market will immediately look for “who’s next”?

That “who” is Portugal.

 Yet to push Greece over the edge risks instant contagion to Portugal, which has higher levels of total debt, and an equally bad current account deficit near 9pc of GDP, and is just as unable to comply with Germany’s austerity dictates in the long run. From there the chain-reaction into EMU’s soft-core would be fast and furious.

 Portugal’s 2-year bonds are already 15% and a Greek default will push them higher. That would push Portugal out of the private debt markets and make them dependent on a European bailout too.

   If Europe lets Greece default, they will let Portugal default too. Portugal’s debt to GDP ratio is well above 100%.

  100% is also the expected chances of default by Greece, Ireland, and Portugal.

 “BNP Paribas SA, Societe Generale and Credit Agricole SA (ACA), France’s largest banks by market value, are trading at levels that imply a 100 percent loss on Greek, Irish and Portuguese holdings, according to Barclays. In the case of Paris-based Societe Generale, the share price even implies full writedowns on Italian and Spanish debt, according to Barclays.”

 Of course the Portugal default, after the Greek default, might take months to play out. Important things will happen before then. Those important things involve Europe’s banking system.

   Banks typically retain sovereign debt as their core holdings against private sector defaults. For example, BofA will hold safe Treasuries in reserve to protect against defaults in their subprime mortgage holdings.

   European banks are no different, except that they will typically hold the government debt of their respective nations…and that’s the problem.

 European banks are leveraged to the hilt with sovereign debt. If that sovereign debt defaults and gets marked down, then their capital reserves could be entirely wiped out, thus making the banks insolvent.

  Remember that Lehman Brothers was leveraged at 31 to 1 when it went under. Today, Germany’s banks are leveraged at 32 to 1, and Germany’s banks aren’t even the ones in the most trouble.

  Moody’s cut the ratings of two French banks today. This comes just a day after this stunning news article from the WSJ.

 ‘We can no longer borrow dollars. U.S. money-market funds are not lending to us anymore,” a bank executive for BNP Paribas, who declines to be named, told me last week. “Since we don’t have access to dollars anymore, we’re creating a market in euros. This is a first. . . . We hope it will work, otherwise the downward spiral will be hell. We will no longer be trusted at all and no one will lend to us anymore.”

…

  BNP, Société Générale and Crédit Agricole together hold nearly $57 billion in Greek sovereign and private debt, versus $34 billion held by the largest German banks and $14 billion at British banks. French banks also held more than €140 billion in total Spanish debt and almost €400 billion in Italian debt as of December, according to the latest figures from the Bank for International Settlements. If either of these latter two governments were to default, their banking systems could collapse and take the French system with them.

  “Look at the French banks’ debt holdings versus those of U.S. banks,” he continues. “The total debt of the three big U.S. banks (Bank of America, JP Morgan and Citigroup) is $5.86 trillion, or 39% of GDP, while the debts of BNP, Crédit Agricole and Société Générale come to €4.7 trillion, or 250% of French GDP.”

 For France’s big three banks, their exposure to Greek debt is only slightly smaller than their entire present market capitalization, their exposure to Italy almost 7 times bigger than the market cap, and their total debt some 78 times bigger.

  A Greek and Portugal default would crush them.

 Just today, two European banks borrowed dollars from the ECB emergency fund, which in turn borrowed from the Federal Reserve.

  Contagion in Europe, if it was allowed to happen, could be devastating to the European economy.

 So what? You are in America, right? How much effect can Europe’s problems have on you?

  For starters, problems in Europe’s banks would immediately spill over to Wall Street.

 “……a European failure is bound to have huge ramifications for U.S. and global financial markets. If there is any doubt on this score, all one need do is consider the U.S. financial system’s massive exposure to European banks. In a recent survey, Fitch Ratings Inc. found that, as of the end of July, the U.S. money-market industry still had over a trillion dollars of direct exposure to European banks-or roughly 45% of money markets’ overall assets. The Bank for International Settlement reports that American banks have loan exposure to German and French banks of more than $1.2 trillion.

   “This overexposure to the European banking system should be keeping Mr. Obama awake at night. That’s because those European banks, in turn, are all too exposed to the $2 trillion sovereign-debt market for Greece, Ireland, Portugal and Spain-and they have yet to recognize the large loan losses that they are bound to experience on their holdings of sovereign debt.”

 Because of Washington’s failure to pass real financial reforms last year, we are looking at a meltdown on Wall Street yet again. Except this time, Washington doesn’t have the money to bail out the bank CEOs, and the public doesn’t seem incline to put up with it (not in the days of austerity).

  But it ends there, right? Wrong.

 In the days leading up to the collapse of Lehman Brothers, then French Finance Minister (now IMF Managing Director) Chistine Lagarde told then-Treasury Secretary Hank Paulson that he could not allow Lehman to fail. The ramifications would be catastrophic, she said.  She was mostly right.

   Three years later, it will be Angela Merkel talking to President Obama,Treasury Secretary Geithner and Federal Reserve Bank Chairman Ben Bernanke with exactly the same message.  The United States government and the Federal Reserve must come to the rescue of the Eurozone or the ramifications will be catastrophic. And she will say that she needs roughly $1 trillion in financial guarantees and liquidity support.  That’s the number that will calm the markets.

 You read that right. Europe will be asking the Federal Reserve for $1 Trillion to bail them out.

  Now this is not unprecedented. The Fed, to a large part, and backed by the American taxpayer, bailed out Europe’s banks in 2008-2009. Now they are coming back for a much bigger bailout.

  Will they get it? That is impossible to say, but I can’t see how it can be politically justified. On the other hand…

 If Obama goes forward and provides all or part of the $1 trillion guarantee, he will likely cut his own political throat in so doing.

   If Obama declines to go forward and provide all or part of the $1 trillion guarantee, he will likely preside over the second massively destabilizing financial panic in four years, thus insuring a second Great Recession, thus cutting his own political throat.

 The price of not reforming the financial system just keeps getting larger. At what point do the American people finally say “enough”?