To default, or not to default: that is the conundrum

07.09.2011 - Money Matters

We thank William Shakespeare and his famous phrase from Hamlet, “To be, or not to be: that is the question” for the inspiration of our title.  In short, it sums up the dilemma facing the European Central Bank (ECB) and the leaders of the European Union (EU) countries regarding the sovereign debt crisis embroiling Greece.

At the end of June at the behest of the ECB and EU leaders, Greece adopted new austerity measures that many are calling draconian.  In coming to terms, Greece will now receive the next tranche of bailout funding.  Once again, they have managed to temporarily solve the crisis or as the headlines in the media have trumpeted, they have “kicked the can down the road once more.“

The crisis began in December 2009 when it was discovered that the predecessors of the newly elected Greek prime minister had hidden the size of Greece’s massive budget deficit. Inevitably, financial markets reacted with consternation and sent interest rates for Greek debt spiraling upwards.  The rock-bottom interest rates prevailing for much of the previous decade quickly disappeared.

In early 2010 a bailout package for Greece of some $163 billion was cobbled together but proved insufficient.  Fast forward to 2011 and another crisis was at hand that required another bailout.  Germany, with the most vibrant economy in the EU, was insisting that any further aid would require bondholders to take a “haircut.”

There was significant opposition to this proposal by the ECB which had accepted a large amount of Greek debt as collateral to keep Greek banks solvent.  France was also opposed since its banks were the most exposed to Greek bonds.  Together they were able to block the idea.  The concern was that any restructuring was likely to be considered a default and the contagion to other struggling European countries would precipitate another recession.

Many economists have said that Greece is unlikely to ever be in a position to repay their ballooning debts.  One does not need to be an economist to conclude that Greece will default.  It is just a question of when.  Almost anyone will reach the same conclusion if they read the October 1, 2010 Vanity Fair article Beware of Greeks Bearing Bonds, by Michael Lewis which lays out the origins of the crisis.

The implications of a Greek default for the United States (US) are unknown.  What is known is that US banks are not holding much sovereign Greek debt nor that of the other struggling EU countries.  On the other hand they hold a considerable amount of credit default swaps (derivatives) of large European banks that hold much of the sovereign Greek debt.  One only needs to recall Warren Buffett’s 2002 letter to the Shareholders of Berkshire Hathaway in which he referred to derivatives as “financial weapons of mass destruction.”

The issue of contagion, while not explicitly stated, was readily apparent during a speech by Eric S. Rosengren, President of the Federal Reserve Bank of Boston on June 3, 2001.  He commented that “money market mutual funds have the potential to be impacted should there be unexpected international financial problems emanating from Europe.”  Earlier in his speech he noted that during the financial crisis the Reserve Primary Fund, one of the oldest money market funds, had to “redeem shares for less than one dollar.”  It is well documented that many US money market funds hold significant amounts of debt from European banks.

Again, we must thank Will and his As You Like It for our final thought:  “All the world’s a stage, and all the men and women merely players; they have their exits and their entrances;” Greece, it will soon be your time to exit, stage left.  The domino effect of such a shock to the international financial system may well bring about another recession.