A report from inside the euro crisis says saving Greece will cost much more and take much longer than expected. Politically, that’s not doable, making default likely.
From the beginning of the European debt crisis, Eurozone leaders have been one step behind. That’s why this crisis has lasted so long, and grown so wide and deep.
And it’s now clear, on the eve of yet another emergency summit meeting on Wednesday, that the currency union’s political and financial leaders are about to do it again. Whatever cobbled-together solution they announce as their grand plan that day will, once again, be a step behind the evolution of the crisis.
And this time, the lag will be especially big and potentially devastating to hopes of ending this crisis.
Recent news makes it clear that the crisis has now become primarily a political one. But Eurozone leaders continue to treat it as a crisis that can be solved with technical financial fixes, such as insurance schemes to leverage the European Financial Stability Facility.
The lag in addressing the euro crisis as a political crisis means that when—notice I’m not saying "if"—Greece defaults, the damage to the European banking system will be greater than it need have been. In fact, the whole fabric of the great postwar edifice of the European Union will be in danger of collapse.
Sadly, we didn’t have to get to this point.
A Look Inside the Problem
What has happened in the past few days to convince me that the evolution of this crisis has left the proposed solutions so far behind?
Mainly, it was publication by the Financial Times on Saturday of a confidential report on the continued deterioration of the Greek economy from the International Monetary Fund, the European Central Bank, and the European Union—the so-called troika in charge of investigating Greek finances and deciding whether Greecemet the requirements for receiving the next $11 billion in bailout money.
It seems that under the dual impacts of the global economic slowdown and the austerity measures taken by the government to meet the terms of the troika’s rescue package, the Greek economy has contracted more than predicted when the Eurozone put together its rescue package in July.
At that point, calculations were that if Greek bondholders wrote off 21% of the value of their debt and if the Greek government cut its budget and sold off national assets, it would take $150 billion in rescue funds to enable Greece to get to a point—in 2014 or so—where the country would be able to go to the financial markets to meet its financing needs.
The troika’s new calculations show that it’s now likely to take $350 billion and more time—possibly until the end of the decade—to reach that point. And if the Greek economy takes a turn for the worse—if, for example, the zone as a whole falls into recession again—the rescue bill could climb to $610 billion.
That $610 billon exceeds the theoretical $600 billion cap to the European Financial Stability Facility. (I say theoretical because some of the facility has already been committed, and some of that $600 billion isn’t actually available for rescue work because it’s needed to back the facility’s finances.)
Quite a problem, no?
NEXT: Stretching the Money
|pagebreak|Stretching the Money
Right now, it looks like Eurozone leaders are going to try to financially engineer a solution to the problem.
The solution will include leverage to increase the firepower in the European Financial Stability Facility well beyond $600 billion, and some increase in the haircuts that banks and other holders of Greek bonds will have to accept.
There’s a trade-off, you see, between the size of any rescue fund and the size of any write-down in the amount that Greece has to pay its bondholders. For example, to get back to a rescue package roughly the size of the July package—$157 billion instead of $150 billion—and to avoid the need for a $350 billion rescue package, Greek bondholders would have to take a 50% write-down of the value of their bonds.
Considered just as financial engineering, that solution has a number of problems. I am troubled by two in particular.
First, the current estimate of the required rescue package at $350 billion isn’t likely to hold. For example, with further austerity measures, the Greek economy is likely to shrink even more than is now forecast, cutting tax revenue and resulting in even bigger budget deficits.
And it’s reasonable to expect even more slippage of the sort that we’ve seen so far from the Greek government. A sale of assets originally forecast to bring in $91 billion now looks as if it will bring in just $63 billion, according to the troika. Also, cuts to the government workforce have been implemented more slowly than projected.
Second, for this bit of financial engineering to work, the engineers have to thread their solution through a very narrow strait. They’ve got to persuade banks to take a big hit to their balance sheets, and to do it voluntarily.
A forced write-down, credit ratings companies such as Standard & Poor’s have said, would be ruled a default by Greece. That would trigger, in all probability, the insurance features of credit-default swaps. Bondholders who had bought these derivatives to insure against a default would be entitled to payoffs from the financial institutions that had sold these derivatives.
Nobody is quite sure who is holding the bag here. The fear is that some important institution somewhere in Europe—or elsewhere in the world—would wind up with more claims against it than it can afford to pay.
The result could be a replay of the American International Group (AIG) crisis in 2008, which almost brought down the global financial system.
Banks In for a Hit
Of course, even a voluntary write-down of Greek bonds would force banks to take a hit to their balance sheets.
At some banks, says Deutsche Bank (DB), the hit is likely to be relatively small, because total exposure to Greek debt is small, and the bankers involved have already written down the value of their Greek holdings below the 21% discount in the July agreement.
But in other cases—that of the big French banks BNP Paribas (BNPQY), Société Générale (SCGLY) and Credit Agricole (CRARF), for example—the exposure is larger and the write-downs to this point have been smaller. A big write-down as any part of a new Greek rescue package might be enough to trigger the need for a bailout from the French government.
This is where the going gets really, really tight for the financial engineers.
France is trying to close its own budget gap. It is a major provider of guarantees to the European Financial Stability Facility. In fact, its AAA credit rating is critical to the structure of the facility.
Standard & Poor’s and Moody’s have already warned that France may be getting close to the limit of its financial strength with its commitments to the EFSF and to the rescue of French-Belgian bank Dexia. Capital infusions into the big French banks would, in all likelihood, push France over the limit, as far as S&P and Moody’s are concerned.
A downgrade of France to AAA with a negative credit watch wouldn’t cause an immediate problem, but it sure would increase market nervousness. That’s because an actual downgrade to AA from the current AAA would endanger the structure of the European Financial Stability Facility.
And this—the financial engineering side of the crisis—is, in my opinion, the easy part.
NEXT: More Pain
|pagebreak|The Politics of Pain
The really tough problems are political—and that’s where Eurozone leaders have done the least work on a solution.
Consider how tough selling a relatively minor expansion of the powers of the European Financial Stability Facility has been. Voters in Germany, Finland, and the Netherlands have all balked at contributing more to save Greece. The government in Slovakia lost power as part of a bargain to get that country to agree to it.
And now, according to the troika, European voters are looking at a rescue of $350 billion instead of $150 billion. And one that would stretch not to 2014 or so, but to 2021.
And what, in all honesty, do you think the chances are of that getting through the parliaments of Germany and Finland? Both governments have successfully asserted their rights to approve any deal before national leaders like Angela Merkel and Nicolas Sarkozy sign it.
It was difficult to get the November payment of $11 billion approved by the troika and then by Eurozone leaders. Do you think the December payout, which Greece needs to avoid actually defaulting on its debt, will be easier? And how about the next quarter and the next quarter and the next?
When European voters realize they are being asked to pour money down the Greek drain for a decade, the game is done.
A Way to Skirt Reality
This is why the financial engineers are hoping they have come up with a way to disguise that reality.
Instead of expanding the amount of money that European taxpayers will have to send directly to Greece, they hope to craft a deal that keeps payment to Greece relatively unchanged, but that substitutes taxpayer payments to banks for taxpayer payments to the Greeks.
It would work this way: Instead of paying an additional $10 billion to Greece, French taxpayers would pay $10 billion to rescue French banks. And if the financial markets can be encouraged to contribute, that $10 billion might be shaved to, say, $5 billion.
You might ask, what would lead private investors to put money into a scheme like this? My answer is that the financial engineers are working to come up with some combination of guarantees against loss, discounts on market value, and yield that might attract investors such as China’s strategic investment fund.
Of course, the guarantees are still ultimately guarantees from taxpayers, the discounts to market value ultimately come out of taxpayer hides, and any enhanced yield comes out of taxpayer pockets. But this mechanism serves to make it easier to tell taxpayers that this is a private solution and doesn’t involve taxpayer money.
Of course, that would be a lie. But…
The politics of this version of three-card monte are, to put it mildly, iffy. It depends on selling this to voters (and hoping that they’re not paying attention, always a dangerous hope when money is at stake).
It depends on keeping opposition politicians at bay in Germany, Finland, and the Netherlands, and on keeping internal opposition under control in Germany.
It depends on the Greek government being willing to impose unpopular austerity on that country for a decade.
It depends on bankers deciding that they’ll take a voluntary haircut, accepting 50% to 60% of government money, rather than seeing if they can get a better deal in the financial markets, thanks to loose accounting.
And it depends on keeping that political balance together for what increasingly looks like at least a decade more.
I think we’re already close to crisis fatigue among taxpayers. Keeping this going for ten years is out of the question. If this "solution" were to make it to 2013, I’d be surprised.
Time to Face the Music
The problem with going down this route and then failing is that Eurozone leaders will spend a lot of emotional, political, and actual capital that they should be spending on preparing for a Greek default.
Every euro they take out of taxpayer pockets now is one less available for financing a transition to default. Every bit of political strong-arming or payoff for votes now makes selling the steps needed for an orderly default that much harder. Every bit of trust and goodwill burned now is that much less available for a default solution.
I think a Greek default is coming. I can’t see a way around it. And frankly the global financial system would be better off if European political and financial leaders started getting ready for it, rather than pretending that there’s some way to engineer a solution to this crisis.
I think the financial markets may get enough of what they want from Europe in the next week to produce an end-of-the-year rally. But I don’t think they’ll get what we all need to put an end to this crisis.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of June, see the fund’s portfolio here.
