Economics: The Greek Debt Fallout

The euro zone's ongoing crisis talks have raised the specter of 60% haircuts for the Greek government's creditors. Not surprisingly, the cost of insuring Greek debt against default keeps hitting fresh highs. As of Tuesday [October 25th] afternoon, Greek credit default swap (CDS) protection stood at 5969.36 basis points, meaning that it would cost €5.97 million to insure €10 million of Greek debt for the next five years.

Because so much bank debt is bought together with insurance, many of the counterparties to Europe's Greek debt burden are American institutions. If Greece or any of Europe's other troubled sovereigns were to default on their debt obligations, the American financial sector would take a palpable hit.

According to the Bank for International Settlements, U.S. creditors own just 5% of direct exposure to Greek debt. But they are also indirectly exposed to at least 43% of such debt through CDSs, which total upwards of €25 billion. This equals about half of the European Central Bank's direct Greek exposure of €52 billion.

Meanwhile France's BNP Paribas, Groupe BPCE and Societe Generale, along with Belgium's Dexia, Germany's Commerzbank and Deutsche Bank and Dutch ING Groep, together hold more than more than €130 billion in Greek, Portuguese and Italian debt. The most exposed is France's BNP Paribas, with more than €37 billion in the troubled European countries' debt. The most exposed German institution, Commerzbank, holds more than €15 billion. More worrying still, markets have woken up to the interconnectedness of Europe's banking and sovereign-debt woes just as Europe's 90 largest banks (which this summer completed the EU's so-called stress tests) queue to roll over a total of €5.4 trillion of debt in the next two years alone.

A large write-down of Greek sovereign debt would cripple the country's banks unless they are refinanced instantly by the ECB or the European Financial Stability Facility. Along with their sovereign exposures, French banks hold up to 20% of Greek bank debt, or about €25 billion in a conservative estimate. German banks' exposure to Greek banking debt is just as high, with the state-owned Hypo Real Estate's holdings alone accounting for €8 billion, according to Barclays Capital.

As for the ECB, it would not only suffer heavy losses on its own holdings of Greek bonds in the event of a default. Having received those bonds as collateral from European banks with liquidity constraints, it might also have to call the loans and return the bonds to those banks, or ask them to make up the lost value of the collateral with cash. The banks would then need to find almost €330 billion in cash to pay back the ECB or compensate it for the losses brought about by the collateral default. The ECB might even invite questions as to its own solvency, though which European government would be ready and willing to recapitalize it is an open question.

Loud and persistent voices have recently called for the creation of a European TARP. Simply put, the idea is that European banks on the verge of collapse would be buying bonds from a special government-funded vehicle that is itself stocked full of bonds issued by some of those same insolvent European governments. The banks will then use these bonds as collateral to borrow money from the ECB, which is underwritten by European governments. The ECB would end up holding the loans to undercapitalized and almost insolvent banks, as well as bonds backed by debt issued by insolvent countries as collateral. Is it any wonder the ECB has resisted Greek haircuts for so long?

It's become fashionable to compare Greece and the CDS-swamped euro crisis to the Lehman Brothers meltdown. Given the true scale of the problem though, it's hard not to worry that Europe's crash, and the ripple effects around the globe, could be even worse.

For more, see The Greek Debt Fallout by Athanasios T. Ladopoulos, October 26, 2011 at WSJ.com.