Greece is a mess. Since the first crisis over their fiscal situation began 18 months ago, Greece has hobbled along, trying to avoid a default. Last year, in May 2010, Greece accepted a 110BB Euro bailout package to refinance existing maturities of bonds, as well as to fund its yawning deficits. The bailout required austerity measures on the Greeks however, including huge spending cuts. Government wages were cut 15%, pensions curtailed and public services reduced. The economic hit has been meaningful, with GDP down 3-5% likely in 2011. And, only one year later, Greece again is on the brink of default. I wonder when people will realize that you cannot solve a debt crisis with more debt.
Greece joined the Euro currency in 2000. This enabled Greeks (the government as well as businesses) to borrow at extremely low interest rates. The following decade was marked by a huge credit binge, one that took GDP from roughly 100BB Euros, to a peak of 230BB Euros in 2008. When the liquidity crisis hit in 2008, Greece's economy got hurt badly, while at the same time its debt problems began to come to the fore.
While Greece reported sub 3% deficits for years, and total debt less than 60% of GDP, as required by the Maastrict Treaty (to be a member of the Euro), the reality was far worse. Thanks to unreported government expenditures in military spending, as well as in healthcare spending, real annual deficits were well north of 5% of GDP. And, in 2009, the Greek's number fudging was revealed, causing concerns about it's debt levels, and sparking the first sell off in Greek bonds. As a side note, Goldman Sachs had been designing currency swaps that enabled Greece to avoid reporting a cool $1BB of Greek public debt. At the same time, they began buying credit default swaps on Greece. That is, shorting their debt. Nice. I am amazed the regulators had nothing to say about that.
By 2009, Greek deficits spiked to an unwieldy 13% of GDP, far far north of the 3% required by Euroland. And, Greek government debt had accumulated to a hefty 300+BB Euros, which amounted to 127% of GDP. Typically, the tipping point is around 140-150% of Debt to GDP. Greece was basically on the verge of insolvency. At this level of debt, interest rates tend to skyrocket as investors demand far larger returns to invest in riskier bonds. And they have. Today we are seeing extremely high rates on Greek debt. The 2 year Greek note yields 29%. And Greek 10 year notes are around 18%. According to the WSJ, the CDS market implies a 75% chance of default on Greek debt. Personally, I think its higher.
What the Europeans, and the rest of the world, fear is contagion. This is why this mess is rattling markets everywhere. I know, how can an economy the size of Mississippi (no offense Mississippians), scare investors from Asia to the US? Well, the problem is that 150BB Euros of Greek debt is held internationally, mostly by big banks in Europe. French banks alone hold 57BB Euros of this debt, German banks 34BB Euros. What if you are a counterparty to, say, Credit Agricole in France?
Specifically, Credit Agricole has 71BB Euros of Tier 1 equity capital, against 1.6 TRILLION of assets. That is, its 21x levered - or $21 bucks of debt for every $1 in equity! Ridiculously high. Further, they own 22BB euros of Greek debt. If that debt becomes worth 50c on the dollar, then that's a 15% hit to their equity, 11BB euros. So if Greece defaults, then Credit Agricole would likely have to raise outside capital, which would dilute their equity further. Stock sells off. In fact, Moody's downgraded 3 French banks this week, citing Greek loan exposure on their balance sheets.
It gets worse. Credit Ag also has 1.5 Trillion of debt in the form of depositors, bonds, and loans from other banks. What happens when these 1.5 Trillion of lenders/depositors get scared as the stock craters? They obviously rush to withdraw their money as fast as possible. A meaningful % of their 500BB euros of depositors, 150BB euros of overnight/interbank loans could get called. That 60-70BB of capital would get eaten up very very quickly. Literally overnight. It's exactly what happened to Lehman Brothers in September 2008.
Admittedly this is a bit dramatic, but the contagion could spread because US investors in money market accounts have huge exposure to European banks. According to Fitch, 44% of assets at the ten biggest money market funds are invested in overnight loans to European banks. You likely have unknowingly lent money to Credit Agricole (or BNP Paribas or SocGen). And if it goes down, then your seemingly "riskless" money market account takes a hit. If US investors start pulling money out of their money market accounts, then the run on the entire financial system would begin again, just as it did in the Fall of 2008.
The worst off is obviously Greece itself. Or rather, their banks which hold 200BB euros of their own debt. Greek citizens are depositors at big Greek financial institutions too, and a default could jeopardize the entire Greek financial system. I merely point this out, not to frighten anyone, but to point out that the world's financial system is built on too much leverage. The holders of debt of an overlevered economy (Greece), are overlevered banks in Europe & Greece. And investors in European banks are money market investors all over the world. That is you and me. (well not me actually, just you.)
Part of the solution to the problem seems to be to get the solvent countries to provide enough in loans to keep Greece from defaulting. It's perhaps the only way to avoid another panic, this time starting in Europe and spreading worldwide. But a loan package to get them through 2011, will just have to be upped again in 2012 and 2013, etc. It can't go on forever, eventually Greece has to restructure.
THE GOOD NEWS
To sum up: you have 150BB Euros of Greek public debt owned in Euroland, that is worth 25-50c on the dollar. Net net that is a 100BB Euros of losses that have to be borne among European banks. Sure Greece itself gets smoked, but to some extent, they dug their own debt hole. They can dig themselves out of it. So, really, 100BB Euro's of losses is quite manageable given time to reserve for it, to announce some capital raises among banks to offset losses, and to create an orderly restructuring of Greek debt. I mean, the US housing bubble caused 1.2 TRILLION in bank losses. So why all the fuss over $140BB (USD) of Greek losses. Greece alone is very fixable.
THE (REALLY) BAD NEWS
The bigger contagion problem extends beyond Greece. If you let Greece default, then likely you kick them out of the Euro currency. Ok. But what about the other PIIGS? Portugal, Italy, Ireland, and Spain? And Belgium is also under mountains of debt, 330BB Euros about the same as Greece. While Greece carried "only" 120% Debt to GDP 3 years ago when the problem first came to light, now its around 152%. The PIGS (and Belgium) today are at:
Country Public Debt (Euros) Debt/GDP
Belgium 330MM 100%
Portugal 200MM 83%
Ireland 100MM 100%
Italy 1900MM 120%
Greece 330MM 142%
Spain 650MM 70%
This is very scary. 3.5TT Euros of debt. If these bonds end up restructuring, the Euro then completely unravels. Recoveries on this debt would be 25-50% best case. That is at least a 1.7TT Euro hit to banks and holders of this debt worldwide. That is $2.4 TRILLION dollars of potential losses, at least. This is much bigger than the housing losses in the US, which almost brought down the entire system.
Of course a big part of the explanation was that housing losses were shifted from the private sector to the public's balance sheet. This debt has not gone away. We avoided a total meltdown by having US and European governments bail the banks out. What happens when the governments of Europe and the US need bailing out? As I pointed out from the Credit Agricole examples, banks holding this debt will potentially face a Lehman style outcome.
Greece is perhaps the canary in the coal mine. It's going to avoid a restructuring this year it seems, but what happens in 2-4 years, when not only Greece, but all of the PIIGS have a debt crisis?
POLITICS OF GREEK BAILOUT #2
The EU authorities apparently are close to putting together a second Greek bailout. The IMF has pledged money today, Germany is backing down on its tough "reprofiling" talks. (They wanted to extend maturities out by 7 years). While Greece has 30BB euros of maturities in 2011, and another 30BB in 2012, the European leaders have no other choice it seems but to try to keep it together.
The prospect of more government cuts is causing more rioting in Greece right now however. The headlines look identical to a year ago with tear gas being fired upon demonstrators in Athens. Since unemployment has spiked to 16%, more cuts just accelerates their death spiral economically speaking. This causes GDP to fall more, and Greece's Debt/GDP ratio to worsen.
WHAT SHOULD BE DONE
Greece should drop out of the Euro voluntarily. Restructure their bonds in a pre-arranged fashion. Offer a deal to give holders say 25c on the dollar. I still have not quite understood the Greek's rationale behind staying in the Euro. To stay in requires years of austerity, government budget cutting, and raising taxes. It can only result in a decade long depression, just to keep a common currency with your neighbors. Using the Euro does keep Greek inflation in check, but with a strong currency, Greece's economy will struggle to grow exports and compete with more productive, efficient countries (like Germany).
If Greece reduces debt by 75%, and goes back to using Drachma's instead of Euros, then the value of that Drachma will be awful. Horribly awful in fact, especially against any G7 currency. The cost of imports into Greece (think oil) will skyrocket, causing inflationary problems. But the benefits of inflation and restructuring are that it will fix their current account deficit problem, as well as their fiscal budgetary problems. The pain will be severe for 1-2 years, but then the bad debts are wiped away, Greece has a devalued currency, helping exports, which in turn helps the unemployment problem. To me, a decade of deflation and depression to maintain a currency whose benefits mostly go to Germany makes zero sense.
Risk aversion will be paramount for the time when Greece actually does default. I think its out there, but I cannot even guess if it will be next year or 2014. Euro puts are potentially a decent trade, but you have to get the timing right. 135 strike Sept Puts on FXE cost 7.50. So you need a 127.50 Euro price to break even by September, with current exchange rates around 142. Seems expensive to me.
Clearly financials holding PIIGS sovereign debt will also suffer in Europe, as banks there are like banks here loaded with crummy mortgages. Hard to find places to hide, but I still like gold, big cap defensive names, shorter duration corporate bonds and cash. Good luck.