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November 6, 2011

Editorial: What Happens if Greece Defaults?

There's been a good deal of discussion done regarding the Greek debt crisis over the past two years. One thing is clear, this country did not get into the fiscal nightmare it is in now by not taxing its citizens enough. The life of entitlement, spending 2/3rds of your life not working, and having everything paid for you is coming to roost in Greece.

With the government teetering and a bailout offer on the table, we need to examine what scenarios could unfold if Greece defaults. Greece currently has around $350 billion in debt. There are two major parties I want to concern my scenario with; those with credit default swaps and those without.

1) Investors without credit default swaps

Investors that do not have credit default swaps will have to write down their balance sheets up to 100% of the bond's value. This could lead to tens of billions of dollars in simultaneous write-downs from banks throughout Europe and the world. This will certainly put stress on available capital in the banking system and the availability of credit to consumers. Banks will likely fail as a result of unprotected defaults.

2) Investors with credit default swaps

Investors with credit default swaps will need to write their portfolio down to the value of the insurance claim. Then, they will need to file their claim to recover whatever portion of the investment they insured. While this may seem safer on the banking system, it actually will put pressure on institutions that sold those credit default swaps. This is exactly the scenario that landed AIG in the middle of a massive bailout in 2008. This could cause insurance companies to fail.

3) Broader implications

Outside of the direct investment market, the failure of Greece will lead to investors needing cash, no matter which way things slice. The first thing that investors will turn towards are the bonds in risky countries such as Italy, Ireland, Portugal, and Spain. This will drive interest rates in those countries skyward and almost certainly lead to failure.

Common Sense Capitalism believes that if a second country (among the four mentioned above) also defaults, all countries in that group will default as well. Italy, a top ten economy in the world, is too big to save. If these countries fail, the above scenario would exacerbate five to ten fold and the entire global economy could fall into a depression.

Possible Solution

I believe that the ECB should buy all Greek debt at 50% of its value and lock out the Greek government from creating any additional debt for an undetermined time. The ECB should set a fixed interest of between 6% and 8% for the Greeks to pay. Any default on payments from the Greeks to the ECB should be handled by the ECB.

From the write-down to $175 billion, the ECB needs to partition the debt into 10 or 20 packets of $9 to $18 billion each and sell these to private institutions over a period of years. Essentially the debt is to be placed on a public balance sheet and then privatized.

The solution stinks, but it avoids the possibility of a domino default (at least a default starting in Greece) and balances the Greek budget. One thing is for certain- austerity is coming to Greece whether the people there like it or not.

We in the United States ought to look at the writing on the wall and learn a lesson from Greece.

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