Pella Chronicle


July 6, 2011

If Greece defaults on debt, many will get hurt

Pella — You have no doubt heard the concerns over Greece and whether the government might default on its debt. Their bonds have been downgraded to junk status by S&P and the interest rate on short term Greek bonds is over 20 percent.

When a country has to pay that much to borrow money, you know there is extreme worry that its debt will not be paid back.

In my opinion, it’s not a matter of “if” Greece will default, but “when.”

Many people think this is just a problem for Greece or the Eurozone and really doesn’t matter to the rest of us. But is that really the case? If so, savers all over the world, including U.S. retirees, would likely be impacted.

Greek banks are heavily exposed to their own sovereign debt and a default would require many of them to seek new capital to make up for the losses. This would likely trigger a run on the banks by Greek depositors. It is very likely that the Greek government would be forced to declare a “bank holiday” to prevent a run. Eventually, the most exposed Greek banks would have to be nationalized.

Europe’s banks are big holders of Greek debt -- $53 billion with France, Germany and the U.K. the most exposed. If bondholders were required to take a 40 percent ‘haircut’, i.e. reduction in what they will get paid, this would translate to losses of about $22 billion in U.S dollars.

Remember the term “Credit Default Swaps?” Most people had never heard of them before the AIG blow-up. A Credit Default Swap, or CDS, is basically a financial institution selling an insurance policy on a bond that would pay the holder the value of the bond if the issuer defaults. They are traded in private transactions and no one really knows for sure how many are out there, who the counter-parties are, and what kind of collateral exists to be sure the issuer can actually pay off if there is a default.

According to economist Kash Monsori, in looking at a detailed report from the Bank of International Settlements, U.S. banks have sold about $120 billion of credit default swaps to European banks. A default would trigger a “credit event” payout on these insurance contracts. Remember AIG? It was issuing CDSs on mortgage backed securities and were on the hook for far more than they could pay when it all blew up. Let’s think about that for a minute. When, not if, Greece defaults, U.S. banks are going to have to dip into capital to pay those commitments. Capital that should be available for loans to businesses but will have to be paid to European banks instead.

If doubts about the stability of financial institutions with direct and indirect exposure to Greece spread, it could lead to another global credit crunch. Banks may hesitate to extend credit to each other out of fear about exposures.

It’s not just Greece though. Ireland and Portugal are facing years of slow economic growth as their governments attempt to bring down debt levels and stabilize their banking systems.

The turmoil across Europe may shake the government in Germany. The German people strongly oppose bailouts of what they view as less responsible countries.

U.S. consumer confidence is already at record lows. A global credit crisis would likely convince U.S. consumers to reduce spending and increase savings. This could drag the already slowing American economy nearer to a recession.

Any way you look at it, this is not just a little problem in Greece. It affects all of us and you need to understand the implications of it for your investments.

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