Let Greece Default

Includes: FXE
by: Shareholders Unite

End the misery of the Greeks; it's truly awful. They desperately need some kind of new start or at least a ray of light at the end of the tunnel. Even in simple monetary terms the current course isn't going anywhere.

We know Greece can never pay all that debt back, the scenario of the last 'rescue' package was that debt/GDP would fall to 120% of GDP by 2020 on 2% growth per year, on average, something they're highly unlikely to achieve as the economy is still contracting with awesome speed. Information has leaked out of the IMF that things are getting much worse.

Unemployment as surged to 18.8% (from 13.3% a year ago) and basically every social indicator one can think off is pointing red. Hospitals are facing shortages, homelessness, suicide, crime and HIV cases are up, Greece is facing a humanitarian crisis, not just a financial one. And it doesn't have the means to deal with it. People are even giving away their children.

There even seems to be some discord between the eurozone creditors and the IMF about how to handle it, with the IMF favoring a less drastic austerity approach. Here is The UK Telegraph:

Greece has been subjected to the greatest fiscal squeeze ever attempted in a modern industrial state, without any offsetting monetary stimulus or devaluation. The economy has so far collapsed by 14pc to 16pc since the peak – depending who you ask – and is spiralling downwards at a vertiginous pace.

Meanwhile, depositors are fleeing Greek banks and the latter are now completely dependent on the ECB. This is somewhat ironic, as contrary to many Northern European banks, Greek banks were relatively healthy and didn't over-leverage or binge on risky investments (bar Greek public debt).

A big part of the problem is that while Greece has effected many budget cuts and tax hikes, reality on the ground is rather different. A big problem is tax collection, for instance. There is an arrears of some 60 billion euro due to widespread tax evasion and endlessly drawn out court cases. Many tax collectors are not motivated as they, like all civil servants had to swallow 30% salary cuts and only one in 10 vacancies are filled.

And invariably, it's the common employee that bears the biggest brunt as the rich are leaving the country (or their money does) and the independent professions have many ways to disguise their income. Cardiologists earn 25.000 euros per year, according to tax records.

The 50 billion euro the Greek government is supposed to collect through privatization is a mirage. Nobody is going to invest in a country that might very well be on the verge of collapse and leaving the euro. Apart from that, labor laws are such that it's quite difficult to fire people so new owners would have a hard time reorganizing the privatized companies.

What the country would need is investments and structural reforms, only these can create a functioning economy in time. The slash and burn approach that has been taken so far has clearly passed its usefulness. In a way, it was useful as the steep salary cuts have gone some way toward the 'internal devaluation' that is needed to make the Greek economy competitive again if it stays within the euro.

The latter is the better option, as leaving the euro would trigger a bank run, create all sorts of problems with debt contracts (not only public debt, which will be rewritten into new drachmes, but more notably with private debt) and could trigger contagion. What would a Portuguese depositor in a Portuguese bank do when he reads headlines like that?

While Greek public debt gets all the headlines, exposure of the rest of the eurozone to Greek private debt is likely to be a multiple of its exposure to public debt, all made in a period in which cross-border risk seemed a thing of the past, at least in the eurozone. It will be a rude awakening.

And while we certainly hope that most banks have gotten rid of their Greek bond, are we really sure? Do we want to find out? There could yet be a complete freeze of bank lending as a result, although the ECB will stand ready to remedy this with unlimited funding.


Speaking about the ECB, one of the main contentions is whether it should take part in any debt write-off. So far, it has been vehemently opposed to that. The ECB holds some 40-55 billion euro (depending on the source) in Greek bonds, but if only things were limited to that.

Greek banks have put up Greek bonds (or their own bonds guaranteed by the Greek government) as collateral for loans from the ECB, since they can't get funding anywhere else and face rather steep depositor withdrawals.

Should the ECB take a hit on the Greek bonds, a considerable infusion of capital is necessary.

Other official creditors derive from participation in the first Greek bailout package (May 2010). This package was worth 110 billion euro, of which 73 billion has already been received by Greece, 20 billion from the IMF and 53 billion from other eurozone countries.

Private creditors (banks, insurance companies, investment funds, hedge funds and the like) hold some 205 billion euro of bonds. The private creditors should already have written off most of this, so the damage here is not likely to be great, apart for Greek banks and insurance companies, probably.

The talks about the 50% haircut of this 200 billion euro in private debt outstanding have been stalled. But an increasing part of this is now in the hands of so-called 'vulture' funds that have all kinds of funny incentives to hold out instead of settling. For instance, by holding out, they could trigger a default, which could be a bonanza for some holding credit default swaps (CDS).

Others bought Greek debt for 30 cents to the euro and are gambling the eurozone won't let Greece go bankrupt, in which case the interest on the debt is, well, quite substantial.

And they have means to be a complication. Not only does the group negotiating with Greece change its composition continuously (as Greek paper changes hands), if they accumulate more than 25% of a particular series of bonds they can prevent the contracts being re-written. There are all kinds of potentially very lucrative trades to be made:

“I’m holding March 2012 GGBs and shorting banks, because if Greece defaults messily, then banks will struggle. It’s really a bet on how long this takes – if the PSI is not in place before March then the bonds could be paid in full,” said one hedge fund trader.

What to do?

Let's simply take stock of what is known:

  • Greece leaving the euro creates a very risky situation; this is most likely not a good idea.
  • With Greek salaries already having been slashed, there is less need for a devaluation anyway.
  • It's quite clear that realistically, Greece will only ever be able to pay just a fraction of the outstanding public debt. So either a default has to take place, or official lenders have to take a (large) hit, or negotiations should start with the private sector to take an even larger than 50% haircut. But since these negotiations are already stalled at the moment for the 50% haircut, this isn't likely to lead to results either.
  • The current course of austerity is way past its usefulness; the Greek economy is spiraling downward as a result.

There isn't an easy solution. Pressure needs to be kept on Greece to reform its economy. Conditions can't be seen to be too generous, otherwise the Portuguese will want a similar easy way out. Both of these considerations mitigate against some form of complete debt write-off, which would also be very expensive for the eurozone taxpayer as the ECB would have to be recapitalized.

If the private sector has to take a much bigger hit there are two sorts of casualties. Greek banks and pension funds will have to be recapitalized, and the funds now buying up Greek debt will take a loss. Since many of the latter play a rather destructive role and are gambling on this not to happen, it might seam that no real damage would be incurred (indeed, some would argue it serves them right).

However, the next time something like this happens they might think twice of functioning as the buyers of last resort, and the market for Portuguese debt might simply disappear altogether should Portugal find itself in similar circumstances.

Taken together, these considerations lead to some public sector haircut and a much bigger private sector haircut. That is, a default with seniority applied to it. It's ugly, messy, certainly not without risk, but a default is probably what most market participants expect anyway. It is unavoidable anyway if the talks with private bond holders on the 50% haircut (which according to the IMF isn't even enough) don't succeed

An alternative would be to forcefully restructure all Greek public debt into very long maturities with low rates (which would immediately rise on the markets) on a take-it or leave-it basis. It's all ugly, very ugly, but we're way past any better solutions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.