Greece: The Only Question Is Who Will Take The Hit

by: George Kesarios

The problem with European politicians is that they simply do not understand market mechanisms. And when you don't take care of things (like a banking or sovereign debt mess) with market procedures, then you get in trouble.

In the case of Greece, the correct thing to do was to restructure the total amount of Greek debt and write off anywhere from 50% to 60% in 2010, while it was still under Greek common law and then recapitalize the banking system, wiping out shareholders and senior bondholders. After several years, the Greek state would resell the banks to the market and recoup the funds it used for restructuring the banks and hopefully, if you did your math correctly, you might even make a small profit. In other words, more or less how the U.S. handled the S&L scandal of the 1980s.

But instead, Europe exchanged Greece's private sector debt with official sector debt, thinking that Greece would be able to pay this debt, if only Greece had a little more time. While everybody at the time knew the math did not work, and there were many voices of concern (among others myself), they nevertheless went along with this charade and everybody padded themselves on the back thinking that the problem was solved.

But the problem was not solved and today European governments face a situation where they know that Greece needs additional debt relief, but they don't know how to say this and explain it to their taxpayers.

But you cannot change the nature of mathematics. One plus one equals two and not 22. There is simply no way that Greece will be able to become solvent with such a pile of debt. The IMF has made it very clear that it will not participate in any additional loans unless they are convinced Greek debt is solved.

So the question is, of who will foot the remaining Greek bill?

  1. Additional private sector haircuts?

  2. European governments?

  3. Might the ECB relinquish its profits?

  4. Buy back a portion of Greek debt on the open market - if you can?

  5. Lower the interest rate on official sector debt?

  6. All of the above

My call is all of the above, because Greece needs at least another 100 billion euros of debt relief and a rescheduling of loans and a lower interest rate. If anything less than this happens, the problem will not be solved and everyone will be wondering want went wrong again.

I have no doubt Europe will deliver and do what has to be done to solve the problem in Greece. Kicking the can down the road one more time will have catastrophic reputations for Greece as well as Europe.

I am however worried about what will happen next, for other countries have similar problems, among them Ireland, where the banks have senior debt they cannot pay and the Irish government cannot afford to take on its balance sheet.

So while I have told you A Grexit Is Not Going To Happen, nevertheless, there are many questions still, as to how Europe will solve all its long term sovereign and banking debt problems.

Investment implications

The implications of not solving this problem are that the euro will keep weakening. Please recall that the main reason for a lower EURUSD is fear of default on part of international investors, and not that Europe has a balance of trade issue (also read: Why Printing Euros Will Make The EURUSD Rise).

Because the minimum bill is at least (bare minimum) 100 billion euros in debt relief, I think that the private sector will take another hit. But because the problem is not just Greece, I think we will see write-downs across the whole of Europe and not just on sovereign debt. A such, European banks are still on my sell list. Among others, Deutsche Bank (DB), Commerzbank (OTCPK:CRZBF), Credit Agricole (OTCPK:CRARY), Barclays (NYSE:BCS), BNP Paribas (OTC:BNOBF), UniCredito and Fortis. In other words, the whole European bank space.

If the problem in Greece is fixed, and a permanent formula is found, I think we will see a flight to risk assets and a big rise in the euro as well as all major indexes. Until a time comes that other European debt issues surface (among others France itself) and we go into risk aversion mode once again.

I see no major implications for the U.S., outside the fact that uncertainty will continue on a global scale and that will be a drag on cross border trade and investment. As far as the markets, risk aversion will continue to be the investment rule.

Bottom line

Greece needs at least another 100 billion in debt relief. If the Greek problem is not solved, the euro will weaken and the dollar will gain ground. If it is solved, the opposite will happen. But in either case, U.S. Indexes will probably be isolated from any loses. (also read: Is The Fiscal Cliff Already Priced In?)

European politicians made a mistake in 2010 and now they have to answer to their taxpayers. Bad time if you are a European politician, especially if you are a German politician running for election in several months.

European politicians have to answer to their markets and to their taxpayers. They have to explain why they have handled the Greek debt problem the way they did and, whether everything they have said from 2010, is either a lie, or, the product of gross incompetence. In either case, European politicians will lose and so will European banks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.