In the last week, we have heard increased talk by senior Eurozone leaders that bank recapitalization is on the front burner. The bailout of Dexia (OTC:DXBGF) by the French and Belgian governments just highlighted the issue.
Although the ECB didn’t lower interest rates at its recent policy meeting, it is clear that the ECB will provide enhanced liquidity to the monetary bloc’s banks by extending the maturity of credits to 12 or 13 months. That makes it easier for banks to get through potentially difficult reporting periods. This is a positive in that the likelihood of an across-the-board European banking system collapse, which would have made Lehman’s demise look like a hiccup, is less likely to occur.
Greek Default Increasingly Likely
One implication of these statements is ironically that a Greek default now becomes increasingly likely. If Eurozone governments were sure they could avert a Greek default, there would be little need for bank recapitalization. Short-term mark-to-market problems could easily be handled with accounting forbearance and a little patience. However, that does not appear to be the case, at least in the minds of a growing number of leaders.
As usual, Greek Government announcements about the state of public finances continue to be bogus, but this time, oddly enough, in a positive direction. It turns out that the Government now claims to have enough money to get through until November, instead of running out of money in October as investors and governments were repeatedly told. Mendacity or incompetence remains rampant in Greek Government circles.
Knock-On Effects of a Greek Default
Given that everything is gradually being put in place for a Greek default, what are the implications of such a default? Well, we now know that bank defaults will likely be avoided, at least for banks in countries with the resources to finance a bailout. Basically this means that most non-Greek banks should avoid default. However, avoiding default does not mean avoiding failure. When a bank fails or more likely, a government intervenes to avert an unambiguous failure, shareholder capital is at great risk.
The Berger or Eureka Plan
I keep getting asked if Eurozone governments can avert a Greek default. The answer is, no, but with an important caveat. Greece cannot meet its payments on time, and according to the terms of the recent bailout package already in place. At a minimum, the package is thus likely to be revised. Nonetheless, unless there is a significant decrease in the Greek Government’s outstanding debt, there is no way that Greece can keep up payments on an on-going basis. The one exception is if the proposed Berger Plan, dubbed by some the Eureka Plan, is successfully implemented. Basically the Berger Plan aims to sell large chunks of Greek Government assets. Although this is theoretically doable, the likelihood that it would succeed appears slim. First, the Government and the Greek people would have to be willing to undertake such a sell-off. Second, foreign investors would have to be willing to purchase these assets. The problem is that Greek civil society will likely make operation of profitmaking ventures resulting from such asset sales highly problematic. It would take investors with extreme risk tolerance. As a result, the sale price of such assets would likely be poor.
A Bigger Bondholder Haircut is Likely
Given that some form of default, going beyond the already programed default resulting from the forced exchange required by the last bailout, is almost a given, the only question still remains, what will the nature of the default be? Since Eurozone leaders are still trying to avoid an unambiguous default, the most likely scenario is for a bigger haircut on bonds held by the private sector, going beyond the 21% loss programmed in the existing package. However, even if the default is structured to avoid triggering CDS contracts, it would still imply much higher write-downs of debt held by financial institutions holding Greek Government bonds. This means that bank capital across the Eurozone will be stretched thin. Thus, even under the best of circumstances, bank recapitalization will be increasingly likely.
Sovereign Ratings at Risk
The problem such recapitalizations pose is that adding more debt, or contingent claims on Eurozone governments, puts many Eurozone government bond ratings under downward pressure. Such downward pressure explains the reluctance, particularly by the French, to admit that a full-sale recapitalization is even required.
France’s AAA Rating at Greatest Risk With Germany Not Far Behind
A Greek default even using a forced exchange approach will raise the need for bank recapitalizations either through government capital injections or government guarantees. Such recapitalizations, or even the recognized need for them, are sufficient to put pressure on France’s AAA rating.
The most likely outcome is for the French rating to be put on negative outlook or review for downgrade by one or more of the leading rating agencies within the next 6-12 months.
An already high debt burden, a political opposition that is even more pro-European (implying even more support for bailouts) and also increasingly likely to win the next Presidential election, and the growing need for French bank recapitalizations all together imply a debt trajectory for France which will no longer be consistent with a AAA rating.
I should add that if Greece is bailed out once again, knowing that it failed to satisfy even its most recent rescue package requirements, and if the Greek problem is pushed into 2012, then other Eurozone governments on the periphery will be under increasing pressure. This will mean that future bailouts will be likely, and more importantly, such bailouts will be larger. This implies potentially larger bank recapitalizations in the future. Such a development would put even Germany’s AAA rating under pressure. After all, even Germany can’t bail out Italy and Spain. Even attempting to do so would imply significant risks to Germany’s creditworthiness.
In conclusion, Greece will default, with only the details and timing in question. The biggest unknown is whether the default triggers CDS payments. Eurozone bank recapitalizations are needed. Similarly, only the timing and precise nature of the recapitalizations are debatable. Bank shareholders are at risk, as well as investors in securities at the bottom end of the capital structure. France’s AAA is at risk. Depending on how the Greek bailout/default plays out in terms of contagion, even Germany’s AAA rating is potentially at risk.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.