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Why Is The Greek Bailout Not Working?

Although Greek's debt problems did not appear overnight it is obvious that something has radically changed in the last 30 days. In a world used to thinking that policy makers can fix markets at will just by deploying their balance sheets it is disconcerting to see the lack of market reaction to the ongoing efforts by the IMF and the EU to avoid a Greek default. The question is why isn't anything working? Is it because the money won't come, because the Greeks won't deliver on the conditions, or are there other factors?

Although the Greek debt/deficit problems have been known for some time they did not seem to have any market impact until late last year. In fact, as late as October 2009, the Greek government didn't seem to have any trouble getting financing as Greek bond yields were around 2.3% for 2 years. During the first quarter of 2010, in the midst of shocking discoveries about off-balance sheet debt and accounting irregularities the yield on 2-year paper soared to 6.6%. By then, conversations about a European bailout began to appear on a daily basis in the financial press. After much dithering by the German government, European commitment to Greece was firmly declared and the IMF was enlisted in the rescue. The process should have climaxed last Sunday with the announcement of a gigantic package of more than 100 million euros which should be sufficient to keep Greece out of the public markets for, at least 18 months.

Under the Hank Paulson description of TARP ("If you have a bazooka in your pocket you won't need to use it") large amounts of public money commitments do their work without ever being deployed as private financing usually steps in to capture, in this case, the Greek spread for the German guarantee. After markets sold off yesterday, the consensus (if after the fact) opinion was that the markets either did not believe the monies will be forthcoming or that they process will fail over Greek intransigence. Although Ms. Merkel's speeches do not betray any conspiracy, the 48-hour Greek strike does give this theory some credence. In my opinion, however, there is something completely different and perhaps unavoidable at play.

Last Sunday, the NY Times published a useful diagram to show why Europe is so concerned about Greece ("Europe's Web of Debt"). In simple terms, the German and French banks have too much Greek debt much in the SAME way many banks own too much real estate and/or toxic assets (they still do, by the way).

Consider the case of a risk manager at a large German bank. You have been told, very recently, that owning so much Greek debt is bad banking and that you should have never accumulated so much. As luck will have it, you, your boss, and the regulator, agree that you will get a chance to get out either through bond maturities or by selling your risk as Germany will not allow Greece to go bankrupt. You are just waiting for the bonds to rally from the low 80's to something closer to par, where you have them marked as investments held to maturity often are, to cut your exposure.

Under the scenario above, every announcement meets the aggregate of all banks who have been natural buyers of Greek debt over the past n-years as better sellers and NOT as buyers as the bazooka deployers would want. In other words, the EU tried to bluff the market into financing Greece for a while longer and the market, unbeknown to its individual components, is calling the bluff.

Markets are about mass psychology. What policy makers fail to understand, is that the same participants who had no trouble accumulating Greek bonds at 150bps over German credit are unlikely to be enticed to resume financing at 14.5% over 2 years because they already own too much Greek debt. This, in my opinion, is why the Greek curve has stayed inverted in the face of positive announcements and why it is likely to stay that way. In other words, even if Germany would somehow agree to underwrite Greek risk no matter what for 3 years, which is very unlikely, the curve will stay inverted from 4 years forward (i.e. beyond the German guarantee) until all the excess Greek debt (that over what banks really think is too much) matures.

Like our sub prime borrowers, Greece borrowed too much over many years. The banks who bought this debt are now chocking on the risk and there aren't any new risk takers to take the balance. No amount of austerity from the Greeks will change the fact that 120% debt to GDP is now perceived as too high.  Debt binges usually work themselves out over time or through defaults and this time is...the same.

Disclosure: No positions