“Greece is on the verge of defaulting on 490 billion euros ($540 billion) in loans, bond obligations, central-bank liquidity assistance, and interbank balances. Who will bear those losses? Greece’s creditors, which are all public entities across the euro zone, and that are on the hook for some €335 billion in loan guarantees…

…How will those losses be covered? The (Greek) government appears ready to renege on its debt obligations. So Greece’s creditors are going to lose money—a lot of money. Since these creditors are public entities, the losses will be borne, initially, by the public… So the ultimate loser in a Greek default would be the euro-zone sovereign-bond market, which is already vulnerable. Yields are near all-time lows, and durations are high. Even small fluctuations in yield mean a volatile response in prices. This explains why euro-zone governments are so engaged in talks with the Greeks. Higher bond yields mean higher borrowing costs. Higher borrowing costs and less investment will delay the euro zone’s recovery from its seven-year depression. Public money raised to cover these markers is cash that could have been used for productive public or private investment…The ultimate cost of Greece’s default is yet to be seen, but it is surely larger than it seems.”, Carl B. Weinberg, “How a Greek Default Could Hammer Bonds”, Barrons, July 4, 2015

Feature

How a Greek Default Could Hammer Bonds

Euro-zone governments will have to cover some $370 billion in losses if Greece rejects a bailout.

By Carl B. Weinberg

Greece is on the verge of defaulting on 490 billion euros ($540 billion) in loans, bond obligations, central-bank liquidity assistance, and interbank balances. Who will bear those losses? Greece’s creditors, which are all public entities across the euro zone, and that are on the hook for some €335 billion in loan guarantees. How will those losses be covered? Bonds will have to be sold that will roughly equal the increase in annual debt purchases by the European Central Bank announced last January.

As Greece debates a bailout, euro-zone governments gird for the long-term consequences. Photo: Louisa Gouliamaki/Getty Images

This is a hit to the European financial system nearly as big as Lehman Brothers’ balance sheet was in 2008.

There are precious few alternatives left for Greece or Prime Minister Alexis Tsipras. His government has walked out of talks with its creditors, and he has called a national referendum for July 5. Its choices are to accept “help” in the form of new loans to replace old loans (and accept austerity conditions), negotiate a debt restructuring with creditors, or default. The government has said it doesn’t want new loans—it wants debt relief. An International Monetary Fund report on Thursday said that without at least $36 billion in new money over the next three years, Greece can’t meet its obligations without debt reduction. The government appears ready to renege on its debt obligations.

So Greece’s creditors are going to lose money—a lot of money. Since these creditors are public entities, the losses will be borne, initially, by the public.

You can’t find public-sector exposure in the national accounts of lending governments because they are off-balance-sheet contingent liabilities that don’t exist until they are needed. But they add up to hundreds of billions of euros in guarantees for everything from the European Stability Mechanism, or ESM, to the ECB, to the interbank clearing system. Bonds will have to be sold to cover those markers. Issuance on this scale promises to be a blow for a market already vulnerable to a price correction.

TALKS BETWEEN THE GREEK government and its creditors have nothing to do with saving Greece or bailing it out. This crisis is about managing the resolution of bad Greek assets in a way that inconveniences creditor governments the least, forcing the least net new public borrowing, and minimizing financial system risks. The best way to do that is to avert a hard default, even if it means kicking the can down the road.

Consider the ESM, Greece’s biggest creditor. Under its previous name, the European Financial Stability Facility, it loaned Greece €145 billion. If Greece defaults, the ESM, a Luxembourg corporation owned by the 19 European Monetary Union governments, will have to declare loans to Greece as nonperforming within 120 days. Accounting rules and regulators insist that financial institutions write off nonperforming assets in full, charging losses against reserves and hitting capital.

Here’s the rub: The ESM has no loan-loss contingency reserves. Its only assets—other than loans to Greece—are loans to Ireland and Portugal. Its liabilities are triple A-rated bonds sold to the public. How do you get a triple-A rating on a bond backed entirely by loans to junk-rated sovereign borrowers? Well, the governments guarantee the bonds, and because they are unfunded off-balance-sheet liabilities, they aren’t counted in their debt burdens—unless borrowers default.

If Greece defaults hard, governments will be on the hook for €145 billion in guarantees on those loans to the ESM. We expect credit-rating agencies to insist that these unfunded guarantees be funded. After all, unfunded guarantees are worthless guarantees.

THE STRENGTH OF THESE guarantees is untested. Would the German Bundestag vote tomorrow to raise €35 billion by selling Bunds, the government debt, to cover Germany’s share of ESM losses on Greek bonds? That seems improbable. Bund sales of that scale, if they did occur, would flood the market, raising yields and depressing prices. If, instead, the Bundestag refused to cover its guarantees, then we would see a legal dust-up on a grand scale. With the presumption of valid guarantees, credit raters would have no choice but to downgrade ESM paper. Then losses would be borne by bondholders, and the ESM—the euro zone’s safety net and backstop—couldn’t raise money in the capital markets.

A hard default would produce other losses to be covered. The ECB would have to be recapitalized after it writes off the €89 billion it has loaned the Greek banks to keep them liquid. The ECB would need to call for a capital contribution from its shareholders—the governments.

And don’t forget that Greek banks owe the Target2 bank clearinghouse, a key link in the interbank payment system, an estimated €100 billion. The governments are on the hook to make good that shortfall, too. The cash required to cover these contingencies would have to be funded with new bond sales.

So the ultimate loser in a Greek default would be the euro-zone sovereign-bond market, which is already vulnerable. Yields are near all-time lows, and durations are high. Even small fluctuations in yield mean a volatile response in prices.

This explains why euro-zone governments are so engaged in talks with the Greeks. Higher bond yields mean higher borrowing costs. Higher borrowing costs and less investment will delay the euro zone’s recovery from its seven-year depression. Public money raised to cover these markers is cash that could have been used for productive public or private investment.

What if a downgrade of ESM paper causes a hedge fund to fail, which triggers the demise of the bank that handles its trades? The costs of fixing failed institutions will also, of course, fall on governments. The ultimate cost of Greece’s default is yet to be seen, but it is surely larger than it seems.

CARL B. WEINBERG is founder and chief economist of High-Frequency Economics in Valhalla, N.Y.

Posted on July 7, 2015, in Postings. Bookmark the permalink. Leave a comment.

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