Why Europe Hasn’t Solved the Greek Debt Crisis


Thanks very much for the huge response to yesterday’s article on What the Greek Debt Crisis is Really About. There is more to report on that crisis today. And we never got to our two options for what happens next. Today’s Daily Reckoning will cover those options and two important but unanswered questions from yesterday.
But hey! Why all this caution and gloom when Europe has solved the Greek debt problem? Europe’s finance ministers finally agreed on a €130 billion deal to help Greece avert a default next month. The deal allows central banks to pass profits on their Greek bond holdings back to Greece to cover some of the needed funding. And of course, it permits Greece to default on over €100 billion worth of debt…without really defaulting.

The deal isn’t worth the paper it’s printed on. A leaked memo prepared for Europe’s finance ministers – BEFORE the deal passed – revealed that the austerity measures could make Greece’s debt-to-GDP blow out to 160% by 2020, instead of reducing it. This proves the point we made yesterday: the bailout is not about reducing Greek’s debt at all.

What’s worse, finance ministers were told that Greece would eventually need another bailout anyway, even after this rescue plan. Under the “tailored downside scenario” as reported by the Financial Times, Greece would need €245 billion in bailout funds to pay its debts and recapitalise its banking sector. Before the ink was even dry on the first agreement, larger amounts for a future bailout were already being discussed.

There’s no need to re-make the case we made yesterday. But yesterday’s essay raised two important questions without answering them. First, who are the private creditors being forced to take a loss on their bonds? Second, which financial institutions have the most to lose in the derivatives market if Greece defaults?

The first question is important because private creditors are still the ones who could bring the whole deal unstuck. It probably doesn’t make sense to you that a lender would voluntarily accept a 74% loss in net present on an investment in anything but the direst circumstances. So who are these lenders and why are they allowing themselves to be rolled?

The major creditors to Greece – the firms that stand to lose the most from a default – are represented by the Institute for International Finance (IIF). The IIF negotiated the debt swap deal, which includes the 74% write-down on behalf of its members. The important point is that those members still have to individually agree to the terms.

Who are the members? According to BusinessWeek

“The IIF’s steering committee that negotiated the swap included representatives from banks and insurers with the largest holdings of Greek government bonds, including National Bank of Greece SA, BNP Paribas, Commerzbank AG, Deutsche Bank, Intesa Sanpaolo SpA, ING Groep NV, Allianz SE and Axa.”

The IIF has a larger group called the “creditors committee” made up of 32 insurers and banks. These are the main banks and financial firms facing the write-down in the value of their Greek debt. So why are they willing?

The main answer is that they’ve already written that value down on their books. They’ve used the three months since the Long Term Refinancing Operation (LTRO) began to prepare for just this moment. They could’ve borrowed money from the European Central Bank (ECB) to replenish their capital levels after taking the Greek loss.

In other words, they don’t mind taking the loss now because they’ve been planning on it for three months with the ECB. And because many of the firms in the IIF are the same as the firms in the ISDA we mentioned yesterday, they are all keen to save each other’s skin.

It’s possible, of course, that one or two creditors to Greece simply refuse to go along with the deal as negotiated by the IIF. If you were an old-fashioned advocate for the rule of law and the rights of secured creditors, you’d object to the deal on principle. But principle and the rule of law don’t matter much in the financial world right now.

Besides, under the “collective action clauses” we mentioned yesterday, the Greek government can pass a law which, according to BW, “allow it to enforce losses on bondholders refusing to take up the offer. The government would need support from the owners of 50 percent of the bonds to force the rest to accept.”

Greek’s four largest banks are the government’s biggest creditors. If they throw their lot in with BNP Paribas, Deutsche Bank, and the other key members of the IIF, any smaller creditors wishing to object (like a hedge fund) will be forced to go along. The fix is in, in other words.

We know now that private creditors will mostly go along because they all belong to the same club. What’s more, that club has set up a bank, called the European Central Bank, which is happy to provide members of the club with as much money as they need to offset their losses from Greece and still remain solvent and liquid.

This brings us to the second question, who stands to lose the most from a Greek default? Well, a default would trigger a chain reaction in the derivatives market. Insurance policies purchased against default would be activated. The insurer who sold that policy would have to pay up.

As we said yesterday, the nominal amount of Greek debt shouldn’t be enough to take down the market. But in the derivatives market, it’s not the nominal amount of debt that matters. This can get complicated. Let’s try and keep it simple.

In the real world, you buy insurance from an insurance company. For example, you can buy insurance to cover your house from fire or flood damage. When you buy it, you buy one policy from one company and pay one premium. That’s not how it works in the financial derivatives market.

In the financial world, anyone can sell insurance on anything to anyone. You can sell more than one insurance policy – a credit default swap for example – on one asset, like a Greek government bond. This is how it comes to pass that the amount of derivatives far exceeds the value of the underlying assets in the financial system.

In the interests of sanity and clarity, we won’t write a lot more about what derivatives are and how they work. But you should know according to the Bank of International Settlements, the total notional value of the over-the-counter global derivatives market was $708 trillion in June of 2011, or 11.4 times the size of global GDP in 2010.

You can imagine the carnage. As assets linked to one another fall or collapse in price, the whole market unwinds. The profits of the banking system vanish. The financial system is revealed as a giant leveraged sham based on the expansion of debt.

Now the ISDA will tell you that the “notional value” of derivatives overstates the size of the market. Its year-end market analysis for 2010, the ISDA wrote that once you “net out” the market, it’s only about $21 trillion in size, or 3.5% of notional value. In other words, if all the parties who owed each other money cancel out their obligations, the real size of the obligations would be much smaller.

A simple way to think about this is that if you owed Fred $10 and Fred owed you $10, the notional value of your debts is $20. In reality you really owe each other nothing because your obligations are the same. If Fred owes you $13 and you owe Fred $10, then the net value of your mutual obligations is $3.

This is a grossly simplistic version of netting out. But the ISDA says that derivatives don’t really imperil the financial system because the “netting” value is a fraction of the “notional” value. We could all simply forgive each other’s debts and we’d be back where we started.

If that were the case, the members of the ISDA wouldn’t be worried about the credit default swaps related to Greek debt. But they are. And the members most worried are the five US banks that write 97% of all credit default swap contracts in the US.

Those banks – JP Morgan, Morgan Stanley, Goldman Sachs, Bank of America, and Citigroup – are all represented on the board of directors of the ISDA. Those banks have collected income by selling credit default insurance on European banks. Those banks stand to lose the most if Greece defaults.

It’s not that complicated at all, then, is it? Banks in Europe don’t want Greece to default because they own Greek debt. Banks in America don’t want Greece to default because it would trigger payments on the credit default swaps they’ve sold. The solvency of banks on both sides of the Atlantic depends on Europe’s most-indebted governments never defaulting on their bonds.

This puts the interest of the bankers and their central banks in direct opposition to the people responsible for paying off the accumulated debts of the Welfare State. The Greeks in Greece. The Spanish in Spain. The Italians in Italy. The Irish in Ireland. And the Americans in America.

To be sure, all these people got the government they deserve. And for the most part, none of them complained about the true nature of the financial system when credit expanded and drove house and stock prices up. But now that the butcher’s bill for the boom has arrived, we all realise whose ox is about to get gored. Yours.

Journey to the Stars

There are two options for what happens next. And since it is a beautiful, sunny day in St Kilda, and since we live in a universe based on light, let’s view these options in terms of light. One option is the natural evolution of our sun to a red giant and then a white dwarf. The other option is a supernova.

In the first option, the European Superstate expands to become a global superstate, or a new world order, financed by the bankers and run for the benefit of both. This relentless expansion creates a fascist Superstate, and is a little like the evolution of our sun.

Our sun, of course, is a star. And stars have life cycles. As our sun burns through its supply of hydrogen over the next five billion years or so, gravity will cause it to collapse on itself. But as it compacts, it will reach out one last time and unleash even more energy. It will become a Red Giant.

The debt-based global financial system could become a Red Giant in the next few years. Bailouts, quantitative easing, and the total suppression of real and sound money would allow for one final shining red global moment. And then?

A Red Giant eventually runs out of puff. But not before doing a lot of damage first. When our sun expands to a Red Giant it will destroy or make uninhabitable all the planets in the inner solar system, including our little blue planet Earth. But don’t cancel your season tickets to the footy just yet. This evolution in solar life is about five billion years away.

By the way, after the Red Giant comes the White Dwarf. The White Dwarf is the core of the original star. It’s all that’s left, and it doesn’t put out much heat or light. This is what the global economy will become if the expansion of debt and the State proceed along their current path.

The other option is that our whole financial system goes supernova. A supernova is a sudden, violent, and short-lived explosion of a star. It creates enough light to outshine an entire galaxy and can be seen in faraway places in the universe many years later. In the current context, a popular and violent revolt is the equivalent of a supernova.

Our knowledge of supernovae is limited. But we understand they occur at the end of a star’s life, when its gravity collapses on itself. If you view gravity as trust, then the collapse in the trust of the current financial system is just the sort of thing that could cause it to go supernova.

We like these explanations for several reasons. First, both are possibilities in the natural evolution of stars. But more importantly, if you view your financial future in stellar terms, it forces you to the realisation that there are just some things in the universe you can’t do anything about. No amount of worrying will change the result.

In this case, whether the financial system goes Red Giant or supernova is ultimately out of your control. In either case, you can see that a financial system based on debt and unsound money is doomed to a certain evolutionary fate: death. What you CAN control is how you prepare for that death.

Fortunately, avoiding the harmful effects of a financial system implosion is more practical than surviving a supernova or Red Giant, but only just. In the coming weeks and months, it will be our mission to help you survive your journey through the stars while enjoying the ride.


Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

Leave a Reply

5 Comments on "Why Europe Hasn’t Solved the Greek Debt Crisis"

Notify of

Sort by:   newest | oldest | most voted
4 years 8 months ago

Dan, are we all doomed?
Big brother is everywhere, watching, listening, waiting.
Perhaps I should take what little money I have and have one great big party – at least that would give some short term pleasure. Reading the Bill Bonner story on life in Argentina shows some remarkable similarities with what is happening in Australia and in America. Civil liberties are being eroded around the globe. The loss of privacy and the all watching authorities (cameras monitoring your every move) is taking its toll on our way of life.
What will be will be.

4 years 8 months ago
Before Greece defaults and gets booted out of the Eurozone there are Eastern European and Baltic outliers where the liabilities jumped the Eurozone into near surrounds creating asset inflation that could only later be the smoke collateral that would blow up the actuarially insane derivative bets and principal of the loans made based upon them. The following link is more about all those Swiss Franc and Euro mortgage loans and the demand for a Hungarian sovereign bailout of those lending banks whose currency swap and CDS cover will blow up both the EU private bankers and all those US banker… Read more »
4 years 8 months ago

If Australian financial journalists think that the RBA really has a defencible perspective on alternate forms of derivatives clearing then why not ask Stevens what that perspective is?

Trying to keep extend and pretend on the smoke collateral rolling underlining all the big mates omnidirectional bets for a few moments longer is about the only “perspective” he is bringing to the table


4 years 8 months ago

US$55 Billion owed to French Banks who account for nearly half of the outstanding (European) debt. That is the reason for the frantic EU efforts to shore up Greek finances.

Macro Analyst
Macro Analyst
4 years 8 months ago

Excellent article and in my opinion, the Greece crisis might only be solved after the exit of greece from the Euro in the foreseeable future. This scenario is very likely as civil unrest grows in Greece. Finally, they might choose to have a currency of their own and resort to any amount of money printing instead of being restricted by austerity measures. The scenario will be good (in medium-term) for both Greece and the Euro

Letters will be edited for clarity, punctuation, spelling and length. Abusive or off-topic comments will not be posted. We will not post all comments.
If you would prefer to email the editor, you can do so by sending an email to letters@dailyreckoning.com.au