Why a Greek Default is Only a Matter of Time

Yields on two-year Greek governments reach 46.84% last Friday. This is roughly comparable to yields on Argentine bonds in early December 2001 — only a month before the country defaulted on its debt.

Similar interest rates occurred this spring in Greece before the second bailout package was put together. The bailout saved Greece from defaulting back then, but the bailout is now falling apart while the fiscal situation in Greece continues to deteriorate. The risk of default in the near future has returned, but the will to stop it this time around is much weaker than in the past. 

Finland and a number of other countries have already demanded collateral from the Greek government for their contribution to the bailout and this reduces the money available that can be used by the Greek government to pay off its debts. Then talks between the Greek government and the ECB, EU, and IMF broke down last Friday (September 2nd) because Greece admitted it will not meet its deficit reduction and privatization targets for the year. This potentially puts the next $8 billion tranche in bailout payments in jeopardy. The talks are supposed to resume in 10 days. Even more challenges will have to be faced this coming week. 

Citizens of the fiscally solvent EU countries are getting tired of paying to support what they see as the profligate spending habits of the EU’s weaker economies. The bailout efforts have been lead by German Chancellor Angela Merkel, but support within her country has never been strong for them. Her ruling party has lost six regional elections this year, including one in her own home state this weekend. Any more pro-bailout efforts will only further weaken her politically. 

At the same time that efforts are taking place to undermine the second bailout, more and more money is needed by Greece. Like many other heavily-indebted countries in the past, Greece is dealing with a destructive feedback loop of inexorably escalating interest costs that cause its debt to continue to rise regardless of what efforts it makes to control it. The Greek government claimed a debt to GDP ratio of 120% in 2010 during the first bailout talks. It is now estimated to be as high as 160%. Interest payments on that debt could be as high as 24% of GDP at current rates (the 10-year bond is yielding over 18%). Despite the first bailout and now the second bailout, interest rates keep going higher, the national debt keeps getting bigger and the problem keeps getting worse.

Since someone elsewhere had to lend all the money that is in danger of not being paid back, Greek debt problems are not isolated to Greece, but are having a major impact on the big banks in France and Germany (the real reason Germany and France are so anxious to bail out Greece). The debt problem moreover is being spread through contagion to Spain and Italy, both of which are much larger economies and which are ultimately “too big to bail”. This is casting a wider net of impacted banks. By the last week of August, credit default swaps (insurance on bonds) were rising to crisis levels for the Royal Bank of Scotland, BNP Paribas, Deutsche Bank and Intesa Sanpaolo. The problem seems to be a shortage of liquidity, just as was the case in the fall of 2008. 

It has also been reported that many European financial institutions have losses on bond holdings, despite the ECB actively supporting Spanish and Italian bond prices. The global banking system has approximately $2 trillion in exposure to Greek, Irish, Portuguese, Spanish and Italian debt. On Monday, the yield premiums on Italian and Spanish 10-year government bonds over the equivalent German Bund hit their highest in a month. Italian bonds traded at 5.5%, well above the 5% rate at which the ECB has been buying recently. Italy has to roll over 62 billion euros in bonds by the end of the month.

Stocks have of course been negatively impacted by the problems in Greece and this will continue until there is some resolution. The German DAX had another mini-crash on Monday, falling 5.28% or 292 points. The drop in Paris was just under the 5% mark that defines a crash day. London held up somewhat better as it has during the entire crisis so far. U.S. markets were closed. 

At this point, the only thing that can prevent a default by Greece is if its entire debt is bailed out by the EU and IMF (this would require a third and even fourth bailout package). This is not going to happen. The second bailout itself is highly unlikely to go through as planned. Without it, Greece will default this fall. With it, a little more time will be bought before a third bailout is needed – and support for that measure doesn’t exist and isn’t likely to exist. The important question concerning Greek default seems not to be if, but when. 

Daryl Montgomery
Author, “Inflation Investing – A Guide for the 2010s”
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. There is no intention to endorse the purchase or sale of any security.