Greeks Bearing Grifts

And if the threat of starvation and a southern land rush weren’t enough here on Disaster Wednesday, there’s always Greece:

…But conditions in European markets are deteriorating. The main risk from Greece has always been contagion, and that process is already under way.

Most directly, prices of Portuguese and Irish bonds have fallen sharply, with 10-year yields rising above 11% and the cost of insuring their debt at record levels. The gap between Spanish and German 10-year bond yields is at its widest since January. The market is effectively giving no credit for any reforms or budget policies set out in the past six months.

The next link in the chain, the banking system, has been affected. In Spain, progress by banks on regaining market access has gone into reverse: Average borrowing from the European Central Bank jumped to €53 billion ($76.32 billion) in May from €42 billion in April.

Meanwhile, the contagion into core banks may be being underestimated by investors. Moody’s on Tuesday said it could downgrade France’s BNP Paribas, Société Générale and Crédit Agricole due to their holdings of Greek debt, and the ratings firm is looking at whether other banks could face similar risks.

Disturbingly, the worries have now reached non-financial companies, which have been virtually bulletproof this year. Investment-grade bond issuance has come to a near-standstill.

I seem to remember having seen this movie before, as the prequel to to 2008’s Episode IV: A New Hope.  It may provide some cold comfort to Americans that this time, it’s taking place in Austrian, even if Germany’s pending LBO of the rest of Europe isn’t the Teutonic Shift the President had in mind a couple of weeks ago.

But there’s no particular reason to be complacent.  Just as we’ve managed to convert our economy from fast-falling to encased-in-amber stasis, we could be in for another financial shock.  Megan McArdle suggests one route: (I hate to quote a post in almost its entirety, but it’s short, and I don’t think I can say it better)

During the wave of banking regulation that followed the Great Depression, the government slapped heavy controls on the interest rates that banks could offer.  They weren’t very good, which made the banks sounder, and consumers worse off.  When inflation and interest rates rose in the late sixties, this became a big problem.  Then some clever chap came up with the money market fund.  Legally it worked like an investment fund, not a bank account: you invested in shares, with each share priced at a dollar.  The fund invested in the commercial paper market and committed to keep each share worth exactly one dollar; whatever investment return they got was paid out as interest on your shares.  This gave you something that looked a lot like a bank account, without all the legal tsuris.

In 2008, it turns out that these money market accounts were–as was always pretty obvious–a lot more like bank accounts than mutual fund shares.  The Reserve Primary fund held a lot of Lehmann Brothers commercial paper, which plunged close to zero, meaning that there were no longer enough assets in the fund to make all the shares worth at least a dollar.  This is known as “breaking the buck”, and it was not the first time it had happened.  But it was the first time in more than a decade that it had happened at a fund which didn’t have enough money to top up the assets in the fund to bring them back to a value of $1.  Bigger investment houses had been quietly topping up their money market funds for month, but Reserve Primary was a smaller firm, and they didn’t have the spare cash handy.
This triggered a run on the money markets, which the government really only stopped by a) passing TARP and b) guaranteeing money market funds.  But as Matt Yglesias points out, Dodd-Frank stripped Treasury of the authority to do such a thing again. And now the money markets are exposed to a Greek default.

Something like 45% of US Money Market funds have some direct exposure to Greek debt.  Greece defaults, and many of these funds may be breaking the buck without Big Ben backstopping for them.

But that’s only the direct exposure.  Then, there’s the indirect exposure, though insurance, and (probably) Credit Default Swaps:

Finally, it’s worth noting that once you account for the substantial payouts that US agents will have to make to European creditors in the case of a default by one of the PIGs, financial institutions in the US have roughly as much to lose from default as those in France and Germany. (See the figures in blue in the table above.) The apparent eagerness of US banks and insurance companies to sell default insurance to European creditors means that they will now have to substantially share in the pain inflicted by a PIG default.

The risk to US banks itself may be small, but the effects of having sold this insurance, and of people finding out that they sold this insurance, could be substantial:

The big US banks are well-capitalized now, and can fairly easily absorb losses of several billions of dollars in the event of a Greek default. But two serious concerns remain. First, I fear that this may have the potential consequence of exacerbating the flight to safety that will happen in the event of Greece’s default; if you have no idea who is really going to be on the hook and ultimately liable for CDS payments, your best strategy may be to trust no one. I don’t think that triggering post-traumatic flashbacks of the fall of 2008 is going to do good things to the market or the economy. Second, I wonder if there’s a public relations disaster just lying in wait for the big US banks. After all, how will you feel (assuming you don’t work on Wall Street) when you read the headline that Big Bank X lost money because it sold billions of dollars of credit default insurance while it was on taxpayer life-support? Rightly or wrongly, I’m guessing that Big Bank X will not be very popular for a while.

This also doesn’t address the US banks’ exposure to the European banks, the ones that may go under when Greece finally decides to call it quits.  They may have positive exposure to those banks, and find that holdings in them, or loans to them, are suddenly less liquid than they had hoped.

There’s one other issue that I haven’t see addressed anywhere, and that’s the question of securitized Greek debt.  Remember that we thought the subprime crisis could be “contained,” because subprime mortgages were such a small portion of the overall mortgage market, never mind the credit markets as a whole.  Then it turned out that the subprime assets were poisoning entire classes of securities, since they were so highly leveraged.  Is it possible – and this is purely speculation, I really do not know the answer to this – it is possible that people have done the same thing with sovereign debt, and that there are CDOs out there with Greek debt incorporated into them?  Securities that could suddenly default, even though they only contain a small mix of drachmas in there?

Carmen Reinhart and Ken Rogoff point out that after every financial crisis, governments find themselves with significantly higher debt, as they seek to stop the dominoes from falling.  The potential exists for European governments to become dominoes themselves, and if McArdle is right, there’s some risk (probably small, but hard to say how much) that won’t even be able to step in again and keep our own house in order.

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