While everyone was busy ruminating on how little impact a Greek default would have on the global economy, the IIF - the syndicate of banks dedicated to the perpetuation of the status quo - was busy doing precisely the opposite. In a Confidential Staff Note that was making the rounds in the past 2 weeks titled "Implications of a Disorderly Greek Default and Euro Exit" the IIF was doing its best Hank Paulson imitation in an attempt to scare the Bejeezus out of potential hold outs everywhere, by "quantifying" the impact form a Greek failure. The end result: "It is difficult to add all these contingent liabilities up with any degree of precision, although it is hard to see how they would not exceed €1 trillion." In other words, hold out at your own peril. Of course, what the IIF does not understand, is that for hedge funds it is precisely this kind of systemic nuisance value that makes holding out that much more valuable, as they understand all too well that they have all the cards on the table. And while a Greek default could be delayed even if full PSI was not attained by Thursday, it would simply make paying off the holdouts the cheapest cost strategy for the IIF, for Europe and for the world's banks. Unless of course, the IIF is bluffing, in which case the memorandum is not worth its weight in 2020 US Treasurys.
Some highlights from the report:
First, "quantifying" the fallout from a disorderly default, based on the one thing that everyone always forgets (as was the case in Bank of America)- contingent liabilities:
- Direct losses on Greek debt holdings (€73 billion) that would probably result from a generalized default on Greek debt (owed to both private and public sector creditors);
- Sizeable potential losses by the ECB: we estimate that ECB exposure to Greece (€177 billion) is over 200% of the ECB’s capital base;
- The likely need to provide substantial additional support to both Portugal and Ireland (government and well as banks) to convince market participants that these countries were indeed fully insulated from Greece (possibly a combined €380 billion over a 5 year horizon);
- The likely need to provide substantial support to Spain and Italy to stem contagion there (possibly another €350 billion of combined support from the EFSF/ESM and IMF);
- The ECB would be directly damaged by a Greek default, but would come under pressure to significantly expand its SMP (currently €219 billion) to support sovereign debt markets;
- There would be sizeable bank recapitalization costs, which could easily be €160 billion. Private investors would be very leery to provide additional equity, thus leaving governments with the choice of either funding the equity themselves, or seeing banks achieve improved ratios through even sharper deleveraging;
- There would be lost tax revenues from weaker Euro Area growth and higher interest payments from higher debt levels implied in providing additional lending;
- There would be lower tax revenues resulting from lower global growth. The global growth implications of a disorderly default are, ex ante, hard to quantify.
- Lehman Brothers was far smaller than Greece and its demise was supposedly well anticipated. It is very hard to be confident about how producers and consumers in the Euro Area and beyond will respond when such an extreme event as a disorderly sovereign default occurs.
A disorderly default, which would happen if hedge funds refuse to comply with the coercive exchange offer, means game over for Greece:
Given these financial traumas, it is difficult to conceive that Greece can remain a functioning member of the Euro Area in the event of a disorderly default. The Greek authorities would have little option but to regain monetary policy independence by exiting from the Euro Area and introducing a new national currency.
The practical difficulties, costs (both for the government and the private businesses in terms of switching to a new payments system) and implications of such a rushed decision would be substantial. Practical difficulties in day-to-day transactions would be serious as there would be no easy way to separate the Euro notes circulating in Greece from those circulating in other Euro Area countries, with a potential for further capital flight. There would also be major difficulties/challenges in sorting out the appropriate re-denomination and valuation of existing financial assets and liabilities in current private and public sector balance sheets, in different jurisdictions.
In the circumstances, the Greek authorities would be forced to resort to borrowing from the Bank of Greece to cover budget spending, recapitalize the Greek commercial banks (which would be de facto nationalized) and put in place minimum facilities for the provision of credit to the private sector. The risk of embarking on a vicious circle of inflation and devaluation would be significant. Draconian capital controls would almost certainly be re-introduced.
The issue of whether Greece can remain in the European Union after defaulting and leaving the Euro Area is not clear-cut. The likely imposition of capital controls and possible inability to honor other EU laws and directives would raise important questions.
The Lisbon Treaty, in force since 2009, introduced an EU exit clause, but does not provide for an exit from the Euro Area. The European Commission has confirmed that there was no provision under EU treaties to exit the Euro without also leaving the EU. In any event, leaving the EA/EU would mean negotiating Treaty changes––essentially negotiating Greece’s disengagement from a vast web of privileges and obligations with all other Treaty members who will have to agree with the changes. This will be a lengthy and messy process, during which financial markets will be driven by panic capital flights spreading contagion to the rest of Europe and the global economy.
Of course, Greece would not be dragged into the abyss alone:
Investors experiencing a traumatic loss in value on their Greek holdings are far more likely to be conservative in their assessment about whether such this might occur in the case of other countries.
Problems in Greece spread to Ireland and Portugal in 2010-11, leading the European authorities to assemble large programs to take all three countries out of the market through 2012. The obvious focus will be on whether a second round of contagion might spread.
One issue that should be emphasized is that in the circumstances of a disorderly default, the problem of contagion results not so much from the breakdown in trust that creditors have about debtors, so much as the breakdown in trust that creditors have about each other.
Greece has delivered on many fronts, but has failed on others; other peripheral countries started with fewer problems and have delivered more on a broader array of fronts, including those of key structural adjustments. These efforts are liable to overwhelmed, however, in an environment where investors become once more focused not so much on the return on their investment, as the return of their investment.
Despite bold efforts by the government, contagion would likely be most acute in the case of Portugal, which lost financial market access in early 2011, is already rated well below investment grade by the major agencies, and whose debt currently trades at distressed yield levels. It might then quickly spread to Ireland, Italy and Spain (the latter two continue to roll over their debt in financial markets, but have seen their yields remain elevated despite some decline). Italian and Spanish banks have become far more dependent on ECB funding in recent months.
Portugal would be next:
The adverse shock for Portugal, which has to implement a particularly ambitious fiscal adjustment this year against the backdrop of a much weaker growth outlook, will be particularly strong. Indeed, the recent sharp increase in government bond spreads suggests that markets are already concerned about possible fallout from Greece. A disorderly Greek default is likely to prevent Portuguese borrowers form returning to capital markets any time soon. If, by way of illustration, it is assumed that Portugal is unable to access markets through 2016, then official lenders would be required to:
- Provide €16 billion annually in financing to the government from 2013 through 2016, or €65 billion in total;
- Help assure that €77 billion of term funding is available through 2016, or about €15 billion a year from 2012 through 2016, together with the refinancing for some €86 billion in short-term credit to fulfill the obligations of Portuguese banks and corporates to foreign lenders;
- Help assure financing sufficient to manage some €330 billion in debt owed by Portuguese corporates and households to domestic banks, 7 percent of which are nonperforming, and some €220 billion owed by Portuguese banks and corporates to foreign lenders. (Relative to GDP, these exposures amount to 194 percent and 129 percent, respectively.)
Next would be Ireland, Spain, Italy and so on (full details inside the memo). But the biggest risk as all know, is the ECB, the European Banking System, and finally the Fed itself.
Prominent among the broader implications of a disorderly Greek default and Euro Area exit would be the additional capital requirements that markets and supervisors could be expected to place on European banks as a result of both actual and potential losses resulting from the asset prices declines and credit losses that would follow from a disorderly default.
Rough calculations assuming the need to offset increases in yields of 300 basis points on Spanish and Italian debt would indicate a need for an additional €100-€110 billion of capital for the larger banks covered by EBA stress tests. Factoring in the effects of further/renewed declines in Portuguese and Irish bond prices (to 20 percent of par) would add another €25-€30 billion in capital needs. Assuming as well increases in yields on French and Belgian bonds could result in a further €20-€25 billion of needs. Taking these together, the additonal sovereign buffer requirement could total nearly €160 billion. This would be four times the roughly €40 billion in sovereign exposure buffers the EBA required in its October 2011 recapitalization exercise.
Leaving aside the considerable additional capital that would be needed to provide for the increase in nonperforming loans that could be expected to result from a renewed weakening of activity across the Euro Area, these more expensive sovereign buffers to be met either by raising additional capital of this magnitude from private markets or from additional capital injections by Euro Area governments.
The latter would add directly further to government debt and potentially to the deficit, depending on the precise form of capital support. If, one the other hand, the bulk is to be raised in private markets, then recent evidence suggests that this would likely result in accelerated credit deleveraging, which would have a substantial further adverse effect on Euro Area economic activity. In turn, this would further weaken government revenue in a
Next: global trade would implode:
The Euro Area accounts for about 19% of the world economy. If the loss in Euro Area GDP were to have a multiplier effect on the rest of the world of a similar proportion, then each percentage point lost in Euro Area GDP would translate into an income loss elsewhere of about €90 billion.
These ripples would spread beyond the Euro Area through two key transmission mechanisms:
- There would be a direct hit to global aggregate demand and trade flows. The Euro Area accounts for about 26% of world trade. Countries closer to the Euro Area -- including the Eastern and Central Europe, the United Kingdom and the Nordic countries -- would be most affected, but the ripples would be far more widespread than that. Importantly, it should be noted that exports to the Euro Area account for about 4% of China’s GDP and about 2% of GDP for both India and Brazil. The US and Japan are less exposed to this direct trade channel (exports to the Euro Area account for about 1% of GDP in both cases).
- Financial linkages are potentially more powerful, especially since market developments since the onset of the crisis in 2007 have highlighted a propensity for “runs” to occur on a scale and at a pace that had previously been unimagined. Many policy makers incorrectly believed that the fallout from a Lehman bankruptcy would be contained, since markets had been apparently pricing in a significant default risk well ahead of the actual event.
The conclusion: sign the dotted line you evil hedge fund, or the wrath of the world will fall upon your shoulders:
Deliberations now about providing the additional official funding needed to facilitate an orderly restructuring of Greek debt are understandable given the large upfront outlays – €60 billion for bank recapitalization and credit enhancements – needed to secure €100 billion of nominal debt reduction, the large interest savings – on the order of €7-8 billion a year initially – that would result from the proposed bond exchange with private sector creditors. Together with this large effective interest subsidy, the reprofiling and lengthening of maturities on the new bonds to 30 years would help lay the basis for renewed growth.
Catastrophic bankruptcy, however, would put at grave risk much of what has been achieved by Greece since 2009. Social strains would intensify as the economy reeled and unemployment surged from an elevated level already in excess of 20 percent. Living standards would collapse with economic activity and the further diminution of the Greek state’s ability to provide basic social services and support. Against this backdrop, it would become more difficult -- not less --to build the political consensus needed to free the economy, the government and the society from vested interests that deeper crisis would more firmly entrench. Whatever its economic benefits, a sharply depreciated “new” drachma under these circumstances would assure that the costs of adjustment, now greatly increased, would be distributed even more unevenly than at present.
Europe, too, would take a considerable step backwards, not just because of the considerable additional financial costs that look likely to result from intensified contagion and inadequate firewalls. Europe’s governments and its core institutions, the ECB in particular, would incur enormous financial losses not four years removed from the large but more limited ones incurred in the wake of the Lehman crisis. Tightened fiscal rules would prove still more constraining to growth, employment and living standards under the strains of the additional resources needed to recapitalize banks and the ECB and as a result of the revenue foregone as activity contracts. Sitting governments would be hard pressed to convince electorates that their mandates should be extended.
So... what was it about hedge funds not having the upper hand again?
Full memorandum of mutual aassured destruction handed out to every hold out hedge fund with gusto.