European Market Turmoil

Rating agencies have determined that any extension of maturities of Greek debt or involuntary rollover of current holdings of Greek debt would constitute a default. In recent days, discussions have suggested that current debt holders would be able to roll existing Greek debt as it matures on a ‘voluntary’ basis. With existing Greek debt selling at a very deep discount (10 year yields are above 18% and 2 year yields above 28%), no institution would roll over a bond at par, when it could be purchased in the open market for $.50 on the dollar.

It seems in these desperate times, everyone involved wants Greece to receive more funding in a manner that avoids triggering a default now, even though everyone knows Greece will never repay the loans they have already received. Perhaps secretly, current holders of Greek debt will be made an offer they can’t refuse. Many doubt the financial markets will be so willing to participate.

For many, peripheral Greece is merely the tip of the debt iceberg .The European banking system is on course to collide with, irrespective of any last ditch manoeuvrings. The fundamental problem is that Portugal, Ireland, Greece and Spain (the PIGS) have too much debt, and too little economic growth to service their debt loads. Germany and France have $541 billion of exposure to these weak countries. The Majority consensus is that it is merely a question of when Greece defaults, not if. And when that happens, banks in Portugal and Spain will be severely impacted. According to the BIS (Bank of International Settlement), French banks own $57 billion of Greek debt. On June 15, Moody’s warned it may downgrade three French banks (BNPP, CASA & SocGen), due to their exposure to Greece. In an example of how interconnected the global financial system is, Fitch ratings reported that as of May, almost 50% of the assets in the ten largest prime money market funds were invested in short-term loans to European banks.

Fitch noted these funds have sold much of their holdings of Portuguese, Spanish and Irish debt, and have never held Greek bank debt. In another example of how interconnected the global financial system is today, U.S. banks and insurance companies have issued default insurance on Greek, Portuguese and Irish debt through credit default swaps purchased by French and German institutions. The French and German institutions will receive payments from the U.S. banks and insurance companies issuing the credit default swaps, for the amount of the insurance coverage upon a default by Greece. Even though U.S. institutions hold only 5% of Greek debt, their exposure to a Greek default is likely to be larger than their actual holdings of Greek debt, since they will have to pay for the amount of debt they insured to the German and French institutions. Since credit default swaps aren't an exchange traded or through a clearing house, no one knows precisely the total value of credit default swaps on Greek debt, and consequently, the exposure for U.S. banks and insurance companies. And, if one of these institutions just happens to be too big to fail, the problem will just exacerbate more.

While the news today that Greece has accepted another austerity measure package was met with optimism the Euro sovereign debt crisis is far from over. The Euro will continue to experience high volatility over the coming months and years as governments try to come up with a more permanent solution.