No-one is really sure what will happen if Greece defaults

The Greek prime minister won a confidence vote last night, the first stage in pushing through the austerity measures demanded by the EU as a condition for another bailout.

As Nosemonkey says, there is plenty of expert opinion available about what might happen next but the 2008 financial crisis showed that most economic predictions were mistaken, so why should these be any different? If Greece defaults, no-one really knows what will happen next.

The reasons for this uncertainty are much the same as they were in 2008. The trading of complex credit derivatives between banks means that no-one is quite sure what the knock-on effect of a Greek default might be, just as no-one was sure what the collapse of Lehman Brothers would mean, until it happened. 

The UK banks, for example, do not appear to have much exposure to Greek government debt – an estimated $4bn. But UK banks have also lent to Greek banks which, in turn, have lent money to their government. If the Greek banks were to collapse, UK banks could be hit for $13.1bn. (For a more detailed explanation see FullFact.)

A Greek default could also lead to a devaluing of sovereign debt and an increased risk of default in other distressed economies like Portugal and Ireland. UK banks have more exposure to these economies so the potential losses rise still further.

Then there are Credit Default Swaps, those “financial weapons of mass destruction“. These are the insurance policies taken out by investors against loan defaults. The trouble is, no-one is quite sure who has sold which CDSs to whom, as DemitrisL explains

What we are missing from the above data is the amount of CDS or other hedging strategies, that the foreign holders of the Greek debt have used, in order to protect themselves, as well as ECB’s big exposure to Greece through its lending to Greek banks (check Tracy Alloway’s excellent article, citing JPMorgan’s estimates on the issue: http://ftalphaville.ft.com/blog/2011/05/09/563016/) .

Sovereign CDS market is an OTC market, meaning that there is not enough transparency. Consequently, we do not have access to quality facts, ie which part of the traded amounts is invested for hedging purposes and which part is on naked CDS positions, effectively betting on a Greek default.

In other words, if Greece defaults, some institutions will have to pay out (or pehaps they won’t) and others, who insured against a default, will recieve a payout (or perhaps not). And no-one is really sure who’s exposed for what and by how much.

Taken together, and combined with a pessimistic mind-set, all these factors can give you some really big numbers for the UK’s potential exposure to a Greek default.

The trouble with contagion is that it is…er…contagious. This piece at Wall Street Manna explains how $38m of sub-prime losses turned into $280m losses on the related derivatives. If no-one is quite sure who is exposed to such potential losses, the uncertainty causes panic. Credit dries up not because people know certain financial institutions are a bad risk but because they fear they all might be. People start to assume the worst and so the worst happens. That’s how $150bn in sub-prime losses led to $2.28 trillion in bank losses. The world’s financial system is so interdependent that any financial crisis has a multiplier effect. Just as mortgage defaults in the US can lead to a collapse of major financial institutions around the world, so a Greek debt default could lead to …well…who knows what?

Update: There is an interesting discussion going on about this on Tim Worstall’s blog. Tim reckons the UK banks’ CDS exposure is about £30bn but that the gains and losses by individual banks will cancel each other out.

This comment from Mark Wadsworth made me chuckle:

What this is really about is the banks ‘sending a message’ to the UK government that they are too big to fail and could do with bailing out again or else Something Terrible Will Happen But We Know Not What.

Let’s hope they are both right.

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2 Responses to No-one is really sure what will happen if Greece defaults

  1. Pingback: No-one is really sure what will happen if Greece defaults - Rick - Member Blogs - HR Blogs - HR Space from Personnel Today and Xpert HR

  2. Smedds says:

    At last someone who is getting to the crux of the matter.
    This has nothing at all to do with the Greek people. The politicians are dressing this up as some sort of moral crusade to save Europe. Insisting that Greece plow on and continue with the rescue package with great self sacrifice. In reality the large financial institutions, who have encouraged past risk taking and loans to gather large revenues are now worried about their overall losses to other economies and eventually their own returns if Greece default.

    I fear that the real reason politicians want Greece to struggle on and not default has absolutely nothing to do with Greece but everything to do with the exposure of International Financial Institutions- Very much like the crisis in the far east, where the large Banks and institutions leveraged the world bank to broker a killer deal, making sure they only stuck around long enough to ensure they covered their own liabilities, Then you could not see them for dust.

    The same will happen with Greece, they will be persuaded by the central european banks into continuing to take loans they cannot afford to ensure they do not default. Long enough ( maybe 1-2 years ) so that the large institutions who are really influincing the large European goverments can then ensure they have the money back/covered.

    Any loans given to Greece will undoubtably be used first and foremost to cover the exposure of these large institutions not only in Greece but also in the other exposed countries such as Spain, Portugal and Ireland. Like every good magician maybe we should be looking at the exposure in these other areas to see who is really pulling the strings with Greece.

    Whoever is brokering these deals I do not believe Greece’s welfare is the main goal here. The average Greek person will see that they are paying a great ammount to ensue that the risk taking banks and politicians get away with it again. This will inevitably lead to discontent and default and once the Greek people have had enough they will protest and chaos will reign. As long as this is after the big boys have got their money and covered themselves elsewhere I don’t think the governments will really care.

    The losers in this will be the Greek people and as they should know from past experience. If someone is giving you the gift of a large wooden horse (in the form of a rescue loan) . Then you should be very, very careful what is hidden inside!!!

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