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.
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.