Tuesday, February 21, 2012

The Greece Bailout: Do Not Trigger The Bomb

**March 9th update** See bottom for link.

You have read the headlines.  Greece has been saved. The world has been saved. Again. As always, there is more to the story than the headlines provide, and as always, I will try to discuss what is taking place in as simple terms as possible.

Greece is a tiny spec in terms of the global economy.  It is even a tiny spec in terms of the European economy.  The issue at hand here in these endless hours of Greece bailout negotiations is not regarding the quantity of money needed to keep Greece alive, it is the terms of the deal that will then be used as a precedent for every domino down the line in the coming European bailouts.  That is why policy makers are walking on eggshells.  A mistake with this Greece/"Bear Stearns" bailout may set the stage for the Portugal/"Lehman" moment that is right around corner.

Right now Greece is bankrupt.  On March 20, they have bonds that will need to be rolled over, which they cannot finance.  Without the bailout that took place last night, that roll over would not have happened and a Greek default would begin on March 21.

The financial leaders around the world desperately do not want a formal default to occur. They have been in negotiations for weeks trying to come up with a way to keep Greece alive for just a little longer.  Why are they so concerned about tiny Greece?  This story has a very interesting twist.

Think of saving Greece as trying to disarm a bomb.  If you make the wrong move the bomb will explode, possibly setting off other bombs that cannot currently be seen.  These "off balance sheet" bombs are called Credit Default Swaps.  CDS in simple terms are an insurance contract that are triggered if Greece is considered in formal "default."

So, not only do the financial leaders have to come up with a way to give Greece money and write down a large portion of their debt, but they must do it without triggering the bomb.  It is like an episode of "24" with Jack Bauer only the story at times is even more unrealistic.

To keep the bomb from going off, Greece bond holders must "agree" unanimously to take a write down.  The bailout last night said that private debt holders should agree to write down 107 billion euros.  The easy part was to put a number on the page.  The more difficult part will now be getting every private Greek debt holder to agree to take a loss.

Here is the first problem.  Many of the investors who bought Greek bonds also simultaneously purchased insurance (CDS) on the debt to hedge their position.  If Greek debt went up in value then they keep the profits.  If Greek debt defaults then they have the insurance payment to help cover losses. Greece's plan is to show up at their office and ask them to "accept" a 50% haircut on their investment, which would then cause their insurance payment not to come in the mail.

What do you think their answer will be?  It will obviously be no.  The hedge funds and investment bankers purchasing Greece debt are killers backed by financial algorithms.  They care very little about the man starving on the streets of Greece.

There is a way Greece can avert this issue.  They can issue a "collective action clause" which means that an agreement by a majority of bondholders would create a write down for all bond holders.

The problem?  As of this moment triggering the CAC would trigger the bomb.


How this will be handled over the coming weeks is the crucial portion of the debt negotiations.  If the bomb is triggered for Greece then it sets the precedent that it will be triggered for Portugal, Spain, and Italy.

While Greece can easily be contained, Spain and Italy are impossible.  The size of both the bailout funds needed and their bomb explosion are like Lehman x 1,000.

The problem, as I have discussed in detail in the past, is that no one can see where the losses will be taking place in the banking system, which means no one will trust anyone.  Money stops moving and freezes.

Where we go from here is impossible to know.  We are so far over the edge of the cliff and into the abyss that it is truly staggering.  The average person has no idea how thin the thread is that our entire financial system hangs on today.

The stock market, just as in the fall of 2007, is completely oblivious to the danger ahead.  I continue to believe that the global debt crisis will not be contained.  I believe we have one more deflationary downdraft ahead of us before the next major re-flation upward.  The process could take years to unfold, or it could begin tomorrow.  I recommend staying in safe assets and remaining patient.  Having capital available when the next "risk-off" moment comes will be extremely important.

Update March 9th: Bomb Triggered: ISDA Determines Greek Restructuring A Credit Event

4 comments:

  1. This is the "derivatives meltdown" we always talked about in the 90s. Only now the size of the deriv problem is not $1T but $1,000T+

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  2. I love the analogies. I hope you don't mind if I use some of this for my blog. http://usa-wethepeople.com/

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