I can’t help laughing at the Financial Times headline story Athens threat to bond holdouts.

Greece has threatened to default on any of its bondholders who do not take part in this week’s €206bn debt restructuring, raising the pressure on potential holdouts.

The threat is aimed in particular at the 14 per cent of investors who own Greek bonds issued under international law. The remaining 86 per cent, who own bonds covered by Greek law, were warned in the same statement that Greece would use so-called collective action clauses to make any deal binding on any holdouts.

People involved in the deal said there would be no sympathy for any holdouts in the international law bonds, as many of them were hedge funds who had bought in on the hope of being paid back in full as other investors suffered losses of about 75 per cent.

“They will be portrayed as evil hedge funds and nobody will have any pity for them. That means you can be violent with them. They need to realise that they don’t have a free option here,” one person close to the deal said.

Pitiful Threat

This pitiful threat demonizing evil hedge funds will prove to be as effective as a parent telling a child, “If you don’t clean up your room, I will give you piece of cake”.

The hedge funds want a default. They are the ones covered with CDS contracts that will pay them in case of default. Those covered by CDS contracts have no incentive to agree to deals and threats to blow the entire deal sky high is exactly what most of the holdouts want to hear.

Implications of a Disorderly Greek Default and Euro Exit

Even more pathetic than the Greek “threat” is a “confidential” (purposely leaked) report by the Institute of International Finance which which represents about 450 banks and other private creditors to Greece.

The Wall Street Journal has posted the document, Implications of a Disorderly Greek Default and Euro Exit so let’s take a look at the hype.

  1. 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);
  2. Sizeable potential losses by the ECB: we estimate that ECB exposure to Greece (€177 billion) is over 200% of the ECB’s capital base;
  3. 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);
  4. 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);
  5. 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;
  6. 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;
  7. There would be lost tax revenues from weaker Euro Area growth and higher interest payments from higher debt levels implied in providing additional lending;
  8. 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.

There is a more profound issue, however. The increased involvement of the ECB in
supporting the Euro Area financial system has been such that a disorderly Greek default would lead to significant losses and strains on the ECB itself. When combined with the strong likelihood that a disorderly Greek default would lead to the hurried exit of Greece from the Euro Area, this financial shock to the ECB could raise significant stability issues about the monetary union.

Self-Serving, Misguided Hype by IIF

That “confidential” PDF is one of the biggest examples of self-serving nonsensical financial hype stories as you can find anywhere. It was put together by nannyzone supporters attempting to scare everyone about eurozone breakup costs.

For starters the ECB will not be impacted by Greece regardless of what happens. The ECB would be made whole by EMU member nations if necessary.

Moreover, the idea that tiny Greece will “cause” a Lehman-like cascade is farcical. The “cause” of this mess is the woefully inept treaty that created the eurozone.

Greece, Spain, and Portugal are all bankrupt and all will exit the eurozone in due time and one cannot lay the blame for this on Greece. Indeed, had the fools at the EMU, IMF, and ECB allowed Greece to default two years ago, damage would have been minimized.

Foolish attempts to “contain” Greece made matters far worse. That the damages will be higher now is a direct consequence of the ECB president Jaan-Claude Trichet’s policy “we say no to default”.

At every opportunity to do the right thing (let Greece default), bureaucrats in the ECB, IMF, and EMU member countries threw more and more money at  Greece in repeated attempts to prevent the inevitable.

Only Realistic Solution is Eurozone Breakup

Throwing still more money at Greece now will not prevent Greece, Portugal, and Spain from leaving the eurozone later. Instead, repeated attempts to stay on this road-to-ruin will do nothing but up costs later on, just as Miracle Monti’s misguided LTRO programs will likewise do.

For a more realistic discussion of the impacts and a recommended proper approach, please consider Report Shows Netherlands Would Benefit by Leaving Eurozone; Country by Country Aggregate Costs; Dutch Freedom Party Wants Euro Exit Referendum; Critical Juncture for Eurozone

The euro and the eurozone are fundamentally flawed. Those flaws cannot be fixed by throwing more money at the problem. The only solution that really works is a breakup of the Eurozone, and the sooner the bureaucrats accept that simple fact, the better off everyone will be.

Mike “Mish” Shedlock
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