Endgame

If you follow the global markets, one word has been on everyone’s mind lately: Greece. The U.S. and the world have been waiting for two years for the Euro zone and Greece to agree on a solution to their debt problem. Greece owes $455 billion (€355 billion) and has not been able to pay this money back without the help of loans from other countries.[1] As the world waits to see the endgame, stock values remain in a holding pattern.

In 2011, the U.S. stock market ended the year flat, having gone up a mere 2% for the year.[2] Much of this market sluggishness was due to the economic uncertainty coming out of Europe.

During the past six months, stock prices have temporarily risen on rumors of a deal to fix the debt problem in Greece, only to plummet when the fix falls apart. While some stock pundits are predicting a rise in the markets for 2012, even without a resolution to the Greek debt crisis, other pundits are certain the markets cannot advance until the Greek debt issue is solved.

I can’t see the future, but as an avid student of global banking and stock markets, here is what I think is going to happen based on the evidence that has come out since October 2011: Greece will default and leave the Euro zone.

Why such a gloomy forecast?  On March 20th, 2012, Greece has to make an $18 billion bond payment to those who have loaned the country $455 billion.[3] As of today, Greece doesn’t have the money to pay back their debt, and needs a loan for the $18 billion payment.[4]  Greece must pay the $18 billion by March 20th, or the banks that are owed will call Greece in default. This $18 billion payment, if missed, puts Greece that much closer to being removed from the Euro zone.

As part of the larger plan to get out of debt, Greece and the Euro zone’s financial leaders have proposed reducing the value of Greece’s debt. This is called a write-down. $206 billion of the $455 billion that Greece owes is held by financial institutions (including U.S. banks) in the form of bonds.[5] Greece wants these institutions to take a 50% write-down (haircut) on the bonds, hoping to issue each bank a new bond for the balance of the outstanding loan. The balance would then be paid back to the bank over time.

So what’s the problem with this proposal? The financial institutions understand that even with the 50% write-down, Greece won’t be able to pay. Why? Their debt to GDP ratio (debt:GDP), currently at 152%, is just too high. Even if the banks take the 50% write-down on what they are owed, Greece’s debt:GDP will only fall to 120%.

In order for Greece to realistically be able to pay down its debts, experts say it must get its debt:GDP below 100%. For this to happen, the financial institutions that own Greek debt ultimately need to take an 80% write-down on their bonds; 50% is not enough.[6] U.S. banks would also get hit with the 80% haircut on their Greek debt holdings.

But that’s not all. If the financial institutions accept any write-downs, they will have to show the devalued bonds as a loss on their books. Write downs of 50% or more will cause most of the bond-holder banks to become insolvent, because up until now they have listed the Greek bonds as a profit on their books. (Banks can call a bond a profit thanks to accounting rules that say any debt held against a country – Sovereign debt – is considered safe debt that will always be paid back).

The goal of businesses is to make money year after year. Most companies manage against losses by having cash on hand from profitable years to offset any losses. The banks in Europe today do not have extra cash on hand, having just recovered from the downturn in world markets following the housing crisis in 2008-2009.  What little cash the European banks do have will not be nearly enough to cover the BILLIONS in losses they would have to absorb in the event of a Greek-debt write-down or default.

The European Central Bank (ECB) is aware of this problem and has been quietly loaning banks billions of dollars in a program called the Long Term Refinancing Operation (LTRO). LTRO is a way of bailing out the banks before they’re in trouble, without actually calling it a bailout. This money is being loaned at very low interest rates to help the banks stockpile cash in order to absorb potential losses from a Greek financial meltdown.

In December 2011 the ECB loaned $638 billion (€489 billion) to the European banks.[7] The ECB is rumored to be loaning anywhere from $1 trillion to $10 trillion to the European banks in February 2012.[8]

Are you following so far? Good, let’s keep going.

When Greece defaults, they will be removed from the Euro zone and have to go back to their old currency, the drachma. Why? The Euro zone does not want to be on the hook for future bailouts. At this point, the drachma would be valued at roughly 20 cents to the dollar, putting the country at around 100% debt:GDP.

With Greece out of the Euro zone, its citizens will have to figure out how to live within their means. This will be a very painful process, but they will have no choice. European banks will not be in a financial position to bail Greece out again, as they will be paying back the trillions that they themselves borrowed from the ECB.

What brought Greece to the brink of default?  Many factors, including:

* One in three workers worked for the government in 2011.[9]

* Greece has a cultural tradition of tax avoidance and corruption.[10]

* Greece does not have a large manufacturing economy.

* When the global economy slowed down in 2008 – 2009, the Greek government had no way to increase revenues.

* Rather than make tough cutbacks, the Greek government simply borrowed the money needed to cover the shortfalls and kept on spending at their pre-2008 level.

Another challenge for Greece is that ordinary citizens are currently withdrawing their money from local banks, and depositing it in banks outside of Greece. (A Euro in a French bank has the same value as a Euro in a Greek bank.) In 2011, around €36.7 billion in cash from Greece’s banks left the country and was deposited in banks outside of Greece.[11] This loss of capital is making it impossible for Greek banks to make loans which would help to get their economy moving again.

So where does this leave the U.S. after Greece defaults?  Not in a very good place.

U.S. banks have made loans to Greece that total around $41 billion.[12] Our banks also purchased trillions of dollars in Credit Default Swaps (CDS) against Greek and other European countries’ debt.

A CDS is just a name for an insurance policy that protects the lender if the borrower does not pay back on the loan.  In this case, the CDS’s protect all lenders if Greece cannot pay back their loans. If the CDS’s can’t be paid, (because there is not enough money to cover all of the them), then our banks would need trillions of dollars to cover their losses. Where can our banks get that kind of money?  The U.S. Federal Reserve.

However, based on President Obama’s recent State of the Union address in which he declared, “No more bailouts for banks by the American people,”[13] the Fed will not be allowed to cover the banks’ shortfall.  Without a bailout our banks will be forced to take massive losses, causing the stock market to go down as people (fearing a repeat of 2008) start pulling their money out of the market.

At this point President Obama will be forced to do a U-turn on his promise, and he will bail out the banks and Wall Street for a second time.

With bail-out money flowing once again, the Fed could start another massive program in which banks get trillions in loans, (think “TARP”), and the stock market gets a boost via Federal Reserve stock purchases, similar to 2008-2009.[14]

The stock market, after an initial negative reaction to the Greek default, would start to recover due to the massive influx of taxpayer money from the Fed.

How deep the stock market drops and how quickly it recovers is dependent, in part, on how long the Government waits to intervene.  The recovery will also depend on how much capital the Government injects into the stock market.  In January 2012, Federal Reserve Chairman Ben Bernanke stated that the Fed stands ready to help if the situation warrants.[15]

Meanwhile, back in Europe, a recovery is taking shape. Their banks will be solvent, thanks to the trillions of dollars they got from the ECB.  With their debt and losses covered, Euro zone banks can get back to the business of loaning money to the private sector.

Hang on – we’re almost there!  Europe has one more looming problem; Portugal. Since 2008, Portugal has received massive bail-out loans and it appears they are going to need another bailout soon.[16]  Portugal’s private debt load currently stands at 230% of their GDP![17]  Ultimately, this crushing level of Portuguese debt will cause their country to default and they will also leave the Euro-zone.

Like Greece, Portugal will have to return to their own currency and survive outside of the Euro zone.

Without Greece and Portugal draining Europe’s coffers, the region will start to recover slowly.

The scenario that is about to unfold in Europe should be a warning for all of us here in the U.S.  If we do not get our spending in line with our revenues, we run the risk of winding up just like Greece and Portugal. Our debt:GDP ratio has already surpassed the 100% mark, and our deficit will be expanding by an additional $1.2 trillion this year alone![18]

European countries have the ability to revert to their old currencies when they leave the Euro zone. We do not have that option. The dollar is the reserve currency of the world, meaning that global trade is based on dollars. If the dollar loses its standing, the U.S. will lose it’s position as a world financial leader, and we will be subject to the demands of whatever currency replaces the dollar as the new reserve currency.

The only way for the U.S. to avoid a tragic Greek ending like this is to get our spending in line with our revenue. Greece had a chance to do this and failed. We cannot. It is critical that we elect candidates in 2012 who recognize that we MUST rein in our spending to avoid an endgame like Greece will experience.

Even if Greece is able to secure a deal that allows them to avoid bankruptcy, it will almost certainly not be a good deal for Greece, having been crafted by other countries who are looking to secure their own interests.

As citizens of the United States of America we must never allow lack of fiscal responsibility to put us at the mercy of others.

Learn the facts.

Get the word out.

Vet the candidates.

Support in every way possible those who will not flinch in the face of this crisis.

Vote.

Stop the insanity while we all still can.