In debt and disorderly

If bondholders refuse to take part in Greece's bond swap plan, the country could face a disorderly default, triggering a European banking crisis and US contagion.

Investors reeled in horror overnight after Greece raised the prospect of a disorderly default by threatening not to pay private sector bondholders who refuse to take part in its debt restructuring aimed at wiping €100 billion off the country’s debt burden.

Greece’s public debt management agency warned in a statement that Athens "does not contemplate the availability of funds” to pay private investors who hold onto their old bonds, rather than swapping them for new bonds and taking a loss of around 75 per cent on their investments.

Athens needs 75 per cent of its private sector bondholders - including banks, pension funds and hedge funds – to take part in the swap to avoid resorting to collective action clauses (CACs) which would force all bond holders to participate in the deal. That would likely constitute a credit event that would trigger credit default swaps (a form of insurance on the bonds) and fuel market turbulence.

But if fewer than 66 per cent of bond holders agree to the debt swap, the CACs can’t be triggered, and Greece has no way of forcing recalcitrant bondholders to participate in the swap. Athens is now ramping up the pressure on these holdouts by warning that they will receive nothing after the debt swap takes place. According to market participants, this would result in a disorderly default, with potentially disastrous consequences.

According to a recent note from the London-based consultancy, Lombard Street Research, "a Greek or any other significant default will precipitate a European banking crisis in the foreseeable future. Markets are already speculating on Portuguese negotiations for haircuts and Ireland can’t be far behind, as it elected the current government to negotiate haircuts on private holdings of bank debt.”

It also notes that insolvent European banks sold many credit default swaps, which means there is huge counterparty risk.

Lombard notes that the US investment bank Lehman Brothers defaulted 13 months after the US TED spread (the difference between interest rates on interbank loans and on short-term US government debt) climbed above 100 basis points. It notes that the European equivalent crossed 100 basis points in September 2011, so a banking crisis could occur in the Northern Hemisphere’s autumn, provided that the normal incubation period for crisis is around a year or so.

According to Lombard, "contagion to US (and global) banking systems is inevitable”. It points out that US banks have a significant exposure to Europe, through lending to governments and their exposures to financial and nonfinancial institutions. US claims on the ‘Club Med’ countries, plus Germany and France and the UK banking sector make up around 80 per cent of the total equity of US banks.

In addition to their eurozone problems, Lombard points out that US banks still have to work through the remaining legacy of the sub-prime crisis.

"Noncurrent real estate loans in the US remain elevated, at 6.5 per cent of the total – compared with only 0.7 per cent in the 2005-06 period – and stand to rise again if the US economy deteriorates in 2012. Banks’ quarterly rate of provisioning looks inadequate to cope with even current levels of noncurrent loans.”

Lombard notes that US banks’ quarterly provisions for problem loans now stand at around one-third of their 2008 average, even though their noncurrent loans (loans that are not meeting their interest payments) are down by only 20 per cent since their peak in the first quarter of 2010.

As it points out: "US banks are in a poor position to withstand a European banking crisis. They appear well capitalised with assets 11.9 times net tangible equity. However, they need an estimated $400-$600 billion of capital to absorb the cost of marking their toxic assets to market, which raises their effective leverage to 19 to 28 times – too high to weather the recession and European banking crisis without significant failures.”

Lombard offers a deeply pessimistic prognosis. Insolvency, it says, will keep dragging the eurozone economy down until sovereign and bank balance sheets are repaired. While other developed economies are in a less dire position than the eurozone, slow economic growth and deteriorating government balance sheets are pushing many of them in the same direction.

"Banking problems are becoming more acute and Europe is the canary,” it says.


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