A Crisis of Massive Proportion.

Well, we had the obligatory G-8 meeting at Camp David last weekend,

and appropriate lip service was paid to keeping Greece in the euro zone, but the economists who are watching the continuing financial crisis in Europe are rapidly coming to two conclusions: 1) Greece is likely to abandon the common euro currency now used by 17 European countries. And 2) there will be a damaging domino effect throughout most of Europe.

One of the effects of this abandonment results from the impending Greek revival of its traditional currency, the Drachma. Salaries and prices within Greece would be converted from euros to drachmas, and the drachma would be allowed to depreciate to make the Greek economy more competitive.

The problem comes with debts that are denominated in euros, especially if the lenders are outside of Greece. These lenders would naturally resist being repaid with less valuable drachmas. However, if Greek borrowers have to repay the loans with euros, the debt would become more expensive for them to pay off after the drachma is devalued.

The most likely result therefore, is that debts to non-Greek creditors would become useless after Greece switches to the drachma.

(Shocked face here – I believe we predicted this back in January).

After all of the inevitable lawsuits, defaults, forced reductions in repayment, the lenders end up holding an empty bag and losing big money. Just as in the U.S. banking crisis of 2007-2008, once some banks lose enough money to become troubled, the contagion spreads to other banks, because they are all tethered to one another as co-parties.

The Central Bank and the IMF would step in and try to stabilize the situation, and Germany would take its lumps (and perhaps a few islands) and after a couple of years on the Drachma, Greece stabilizes itself and life goes on. Sounds ugly, but generally benign, right? Unless you happen to be a Greek, that is. But what else might happen?

Well, there is always our friend, the derivative, and it could easily set off a global chain reaction. You know derivatives, right? They are the complex, “synthetic” financial securities, which Warren Buffett famously referred to as “financial weapons of mass destruction.” And which recently caused Jamie Dimon some embarrassment and a $2B loss.

In the case of government bonds, these instruments are known as credit derivatives. They include all sorts of loans secured by bonds as well as incredibly complicated vehicles that amount to insurance policies if the bonds default, like CDS. No one really knows how much of this stuff is sloshing around the international financial system, but the total value for all types of bonds was estimated at more than $50 trillion in 2008 and has continued to grow rapidly since then.

Trouble is, if the bonds underlying these derivatives become questionable, all the derivatives become uncertain too, even if they add up to far more than the value of the bonds themselves. Moreover, some of the synthetic investments based on Greek bonds could be governed by Greek law, some by British law (if anything originated in London) and some by U.S. law (if Wall Street was involved).

What if one legal system accepts the conversion of euro loans into drachmas and another doesn’t? Everything could be thrown into the courts for months. Even worse, if synthetic investments secured by Greek bonds become untrustworthy, why would anyone trust similarly complex investments involving Spanish bonds or Italian bonds?

The result of a meltdown in the world of derivative investments could cause far more chaos than simple bond defaults, because at the very least, it would be almost impossible to figure out who owed how much to whom.

So, let’s say Greece recovers quickly, and Italy, Spain, Ireland and Portugal want out of the euro zone too. There is the very real possibility that Greece abandons the euro and bounces back surprisingly fast. In fact, that is exactly what we urged them to do back in January.

But, our recommendation while good for Greece, would cause another sort of disaster, potentially much, much larger than the one facing the Greeks. Both Argentina and Iceland suffered currency collapses, but after a horrible year or two, they each rebounded and were better off than if they had fought to save a failing currency. Analysts point out that both countries were big exporters of grain, meat or fish and those sales boomed after currencies were devalued.

Greece, in its own way, could profit from a similar recovery — a rebound in tourism. A 30% drop in the exchange rate might make a vacation in Greece the best deal in years. Even for Germans.

Good for Greece, but not so good for Europe and really bad for the U.S.  How could the Italian government convince its people of the need for higher taxes or the Spanish government explain soaring unemployment if Greece were obviously better off outside the euro zone? They couldn’t and wouldn’t even try. In order to remain in office, any politician worth his salt would say, “Hey. Let’s follow Greece’s lead.” Then the entire European Union would likely unravel, with Germany leading the way and with Global financial consequences many times greater than those resulting from Greece alone.

U.S banks are deeply invested in the European outcome and are in the impossible position of needing to hold their positions otherwise risk a banking panic of global proportions. The best they can do now is hope and pray, neither of which has ever been a really good strategy. However, the best you can do now is to sell all your bank stocks and watch the show safely from the sidelines.

And, what a show it is bound to be.

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About Steve King

iPeopleFINANCE™ Chief Operating Officer. Former CEO of Endymion Systems, Inc. a $36m Information Systems Services company. Co-founder of the Cambridge Systems Group, the creator of ACF2, the leading IBM Mainframe Data Center Security product; acquired by Computer Associates. IBM, seeCommerce, marchFIRST, Connectandsell alumni. UC Berkeley alumni. View all posts by Steve King

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