Complex Made Simple

Greek tragedy spreads throughout Europe

Europe is still suffering a severe debt crisis, with Greece playing a leading role. In February, I wrote that it would be highly doubtful whether European countries (and the European currency) would recover from their own 'Greek tragedy' soon. Eight months later, the euro is trading at $1.32 versus almost $1.37 in February after reaching a high of $1.48 in May.

Although the euro strengthened from February through May, the European currency deteriorated subsequently due to a worsening European debt crisis. An end to this crisis is not yet in sight and even worse, Greece is struggling to stay alive and had to be supported again with more than €100bn in aid for the second time since 2010.

Recently a troika of representatives from the European Union, the IMF and the European Central Bank returned home with empty hands because of the fact that Greece did not take enough measures to cut down spending. Nevertheless,Greece managed this week to receive a new tranche of €8bn.

Last year, Greece debt totalled €328bn which was approximately 142.8% of its GDP. It is estimated that the debt will balloon to 166% of GDP in 2012. The charts illustrate the yield of the Greece bonds, where the 1 year bond has a yield of more than 125% and the 2 year bond yields more than 60%.

Technically speaking, Greece is bankrupt and is being kept alive artificially. In fact, the situation is hopeless. The chart of the (5 year) Credit Default Swaps on Greece went off the chart and reached nearly 7000 basis points in September, before falling back towards 5000 basis points. That means that a buyer had to pay the writer of the CDS $7m to insure $10m of debt for 5 years.

In case of a ‘credit event’ (or default), the seller has to pay the buyer of the CDS $10m. 1500 basis points means a probability of 76% that a company or country will default on its debts.

To put in perspective, the blue line on the chart is the price development of the CDS of Greece. Portugal (green line) is following suit.

The problem is that European financial institutions and pension funds have a big exposure in Greek bonds. In other words: a default by Greece would imply a write down of several billion euros, which would probably lead to a collapse of the European financial system.

A worrisome sign is the fact that Belgium bank Dexia has run into trouble this week. The emergency has been so high that the Belgium authorities have scheduled a rescue plan.

Sources were referring to a possible nationalization of the troubled bank and/or creating a ‘bad bank’ in which toxic assets could be dumped. Dexia’s exposure in Greece (based on the stress test according to UBS) has been 39% of its equity in 2010. The panic in Belgium illustrates perfectly how serious the European debt problem is.

In size, the biggest problem in Europe is not Greece, but Italy. The reason that European politicians prefer to keep Greece ‘alive’ is the fear of a domino-effect in case of a default. If Greece defaults, it is feared that other countries which are also in trouble like Portugal, Italy and Spain, will follow and that the negative spiral will continue.