Easy Street

So What if Greece’s Bailout Doesn’t Work? An Apocalyptic Primer.

Heidi Moore Mar 5, 2012

Doom does, to some extent, follow a predictable path. The Mayans had their prophecies, Nostradamus had his “Centuries,” and the Institute of International Finance has its “Implications of a Disorderly Greek Default.”

The IIF is best known as the group of financial institutions who signed off on Greece’s $140 billion bailout payment – complete with brutal bond swap – under the theory that getting some money is better than no money at all.

A group of hedge funds – which may account for up to 25% of Greek bondholders – disagrees. That group is making dissatisfied noises and threatening gestures. Some of them bought contracts, called credit-default swaps, that were guaranteed to pay out if Greece defaults. Some estimates hold that Greek CDS would be worth about $4 billion.

In contrast, the IIF created a document two weeks ago that predicted that a Greek failure would cost $1.3 trillion. The IIF circulated a document that describes a financial dystopia that will force endless dominoes of bailouts and crisis in Europe if everyone doesn’t just shut up and allow the Greek bailout to go on.

If you’re playing along at home, the game is this: to get their $4 billion, those hedge funds want to get a Greek default declared.

Almost no one else wants Greece to be declared in default – not banks worried about more financial instability; not European citizens fretting about riots; not American companies reluctant to risk international financial contagion. A Greek default may trigger a European financial crisis that would cost up to $1.3 trillion, including a $463 billion bailout of Italy and Spain. Spoiler: the IIF expects that a Greek default would cause a European financial collapse.

But these hedge funds can’t wait for a default.

The past week, as a result, has included some admirably medieval navel-gazing on what constitutes a “default,” the same way scholars of the Middle Ages debated how many angels could dance on the head of a pin. Moody’s calls Greece’s situation a “selective default,” a deliciously vague term that means something like a technical default. Some hedge funds and observers claim that the bailout is itself a default, since all bondholders have to take a 74% cut to the value of their bonds – except for the European Central Bank, which gets to keep every delicious penny it invested. Still others expect a default next week, when Greece may have to pass a law to force all its bondholders to accept the lower-priced new bonds.

The hedge funds are yelling that a Greek bailout without a default is a violation of rules, contracts, authority, and the trust that makes the financial markets run. This should be taken with a grain of salt. Hedge funds are the rebel ninjas of the financial world; rules usually matter very little to them, although profits do.

More importantly, allowing a very small amount of credit-default swaps to derail the European economy to the tune of $1.3 trillion is a case of letting the financial tail wag the dog. Having worked so hard to guarantee some stability in the financial system, European officials may be wise to avoid letting the year’s work devolve in chaos.

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