Let me illustrate how silly the ECB’s pretend and pretend plan is by this example…
Say you own some of the 5 year Greek bonds paying 3.9% that come due on August 20. You are being encouraged to voluntarily roll that into a new 7 year bond paying the same interest rate. But you could buy a 2 year Greek bond paying 30% interest right now. Are you going to volunteer for a longer term bond that pays a fraction of the interest rate? Other than large European banks (about 25% of Greek bond holders), probably few investors will do the roll-over. Thus the opinion of ratings agencies (and me): this will be a default because only someone under duress would agree to such a bad deal.
Last week we learned that Germany caved from their extend and pretend position to the whims of the French and the ECB — a plan I call pretend and pretend. The simplified version of the ECB’s proposed solution is to have investors that own Greek sovereign bonds voluntarily allow their bonds to mature and reinvest that bond (at face value) into a new and longer term Greek bond.
This is madness.
Even if :
• the confidence vote passes (it did on Tuesday night)
• Greek Parliament passes more austerity legislation (The ultimatum from the IMF & EU is Greece has until June 28 to pass a $40B package of cuts & tax increases for 5 years of guaranteed recession / austerity package.) The Greek Parliament will likely pass this on Tuesday (the 28th).
• the ECB & IMF agree to throw good money after bad and lend another $170B to Greece with the proviso that investors will volunteer to roll over their Greek bonds. (the EU & IMF agreed to this on Thursday afternoon.)
then, it will still be a default.
What’s driving this accelerated madness ?
Greek bond redemptions:
• July 15 2.4B euro in short term (less than 1 year) notes
• July 22 1.6B euro in short term (less than 1 year) notes
• Aug 19 1.6B euro in short term (less than 1 year) notes
• Aug 20 6.6B euro in 5 year bonds
Right now, Greece does not have the money to pay back these bondholders. For this, it needs the next $17B installment from the EU & IMF (per the $155B Greek bailout 1..0 last year). Odds are good, they’ll get it just in time.
If Greece’s parliament can’t approve or won’t implement the latest round of austerity measures, it is possible the ECB could revert to its old tricks and begin paying off these maturing loans on behalf of Greece –and at 100 cents on the dollar — via a backdoor bond market channel. Yes, this would be a violation of the treaty that founded the euro currency. But they’ve done similar clandestine bond buying last year and earlier this year. At some point (soon) the public in Finland, The Netherlands, and Germany are going to revolt in protest of the ECB putting them on the hook for PIIGS loan losses.
Unless / until Greece decides to bolt, this game of pretend and pretend will keep going as long as German banks need to build their cash reserves to a point they are confident they can survive contagion from PIIGS defaults. But they have to hurry.. Voters in Germany, Finland, and The Netherlands will call an end to the game as soon they get the chance. Of course, the anger of the German public remains subdued compared to what the Greeks are showing and will show in the coming days.
Pray that large US banks are hoarding cash. They’re on the hook for several hundred $B in credit default swaps to Europe’s banks if the PIIGS default.
side note: there’s also $60T (yes, that’s a T, not a B) floating around in other derivatives that we do not know the impact of. Banks insist on keeping them out of view of regulators so they can make fat profits. This is why AIG blew up so quickly. Credit Default Swaps (CDS) are really WMDs.