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The Coming Storm in Europe

Dark and ominous clouds are rumbling over Europe and a financial storm could strike at any time. Esteemed Levy Institute scholar Marshall Auerback recently offered his analysis of the latest developments in the European financial crisis on the Business News Network. In the interview, he discussed the ongoing threat of sovereign defaults and European leaders’ efforts to take shelter from the resulting fallout that could occur from those defaults.

Flickr by Navin75

Currently, European countries are negotiating a proposed deal that would require bondholders of Greek debt to take a 70 percent haircut. “Haircut” is jargon for the percentage of money that creditors will lose. If Greece owes you $100, a 70 percent haircut means you’ll be paid only $30. While Auerback agreed that a 70 percent loss is better than being completely wiped out by a total default, he discussed several potential complications that could end up stymying a deal. If no deal results, Greece will suffer a hard default and possibly set off a string of other countries’ defaults. This scenario would be catastrophic.

First, if holders of Greek bonds get a 70 percent haircut, bondholders of other struggling nations that are also at risk of default such as Portugal and Spain may seek a similar, “me too” agreement. But not every troubled country can get a deal like the one contemplated for Greece because too many lenders would lose too much of their investments, and lending could grind to a halt. To complicate things, if there’s no deal on Portuguese and Spanish debt, then Spain and Portugal might block the Greek deal, possibly leading to the catastrophic scenario of Greece suffering a hard default and setting off a string of defaults across Europe. One thing is clear: we’re at a point where there are no good options, only bad and worse ones. The least bad option now seems to be for all governments and their respective bondholders to accept this 70 percent Greek haircut and restructure other struggling countries’ debt separately.

Second, because certain members of the E.U. do not have faith in Greece’s ability to resurrect its own economy, Greece may have to sustain increased austerity and hand over its authority to tax its citizens to Germany as part of the deal. Germany will be providing most of the money that Greece uses to pay its debts and wants to make sure that the money is being spent appropriately. Auerback described this as, “in effect, turning Greece into a European colony,” and if this change happens, he expects the humiliation of the loss of national sovereignty to incite fury within Greece.

Finally, problems with credit default swaps on Greek debt may crash onto the scene. Credit default swaps act as “insurance” against a bond’s default. Hedge funds have allegedly bought credit default swaps on Greek debt—likely without buying the underlying debt—so they can get paid and hit a windfall when (not if) Greece ultimately fails. Essentially, they are “Banking on Failure.” Auerback says, “These credit default swaps are like Frankenstein financial products, they shouldn’t be allowed and there should be no reason for the authorities to accommodate these things.” However, it’s still questionable whether credit default swaps on Greek debt will pay. The banks insuring the debt will likely argue the bondholders are taking a “voluntary” haircut, while the swaps holders will say it is voluntary only the way that someone being robbed at gunpoint “voluntarily” hands over money. To complicate things further, the process for determining when credit default swap payments are triggered is “murky, unregulated, and replete with conflicts of interest.”

Several months ago, the question was WHETHER Greece would default. Now, the question is HOW Greece will default and how that default impacts everyone else. The storm is about to unleash its wrath. Let’s hope everyone weathers it.

Watch Auerback’s complete interview here.