"Time to think of policy options of the last resort"
For months the top leaders of the European Union resisted the idea of a bailout for Greece, wringing their hands over the estimated $61 billion cost. While the jawboning continued, the infection took hold. Bond vigilantes drove the Greeks' borrowing costs into the double digits. Investors, fearing a contagion in Europe's southern tier, dumped the stocks and bonds of Portugal and Spain. As it spread, markets started to pummel European banks and insurers for their exposure to what could prove to be one of the worst sovereign debt disasters ever. A bank crisis and a debt crisis rolled into one—the medical bills for this extreme case will make Europe long for the modest $61 billion of just a few weeks past.
Europe's banks and insurers hold some $193 billion in Greek debt. That's a fair piece of change, but it's no longer the central issue. For one thing, the debt is distributed among dozens of companies. Commerzbank and ING (ING) each hold $3.9 billion in Greek government debt. Writing off 50% of that would hurt, but it wouldn't send a major European banking institution toppling.
The bigger issue is metastasis. Nomura International (NMR) analyst Daragh Quinn noted, "Sovereign risk concerns are spreading to Portugal and Spain, as witnessed by a widening of bond spreads in these countries." In late April, ratings agency Standard & Poor's (MHP) not only downgraded Greek debt to junk, it knocked Portuguese sovereigns down two notches as well, and lowered Spain the next day.
Since investors are now worried about the fiscal health of the weaker European players, the borrowing costs of the Spanish, Portuguese, and Irish governments are jumping. Each of these countries may ultimately be forced to seek a bailout and break its pledge to pay off its debts in full.
Even if the worst doesn't come to pass, Europe's banks will have a lot of pain to absorb through writedowns of billions in bonds and loans. Belgian-Dutch insurer Fortis, for example, holds $5.4 billion in Greek government debt—and $4.1 billion of Portuguese government debt, according to bank statements and public documents. Europe's banks aren't saying how much in vulnerable debt they hold overall, but it adds up. The banks' exposure to Portugal comes to $240 billion; exposure to Spanish debt is another $832 billion. Some of the big banks are also heavily involved in Greece. France's Crédit Agricole and Société Générale have big stakes in Greek banks. SocGen's Greek affiliate has lost money every year since 2003.
The second Greek problem for the banks is the collateral issue. The European Central Bank keeps the Continent's banking system functioning day by day through short-term loans to commercial banks. In these cases the ECB usually accepts the banks' holdings of government bonds as collateral. Greek debt is now rated as junk by S&P: Under current ECB rules, Greek bonds can't be used as collateral by the ECB if Fitch Ratings and Moody's Investors Service (MCO) cut them to junk as well. The Frankfurt-based central bank may have to dilute its collateral rules to keep the Greek banks operating. The ECB's problem of securing solid collateral for its loans will expand greatly if Spain and Portugal lose their investment-grade status, too. In the view of Jacques Cailloux, chief European economist at Royal Bank of Scotland Group (RBS), the central bank may have to start accepting all government debt regardless of its rating and revive last year's policy of lending unlimited amounts for periods up to a year to support the region's banks.
The final problem for the banks is an indirect one. On Apr. 27, the day S&P downgraded Greek debt, shares in London-based Lloyds Banking Group (LYG) slid 8%. Lloyds doesn't have any "material exposure" to Greece, Finance Director Tim Tookey told analysts. That won't matter if panicked investors go on strike and stop buying financial securities of any kind in Europe. "It's all about sovereign risk," says Andrew Lim, an analyst at Matrix Corporate Capital in London commenting on the decline in Lloyds shares. "Ultimately it could lead to contagion for funding costs, and Lloyds is going to be hit."
The fear of a monumental banking crisis is triggering calls for an EU-led bailout that goes beyond Greece. "It is perhaps time to think of policy options of the last resort," says David Mackie, chief European economist at JPMorgan Chase (JPM) in London. "It may now be time for the euro area to do something much more dramatic."
What Mackie has in mind is akin to the Troubled Asset Relief Program that supplied hundreds of billions in assistance to the top U.S. banks, while in Europe's case governments would be the beneficiaries. Mackie calculates that in a worst-case contagion, supporting Spain, Portugal, Ireland, and Greece may cost 8% of the euro zone's GDP. That's equivalent to about $792 billion. "This is a big number, but the region has the fiscal capacity to backstop both banks and these countries," says Mackie. The alternative—an unplanned series of sovereign defaults and an implosion of the banking system—could be far worse.
The bottom line The decision to pursue a regional rescue ultimately depends on Germany, whose voters are hostile to bailouts.