End of the line: What a Greek default means

June 17, 2011, 7:19 PM UTC

FORTUNE — After a year of kicking the proverbial can down the road, it appears more than likely that Greece will default on its massive debt load. Riots and political deadlock in the tiny European nation this week show that there are limits to the amount of economic stress a population can take before they simply give up. While Greece itself will be the hardest hit in a default, the ripple effects of such a move could rock the European banking sector to its core and even create a liquidity event not seen since the dark days of 2008.

But while it is hard to say with certainty what the effects would be if Greece defaults, what seems almost certain at this point is that it will default sometime in the next few months. That should be of no surprise if one looks over the Greek state’s income statement. The country has been forced to slash public spending in order to pay off its massive debt load. Trouble is, those massive cuts in spending have caused the Greek economy to contract, reducing its ability to pay off its debt.

The decision to slash spending wasn’t taken lightly. The austerity measures put in place by the Greek government last year were part of a deal the country made with the European Central Bank and the International Monetary Fund. The country agreed to reduce its spending to receive 110 billion euros over the next five years to help service its existing debt. In essence, the Greeks borrowed money to pay off its creditors.

Anyone who has tried to get out of debt can see the flaw in this strategy. The move simply delays an inevitable default unless serious and truly painful changes are made. Architects of the plan said that it was designed to give Greece some breathing room to “get its house in order.” But by forcing Greece to slash spending so early, the ECB and the IMF basically set the country up to fail.

That’s because so much of the Greek economy is dependent on government spending. By slashing spending so quickly, the country has fallen into a deep depression. Greece’s GDP is expected to contract by 3.5% this year, higher than originally thought, thanks in large part to the spending cuts. The country’s unemployment rate has skyrocketed to 15.9% in the first quarter of this year, up from 14.2% in the previous quarter.

Greece will never be able to “get its house in order” if its economy continues to contract. Despite the massive cuts in spending, the Greeks continue to run a large budget deficit. To make matters worse, the government reported this week that the deficit actually grew by 12.9% during the first five months of this year, which was 13.2% higher than where it was projected to be. Economists estimate that Greece needs a budget surplus of as much as 10% of GDP to fulfill its obligations and stabilize its economy.

It is therefore understandable why some feel that the situation seems hopeless at this point. The Greek parliament is set to vote on further austerity measures required in order to receive their next cash payout by the ECB and IMF. Greek Prime Minister George Papandreou has put forth a plan that would slash 78 billion euros of government spending over the next five years. The opposition party is understandably up in arms and wants the Prime Minister to renegotiate the terms of the ECB deal.

Consequences of contagion

The Prime Minister has been able to push through legislation in the past thanks to his razor-thin majority in the Greek Parliament. But it is very possible that he could lose that majority in the coming days as members of his party start to resign in protest. That would set the Prime Minister up for a vote of no confidence whereby the Greek government would essentially collapse.

If the government falls, it will not be able to push through the cuts required to receive the latest installment of funds under the 110 billion euro plan. That would mean Greece would have to default on its debt due in August, since it simply does not have the money to pay it. This would set off a chain of events that, if not handled properly, could create a massive economic contagion with severe consequences.

A default would mean a complete lockup of the Greek economy. The Greek banking system could collapse as it holds billions of euros of Greek government debt. Other banks would refuse to lend to the Greek banks and the ECB could cut off its cash lifeline. Liquidity would dry up and suddenly there would be no money in Greece.

The ensuing chaos would spiral far beyond Greece’s borders, though. It would first trigger around $5 billion worth of credit default swaps that investors in Greek bonds took out to protect themselves from a default. Financial institutions that issued the CDS would need to pay the face value of the bonds immediately, putting a dent in their bottom line. Furthermore, foreign banks holding Greek government debt would need to write down or even write off the value of that debt given the default.

Sound familiar? It is similar to what happened in 2008 when the banks were forced to write down billions of dollars in mortgage-backed securities. Fortunately, the amount that needs to be written down this time would be somewhat manageable. Foreign banks hold $54.2 billion in Greek government bonds, with 96% of that owned by European banks. German lenders were the largest foreign owners of Greek government bonds at the end of a last year totaling $22.7 billion. French lenders came in second with $15 billion of exposure.

But that is just the government debt. A collapse of the Greek economy would also put Greek private debt in trouble, forcing even more write downs in the European banking sector.

This prompted Moody’s this week to issue credit warnings for three large French banks, BNP Paribas, Societe Generale and Credit Agricole, which hold a combined $65 billion in public and private Greek debt. Write-downs that large would begin to rock the world financial system.

Domino effect

The biggest fear of a Greek default, though, isn’t the default itself, but the message that it would send to other countries struggling to pay off their debts. Already Ireland has started to renege on some of its bond payouts, triggering CDS claims. That could accelerate if Greece defaults as the populations of those countries facing harsh austerity measures push their leaders to “pull a Greece” and simply stop paying off the debt. Cascading defaults in Irish and Portuguese government bonds would again ripple through the European banking sector.

But again, while the amount of government debt held by these two countries is large, it pales in comparison to the amount of public debt taken out by its citizens currently owned by foreign banks. And if the euro collapses as a result of all these defaults, those debts would probably all have to be written off, which could bring massive pain to the banks. The cycle could continue with Spain and Italy tearing up their debts.

For now, the official policy of the ECB and the IMF is to keep the Greeks afloat, notwithstanding the moral hazard of doing so. It is possible that they will throw the rulebook out the window and continue to fund the Greek deficit. But that would just delay the Greek default. Eventually the Greeks and its bondholders need to come to an agreement by which the bondholders take a haircut on the value of their bonds.

Such a restructuring would be tantamount to default, but it could be contained in order to avoid a doomsday scenario.

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