Sunday, October 16, 2011

Why is Alexander The Great's Greece "not allowed to Default"

           Before Entering to topic of why "not allowed to default" let's touch base on why it is defaulting. In one sentence answer is "There is no Alexander the great left in Greece". Countries who have trade / budget deficit, have been going bankrupt for a while. India went bankrupt in 1991. Indian Rupee was devaluated.Russia went bankrupt in 1998. This is no new thing. Over the time great nations adjust themselves and again thrive form it.
           Now is "Greece too big to fail"? Looking into numbers, GDP of Greece $318.1 billion (2010 est.) is smaller than revenue of Exxon Mobil  US$ 383.221 billion (2010) That does not mean it's small number but if you look at world GDP 74.54 Trillion it's hardly 0.4 % of it so it does not sound like too big to fail. Then why there is so much hue and cry on Greece. I think there are multiple reasons behind this complex issue. 

# First of all Greece is not issuing it's own currency ECB (European Central bank) issues it. Hence the standard solution of de-valuating currency and get rid of debt won't work. (One that India and Russia Used during their balance of payment issue)
# Secondly Greece is just tip of an iceberg. What happens with Greece may happen with all (PIIGS) Portugal, Ireland, Italy, Spain and even Finland. If they all default, the viability of Euro as Single currency will almost come to an end.
# Therefore Germany the main force behind Euro is not allowing any sudden default / uncontrolled action from anyone.

European Debt Crisis
On the top of all this the very less discussed but very very crucial reason behind "not allowing" must be CDS (Credit Default Swap). This is how CDS work..

1) Let's say Deutsche Bank  buy  10 Yr bonds form Greece government or any corporate. In order to "mitigate Risk of  bond default" they also buy CDS (kind of Insurance) form other bank. Say JPMC; based on risk involved in Bond JPMC charges "CDS fee" to Deutsche Bank.
2) If Greece pay back as agreed; JPMC gets fees and Deutsche Bank get principal and interest form Greece Government.
3) If Greece can not pay. Deutsche bank claim all their losses to JPMC and JPMC has to pay to Deutsche Bank. 

Now understanding credit default swaps, let's imagine on one fine day PIIGS and Finland default. Immediately creditors like Deutsche Bank / BNP Paribas will run to their CDS issuers (Who knows who they are but surely they are form Financial Big Bank community). We all know how healthy our banks are. Hence we will surely end up in situation where PIIGS country and "CDS issuer" both default. This Situation is called as "Double Default".

So summing up we are in situation where if We put governments as one community and Big Banks as other community. Big Banks are both Creditor and Insurance Provider to Governments. In this game with 1 default of country One bank will fail as CDS issuer and other as creditor (All 3 party lose). Remember in 2008 we learned that "Big Banks can not be allowed to fail" and that's exactly reason why "Greece is not allowed to fail" 

How long this "Not allowed" will be tolerated by Germany and other solvent nations is a million dollar question whose answer is tough. Irony of story again is money that government has is of common man's tax money and money that bank has is common man's saving. so in both cases common man is to lose either way. 

Comments / thoughts welcome.. 

P.S. : Ref : 
" The market size for Credit Default Swaps more than doubled in size each year from $3.7 trillion in 2003. By the end of 2007, the CDS market had a notional value of $62.2 trillion. But notional amount fell during 2008 as a result of dealer "portfolio compression" efforts (replacing offsetting redundant contracts), and by the end of 2008 notional amount outstanding had fallen 38 percent to $38.6 trillion"