Felix Salmon

Mohamed El-Erian is fast becoming the biggest and most important bear in the world when it comes to the consequences of the Greece crisis:

Since Greece is part of a general phenomenon of bloated public finance and higher systemic risk, we should also expect a generalised and volatile step-increase in risk premia around the world. Capital will thus be more selective in terms of destination, as it opts for liquidity over returns and for safe government bonds over equities…

For the next few days, we should worry about cascading disruptions in the European banking system as interbank activities are undermined by renewed uncertainties about each institution’s exposures to peripheral European names.

Mohamed’s talking his book, to a certain extent, here: the more volatile that the world of investment becomes, the more important it is to have smart professionals like the folks at Pimco running your money. Buy-and-hold is a strategy which worked very well for much of the past 50 years or so, but it’s far from obvious that it will continue to work going forwards. And besides, a lot of the tail-risk hedging that Pimco can do is simply impossible for retail investors: how would you hedge the risk of cascading disruptions in the European banking system?

If we’re about to see people move their savings from equities into bonds as stocks become just too volatile to hold for someone with a normal risk appetite, then it’s worth asking serious questions about the best way to invest in bonds, which always need to be actively managed, if only because they have maturity dates. Given that the biggest risks to the bond market are the ones surrounding sovereign default, El-Erian’s drumbeat of op-eds on Greece might well help his company get mandates from investors who want to park their money with a company thinking seriously and presciently on such matters.

Especially since it looks as though, at least until now, he’s been pretty accurate.

Update: Just to be clear, when I say that El-Erian is talking his book, I don’t mean that he’s short Greece, or anything like that. I don’t think he is. I just mean that he increases his assets under management, and makes money, when the world gets complicated. And so it’s in his interest to point out just how complicated the world is getting.

Willem Buiter has joined the group of people convinced that Greece will default. I think he’s too optimistic:

A mix of huge debt and no primary deficit – i.e. needs for external funds to pay for ongoing government spending – constitute “ the exact circumstances that makes a default individually rational for the debtor,” he notes…

The later it happens, the larger the haircut will be, says Buiter. He reckons a 30% cut today would have sufficed, but would have wrought havoc on the capital positions of Greek, French and German commercial banks, which would probably need to be recapitalized immediately, provoking major political embarrassment in Berlin and Paris.

Instead, Buiter says, the plan must be to give some time to those banks to recapitalize, or sneak Greek exposure off private balance sheets and on to public ones.

The problem here is that a 30% cut today would not have sufficed, precisely because Greece is not running anything close to a zero primary deficit. Paul Krugman makes the point:

Here’s the thing: Greece is currently running a huge primary deficit — 8.5 percent of GDP in 2009. So even a complete debt default wouldn’t save Greece from the necessity of savage fiscal austerity.

It follows, then, that a debt restructuring wouldn’t help all that much.

In fact, it’s worse still: even if Greece were running a zero primary deficit (and I’d love to know if it’s ever managed that particular feat), a default without devaluation would still keep the country mired in its current uncompetitive state. If you’re going to go through the massive pain of a default, you might as well get the upside of devaluation at the same time, and exit the euro.

At that point, the only question is: do you default and devalue now, or do you wait a couple of years? Germany and France might well want to wait, in the hope that their banks will be better able to cope with such a thing in a couple of years’ time. But from a Greek perspective, if the pain is coming, best to go through it now and bring forward the growth rebound, rather than push off the devaluation stimulus to an indefinite point in the future.

Amidst the sober analysis and the bloody riots, one expected artifact of the chaos in Greece has been notable by its absence: fevered finger-pointing at speculators in the credit default swap market.

And it’s now becoming clear why:

Barclays Capital analysts point out in their most recent European Credit Alpha report that Greek government bonds have been trading substantially wider than credit default swaps on the sovereign. This creates large potential returns on negative basis packages, especially if there is a credit event in the near term.

The negative basis between five-year bonds and five-year credit default swaps has recently been as great as 200 basis points. However, the basis can be even greater for a basis packaging combining short-dated credit default swaps and long dated bonds, says the report. The old-style restructuring used in Greek sovereign credit default swaps means that obligations of any maturity up to 30 years out can be delivered into any credit default swap.

In English, what this means is that the spread on Greek bonds is substantially larger than the spread on Greece CDS. As a result, you can theoretically lock in a risk-free profit by buying Greek bonds and at the same time buying credit protection on them: the cost of the protection is lower than the yield on the bonds, and the rest of your coupon payments is pure profit.

This also means that you can’t blame the CDS market for sending Greek bond spreads gapping outwards — if anything, the opposite is the case, and Greek bond spreads are probably responsible for upward pressure on Greek CDS spreads. Once again, if you own Greek debt, the CDS market is your friend: you’re better off buying protection on that debt than you are simply selling your bonds outright.

This trade could also help fund the Greek bailout while at the same time providing a solid bid for Greek bonds. I thought in 2009 and I still think now that governments might want to get involved in this trade: they can start buying up large amounts of Greek bonds, and hedging the credit risk in the CDS market. That would reduce Greek bond yields (an obviously positive outcome), while at the same time providing a high-visibility vote of confidence in the European banking system and the counterparty risk that might lie inside it.

Right now people are scared about the high yields on Greek debt, and that’s causing nervousness in financial markets worldwide. There’s not a lot of money going into the Greece basis trade, because it might be quite expensive if you need to fund it, and borrow the money you’re investing in Greek bonds. But that’s not an issue for someone like the German government.

While lending directly to Greece with one hand, Germany could start lending indirectly to Greece by buying its bonds in the secondary market with the other — and thanks to the existence of the CDS market, they don’t even need to take on any extra credit risk when they do so. It wouldn’t be enough to save the country from its fiscal crisis, a permanent solution to which is still remote. But it would surely help at the margin.

(HT: Alea)

Update: A tipster explains the reasons for the negative basis here: there’s forced selling in the bond market, especially from accounts which aren’t allowed to hold debt which has even one junk rating. Greece is also being tossed out of a few bond indices. So that explains the downward pressure on Greek bonds, which doesn’t exist in the CDS market.

Paul Krugman has an intriguing pair of back-to-back blog entries. On Sunday afternoon, he wrote this:

The plan still requires savage austerity on Greece’s part, and ensures a terrible few years for the Greek economy. But it does rise to the scale of the problem, and it might work.

Then, on Monday morning, he followed up with this:

Anyone demanding that countries not run such big deficits is, in effect, calling for higher taxes and slashed spending in the face of a deep recession — Hoovernomics. Is that really what they want? Is that their final answer?

I’m more on board with Monday Krugman than with Sunday Krugman. Steven Erlanger has a good analysis in today’s NYT:

There are serious questions about whether the deep cuts in salaries and benefits the agreement calls for are politically sustainable over time, even as deflation will make it impossible for Greece to grow its way out of debt…

“How can Greece grow out of its debt if there is deflation?” asked Jean-Paul Fitoussi, a professor of economics at the Institut d’Études Politiques in Paris. “Deflation increases the debt burden, so we are following this virtuous circle that is bringing us toward hell. Economics has nothing to do with virtue, which can kill an economy.”…

“Unfortunately for economists, there is democracy,” Mr. Fitoussi said. “If you impose too strict a program, the population will refuse.” Some countries, he acknowledged, have responded quietly so far to deep cuts, like Ireland and Latvia. “But Greeks are not Latvians,” he said, citing serious worker demonstrations already this weekend.

The fact is that the bailout package really doesn’t address the problem, which is one of solvency rather than liquidity. The European loans are being extended at about 5%, which while much lower than market rates is still not low enough to make anything approaching a dent in Greece’s debt dynamics. And by the time the bailout package is exhausted, if Greece even gets that far, its debt-to-GDP ratio will be significantly higher than it is right now, thanks to both a rising numerator and a declining denominator.

So the prospects of an imminent default seem to have eased: Greece will almost certainly have the money to roll over the debts coming due in a couple of weeks. But this is not a solution to the Greek problem, even if Greece successfully implements all the austerity that it’s promising. Which it won’t.

I was on All Things Considered Sunday, talking about “why Europe’s debt crisis matters to Americans”. It’s a question I’ve been asked quite a lot of late, and I have to admit I’m having difficulty answering it. I’m a sovereign-debt geek — just ask me about collective action clauses, exit consents, and the Sovereign Debt Restructuring Mechanism next time you’re suffering from insomnia — so I naturally find all of this fascinating. But I appreciate that not everybody else does, and I’m having difficulty working out whether they should or not.

So, I have two questions, if I may:

1. Should the prospect of default in Greece or elsewhere in Europe concern the average American?
2. If so, why?

All answers gratefully accepted.

Euroweek’s Southpaw column starts off explosively:

A mandate advising Greece on a potential restructuring — understood to have been won by Lazard — is the highest profile piece of business going for bankers working for government clients.

This would seem to imply that Greece has been shopping around this mandate for some time now, and has already settled on Lazard as the bank it’s going to go with. It’s a smart choice: Lazard did a spectacular job recently in both Ecuador and Ivory Coast. But the mere decision to hire advisers sends the message to the market that default is more than just an option. Greece, it seems, is happy to spend serious money on high-priced bankers right now to work out whether and how to do it.

If anybody has the rest of the column — the bit behind the paywall — I’d love to see it. And if anybody sees Lazard’s Michele Lamarche spending a lot of time in Athens, I think we can assume she isn’t on holiday.

On Monday, I looked at Germany’s attitude to Greece from a nationalist/tactical perspective, and promptly got slapped down by dsquared: “Congratulations,” he wrote, “you’ve proved the impossibility of not only the 2004 and 2007 accessions, but also of the Common Agricultural Policy.”

But the fact is that the Europe which grew in 2004 and 2007, and the Europe which came together to create the CAP, now looks as though it is falling apart. Philip Stephens has an essay in today’s FT which diagnoses this well, and which captures the sudden shift that we’ve seen of late, from the “reassuringly ineluctable” EU of a couple of years ago to something much more precarious today:

Europe no longer carries the stamp of inevitability. Quite suddenly, it has become almost as easy to foresee a future in which the Union fractures…

Germany relishes instead the chance to become a “normal” country, separating what it sees as its national from the European interest. Helmut Kohl’s historical insights are forgotten in the insistence that German taxpayers should not be asked to remain the continent’s paymaster. So too are Berlin’s long-term interests in European-wide political stability and in open markets for its exports.

France struggles with the dynamics of a Union in which more Europe no longer necessarily means more France. Nicolas Sarkozy’s admirable energy is unconnected to strategic purpose. Britain, as ever, stands half on the sidelines. Italy, led by Silvio Berlusconi, has removed itself from influence.

There have been moments of stasis before. But the rules have changed. The fall of the Berlin Wall and the collapse of communism have turned an enterprise of necessity into one of choice. If the Union falls into disrepair everyone will still be the loser; but the threat no longer seems an existential one…

The response of Europe’s politicians has been to sacrifice the strategic to the tactical.

Stephens diagnoses this as a failure of leadership, and narrowly he’s right; certainly it’s impossible to imagine today’s European heads of state making the collective decision to adopt the euro.

But Paul Krugman takes the opposite tack: the failure of leadership, he says, was encapsulated in the decision to adopt the euro in the first place.

The deficit hawks are already trying to appropriate the European crisis, presenting it as an object lesson in the evils of government red ink. What the crisis really demonstrates, however, is the dangers of putting yourself in a policy straitjacket. When they joined the euro, the governments of Greece, Portugal and Spain denied themselves the ability to do some bad things, like printing too much money; but they also denied themselves the ability to respond flexibly to events.

And when crisis strikes, governments need to be able to act. That’s what the architects of the euro forgot — and the rest of us need to remember.

I’m probably closer to Stephens than to Krugman on this one, but it’s true that the architects of the euro assumed that it would foster political unity, in much the same way as some couples think that having a baby will help to save their marriage. Certainly the stakes were raised, but if Germany and Greece never really got on very well in the first place, it was with hindsight far too optimistic to assume that joining together in monetary matrimony would suddenly make them sovereign soul-mates. When they were just cohabiting in the EU, their differences were manageable. But now they’ve had the euro together, that’s not true any more.

Remember all those Swiss banks with massive exposure to Greece? Er, never mind. The WSJ’s Brian Blackstone has* this great little chart, which shows Switzerland’s $79 billion of exposure falling by 95% between the third and fourth quarters. He’s got to the bottom of what exactly happened, too. And it has nothing whatsoever to do with CDS:

Eurobank EFG is based in Athens, listed on the Athens stock exchange and has roughly 1,600 branches in Greece and other countries in Central, Eastern and Southern Europe. It is controlled by EFG Group, a holding company that is indirectly controlled by the billionaire Latsis family of Greece.

Until recently, EFG Group had its headquarters in Switzerland…

It is unlikely that the bank posed any significant financial risk to Switzerland. Like all Greek banks, its deposits are insured by the Greek government.

Eurobank EFG’s exposure was classified as Swiss because its parent company was based in Switzerland. In the fourth quarter, the parent company underwent a restructuring; EFG Group is now based in Luxembourg but not classified as a bank there.

It seems that the BIS itself is in dire need of moving from a rules-based to a principles-based regime. EFG is a Greek bank, it was always a Greek bank, and it should always have been reported as such. If some narrow-minded bureaucrat decided that the rules meant that it had to be reported as Swiss, then obviously the BIS should have changed the rules. It’s worth asking why that never happened.

Update: Reuters had it first. And I think, although BIS statistics are very confusing, that what we’re looking at here is double-counting: EFG showing up in both the Greece and the Switzerland statistics. Until Q4, at which point it was just Greece.

Update 2: Or maybe Alphaville had it first.

Peter Boone and Simon Johnson have a long and dense post on the eurocrisis today, which has a lot of different diagnoses and conclusions. I don’t agree with all of it, but I do think they touch on something important when they trace it all back to the way that the ECB became a quasi-fiscal agent:

The underlying problem is the rule for printing money: in the eurozone, any government can finance itself by issuing bonds directly (or indirectly) to commercial banks, and then having those banks “repo” them (i.e., borrow using these bonds as collateral) at the ECB in return for fresh euros. The commercial banks make a profit because the ECB charges them very little for those loans, while the governments get the money – and can thus finance larger budget deficits. The problem is that eventually that government has to pay back its debt or, more modestly, at least stabilize its public debt levels.

This same structure directly distorts the incentives of commercial banks: they have a backstop at the ECB, which is the “lender of last resort”; and the ECB and European Union (EU) put a great deal of pressure on each nation to bail out commercial banks in trouble. When a country joins the eurozone, its banks win access to a large amount of cheap financing, along with the expectation they will be bailed out when they make mistakes. This, in turn, enables the banks to greatly expand their balance sheets, ploughing into domestic real estate, overseas expansion, or crazy junk products issued by Goldman Sachs. Just think of Ireland and Spain, where the banks took on massive loans that are now sinking the country.

Given the eurozone provides easy access to cheap money, it is no wonder that many more nations want to join. No wonder also that it blew up.

The magnitude of the problem that Boone and Johnson describe here is of course directly related to the spread between the ECB repo rate, on the one hand, and any given nation’s funding cost, on the other. As that spread increases — and it’s been increasing wildly over the past few weeks in places like Greece — the moral hazard associated with this trade skyrockets.

And I think Boone and Johnson might also have touched on the important question of who’s buying PIIGS debt in general, and Greek debt in particular, at its current non-distressed levels. It’s not those emerging-market bond investors, crossing over into higher yields in Greece. They always price credit risk, and they don’t like what they see. (Remember that for many years Mohamed El-Erian was the most important and powerful emerging-market bond investor in the world.) Instead, it’s our old friends the banks, wallowing in the carry trade. They know, after all, that even if Greece isn’t bailed out, they will be.

Mohamed El-Erian has an important piece on Greece in tomorrow’s FT; if you want to boil his 750-word article down to 3, it’s basically “Greece will default”.

El-Erian comes to this conclusion using three logical steps. The first:

A number of things have to happen very fast over the next few days to have some chance of salvaging the situation. At the very minimum, the government in Greece must come up with a credible multi-year adjustment plan that, critically, has the support of Greek society; EU members must come up with sizeable funds that can be quickly released and which are underpinned by the relevant approval of national parliaments; and the IMF must secure sufficient assurances from Greece (in the form of clear policy actions) and the EU (in the form of unambiguous financing assurances) to lead and co-ordinate the process.

And a squadron of flying pigs dropping 100-euro notes from helicopters across both the Greek and Iberian peninsulas would probably help too. The fact is that far from all of these things happening in the next few days, the base-case scenario is that none of them will. (The “sizeable funds” might appear, but don’t believe for a minute that national parliaments won’t object.) And on top of that, El-Erian notes drily that “the official sector has yet to prove itself effective at crisis management” — or, to put it another way, if you really think the IMF can cope with a Greek crisis, just look at how it coped at previous crises in Asia, Russia, and Latin America.

The second part of the argument is this:

The disorderly market moves of recent days will place even greater pressure on the balance sheets of Greek banks and their counterparties in Europe and elsewhere. The already material risks of disorderly bank deposit outflows and capital flights are increasing. The bottom line is simple yet consequential: the Greek debt crisis has morphed into something that is potentially more sinister for Europe and the global economy. What started out as a public finance issue is quickly turning into a banking problem too; and, what started out as a Greek issue has become a full- blown crisis for Europe.

This, in a sense, hardly needs saying: all public finance crises are also banking crises. The world has never seen an insolvent country with solvent banks, and Greece won’t be the first. But of course it’s not just Greek banks we’re worried about here, it’s also other banks across Europe — French, German and Swiss banks in general, and Fortis, Dexia and SocGen in particular, seem to be particularly at risk. Greece has always borrowed heavily from abroad, and its lenders are now in a very tough spot; needless to say, all those banks will get bailed out before they’re allowed to fail.

Finally, concludes El-Erian:

Absent some remarkable change in the next few days, things will get even more complex for the official sector. It may have no choice but to combine its own exceptional financing efforts with talks on a controversial approach that will be familiar to veteran emerging market observers – PSI, or “private sector involvement”.

PSI is the polite way to talk about the restructuring of some of the sovereign debt held by the private sector. It is based on a concept of burden-sharing in a disorderly world. It can appeal to governments as a seemingly easy way to ensure that massive public sector support to crisis countries does not flow back out in the form of payments to private creditors. Yet PSI is also hard to design comprehensively, harder to implement well and involves collateral damage and unintended consequences.

This is the “Greece will default” bit. El-Erian doesn’t quite come out and say so directly, but that’s how I read his “may have no choice but to” language: it’s about as close as the CEO of Pimco can come to saying that Greece will default without being accused of inciting panic. He even provides the requisite euphemism for the public sector to use: “private sector involvement”.

Consider the alternative, which is that the bulk of any EU/IMF bailout package would go to paying off in full all those speculators who have been buying Greek debt at 18% interest rates. It’s the too-big-to-fail problem all over again, exacerbated by the fact that if Greece gets a bailout, you can be sure that other countries are going to want one too, starting with Portugal, and working on from there. At some point, the German population simply won’t abide it: they’ve got their fiscal house in order, and they understandably don’t want to spend their hard-earned euros on paying off the debts of countries which, as Tyler Cowen puts it, “have been pretending to be much wealthier than they really are and to make financial plans on that basis”.

A Greek bailout package — any bailout package, really — is much more palatable when there isn’t anybody obviously being bailed out: when the distressed and insolvent borrower has to endure painful austerity, and when its lenders too suffer a certain amount of pain. To put it in US terms, we’re looking for something much more like GM or Chrysler, and much less like Bear Stearns. But of course GM and Chrysler were put into bankruptcy, and there’s no such thing as sovereign bankruptcy, which makes the whole problem that much more difficult and prone to what El-Erian calls “collateral damage and unintended consequences”.

El-Erian talks about how this approach “will be familiar to veteran emerging market observers”, but there’s a lot going on here which we haven’t seen in emerging markets before: a debt-to-GDP ratio of well over 100%; a country facing default which still has two investment-grade credit ratings; and, of course, the formal economic and monetary ties to risk-free developed nations.

It’s worth remembering Mexico’s tequila crisis of 1994-5. That was a liquidity crisis, not a solvency crisis, but even then the US bailout (a now-tiny-seeming $20 billion) had to come from a little-known Treasury slush fund since there was no way that it was going to receive Congressional approval. What’s more, the US ended up making a profit on that bailout, while as every German knows, any Greek bailout funds are unlikely to be repaid in full. And the US aid was extended only after Mexico had devalued and thereby become competitive again.

It’s impossible for Greece to devalue without defaulting, given that all of its debt is in euros. El-Erian doesn’t talk about devaluation in his article, but it’s clearly still a possibility. A default, meanwhile, is increasingly looking like it’s probable in the short-to-medium term, and near-certain in the long term. Countries have come back from high debt-to-GDP ratios in the past. But not with interest rates at these kind of levels, and only through devaluation.

I think I’m going to go join Paul Krugman under that table.

Nouriel Roubini, it can be safely said, gives good panel — especially when the subject is the eurozone and the possible disintegration thereof. He’s been bearish on the PIGS in general and on Italy in particular for many years now, but I don’t think it comes as much surprise to him or to anybody else that Greece is the first country really in the firing line.

One of the most interesting things about the status quo post-downgrade is that no one seems to have a clue what the base-case scenario is. Are the markets still expecting Greece to get bailed out, but adding on an ever-increasing yield premium to account for the possibility that it won’t be? Are they, like panelist James McCaughan, expecting an orderly debt restructuring later this year, with an effective haircut in the 20-40% range? They certainly don’t seem to be expecting anything worse than that — Greece’s bonds are trading at high yields, yes, but not at distressed levels, and there’s still room to lose a lot of money on those 2-year bonds if they end up defaulting.

My feeling is that the base case is one of muddling through for the next 2-3 years, with Greece scrounging up enough money from the EU and IMF to avoid a default, and Europe’s banks meanwhile staying profitable enough thanks to the ECB’s monetary policy that they build up their solvency for when the inevitable default does occur a few years down the road.

But it’s not clear that the markets are going to let that happen. It’s all well and good for the Germans and others to cover the Greek fiscal deficit for the next three years, and even to insist on tough fiscal adjustment at the same time. But if Greek yields stay anywhere near their current levels, there’s a good risk that would be politically unacceptable in both Germany and Greece. Sweden’s Bo Lundgren was also on the panel, and he helped explain how the Swedish population has the crucial and decidedly un-Greek ability to unite behind unpopular yet necessary policies once their political leaders have set a certain course. Greece, which is already seeing riots at any hint of fiscal austerity, just isn’t the kind of nation which is likely to decide that five years of wage cuts in a painful and deflationary recession is a price worth paying to stay current on the national debt.

Meanwhile, Tony Barber has already come to the conclusion that as far as Greece is concerned, “the political conditions for extra financial help from Germany just do not exist”.

Nouriel, of course, takes that kind of thinking to its logical conclusion, and kicked off the panel by announcing that it was just in time: “in a few days,” he said, “there might not be a eurozone for us to discuss.” There’s no way that Greece can implement the 10% spending cut it needs to do in order to stop its debt spiralling out of control at current interest rates — and even if it did, the economic effects would be disastrous.

Nouriel’s base case, then, is Argentina 2001: after all, Greece has a much higher debt-to-GDP ratio, much higher deficit-to-GDP ratio, and much higher current-account deficit than Argentina had back then. And if that’s the base case, there’s no way that Greek debt should be trading anywhere near its current levels.

Of course, this being Nouriel, it goes downhill from there: if Greece is worse than Argentina, he says, then Spain is worse than Greece. Its housing bubble and bust has left the banking sector much weaker than Greece’s; its unemployment situation, especially with the under-30 crowd, is much worse than Greece’s; and the cost of any Spain bailout would be so much more enormous than the cost of a Greek bailout as to be almost unthinkable. The only thing that Spain has going for it is that it isn’t quite at the edge of the abyss yet; if it gets its political act together and implements tough fiscal and structural reforms now, it can save itself. But clearly no one saw that happening, given Spain’s political history over the past 20 years.

There’s no good news here. The least bad course of action for Greece, in Nouriel’s eyes, is some kind of coercive yet orderly debt restructuring, which keeps the face value of the debt unchanged but which reduces coupons and pushes out maturities. And an exit from the euro. Alternatively, the ECB steps in and cuts interest rates so low that the euro gets pushed down towards parity with the dollar, which would accomplish something similar without nearly as much pain.

One member of the audience, though, had a really good question: what happens to the European system of sovereign guarantees of interbank lending? When those sovereign guarantees aren’t worth much any more, Euribor is likely to spike, since suddenly there’s a lot more credit risk involved in interbank lending. And there are hundreds of trillions of euros of debt contracts linked to Euribor, which could suddenly get very expensive and take control of short-term interest rates out of the hands of the ECB.

And in any case it’s worth remembering that even though Greece’s debts are small in relation to Spain’s, they’re still large in relation to, say, those of Lehman Brothers. And given that there is no formal mechanism for leaving the euro (or for defaulting on sovereign euro-denominated debt, for that matter), there will almost certainly be a range of unexpected and chaotic events somewhere down the line. That’s why I feel that although Greek bond yields are certainly going to be volatile for a while, we’re going to see higher highs and higher lows — there’s pretty much nothing, at this point, which could reassure the markets and turn Greece back into an interest-rate play rather than a credit play.

Even a massive IMF bailout, which is probably the best-case scenario for Greece right now, wouldn’t suffice to bring yields back down to their pre-crisis levels. As Nouriel pointed out, the IMF, as a preferred creditor, would make sure it was repaid, in the event of default, long before bondholders. And as a result, even if the probability of default dropped, the recovery value on Greek bonds in the event of default would drop as well. And so yields wouldn’t come down as much as you might think.

I covered emerging market sovereign bonds for many years, but I’ve never seen anything like this: a country trading at levels where the bear case is terrifying, the bull case is very hard to articulate, and everybody is talking about a possible default even when the country has an investment-grade credit rating from two agencies and is only one notch below investment grade at the third. Maybe the only thing which really explains what’s going on is that both yields and ratings are sticky. Which would imply that Greece has a long way to deteriorate from here.

When Goldman Sachs noticed a pattern of regular losses in its mortgage book at the end of 2006, it decided to start going short, in a move which helped to position it as the most successful bank in the financial crisis. The markets have learned their lesson: now that Greece and Portugal have been downgraded, the rush to the exits is palpable: the flight to quality is on, and bond yields in the European periphery are going stratospheric.

Greece’s bonds can still be used as collateral at the ECB: Moody’s hasn’t (yet) downgraded them. But S&P’s sovereign-ceiling principles mean that all of Greece’s banks now have a junk rating, and it’s surely now only a matter of time until Moody’s and Fitch follow S&P’s lead and Greek debt becomes a speculative credit instrument rather a government bond which is safe in anybody’s eyes.

The trick about going short an imploding asset class, of course, is that it only works if you’re in the minority. If everybody is doing it, you just get overshooting asset markets and chaos — which is what we’re seeing now. As far as the financial markets are concerned, if any bailout comes now, it’ll be too late: no country can sustain Greece’s combination of funding costs and debt-to-GDP ratio, no matter how much German money it burns through. Plug 13% yields into my Greek debt calculator, and the results aren’t pretty, even if they don’t have any effect at all on all the other optimistic assumptions.

This is the problem with the way in which the EU insisted that Greece reach a point of desperation, exhausting all other funding opportunities, before it turned to Europe for help. At that point, it might be too late. And it’s going to be really hard to persuade Germany and the rest of Europe that lending new money at low rates to a country in this kind of fiscal situation makes any sense at all.

I just had a very interesting conversation poolside at the Beverly Hilton with a couple of high-profile delegates at the Milken Global Conference. The pool, one level down from where all the panels take place: is clearly the place to be: Arnold Schwarzenegger was just a couple of tables away. But I doubt he was talking in great depth about the Greek debt situation and what’s likely to happen there.

I walked away from the conversation decidedly bearish on Greece. Why?

1. It’s not in the interest of Germany’s politicians to bail out Greece. Angela Merkel is taking a hard line on the subject, and you can see why she would — the German electorate has no particular desire to spend billions of euros bailing out the Greeks.
2. It’s not even narrowly in the interest of Germany to bail out Greece. If Germany cares only about itself, rather than the full European Union, then in many ways the best-case scenario for Germany is to see Greece and Portugal default, leave the euro, and then re-enter a few years later at a more competitive exchange rate. That’s better than using German funds to try to sustain the national debt of those countries at their present elevated levels.
3. Even if Germany cares about what might be called “narrow Europe” — Germany, France, Benelux — it still might well rather see Greece and Portugal exiled from the euro, thus making it a more credible currency in the eyes of many.
4. If Germany can’t be sure that Greece will avoid default, it would be much better off simply letting Greece go its own way, and then bailing out its domestic banks if Greek did end up defaulting. The cost of the bank bailout would be lower than the cost of a Greece bailout, and the money would remain within Germany.
5. If Greek did default, though, make no mistake that massive bank bailouts would be necessary — if not in Germany then certainly in places like Italy. Hedge funds and distressed investors aren’t going to start buying Greek debt pre-default: they’re going to wait for the default and the inevitable overshoot in prices, and then buy.
6. Where would Greek debt trade in the event of a default? This is the scariest thing: my highly plugged-in companions both agreed that it wouldn’t just fall to 70 or even 60 cents on the dollar: they saw fair value closer to 40, and said that it would probably fall to 30 before people started buying.
7. Needless to say, if Greek debt was trading at 30 cents on the dollar, it wouldn’t take long for the Portuguese domino to topple. After that, Spain — and then, it’s easy to imagine, Italy, Ireland, UK. And so the stakes are very high: it’s certainly cheaper to bail out Greece with virtually unlimited funds than it is to risk a fully-blown PIIGS default. But there does seem to be the hope or expectation that a line could get drawn in the Iberian sand, and that Italy and Ireland would not be allowed to default even if Portugal and/or Spain imploded.
8. A couple of high-profile sovereign defaults in Europe would actually be welcomed by the fiscally-responsible wing of the Republican party — the people who want to raise taxes rather than lower them. The idea here is that there would be a come-to-Jesus moment and lawmakers would suddenly realize how dangerous large sustained deficits can be, and change their wicked ways.

I buy nearly all of this, with the exception of #6 and #8. My feeling is that a Greek default, while it could in theory be a disorderly and chaotic simple failure to pay, would more likely take the form of a public exchange offer, which would help to put a floor on the price of Greek debt.

And I very much doubt that defaults in southern Europe would improve the fiscal status of the US. To the contrary, the flight-to-quality trade would just make it even cheaper for the US to borrow money, and the lesson we’ve all learned many times is that so long as a country has lots of access to cheap money, it’ll go on borrowing.

But I do think that there’s a pretty low limit to how much money Germany is going to spend bailing out Greece. It’s already bailed out one basket-case European country, when it absorbed East Germany. It’s got no appetite to bail out another.

I haven’t previously heard of Cumberland Advisors, a money manager in Sarasota, Florida. But they’ve been writing some great stuff on the subject of Greek bank runs.

First of all David Kotok set the stage:

Banks in Greece are experiencing runs in the billions of euros. Remember, depositors can remove their money and redeposit in another country in another bank and still do business in the euro. There are sixteen countries in the euro zone. The banking options for euro zone citizens are varied and abundant.

The bank deposit scheme in the euro zone leaves deposit guarantees in the hands of the national governments. In this case Greece is the guarantor. And since the country is in trouble because if its fiscal deficit issues, its banking system is also in trouble. That is because the strength of the national banks deposit guarantees are dependent on the strength of the government’s finances.

Could Greece go the way of Argentina or Iceland, he asked, where deposit insurance turned out to be worth very little? Kotok was ulimately sanguine.

But then Bob Eisenbels picked up the story in a fantastic entry yesterday, comparing Greece’s deposit insurance today to state deposit insurance in the US. The history here is not encouraging:

The US has had a long history, going back into the early 19th century, with decentralized state-sponsored deposit insurance systems that were not backed by the federal government. This includes the New York safety fund system; funds in Vermont and Michigan that were established in the 1800s; and funds in Oklahoma, Kansas, Nebraska, Texas, Mississippi, South and North Dakota, Ohio, Maryland, and Rhode Island that were put in place in the early 1900s. All of these programs failed within a few years. Most recently this happened to the Maryland and Ohio deposit insurance systems in 1985 and Rhode Island in 1991.

Eisenbels points out that in 1985 and even today, Ohio’s GDP is larger than that of Greece.

Bank runs are, by their nature, unpredictable things. WaMu suffered a big run, for instance, despite being FDIC insured, while uninsured customers at Citibank left hundreds of billions of dollars on deposit there, even as Citi teetered on the brink of insolvency. (Most of Citi’s depositors are uninsured, since most of its deposits are overseas.)

But there’s clearly a systemic risk to the Greek economy from bank runs, and it’s unclear how the EU is going to deal with this problem. Maybe there will start to be noises about an implicit EU backstop of Greece’s deposit insurance scheme — but I’m not sure that vague noises would suffice. I suspect that the main obstacle to a run is that Greece neighbors no eurozone country, and so it’s not exactly trivial for a Greek depositor to move her money to a non-Greek bank. Let’s hope that’s enough, for the time being.

How fabulous is this spreadsheet? It allows you to take the official Greek assumptions of what’s going to happen with respect to its fiscal situation over the next few years, and replace them with anything you like.

Play around with anything in the orange cells, except for the ones saying “Nominal GDP growth”: that’s just the sum of the two rows above. It’s pretty easy to come up with some assumptions which show Greece’s debt-to-GDP ratio flattening out at somewhere north of 127%, instead of peaking at 120.6% and then falling to 113%:

Do let me know what kind of results you get. Reuters’s own Brian Love has run a bunch of numbers, including seeing real GDP fall by 3% in 2010, 7% in 2011, and 1% in 2012, before seeing a 3% rebound in 2013. (Those are numbers he got from Simon Johnson.) In that case Greece’s debt-to-GDP ratio rapidly gets higher than 135%, even before you take into account the fact that its borrowing costs would surely be rising sharply at the same time. Put in a steady 8% interest rate for its debt service, and the debt-to-GDP ratio can reach 150% quite easily:

Note that the chart above even assumes that Greece manages to run a primary surplus in 2012 and 2013 — that, before interest payments, it will be spending less than its tax revenues. Even at the end of an incredibly brutal recession. Realistically, the higher the negative numbers on the second line, the higher the negative numbers on the first line as well. That’s all you really need for a debt spiral: you don’t even need the interest rate on your debt to get crazily out of hand.

The stakes, then, could barely be higher. Either Greece manages to implement its current plan, or it comes very close to spiraling out of control into devaluation and/or default. Maybe that’s why the EU isn’t insisting on high levels of conditionality in its rescue package: it knows that the Greeks themselves have every incentive to get this right. Which doesn’t, of course, mean that they’ll succeed.