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Greek game of musical bondholders puts Canada at risk

Thanks to the complex world of credit default swaps, Greek bondholders are not the only ones who have to worry about credit woes in Athens.


Greek Prime Minister George Papandreou speaks with the media as he arrives for an EU summit in Brussels on June 23, 2011 (Geert Vanden Wijngaert/AP)

If you are a glass-half-full sort, then feel free to conclude debt-laden Greece is on a roll. You can be content that after winning a recent confidence vote on cost cutting measures required to avoid a national debt default, Prime Minister George Papandreou’s Socialist government appears to have gained support from the European Union and IMF for its new survival plan. In other words, Greece will now be able to borrow more money while it enacts a harsher round of austerity.

If you see the glass as half empty, of course, you might note there is little reason to expect local economic conditions to improve and that the nation’s new finance minister had some EU member questioning his judgment after just a few days on the job. You might also be concerned by the EU’s determination to kick this can down the road. After all, as we noted in a previous blog, Greece is playing a game of musical bond holders and the longer the game goes on, the worse things will be for all concerned when the music stops.

A Greek debt default is widely seen as inevitable. If it happens, the global economy will be hit by a material event, one that could prove worse than the failure of Lehman because governments around the world are no longer in a position to throw stimulus money around like drunken sailors.

The Greek debt crisis directly threatens the stability of banks and other institutional bondholders across Europe. The EU and its central banking system have about US$127 billion at stake. French and German banks hold US$18.8 billion and US$26.3 billion worth of Greek debt respectively, while British banks have US$3.3 billion at stake. In the U.S., the direct exposure is US$1.8 billion.

Business Insider has compiled lists of national exposure and institutional exposure to Greek debt.

The direct exposure of Canadian banks to a Greek debt fault is reportedly relatively low. But both Bank of Canada Governor Mark Carney and Canadian Finance Minister Jim Flaherty have warned our economy and financial institutions are at risk of serious disruption if a default occurs, which is one of the major reasons that the BoC has been holding off on interest rate hikes. 

What’s the problem? Simple. Financial institutions around the world have exposure to the exposure of Greek bondholders via what is known as a CDS, or credit default swap. CDSes are financial derivatives that function like a default insurance on debt. If a borrower defaults, sellers of a CDS must compensate buyers. These insurance products cost more when the risk of a default rises. And as this BI chart shows, the cost of a 5-year CDS on Greek government debt was soaring to new records in June as Greek Prime Minister George Papandreou was pleading with his cabinet to stay the austerity course.

According to the New York Times, the gross exposure to insurance contracts tied to the EU’s so-called PIIGS is at least US$600 billion. But nobody really knows who would owe what if Greece defaults because derivatives are a dark and complex market. U.S. Federal Reserve chairman Ben Bernanke has said American exposure to an EU debt default is limited when you take into account offsetting positions financial market players put in place. However, Bernanke also once insisted the subprime mortgage fiasco would be contained. “Given the fundamental factors in place that should support the demand for housing,” he said in 2007, “we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited,” Bernanke said

And keep in mind a Greek default could force other PIIGS to follow suit.

If one of the EU’s troubled members defaults, according to a recent analysis of debt responsibilities by economist Kash Mansori, creditors who actually hold bonds will absorb about 70% of the losses while counterparties that sold default insurance will cover the rest. As a result, if Greece were to default, about 94% of the direct losses would fall on European shoulders. But U.S. banks and insurance companies are major CDS players and they would have to make about 56% of the default insurance payouts triggered by such an event. 

The bottom line, according to Mansori, is that financial institutions in Canada’s largest trading partner have roughly as much to lose from a EU default as those in France and Germany.

And if that isn’t enough bad news, the Wall Street Journal is now reporting that House Majority Leader Eric Cantor Thursday was pulling out of budget talks  because the bipartisan group trying to solve America’s far more serious debt woes has reached an impasse over taxes.