EU is set for its own sub-prime crisis

Allister Heath
HUMAN beings have an infinite capacity for self-delusion, especially when it comes to matters financial. I still remember how, in late 2006 and early 2007, all too few investors, financiers, commentators and regulators wanted to believe that the US property market was in the early stages of a crash or that there was anything to panic about. Fewer still thought that the consequences would be bad, let alone were predicting the cataclysmic crisis that followed.

It sometimes seems that the same is true again with Eurozone debt. I’m not suggesting that it will necessarily cause another full-blown crisis or recession, though there is an increasing chance that it will, albeit not this year. But what I find strange is why otherwise rational people still believe that another bail-out or three, combined with a bit of pressure on countries to balance their budgets, will be enough to allow the crisis to go away. There is absolutely no chance of that. The problem is massive – the analogy with sub-prime American mortgages is perfect, on all levels.

Greek debt is too high, the interest rates it has to pay too elevated, its underlying economy too feeble – it is now in a vicious circle from which only bankruptcy can deliver it. Greece will default – it is merely a question of when and what proportion of their debt the bondholders will lose. A third, equally important question, is whether Greece will become the first country to quit the euro and maybe even the EU – either because it is kicked out, or because its electorate refuses to become a EU protectorate and walks out of its own accord.

Greek five-year credit default swaps imply a 60 per cent probability of a default at some point over the next five years, with a one in five chance over the next year, based on a 40 per cent recovery rate. One Moody’s executive suggested that bondholders will suffer a 50-70 per cent haircut. This makes sense: just to bring Greece’s debt to GDP ratio back to the supposedly binding but laughably ineffective Maastricht limit of 60 per cent of GDP would require a 62 per cent haircut.

The official, on-balance sheet Greek national debt is €340bn: local banks and funds own €80bn of this, the European Central Bank (ECB) has €50bn and much of the rest is held by European banks and financial institutions. A 62 per cent write-off would mean a loss of €211bn. This would wipe out most Greek financial institutions, cripple the ECB and cost European banks and funds €130bn.

The pain is getting closer. European banks need to raise capital in preparation; some are already doing that. A few billion won’t be enough; at least €150bn-€200bn will be necessary over the next couple of years for Eurozone financial institutions, especially if more countries begin to fall. British banks are largely in the clear from Greece; their real problems would start if Spain begins to falter too.

European politicians and regulators must study other sovereign defaults of the past 25 years to figure out how best to manage. One option would be a European version of the Brady bonds, issued when Latin American countries went bust in the 1980s.

Last but not least, the European establishment needs to accept that the single currency and the EU’s model of economic management has failed as badly as sub-prime mortgages failed in the US. Unless Europe accepts that its experiment is ending in tears, no progress will ever be possible.
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