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The Greek Charade, Act II: Europeans Keep Kicking the Can, Stocks Rally

Aaron Task
Editor in Chief
Fin - Daily Ticker - US

Financial markets exhaled Wednesday as the Greek parliament passed a $40 billion austerity package. A second vote on implementing the package is set for tomorrow and ongoing protests in Athens could change the political calculus. But the expectation now is Greece will receive a $17 billion tranche of its EU-IMF bailout package and avoid a short-term default.

That's the good news, at least as far as the markets are concerned. European stocks rallied sharply overnight as the euro climbed vs. the dollar. The Dow was recently up 0.6%, on track for a third-straight gain.

The bad news is Greece is going to be unable to pay its debts beyond next month and the austerity package will likely cripple its already struggling economy.

"No country in modern economic history has faced similar debt levels to those of Greece — a debt-to-GDP ratio above 150% - and avoided a default," write analysts at Open Europe, a London-based think tank. "Even with the help of a second bailout and a debt rollover, Greece is still likely to default within the next few years, as the country's poor growth prospects and growing debt burden mean that it will be unable to fund itself post-2014."

Given that, Open Europe believes it's better for Greece to restructure its debts now, estimating the cost of such a move will only increase with time; the firm predicts the haircut taken by Greece's lenders will rise from 50% today to 69% in 2014 following a presumed second bailout.

No Simple Solution

As you'll see in the accompanying video, Henry Blodget couldn't agree more. "To simplify a situation that has become grossly complicated…banks made dumb loans to a country that could not pay them back," he says. "What happens in that situation? You restructure the debt."

If only it were that simple.

Unlike Argentina, Russia or other sovereign deadbeats of the recent past, what happens in Greece has ramifications far beyond its borders. Because it is a member of the EU, Greece cannot "simply" default on its debt and/or devalue its currency and start over. (See: Europe on Edge: What Happens in Greece Will NOT Stay in Greece, Minton Beddoes Says)

So from the beginning of the crisis, some 18 months ago, the goal among European policymakers was to put a "ring-fence" around Greece in order to buy time for Portugal, Ireland, Italy and Spain. (See: Greece Is the Word: "I Think They'll Be Able to Control This," Dow Says)

Moreover, European banks would be unable to handle the hit of a near-term write-down of their Greek debts. In mid-July, regulators will announce the results of new stress tests on European banks and there's already speculation many banks will fail — and that's before a Greek haircut or the new Basel III capital requirements kick in.

"It cannot be emphasised (sic) enough that the main cost from a debt restructuring comes in the form of contagion and the knock-on effects of losses throughout the European banking system," Open Europe says. In addition, many banks exposed to Greece, including Belgian-French Dexia and Germany's Hypo Real Estate, are already largely taxpayer owned, the firm notes, meaning taxpayers would foot "a huge chunk of the bill" for write-downs.

Even if there were the political will in Europe, it's unclear whether there's enough money to recapitalize Europe's banks after forcing them to take a haircut on Greek debt, as Henry suggests. The European Central Bank is already in tightening mode and the Fed under pressure to shrink its balance sheet -- although (surprise!) it has approved the extension of special lending facilities to foreign central banks, The WSJ reports.

China has pledged to keep buying EU debt and has some $3 trillion of foreign currency reserves. But if bailing out Greece is a tough political challenge for German politicians, imagine trying to convince voters selling out to China is a good idea? (Yes, America is doing the same thing...but it's been subtly over time vs. in an emergency-type fire sale. Plus we've got cheap Chinese goods in exchange, which served to appease the masses during the debt bubble.)

In sum, the EU and IMF giving more money to Greece so that it can pay off its lenders is indeed a "charade," as Henry says. But, to borrow from Hyman Roth, this is the (nasty) business the Europeans have chosen. (Up next: America's debt-ceiling vote!)

Aaron Task is the host of The Daily Ticker. You can follow him on Twitter at @atask or email him at altask@yahoo.com