Sunday, September 11, 2011

The Beginning of The Age of Default

There have been many famous epochs in European history and we are now about to witness the dawn of the latest -- the Age of Default.

Greece is verging on financial collapse (this week) and there is no longer any viable way to prevent that collapse. Whatever they may call it, default is on the way and soon, certainly before the year is out perhaps much sooner.

But, that will just be the beginning, as we move swiftly from country to country throughout the Eurozone. There is some chance, but it is slim, that Germany can itself avoid default. The reason for pessimism on Germany is that Germany will end up absorbing the obligations of its major banks, much as Ireland did two years ago. When the bailer bails out too many bailees, then the bailer needs a bailer. Who will bail out Germany?

It will be interesting how this plays out in the US. California, Illinois, and New York have no hope of avoiding bankruptcy. They will, no doubt, appeal to the federal government for relief, which, if given, would only prolong the inevitable.

The question is not whether California, Illinois and NYS will go bankrupt, the question is when. To the extent the federal government absorbs the obligations of these states, such activity will hasten the collapse of the US federal debt market.

None of this involves the losses that you might think. While Greek's nominal debt is $ 450 billion, it's current market value is probably half of that. The market has already dictated a 50 percent default, so that there is only another $ 225 billion left for investors to lose. Ditto for Spain and Italy with corrections for market conditions.

The problem is going to be: most folks have simply assumed that the ECB had some magic formula to avoid a Greek default. The ECB doesn't have such a formula. A Greek default will shock the markets and awaken the markets to the prospect of further defaults both in Europe and in the US. That is the main significance of the Greek default -- the loss of $ 225 billion to bond holders is a relatively minor problem.

For some reason, financial commentators have bought in to the "we can bail out everyone" song that is sung by European politicians and the Obama White House. It's not so and the Greek default will be the first bell that rings to show that it is not so.