Let’s start with a story. You and I are friends. You discover that you’re going to come up a little bit short on the rent this month and ask to borrow $100 from me. I agree, loaning you $100 at 10% interest (we’re just doing that to keep the math simple, I would never loan shark you that bad, you’re my buddy.) So you are going to get $100 this month to pay your rent and pay me back $110 next month when you get paid. That’s a tidy profit for me, relatively speaking, and you don’t get evicted (not that you would get evicted in the US, current averages are well over a year for a foreclosure to go through but that’s another story.)
I however, think that there is a chance, possibly small, possibly large, that you may not be able to pay me back next month and in fact will go into bankruptcy over this $100 I have loaned you. I don’t want to lose my entire investment. Luckily for me, we have another mutual friend who sells insurance on loans, loans he didn’t have any influence over originating. He does this because historically speaking, people like you don’t default on your debts and it’s thought of as an almost risk free way to make some cash.
So I go to this mutual friend and ask to buy insurance against you defaulting. I agree to pay $8 to this guy in return for an insurance policy that says if you default on your $100 loan to me, our little friend will pay me the full value of the loan, $110. This way, I am guaranteed to make money either way. If you pay me back, I make $2, $10 from you minus the $8 I paid for the insurance policy. If you default, I make $10 when our mutual friend pays me my full value, $110. This is a perfect situation for me and assuming I have deep pockets, I’d happily loan all the money I could possibly afford to you because I’m guaranteed to make money. In fact, because of the terms above, I actually make more money if you default. Anyone who believes in the incentives of the market has to see that I’m going to start loaning money regardless of risk because I actually make more money on bad investments. EDIT: As Wes notes in the comments, as described, the math is wrong. I added the risk analysis part and conflated how CDS are typically done where a long or short position is established with my simplified story. It should just say that I make $2 either way to keep things simple. It doesn’t materially change the story so I’m leaving it in.
Our mutual friend however is on the hook in a bad way, though he doesn’t think that. If you default, he has to pay me $110. Even if the risk is low, the punishment for misjudging the likelihood of you defaulting is very, very high. If you lied about your income and in fact have almost no chance of paying, he has badly mispriced the insurance he sold to me. This is not a very good situation.
On the smallest scale, and ignoring a ton of highly relevant but complicated factors, this is exactly what is happening in Greece right now. Banks, predominantly French and German, loaned money to Greece when things were going good. Greece didn’t look like the profligate wastrel now portrayed in the media then. But just in case, those banks sold credit default swaps to other entities just in case Greece didn’t make good on her promises. Suddenly, it’s starting to look like Greece can’t pay things back and may very well have to default. In reality, the prices on Greek debt are already saying Greece WILL have to default. And the kick in the pants is that the entities that sold the insurance policies to those banks for the Greek debt are largely unknown. That is to say, we don’t really have a solid clue who will be left holding the bag with the dead bodies in it if and when Greece defaults.
Here’s another kick in the pants: the people of Greece know that even though the media keeps calling this a bailout, it’s really a loan. They are being asked to accept draconian cuts in services and benefits now with the promise that they will have to pay all this back at some point in the not so distant future. The average Greek knows that their politicians have bent them over in a bad way for decades and that they are now being asked to shoulder the blame, not only for their ruling class’ bad behavior but for the behavior of the idiot banks who never should have been making these loans in the first place. This is why they are rioting and who can blame them.
The thorniness of this situation grows even more tangled when we start to think about what happens if Greek defaults. We really don’t know who is sitting there with billions of dollars in insurance policies against just such an occurrence. What if the Bank of Britain sold some of those swaps? Hell, what if the US government decided to get in the game? Remember AIG? Remember Lehman Brothers? This could be much worse. We’re talking about an entire country’s debts (not to mention Portugal and Ireland) and because the risk associated with that debt has been passed up and up the chain, we won’t know who has to pay back what until we get to the last man standing, currently a complete unknown. This is how a country like Greece, with a tiny 3% of the entire GDP of the EU, could very well cause a systemic crisis at least as large as what we saw in 2008.
On top of all that, we have the issue of the euro as a common currency across nation states that don’t share financial policy. What that means is that when something bad happens in a country in the EU monetarily speaking (say, a country is in terrible debt, has 16% unemployment and an angry populace), individual countries don’t control their own money and thus can’t solve problems in ways a country like the US can (by printing up a bunch of money to pay back the debt.) So all countries in the EU are on the hook for each other, a fact that doesn’t sit to well in Germany who may now have to “bailout” the Greeks (the Germans are not at all blameless in this fiasco but again, a post for another day.) What this means is that if Greece defaults, the risk for a contagion spreading throughout the EU is suddenly very high. If Greece defaults, suddenly the market will wonder if Portugal or Ireland can afford to repay their debts. The price of these bailouts/loans for the Greeks and the Irish are above 5%. Those are terrible terms given the fact that current interest rates in the US hover around 1%. If Greece goes under, no one is going to believe Portugal and Ireland can repay. If those countries go under, suddenly Spain is in line and Spain is a huge chunk of the GDP of the EU. There will be no bailouts for Spain. We’ll just have to kiss the EU goodbye at that point.
When you read the headlines about protests and riots in Greece over the austerity measures and think “Those dumb Greeks, they can’t have their cake and eat it too”, remember this. They are not receiving bailouts. A bailout is what we gave to AIG and GM here in the US. Tax-payer funded cash infusions are bailouts. What the EU is giving to Greece are loans, loans with horribly unfavorable terms. The average person in Greece knows this. That same person also knows that for decades, corruption and cronyism in Greece has been rampant. Rich people in Greece have never paid taxes and they have no plans to start now. This entire burden is being foisted on the lower and middle class Greek. He is being asked to take a pay cut, pay more in taxes and work real hard for the foreseeable future so that German and French banks can get their money back, money he never really saw in the first place because the ruling class of his country absorbed most of it. You can see how he might think that is an exceptionally shitty deal for him.
The only way the euro can continue to survive as a currency is if the German people continue to accept the necessity of the “bailouts” and agree to keep funding them. Germany has a large enough economy that they can do this without too much pain. The Germans benefit greatly from the current arrangement for a variety of reasons and rationally, it’s in their interest to keep the status quo. But electorates are rarely rational. If they stop funding the bailouts, and there is certainly plenty of evidence that they are tired of doing so, the euro is doomed. If Germany refuses to loan money to Greece, Greece defaults followed shortly thereafter by Portugal and Ireland. Then the big hairy elephant of Spain shows up in the middle of the living room and takes a dump on the coffee table. The euro will be gone because no one will be able to afford to keep the debts going.
These are exceptionally tricky times for the EU. What is going on is unprecedented and probably largely unplanned for. Oh sure, there were probably some theoretical games played about “What happens if some country defaults?” but based on how this is being handled, they weren’t very serious about them. The chance of the euro as a currency continuing to exist is falling on a daily basis. This will have huge effects, effects we can’t possibly begin to understand right now. The world economy is going to suffer regardless of what happens until some of the details start to shake out. This would all be a lot of fun to watch if we weren’t all so intricately involved in the result.