Europe's top financial chieftains acknowledged a formerly unspeakable truth yesterday: Greece cannot, now or ever, fully repay the money it borrowed under false pretenses.
The world did not end. There was no panic in the streets. In fact, markets rallied on the news, which is not really news to anyone who has watched the Greek financial tragedy unfold over the past 18 months.
There has been no shortage of people willing to speak truth to power as the Greek crisis dragged on. The problem has been that power was unwilling to speak truth to itself.
Just a week ago, European regulators announced that only eight banks failed a second round of continent-wide stress tests designed to determine whether the banks hold enough capital to survive a worst-case financial scenario. A ninth bank among the 91 tested, German-based Helaba, would have flunked, but the bank demanded that its results be withheld.
Markets did not react favorably to the seemingly good news about Europe's banking sector, because the latest tests, like the round conducted a year earlier, lacked credibility. In the rose-tinted "worst case" scenario envisioned by the regulators, no European nation would default on its sovereign debt, and a passing grade required only a 5 percent capital ratio.
Out in the real world, where people decide where to invest their own money, the Basel standards for capital adequacy call for a minimum 7 percent ratio effective in 2013. In that same real world, not only is Greece considered a high default risk – so high that it currently must pay 35 percent to borrow money for two years – but Ireland and Portugal already require support from fellow Europeans, and Spain and italy are not looking so robust either.
European banks hold about $ 140 billion in Greek government debt. Most of that is owned by Greek banks, which could be wiped out if their government defaults (depending on the terms and nature of the default), and which are already dependent on the European Central Bank for the funding they need to stay in business. The ECB allows the Greek banks to post their Greek government bonds as collateral in exchange for that funding. The Greeks accumulated much of this debt after they joined the euro currency union, during which time Greece regularly hid its poor fiscal condition.
The ECB has been adamant, or was until yesterday, that no default is permissible. This protects the ECB's own financial position, since a default would drive down the value of those Greek bonds that the ECB holds as collateral. Of course, out in the real world, the value of those bonds has already been driven down, since everyone but the ECB has connected that default is inevitable unless some deep-pocketed backer, like Germany, decides to guarantee the debt. In that case, default is still inevitable; It just means that German taxpayers would be the ones taking the losses.
Naturally, this does not sit well with German taxpayers, or with those in other European countries that may be asked to pitch in to cover Athens' unpaid debts. This is why German Chancellor Angela Merkel, in particular, has insisted that private lenders at least share in the "haircut" that somebody will have to take.
So yesterday's reported agreement among the major players is a step forward. Germany and other nations would take on more of the Greek risk, but they would not accept 100 percent of the losses. Someone else is going to have to accept less principal or lower interest than they originally bargained for. This will lead to Greece being declared in default.
The ECB may or may not continue to finance the Greek banking system after default is official. I think the most likely outcome is that a default will be deemed to be "selective," or partial, and that the period in which the country is deemed to be in default will be kept as short as possible. The debt will be restructured during that time to give Greece more time to pay what it owes and to incur lower interest costs in the interim. Other European nations will guarantee a portion of the Greek debt. After the restructuring, Greece will be expected to stay current on its debt payments without have to borrow new money to pay off old loans. This will allow it to escape the "default" label, and will let it do business with the ECB once again.
Default is as close as a sovereign state can get to being declared bankrupt. Bankruptcy is not a happy condition, but it isn't the end of the world either. Creditors have to accept less than they are owed. Debtors have to sacrifice current assets or future earnings to allow creditors to recover as much as is reasonable in the circumstances.
For a country like Greece, bound by currency and treaty to its neighbors, and unable to unilaterally renounce obligations like Argentina did a decade ago, default is going to mean having future austerity enforced by outsiders. Greeks are likely to chafe at the loss of sovereignty and self-determination. Recent rioting in the streets in the sort of chafing I'm talking about, though the intensity of the resentment probably will diminish with time.
It is possible to ignore reality for a time, sometimes for a long time, but it is never possible to hide from it. Yesterday's breakthrough was simply the acknowledgment of what it will really take to get the Greek drama to its final act.