My friend Richard, the engineer, sometimes likes to play dumb and ask me questions about the economy when he already knows the answer. It’s his way of keeping me sharp. This week he asked me: “Why is the Greek debt crisis so important to Europe.” With a population of only 6 million people, Greece represents a very small fraction of the European community. Why not let the Greeks default on their sovereign debt and let them live with the consequences? Why should the rest of Europe bail them out by lending them even more money?
To add further to this irony, he pointed out that the Americans are having a debt crisis now too. Unless they legislate an increase in their own debt ceiling, they too will default. Everyone knows neither the Greeks nor the Americans have the cash to pay off maturing debt. Both nations have to borrow more. But everyone believes the American crisis is not a real crisis: it’s just political bull. Republicans are trying to embarrass a Democratic president, and at the last minute, they will pass the required legislation. But the sorry truth is that neither nation can pay its current debts unless they borrow more.
Richard baited me further by making up a story of two neighbours: an American and a Greek. They each borrowed half a million dollars and opened a restaurant. One served hot dogs, hamburgers and steaks; the other offered souvlaki, mousaka and tzatziki. Both of them were unable to make it work, and both defaulted on their bank loans. Richard challenged me: “Why is this any different from a country defaulting on its loans? We don’t expect the bank to loan them even more money! And don’t tell me it’s because they are so big! On the grand scale of world economics, Greece is simply not that big! There are many cities bigger than the nation of Greece – no-one would bail out New York City, London or Tokyo.”
I reminded him about the 2008, 2009 banking crisis. I reminded him that most European and American banks were over leveraged, just like Greece and the USA. Except in the world of banking, it means the banks loaned too much money to borrowers who couldn’t make the payments. Let’s say that a certain European bank had a loan portfolio that was 22X its capital. And let’s say that part of that capital was invested in Greek Short term notes. And Greek Short term notes were downgraded from A to D. And because of that, the Short term notes dropped in value from 500 million Euros to 400 million Euros. In other words, our bank just lost 100 million Euros. Now it is forced to call in 100 million X 22 Euros in loans, to get back on side. That’s the real problem. That’s what happened in 2008 when the US sub prime mortgage backed paper was downgraded. Once bankers realized they couldn’t find buyers for those US dollar junk mortgages, their value dropped and the crisis unfolded. French banks own a lot of Greek paper. German banks own a lot.
The immediate problem is not with the ones who borrowed the money and can’t pay it back. The problem is with the bankers who loaned them the money. In 2008 their toes were trampled by American investment dealers, and now they are dancing with Zorba the Greek.
Then it was my turn to challenge Richard.
If the situation in Greece (or Italy, Spain, Portugal or Ireland) is really this dangerous, what have you done to protect your investments? In 2008, 2009 the stock market dropped in half. Individual investors need a plan to protect themselves against another banking crisis. What’s your plan? I turned the tables on him: “Why is the Greek debt crisis so important to you?”