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How a Greek default would ripple around the world

A protester wearing a gas mask walks beside a burning van during violent protests against austerity measures in Athens, June 28, 2011.

Yannis Behrakis/Reuters/Yannis Behrakis/Reuters

As the Greek debt crisis goes from bad to worse, worried bankers and policy makers have started throwing the L-word around at every opportunity. Their dire warning: Greece could become another "Lehman moment," spreading financial destruction across the globe.

"If it is Greece alone, that's already big. But if other countries are drawn in through contagion, it could be bigger than Lehman," Deutsche Bank chief executive officer Josef Ackermann said this week.

Invoking the shocking spectre of what happened to the global financial system when the Wall Street heavyweight collapsed in September, 2008, works extremely well as a scare tactic. U.S. policy makers and regulators badly underestimated the market disruption stemming from a sudden loss of confidence in the markets and the vast losses linked to the Lehman bankruptcy.

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The bank owed $600-billion (U.S.) worldwide; its brokerage arm did billions of dollars in transactions for hedge funds; and it was at the centre of huge and opaque international derivatives dealings. Money-market mutual funds had loaded up on Lehman's short-term notes in their search for higher returns than they could get in the U.S. Treasury market. And on top of that, giant insurer AIG had written billions of dollars worth of insurance, in the form of credit default swaps, on Lehman bonds. When the bank went down in flames, the massive bills came due from all sides. And the global financial system seized up almost overnight.

The question now is whether the crisis in one of the euro area's smaller slum zones could trigger something similar or even worse, as Mr. Ackermann suggests. What happens if the angry Greeks reject the harsh new austerity measures being imposed on them in exchange for the next slice of their bailout loans? What about if the rating agencies decide the European Union's efforts to "reprofile" Greek debt with the "voluntary" participation of the banks amounts to a default by any other name?

The Europeans, the International Monetary Fund and other governments and central banks will do all they can to prevent the Greek illness from wreaking widespread havoc, because the potential fallout - another global financial crisis, the unravelling of the economic recovery and the failure of the euro zone itself - is too awful to contemplate. And because they all remember Lehman.

But here's what could happen, in a worst-case scenario, if hotter heads prevail and it turns out there is no plan B.

The dominoes:

Other euro zone countries

Debt-ridden Ireland and Portugal have already been blown off course by the Greek gale. Frozen out of the capital markets by sky-high premiums demanded by investors for the rising risk of owning their bonds, they had to seek bailouts of their own. And Spain, Italy and Belgium have all come under pressure from bond market predators, despite European efforts to fence off the Bailout Three.

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The euro zone reminds risk expert Satyajit Das of a party of mountaineers roped together. As the weaker ones lose their grip, the survival of the stronger climbers is increasingly endangered. The result could be the departure from the euro of the least-competitive members and a breakup or shrinkage of the one-currency-fits-all model. A mortally damaged Europe would put a severe crimp in global prospects for economic growth and could very well trigger another slump while the U.S. economy remains weak.

The European banks

Fragile Greek financial institutions would be the first to go. They hold a combined €70-billion ($99-billion) in Greek government debt, whose value they are not required to write down as long as the principal is not at risk. If they had already been taking provisions for the reduction in value of the debt, their shareholders' equity would be long gone.

The European Central Bank has made it clear it will no longer advance operating capital to the Greek financial system if Athens defaults on the sovereign bonds the ECB holds as collateral for the loans. Greece's banks, which have been struggling with a heavy loss of deposits from nervous Greeks, would have nowhere to go but down and out.

Outside Greece, German banks hold the most Greek public debt, and although they have been slowly reducing their exposure, they still carry what remains at unrealistic values. The French come a respectable second, but their exposure to the crisis is higher, because two French banks, Crédit Agricole and Société Générale, control Greek banks. Moody's has put the those two and BNP Paribas on notice for a possible debt downgrade. Close to 30 Italian banks have also come under scrutiny from rating monitors; and Bank of England Governor Mervyn King has warned that the British financial sector faces its biggest immediate threat from the euro zone crisis.

The global financial system

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U.S., Canadian and other international lenders have little direct exposure to Greece itself. But they have extensive links to the big German, French and British banks and they also may be on the hook through derivatives transactions. U.S. banks have recently been cutting back on their lending to European banks, which is what they did to Lehman in the months leading up to its collapse.

As in the Lehman disaster, a more immediate danger sits in big U.S. money-market funds, whose exposure to a Greek failure is largely guesswork. They hold as much as $1-trillion in short-term notes issued by German, British, French and other European banks, typically those that need the financing for their U.S. operations, according to The Wall Street Journal. Even if these funds are not put at risk by European bank losses, it may not matter. Worried investors are already voting with their feet, having withdrawn more than $50-billion as the crisis has deepened, including $7.3-billion last week alone.

Credit default swaps

There likely isn't another AIG ready to implode. But the Greek crisis has already taken a toll on this derivatives market. Premiums demanded for protecting even some of the low-risk, triple-A credit default swaps in the euro zone have shot up by 15 per cent or more. And the rates demanded for the weaker countries are all far above what their current bond ratings would normally call for.

The total amount of swaps outstanding on government bonds is relatively small - in Greece's case, about $5-billion (U.S.) or 20 per cent of the estimated size of default swaps written on Italy's bonds. Which means only a small fraction of the nearly €90-billion in Greek sovereign debt coming due in the next three years is insured. Sellers of this coverage have to pay up when certain specified credit events occur, such as a failure to make interest or principal payments, or a deferral or restructuring that affects the bond's value. And it's unclear who, exactly, would be on the hook.

Five-year protection on Greece now costs more than 2,000 basis points - that is, it costs more than $2-million to buy insurance on $10-million worth of Greek bonds - and not many investors feel like paying such a hefty insurance tab when there are so many less risky ways to deploy their money.

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