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When the music stops in Greece

By Patrick Van Horn ·
Wednesday, October 12, 2011
Posted: 4 pm ET

In what is becoming almost a common occurrence, the European Union, or EU -- led by France and Germany -- held an emergency meeting this weekend to address the weak financial situation of the European banks. Markets are responding positively, with European and U.S. stock markets up more than 2 percent Monday. But is this an overly optimistic reaction considering the circumstances?

At this point it's not a question if the music will stop for Greece, but when. Banks in the EU have already signaled they are bracing for the worst. Over the weekend, European banks deposited nearly $350 billion in the European Central Bank, or ECB. Normally, these funds would be loaned to other banks for short-term investments. However, European banks are unable to distinguish between "safe" banks that might have low exposure to Greek debt and "bad" banks that would be highly affected by a Greek default. This recent shift of deposits indicates the banking system in Europe is freezing up.

In a sign of tepid precaution, German Chancellor Angela Merkel and French President Nicolas Sarkozy pledged to aid in the recapitalization of banks. This essentially places liquid funds in European banks, enabling them to withstand a shock resulting from the situation in Greece. But there was no formal plan put forth this weekend, only the promise to draft one by the end of the month.

Although there are already signs that the amount of recapitalization they decide on might not be enough. Last week, some European officials were floating the idea that it would require slightly more than $100 billion to make European banks safe. But given the size of their exposure to Greek debt, that figure is likely to be too small to prevent a collapse of the European banking system that would spread worldwide.

The reason financial markets are becoming increasingly concerned about the European banking situation is there is no way to avoid large losses for any of the players involved. There are two possible outcomes at this juncture, and neither one will leave some party unscathed.

A disorderly default, or the Greek government refusing payment on their debt, would spark another financial crisis that would most likely surpass the failure of Lehman Brothers in 2008. The low level of capitalization that Europe is likely to pursue would definitely not be large enough to prevent a full-blown crisis if this outcome prevails. Given that the there isn't enough cash for another round of bailouts in Europe or the U.S., a disorderly default would be the most disastrous for the world economy.

The other option is not entirely attractive either, but proves to be less ruinous.  It's simply an orderly default on their debt instead of a disorderly one. It would still lead to losses for banks or whoever holds Greek bonds, and would require large levels of recapitalization in order to preserve stability by the European governments.

One method to this orderly default would allow Greece to abandon the euro and revert back to the drachma. Greece would then devalue that currency, reducing their debt payments and making their exports to the rest of the world cheaper, which would in turn boost the economy. They could switch back to the euro at a lower exchange rate after that process. However, foreign and domestic depositors would likely rush to withdraw funds before the drachma was devalued, leading to a run on the banks. There would have to be a restriction on capital flows out of Greece and possibly on withdrawals domestically.

Another possibility is to have the ECB or another large financial entity buy up a large amount of Greece's bonds, then restructure that debt to make the repayments more manageable. This still counts as an orderly default, since it signals that Greece was unable to make their debt payments in the future and would be extremely costly concerning the amount of bonds needing to be purchased. But this would result in large losses for the European Central Bank as it leads to lower repayment for the bonds they buy.

World financial markets already hear the music beginning to slow for Greece. The flight to safety by the European banks and the renewed effort to recapitalize the banks make that clear. The only real question that remains is: Who will be left without a seat when the music finally stops?

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