Global Banking System Exposure to the Greek Sovereign Debt Crisis
In the past year, the Greek sovereign debt crisis has been the focus of much financial press. According to the Bank for International Settlements, 24 countries reported that their banking systems had foreign claims on Greek debt as of December 2010, representing a total debt exposure of $145.8 billion and additional exposures of $60.7 billion related to derivative contracts, guarantees, and credit commitments. Moreover, the total risk exposure is highly concentrated in the European banking system, representing nearly 94.0 percent of the total foreign claims on Greek debt. Given the European banking system’s level of exposure to Greek debt, it is little wonder that European leaders have moved quickly to mitigate the risk of a potential Greek default.
In order to reduce the systemic risk related to a potential Greek default, the European Union agreed to support a new program that would provide €109 billion to Greece to fully cover its financing gap. The program will provide the financing through loans that will be issued by the European Financial Stability Fund. The loans will have longer maturities (increased from 7.5 years to a minimum of 15 years) and lower interest rates at levels equivalent to the balance of payments facility (currently around 3.5 percent).
Additionally, the program will include voluntary private sector involvement, where private creditors can exchange their current Greek debt for new debt securities that are fully collateralized or partly collateralized and are priced to produce a 21.0 percent net present loss to the value of the current debt (assuming a 9.0 percent discount rate). Assuming a 90.0 percent participation rate from private investors, the Institute of International Finance (IIF) expects that private investors will contribute €135.0 billion in financing to Greece from mid-2011 till the end of 2020. Additionally, the IIF expects voluntary private sector involvement to significantly improve the maturity profile of Greek debt, increasing it from 6 years to 11. The implications of the new financing program are that private creditors are now certain to sustain losses, and credit agencies are likely to view the exchange of debt at a loss as a default. Upon review of the new program, Moody’s investor service downgraded Greek sovereign debt from Caa1 to Ca to reflect the potential default event.
Given its high debt-to-real GDP ratio and slow GDP growth, Greece was unlikely to be able to achieve healthy levels of debt without defaulting. A recent report by the International Monetary Fund (IMF) projected that Greece’s public debt would peak from its current level of 143 percent of GDP to 172 percent of GDP in 2012 and remain above 130 percent through 2020. In its assumptions, the IMF assumed that Greece would be successful in fully implementing its fiscal adjustment plan and the transfer of government assets to the private sector. Consequently, any deviation would have significant implications in the reduction of Greece’s debt going forward. The IMF estimated that if Greece is unsuccessful in implementing its fiscal program or if it fails to fully realize its planned privatizations, debt could remain at unsustainable levels at around 150 percent of GDP through 2020. Additionally, the IMF lowered its projections for Greek real GDP growth going forward, forecasting a decline of 3.8 percent in 2011, an improvement to 0.6 percent in 2012, and eventually a leveling off to 3.0 percent in 2017. The high levels of existing debt and slow real GDP growth suggest that some form of default is likely the only option for Greece, and additional future defaults are very possible.
A close examination of Greek credit default swaps shows that while investors have lowered their expectations of a Greek default, they still believe that the probability of a default remains very high. Since the announcement of the new financing plan, credit default swaps on Greek sovereign debt have fallen nearly 400 basis points. Credit default swaps are credit derivatives that function as an insurance policy that a creditor can purchase to hedge the risk associated with a borrower defaulting. The seller of the credit default swap would pay the difference between the original face value of the bond and the recovery value in the instance that the borrower fails to make a scheduled payment; however, the seller would not have to pay if a creditor voluntarily trades his current bonds in for new bonds valued at a discount, as is the case in the new Greek financing plan.
Currently, five-year Greek sovereign debt is trading at 1,635 basis points per year (the spread represents the premium the purchaser pays for the insurance policy). Comparatively, it only costs 62.2 basis points per year to insure $10 million in five-year German sovereign debt. Thus, despite the new financing plan proposed, investors still believe that there is a very high probability that Greece may default on its debt.
The direct effects of a Greek default would initially be concentrated within the European banking system. As of December 2010, the U.S. banking system’s total risk exposure to Greece is only $7.3 billion, with other potential exposures related to derivative contracts, guarantees, and credit commitments summing to $34.1 billion (compared to the total risk exposure to Greece of $136.3 billion for European banks). However, given that Europe represents nearly 50.0 percent of the U.S. banking system’s total risk exposure, any credit event that significantly affects the European economy will likely adversely affect the U.S. banking system as well.