Into the Void on Greece

We now have a deal from France, Germany and the ECB: bending European Financial Stability Facility rules to allow recapitalization of banks and create easier credit terms for Euro countries; and debt rollover into longer-term (some might argue “indefinitely long” given Greek debt of 140 percent of GDP) maturities.

Most chillingly, the plan bakes in the likelihood of Greece going into “selective default.” The bond rollover part of the deal would likely trigger such an event as ratings agencies deem it a a non-voluntary haircut. The scare quotes are needed because, as some analysts have observed, “selective default” is akin to being “a little pregnant.”

This is quite scary, since any type of default would trigger the credit default swap doomsday device. Because of the lack of transparency in this part of the derivatives market, no one is quite sure who has been issuing Greek default instruments, and some have speculated that an AIG-type firm or firms pumping out such derivatives is lurking somewhere in the West.

If that is the case, the cost of bailing that firm or those firms will not have been calculated into the French-German plan, and everything goes to pot.

Even if the swaps are not concentrated, last week’s stress tests on European banks have been criticized as highly flawed. In the first place, there is not even consensus on how many actually failed: Bloomberg reported 24, while the Telegraph reported 7, based on different notions of “failure” (Bloomberg counted banks that would have to raise any additional capital).

What’s more, as Simon Nixon as the Wall Street Journal explained, the second-order impact of write-downs has to be considered: The immediate losses banks take on a default will mean higher credit costs and could lead to their ratings getting slashed. This is the “Lehman moment” everyone fears.

The trillion Euro question is whether the markets deem Euro nations have ponied up enough money to bail out everyone who will need a bailout: Greece, its banks, and the most exposed European financial institutions. If the answer is no, we will be headed of the cliff again.