A lot of people seem to think that the way to save Greece is to treat them the same way financial companies were treated after the fall of Lehman Brothers, by giving them temporary freedom from the market. With financials, the freedom from the market was given in numerous ways.
- The discount rate was lowered to give banks access to funds at lower interest rates
- The Federal Reserve provided short term liquidity to banks by increasing the term of overnight loans to 90 days, creating the Term Auction Facility to allowed banks to borrow Treasuries against less liquid paper.
- Market participants were not allowed to be short financial companies for a period of time.
- TARP gave money to banks at rates better than they could get on the open market.
- Changes in accounting rules allowed banks to avoid reporting their losses.
- Banks could exit their AIG trades at favorable marks, giving them free money.
Since this seemed to work for the financial crisis, many of the same ideas are still around for dealing with Greece’s problem. For one thing, there are people calling for the heads of speculators betting against Greek bonds by buying credit default swap protection on Greek bonds that they do not own. Now, it looks like an aid package is going to be passed after the IMF and Greece work out a three year program. The main idea is to prevent Greece from having to go to the markets. They are trying to get the package resolved before some Greek bonds mature on May 19th. Once the package is resolved, the hope is that Greece won’t have to go back to the market for three years; the whisper number is that 120 to 150 billion Euros will be lent to Greece. The idea is that Greece will fix itself without having to deal with excess pressure from the market that raises their debt interest payments and drives them into a deeper hole.
Using the financial companies as a template for fixing Greece misses a fundamental difference: Greece is producing a large deficit while finance companies were profitable despite their insolvency. Protecting banks from the market worked because the banks could earn their way out of the hole that they were in. In some respects they were more profitable than normal because two of their competitors, Bear Stearns and Lehman Brothers, were basically taken out of the market so the illiquidity of the market provided huge rents to established market makers. Greece is in the opposite situation. It is losing money and its GDP will take a large hit after austerity measures are implemented. Without a crisis to spur them on, it is questionable whether or not the unions will stop striking. When some of these unions include tax collectors, the Greek fiscal situation is only going to deteriorate further once the bailout puts the immediate crisis on hold.
Greece is still going to be in trouble, but maybe in the three years without a bailout the European banks holding Greece’s debt can earn enough money to prevent the inevitable default from driving them into bankruptcy. More worrisome, if Greece’s situation doesn’t improve this could be bad for Portugal, Ireland and Spain. Their cost of funding is rather correlated to Greece’s CDS spread, especially for Portugal. If Greece’s CDS spreads get worth then their funding costs continue to go up and there is a possibility of a negative reflexivity loop where their cost of funding goes up so their fundamentals go down which causes their funding costs to go up and so on.