Act III: The Euro Crisis (2010/11)
How Greece becomes a pawn in the hands of investors. How the European Central Bank goes astray. Why the world no longer makes sense to the Greeks. How the Maastricht bet goes bad.
In October 2009, Marko Mrnik's analysts at rating agency Standard & Poor's computed that Greece's debt would increase to 125 percent of economic output in 2010. On the same day, it became more expensive to hedge Greek bonds against default. The default insurance instruments, known in market jargon as credit default swaps (CDS), were an indicator of how bad things stood for Greece. It was now costing $189,000 a year to hedge a $10-million Greek government bond against default. For major investors, it was a signal to get out of Greece.
A few people had also become nervous at the headquarters of the Pacific Investment Company (PIMCO) in Newport Beach, California, about an hour's drive south of Los Angeles.
PIMCO is by far the world's largest investor in government bonds. The company lends governments money by buying their bonds. When PIMCO stops buying a country's bonds, it's a clear sign that the country is on the verge of crisis and possibly even bankruptcy.
PIMCO controls more than $1.3 trillion (1.05 trillion) on behalf of its customers. It is an absurd number, even in these times of superlatives, times of bailout funds and banks being supported with billions upon billions in taxpayer money. Though far from a household word, PIMCO has four times the German national budget to invest.
That's why almost all governments maintain close ties to PIMCO. They send their finance ministers, the heads of their central banks and sometimes even their national leaders to see CEO Mohamed El-Erian and convince him to buy their government bonds.
In the last few weeks of 2009, PIMCO sold all of its Greek bonds. El-Erian says the company wanted to get out before everyone else noticed that the numbers weren't adding up. The company never relies on outside assessments. Instead, it employs hordes of analysts, some of whom used to work at the International Monetary Fund, where El-Erian began his career.
The analysts spend all of their time digging through large quantities of data and the financial statements of nations, re-calculating, preparing projections and feeding numbers into computers. When they don't like what they see, PIMCO gets out.
When Greece was accepted into the euro zone, it was one more reason for PIMCO to buy Greek bonds. El-Erian says the sentiment at PIMCO was that if the Greeks were being granted membership in such an elite club, then Athens would follow the rules -- or the government would be severely sanctioned if it didn't. But that didn't happen. Instead, political concessions were made and the rules were ignored. That, El-Erian argues, is what brought the cancer into the euro zone.
So why didn't the financial markets penalize Greece earlier? Why was the same yardstick applied to Greek government bonds as to German bonds, until only a few years ago? Why did the markets continue to buy the country's bonds?
The Crash of Greek Bonds
On April 27, 2010, a country's debt was downgraded to junk status for the first time in the history of the young currency. Standard & Poor's downgraded Greece's bond rating by three notches, to BB+, putting it at the same level as Azerbaijan and Egypt, and just ahead of countries like Ecuador, El Salvador and Zimbabwe.
Mrnik wrote that Greece's government debt had to be "restructured" -- a fancy word for bankruptcy. Restructuring involves a debt haircut, so that owners of Greek bonds might only get 30 percent of their money back, that is, lenders are only repaid a fraction of the money they lent. The markets view a downgrade as the kiss of death. At this point, anyone who was still holding Greek bonds in his portfolio was crazy -- or a charitable donor.
But the market is neither crazy nor charitable. As soon as the downgrade was announced, Greek bonds were thrown onto the market, causing their prices to plunge. If the Greek government had introduced two-year bonds into the market at that point, it would have had to promise buyers a 13-percent interest rate, up from only 6.3 percent a few days earlier. The rate for 10-year bonds climbed to above 10 percent.
This came as a shock to many European banks. After the Lehman bankruptcy, they had invested heavily in the supposedly safer government bonds, with small yields that suggested security. But now it wasn't only Greek bonds that were seen as risky; confidence was also dwindling in Portugal, Ireland, Spain and even Italy.
Fear in Europe's Financial Capitals
Fear began to spread in places like Frankfurt and London. European banks had invested more than 700 billion in government bonds from the five crisis-stricken countries. And Greek banks alone were holding 50 billion in Greek government bonds. When the government bond rating was downgraded, so were the ratings of Greek banks, as part of a chain reaction that would not stop at Greece's borders.
Government bonds also serve as collateral when banks borrow money from the European Central Bank. The bonds are a key link in monetary transactions, and when their value becomes questionable, the supply of money to economies begins to falter.