Is Greece the next Lehman?

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In the latest news out of Athens, Greek prime minister George Papandreou is offering to give up his post for the cause of Greek salvation. The outlook couldn’t get much worse.

We can all remember the sudden collapse of Lehman Brothers in September 2008, the official launch of the last financial crisis. Panicked investors dumped stocks and bonds around the globe in a desperate flight to cash and quality. Credit froze. Banks buckled. (Some broke.) Trade plummeted. Recession bit hard. Unemployment soared. The global economy was permanent altered.

And here we are, almost three years later, confronted by another possible bankruptcy, that of Greece. We’re talking about a country, not a financial institution, but we can paint an ugly scenario in which the impact of a Greek default would reverberate across the world just like Lehman’s demise. Bondholders hit by losses on Greek debt dump the bonds of the other PIIGS like Ireland, Portugal and Spain, intensifying the European debt crisis. Perhaps the euro zone folds up. Panicked investors sell off stocks and bonds in emerging markets and anything else considered risky. Financial markets freeze up as banks, swamped by new losses, lock down credit. And worst of all, a default by Greece causes confidence in other indebted sovereigns to wobble, sparking debt crisis for the U.K, Japan – even (oh horror of horrors) the United States. It’s 2008 all over again.

OK, so now that we’ve sufficiently scared ourselves dreaming up worst-case scenarios, we have to ask: How likely is it? Can Greece be the next Lehman?

First of all, how likely is a Greek default? Well, maybe not in the realm of metaphysical certitude, but pretty close. Standard & Poor’s cut Greece’s sovereign rating yet again on Monday to the lowest level of any country it rates – below even Pakistan and Granada. That’s a big fat signal that the agency sees a default on the horizon. We could find out about the future of Greece’s solvency over the next few days, as the EU limps towards a second bailout of the country – a total package that could reach nearly $250 billion. The Germans are insisting that part of the deal include losses for bondholders, who would have to swap short-term Greek bonds for longer-term bonds, pushing the repayment out to the end of the decade. That would take the pressure off Greece and reduce the amount of fresh aid the country might require from its European neighbors. But it is nonetheless a form of default.

Will the Germans get their way? Hard to say at this point. The European Central Bank, backed by France, is fiercely opposed to the German plan. The ECB insists that any debt solution involving bondholders would have to be voluntary to limit the fallout the Greek crisis might have on the euro zone and the world economy. But the flaw in the ECB plan is the idea that investors will “voluntarily” line up to rollover or restructure Greek debt. Perhaps national policymakers and central bankers could put pressure on big institutional investors (like banks) to become “volunteers.” But the ECB plan leaves open the possibility that a default avoided today simply turns up later on.

We’ll probably get an idea of how the euro zone bailout plan plays out in coming days. European finance ministers are holding an emergency meeting on Tuesday to try to work out a compromise, and Friday, German Chancellor Angela Merkel and French President Nicolas Sarkozy will meet on the matter. But the two sides are hunkering down in their positions so how this dispute gets resolved is a big question.

Yet however European leaders try to work out the Greek debt crisis, most economists believe that Greece cannot pay back its debts. With a government debt to GDP ratio of 140% and rising and persistent big deficits in Athens, there is near universal agreement that some sort of restructuring is inevitable. As the cheerful Nouriel Roubini put it in a blog for The Financial Times: “Debt restructuring will happen. The question is when (sooner or later) and how (orderly or disorderly).”

What would a Greek default mean for the euro zone? I can’t see a restructuring/default taking place without contagion spreading to the other weak economies of the periphery. Portuguese and Irish bond yields continue to hit euro-era highs, a sign that investors fear that they, too, might require debt restructurings. A Greek default would also make it harder for more core economies, like Spain, to convince investors to buy their sovereign bonds as well. In other words, a Greek default will almost certainly deepen the European debt crisis, and that means the debt crisis will continue to be a threat to the survival of the euro.

And what would a Greek default mean for the world economy? There is some feeling in financial markets that the Greek problem can be contained to Europe. For sure, some European banks, especially in Germany and France, would take a hit from the losses, but the damage, some argue, may not spread far and wide as it did during the Lehman collapse. Yet according to a very good piece in The New York Times, the tentacles of a Greek default could spread much farther afield than many believe. American money-market funds hold bonds of European banks with exposure to Greece, while American financial institutions will be on the hook for a portion of the credit default insurance bill. In other words, the Greece debt crisis may have the potential for going viral like the Lehman collapse.

So however, you slice it, a Greek default would be nasty for the world economy and global financial markets, at a time when the recovery seems to be hitting a soft patch (at best).

Nevertheless, my personal view is that Greece is not Lehman and the impact of a Greek default will not spark a Lehman-like financial crisis.

The main reason is that any restructuring or default by Greece will not come as a surprise to anyone who has picked up a newspaper in the past 18 months. Lehman was a shocker that caught financial markets off guard and created a panic. Greece has been telegraphing its debt problems in big neon lights for months on end. That means the world’s financial institutions and investors have already reduced their holdings of Greek debt or assumed the bonds should be marked down. In other words, the world is more prepared for a Greek meltdown than it was for the Lehman bankruptcy. That doesn’t mean that there won’t be fallout from a Greek default. It just means we know it’s coming, and that makes a big difference to financial markets.

Secondly, a Greek default won’t be a tip-off that there is some greater problem out there in the global economy that we didn’t identify. The Lehman collapse was a lightening flash that the hole in the American financial system caused by subprime and the housing market was much bigger, deeper and scarier than many had imagined, and the consequences of that hole were putting the entire sector at risk. Though the Greek crisis may spread some contagion, we already know that other euro zone economies are weak, indebted and therefore risky for investors. The Greek problem isn’t likely to be a signal that there is another unknown out there waiting to bite us.

Nor do I think a Greek default will raise concerns about other indebted sovereigns beyond the well-known PIIGS. I can’t see investors turning away from U.S. or Japanese debt because of a Greek default. The U.S. may be in terrible fiscal shape. But U.S. debt is not unsustainable in the same way Greece’s is, and the U.S. has far more tools available to it to solve its debt problem – even if that means inflating its way out. The U.S. is not Greece, and investors know that.

The bottom line for me is that the Greek crisis is another negative for the world economy, one that can have serious consequences. But it won’t be 2008 all over again.