There are also tens of billions of dollars of Credit Default Swaps (CDS) outstanding on Greek sovereign debt. Regulators failed to deal with the capital issue in the CDS marketplace in the aftermath of the 2008-2009 AIG meltdown, so it is impossible to predict the effects of a Greek default on this marketplace because there is no information on CDS counterparties and their capital positions. But we suspect these markets, being unregulated, continue to be over-levered.
"Extend and Pretend" Causes Stagnation
The interconnected nature of today's global financial system implies that many other banks around the world face asset impairments and a need for more capital. Many banks could fail.
The stockholders and bondholders of these institutions should suffer losses, and not be recipients of the "moral hazard" of government protection. There will be terrible short-term pain. But, history shows that the pain of balance sheet depressions, while severe, is short-lived. The system returns to health with huge lessons learned about risk.
"Extend and pretend" only imposes a long-term period of economic stagnation as the cancers on bank balance sheets fester. Japan's is a 20-year example of the impact of unrecognized bank losses on the economy. In an interview given to
Investors Business Daily
("Slow Growth Normal For Post-Fin'l Crisis Recoveries," Norm Alster, May 23, 2010) by Vincent Reinhart regarding the paper he recently wrote with his wife, Carmen, concerning the aftermath of 18 financial crises (see
After the Fall
, Aug. 17, 2010), in Japan, "the banks were allowed to carry bad assets on their books at inflated values." As a result, "property prices have declined for 20 years."
As an overview, Reinhart concluded that "the government's willingness to let banks carry bad debt rather than force them to take losses tends to stretch out the process of deleveraging. When you let banks carry their assets at high values relative to their market values, it freezes that market." His prescription: "Recognize the losses ... take the hit." Since it appears that the inability to restart America's economic engine is partly due to bank balance sheet impairment, why is Europe about to go down the same road?
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