Learning the Lehman lesson: Being cruel to be kind

London: There's a theory making the rounds comparing Greece with Lehman Brothers Holdings Inc. Letting Lehman go broke, the story goes, was the worst policy error of the credit crisis; with that lesson learned, the global authorities will do anything to stop a European Union member from defaulting.

I disagree. Letting Lehman collapse wasn't the problem. The guardians of financial stability bungled because they had earlier backstopped Bear Stearns Cos. with a $29 billion (Dh106 billion) dowry to engineer its shotgun marriage to JPMorgan Chase & Co. That created a false sense of security about the size of the safety net, an inconsistency that heightened the ensuing Lehman panic.

Instead, the Federal Reserve should have stood aside and let Bear Stearns fall off the cliff. The splash, while lamentable, would have been smaller. Moral hazard would have been minimised. Lehman would probably have survived, albeit by sacrificing independence and finding a partner to cling to, as Merrill Lynch & Co. did by snuggling up to Bank of America Corp. Financial Darwinism would have been allowed to do its job of keeping the gene pool pure.

Argument

A similar argument applies to Greece. Any intervention on behalf of the European Union or the European Central Bank to rescue the nation from its self-created economic travails would be a disaster for the common-currency project. It would risk paving the way for the similarly profligate to ignore their own fiscal responsibilities, safe in the knowledge that euro membership has its privileges.

Greece owes its lenders about $361 billion, according to June figures compiled by the Bank for International Settlements in Basel, Switzerland. So, make no mistake — a default would be a terrible thing. The consequences of a bailout engineered by Greece's European peers, though, would be far worse.

There is no joint-and-several guarantee for euro adopters. Just because euro-region debt is all denominated in the same currency doesn't mean it's backed by a single lender of last resort. Not only would a bailout of a distressed lender be undesirable for moral reasons, it would also probably be illegal, something European officials seem to be telling bondholders.

German Finance Minister Wolfgang Schaeuble said in the December 21 edition of Bild-Zeitung newspaper that Greece has been living beyond its means for years, and can't expect Germany to pay for Greece's mistakes. Frank Schaeffler, a member of the German parliament's finance committee, said on December 18 that any attempt to accomplish a joint bond sale by both countries "would be the first nail in the coffin of the euro".

Governing Council

ECB Governing Council member Ewald Nowotny told Dow Jones Newswires that the central bank won't bail out debt-burdened euro members. "The ECB has no mandate or intention to take into account the situation of a specific country, especially not with regard to public finances," Dow Jones reported on December 20, citing an interview.

There's no question that Greece is in an economic mess. Its budget deficit is 12.7 per cent of gross domestic product, much worse than the three per cent limit stipulated for euro members. Greek Finance Minister George Papaconstantinou, who says he'll shrink that shortfall to 8.7 per cent next year, says previous governments misled investors about how unfit the nation's finances were.

"There's been some sleight-of-hand," he told BBC Radio 4 in an interview on December 20.

"Especially in 2009, there's been a big difference between data reported and the underlying trends in the deficit."

The Greek banking system has borrowed about 47 billion euros ($67 billion) from the ECB, according to figures compiled by Royal Bank of Scotland Group Plc, based on the amount of collateral the nation has pledged. That's out of the 700 billion euros lodged at the central bank by the region as a whole.

Put another way, Greece has taken almost seven per cent of the emergency liquidity that the ECB has supplied to ease the credit crunch. Its economy, though, accounts for only about 2.7 per cent of the euro area and its public debt is about four per cent of the total outstanding among euro members, according to figures compiled by Bank of America Merrill Lynch.

Greece has already been punished by the rating companies. Fitch cut its grade by one level to BBB+ on December 8. Standard & Poor's followed suit on December 16, warning that a further downgrade is possible "if the government is unable to gain sufficient political support to implement a credible medium-term fiscal consolidation programme." Moody's chopped its assessment this week, also leaving the door open to more downgrades.

Bond Vigilantes

The bond vigilantes are also penalising Greece. The nation's 10-year borrowing cost leaped to six per cent last week, up more than a percentage point in the past month and up from a low for this year of 4.4 per cent in October. Greek debt yields about 2.50 percentage points more than that of Germany, Europe's benchmark borrower. The spread, a measure of how much riskier Greek debt is perceived to be, reached 276 basis points on December 21, more than doubling in five weeks.

At those prices, investors aren't yet pricing in a default. What's not clear, though, is whether their repayment expectations are based on optimism that Greece will mend its ways, or hopes that deeper pockets will be made available should the need arise. Anyone banking on the latter is probably making a costly mistake.