So default by Greece would essentially bankrupt the ECB, and the Euro would essentially be totally destroyed.
... given this simplicity, why do we have such confusion about how to actually do it?
Berlin, backed by the Dutch, Austrians, and Finns, have been arguing for weeks that there can be no new bailout of Greece without the country’s private creditors being forced to suffer losses on their loans. Otherwise, they argue, European taxpayers will be shouldering the costs while the international banks pocket the proceeds.
Leave aside the politically charged “international banks” bit for a moment and this makes perfect sense. Yes, if you do lend money to someone then you do face the risk that they won’t pay you back. This is one of the calculations you should make before deciding to lend them money and it should certainly inform the interest rate at which you are willing to lend that money.
You get that calculation wrong, well, tough. You lose money. But why doesn’t the European Central Bank agree?
The ECB, the European Commission and other EU countries led by France argue that this could pave the way to disaster, with the financial markets decreeing the compulsory “haircuts” on private bondholders a Greek default, a “credit event” that could lay waste to the single currency.
Ah, no, that’s not quite being open about the facts. The reason the ECB doesn’t want there to be a haircut on the bonds is that the ECB owns most of the bonds. So a haircut would likely bankrupt the ECB and that’s what would lay waste to the single currency. Imagine, a central bank going bankrupt: not going to do much for the currency it’s supposed to be a guardian of, is it?
For what has been happening is that the ECB has been buying bonds in the open markets as a way of reducing the interest rate that Greece must pay on market borrowings. Plus, and here’s where it gets more dangerous, it has been taking Greek bonds as collateral against loans to: well, against loans to people like the Greek banks. Which, if there is a haircut on the bonds, will all go bust immediately. Leaving the ECB with that collateral which is now worth so much less than the loan against it that it will (near, maybe,) wipe out the ECB’s capital.
http://www.forbes.com/sites/timworstall/2011/06/16/explaining-the-greek-debt-crisis/