As euro zone officials tackle the debt crisis, they must weigh the threat of any downgrade of Greek debt ratings to default or selective default, which would add fuel to the contagion that has taken hold of bigger euro zone economies in recent weeks.
Euro zone officials will meet on Thursday for more talks on a second Greek bailout, after the euro zone debt crisis spread last week to heavily indebted Italy, the region's third-largest economy.
Policymakers are examining three broad options for securing the private sector's involvement in the second Greek bailout: an EU-funded Greek government buy-back of its own debt on the secondary market; a French plan for a voluntary rollover of maturing Greek debt; and a third option based on a bank tax to raise extra money to help Greece.
A document obtained by Reuters foresaw the two first options triggering at least a selective default ratings on Greek debt but said the third one was unlikely to result in a downgrade.
Rating agencies have played hard ball and have said most kinds of private sector participation in a Greek rescue plan would be perceived as coercive, thereby triggering a default rating.
Below are some possible consequences if this were to happen:
A default rating would worsen the kind of contagion that in recent weeks took Italian and Spanish bond yields to 14-year highs above 6 percent, making it increasingly expensive for those countries to raise money in commercial markets.
It could also precipitate a ratings downgrade for Portugal and Ireland, sending yields on their debt sky-rocketing on fears they too could fail to honor their debt payments.
This would make it even more difficult for their banks, which are already firmly dependent on the ECB for funding, to raise money in interbank markets.
Yields on Spanish and Italian debt could also approach 7 percent, a level beyond which funding costs are perceived to be unsustainable. French bonds may come under further pressure on fears contagion was spreading into core European debt markets.
If Portugal was eventually unable to pay back its debt, the Spanish banking system would take a massive hit. Spanish banks are the most exposed to Portuguese debt, holding more than $80 billion, according to data from the Bank for International Settlements (BIS).
A collapse in the banking system of the euro zone's fourth-largest economy, may put pressure on Spain to recapitalize its banks, and could push its stretched public finances over the edge. The country is already considered too large to be bailed out by the current euro zone rescue fund and would prove a heavy burden to other already struggling big euro zone economies.
"Italy is tied to Spain in that if Spain did need a bailout, then Italy theoretically would be asked to foot some significant part of that bailout cost, which of course the market doesn't believe it can afford," said Richard McGuire, rate strategist at Rabobank.
A struggling Spanish banking system could also have a direct impact on the euro zone's biggest economies — Germany and France — whose banks are the most exposed to Spanish debt. At the end of 2010, French banks had roughly a $140 billion exposure to Spanish debt while German banks' exposure totaled around $180 billion, according to BIS data.
Greek banks currently borrow money from the ECB by using Greek bonds as a safeguard that they will pay back the loans.
If a ratings agency cuts Greece's debt ratings to default or so-called "selective" default, the ECB has said it would refuse to accept Greek bonds as a safeguard in its lending operations, cutting off funding to much of Greece's financial sector.
Having taken such a firm stance, analysts believe the ECB is unlikely to perform a complete U-turn but rather find a way around so that they do not cut off Greek banks completely.
Ideas that have been floated are that it could give the Greek central bank the green light to use an Emergency Liquidity Assistance plan that Ireland is using to keep its banks alive.
Other suggestions include enhancing Greek bonds with additional guarantees or that the ECB may hold off from pulling the plug on Greece until all three major rating agencies put the country into default, rather than at the first opportunity.
"It sets a dangerous precedent for what the future holds if they start allowing defaulted bonds to be posted as collateral," said Patreek Datta, credit analyst at RBS.
Greek banks followed by European peers and the ECB are deemed to be the most exposed to Greek debt.
Most banks would not be forced to sell their Greek debt in the event of a rating agency downgrade to default, an accountant involved in advising banks on their exposure to Greek debt said.
They could choose to do so but may struggle to find buyers or may lose out, selling bonds at a much lower price than their original value.
Instead, the accountant saw a greater risk from banks having to significantly write down their holding of Greek debt in case of default.
"In most cases, it's unlikely that there would be a requirement to liquidate immediately on a downgrade but the question and the challenge would more be around whether or not it pushed people over a line where they concluded that a write-down on the holding was appropriate," the source said.
A large number of institutions are holding Greek bonds in their banking books either at par, or original value, or without having recognized the fall in Greek debt market prices in their earnings. In the case of a default, banks may be required to adjust their Greek bond holdings closer to market value and recognize those losses.
MIXED ASSET FUNDS
A Greek ratings downgrade is not expected to trigger any significant sell-off by mixed asset funds, since many of them would already have dumped Greek holdings as they were reviewed to junk, analysts said.
Out of 2,098 bond and mixed asset funds registered for sale in the UK, 141 have fixed-income investments in Greece, data from Lipper, a Thomson Reuters Unit, showed.
Their exposure to Greek debt averages 0.72 percent per fund -- or 4.85 million pounds ($7.8 million) each.
Tactical funds rather than long-term "buy and hold" funds are more likely to be holding Greek debt, according to Tamara Burnell, head of financial and sovereign research at M&G, which runs almost 200 billion pounds in assets. She said she would be "very surprised" if many investment grade funds still held onto it, she said.
"We do not use ratings to invest. We do our own research on anyone we lend money to, and that includes sovereigns," she said.
"But even those investors who do, I think they are really more ratings-sensitive up the ratings spectrum, so a move from A to BB potentially is a very significant one, but a move from CCC to D is going to have far less impact."
But if contagion were to spread to other assets, analysts fear the funds industry more broadly could be affected. Fitch estimates that during the three months that ended May 31 the 10 largest U.S. money funds had half of their $755 billion in assets in places that were potentially exposed to European banks.
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