Can the European banking system take a Greek Default news imageThe markets did not react well to the Friday combo plate of weaker than expected European growth, Chinese tightening ahead of the anticipated schedule, and less than convincing remarks regarding what if anything the EU intends to do about its little looming sovereign debt crisis. And top it off by having Greece PM Papandreou launch a blistering attack on his would-be rescuers, accusing them of stoking the crisis psychology that was working to his country's disadvantage.

Now some grandstanding at home is probably necessary, given that Greece is almost certain to be subjected to daunting austerity measures and some lack of sovereignity. But snapping at the hand that has yet to feed you is not very smart. Swedish Lex, in comments, has indicated that this sort of behavior could scuttle the rescue operation.

But as much as there are ample reasons to suspect a bailout will not come together in time, there is one big reason to think that the powers that be will perceive it to be necessary: a Greek default would push the European banks over the edge. The large institutions were thinly capitalized in the good times, and have recognized even less of the losses sitting on their books than their US peers. John Mauldin quotes Lisa Hintz of Moody's:

The recent credit crisis was over a few trillion in bad, mostly US, mortgage debts, with most of that at US banks. Greek debt is $350 billion, with about $270 billion of that spread among just three European countries and their banks. Make no mistake, a Greek default is another potential credit crisis in the making. As noted above, it is not just the writedown of Greek debt; it is the mark-to-market of other sovereign debt.

That would bankrupt the bulk of the European banking system, which is why it is unlikely to be allowed to happen. Just as the Fed (under Volker!) allowed US banks to mark up Latin American debt that had defaulted to its original loan value (and only slowly did they write it down; it took many years), I think the same thing will happen in Europe. Or the ECB will provide liquidity. Or there may be any of several other measures to keep things moving along. But real mark-to-market? Unlikely.

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