RUTHFULLY YOURS

If it’s Thursday it must mean that Europe is out with another scheme to delay its eventual reckoning with Greek insolvency. This one comes courtesy of France and is, no surprise, tailor-made to help French and German banks. Unfortunately it leaves Greece in a worse fiscal position and increases risk to European taxpayers and other investors in Greek debt.

The ratio of Greek debt to GDP is now 155% and is slated to peak at 170% next year, which is another way of saying that this is too big a problem to grow out of. Even with the European Union and International Monetary Fund plowing billions into Greek coffers and Greek politicians cutting budgets in the midst of a sharp economic contraction, the prospects for avoiding default are slim to none.

The best path to recovery for Greece and the EU would be to recognize that Athens is broke, to restructure the debt to levels that Greece can realistically pay, and then let markets punish Greek profligacy by denying the government access to capital at good rates until it accomplishes the necessary reforms.

French President Nicolas Sarkozy is resisting this path—for reasons that we will get to in a minute. Instead he wants to offer bond holders the chance to voluntarily roll debt maturing between 2011 and 2014 into 30-year paper. Under the only scenario that investors are likely to accept, a little more than half of the face-value of a €100 bond would be redeemed for cash and a triple-A, sovereign, zero-coupon bond. The rest (€49) would be reinvested in a 30-year Greek bond with a coupon that is higher than what they now receive and is tied to GDP growth. As an example, new bonds would pay an average effective interest rate of 10% if Greece grows at 2% a year.

Creditors who accept the plan will instantly reduce their exposure to Greece by more than 50% and almost double their return even with very low growth rates. (What’s French for “a gimme”?) Yet neither Greeks, nor European taxpayers nor other bond holders will fare so well.

Let’s start with what happens to Greece: It gets more debt. Because the new bonds will replace bonds with an interest rate of 4.5%-5% annually, the cost of servicing the new debt will double. This interest rate differential means that over the 30-year life of the new bonds, the burden of this debt doubles. Trying to understand why the EU would want to take an unsustainable debt burden and make it worse is, well, Greek to us. This week’s riots and yesterday’s narrow victory in Athens for another austerity package shows where this will lead.

But Greeks are not the only losers. The bond holders of other maturities will also suffer because the probability that Greece will eventually default will go up, as will the odds of a lower recovery value on the bonds. Meanwhile, European taxpayers, along with the IMF, will be asked to continue shoveling money into Greece, on the premise that it can dig itself out of a hopelessly deep hole.

Neither France nor Germany can defend this plan on grounds that a Greek default would destroy their banks. Of the €285 billion total bonds outstanding, French and German banks are estimated to hold a combined €28 billion. That’s the most of any banking system outside of Greece. Still, even a 50% write-down would not destroy these banks. BNP Paribas is the largest private holder of Greek debt outside of Greece, and in May CEO Baudouin Prot said that a 30% write-down of its Greek holdings would reduce its earnings per share by only 3%.

So why not let Greece fail so it can recover faster? One answer lies in the French and European Central Bank conviction that a Greek restructuring would drive contagion. Portugal and Ireland will next ask to give their creditors haircuts, the theory goes, causing large losses for Spanish banks that will have to be recapitalized by the Spanish government.

If that bankrupts Madrid, huge losses will ripple across the European financial system. Then French and German taxpayers might have to recapitalize their banks—an unhappy prospect for Mr. Sarkozy with elections in the offing.

These are reasonable concerns but far from certain, and they are containable if European leaders had the wit and will to work out loss-sharing debt accords for Ireland, Spain and the rest. It also isn’t clear how raising the cost of Greek debt alleviates the problem. Instead, this proposal appears to be a political bargain. Germany and the Netherlands have been insisting that private creditors shoulder some of the burden. With its proposal, France can say it has included private creditors toward what it calls a solution.

But perhaps someone can tell us how creditors are sharing any pain when they take out half of their investment and double their return on the remainder?

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