Greece, Portugal and the EU: How Much Will the Rescue Mission Really Cost?

While the Senate hearings probing Goldman Sachs's (GS) Abacus deal dominated yesterday's media, the real action was happening in Europe -- and global markets responded accordingly. After Standard & Poor's cut Greece's sovereign debt rating to junk status, investors aren't sure where the overborrowed-EU-country contagion ends -- or how much it'll cost to rescue Greece and Portugal, and possibly Spain.

Stock markets tumbled in synchrony on Tuesday, with the Dow Jones Industrial Average losing 1.9% and the Stoxx Europe 600 index falling 3.1%, and on Wednesday as Japan's Nikkei 225 declined 2.8%. But the news is probably worse for holders of debt in the EU countries with the biggest budget deficits. In addition to dropping Greece to a speculative-grade BB-, S&P lowered Portugal's credit rating two notches to A-. The Greek junk rating marks the first time a euro-zone nation has fallen that far. The downgrades spotlight the high ratio of budget deficits to GDP in Greece (13.6%) and Portugal (9.4%). Another worry is Spain, where the ratio is 11.2%.

If this feels a bit familiar, it should. It's another variation on the tired theme of overborrowing. In 2008, many big financial firms fell into a similar death spiral. Banks like Lehman Brothers had borrowed too much money to place bets on mortgage-backed securities. When those MBS dropped in value, the banks had to write down their value, and that raised doubts about Lehman's ability to repay its loans. As those doubts deepened, Lehman found it impossible to do the needed borrowing to keep its business going, and it went bankrupt.

Facing a 70% Haircut?

These financial doom loops can bring down countries as well as companies. What happens if a country goes bankrupt isn't pretty. In December 2001, Argentina defaulted on $103 billion in loans, and in 2005 it offered to swap that debt for new bonds at 30 cents on the dollar. Bloomberg News suggests the possibility of a similar 70% haircut on $265 billion worth of Greek bonds. It's not hard to see why bond investors would feel bad about the possibility of booking a 70% or greater loss on their investment.

And it's not guaranteed at this point that bailout money will be there to save Greece, Portugal and perhaps Spain. The New York Times reports that the cost of rescuing the EU's problem children could total $639 billion: $120 billion for Greece, $53 billion for Portugal $466 billion for Spain. But does that really capture the full cost?

That might come close to covering what those governments need to stay solvent, but nobody really knows the total cost to investors because of all the unregulated side bets that have been made through credit default swaps, which are at the heart of Goldman's Abacus deal and helped spark the financial crisis in the first place.

A Missed Opportunity in the Senate

The biggest crime is that in the U.S., politicians spent Tuesday chasing a killer sound-bite during the Goldman hearings while the risk of unregulated and poorly capitalized bets on global debt defaults remain a perfectly legal hazard that does little to bring stability to the world financial system. (In retrospect, with the tumbling markets as a backdrop it would have been better political theater for the senators to have focused on Goldman's role in Greece's debt problems.)

In a more perfect world, individuals, companies and governments wouldn't borrow more than they can pay back -- or worse, try to hide the fact that they're unable to repay. The truth always does come out in the end. The questions now for the EU are the same that Washington faced in 2008: How much it will cost to clean up the mess, and who will foot the bill?