Are Greek Sovereign Debt Tremors a Start of a New Phase of the Crisis?

After the months of buoyant markets, a return to crisis-type headlines seems troublingly familiar, even though the perturbations of the last day or so are a pale shadow of the worst months of the crisis. And some are making the bull case. For instance, a headline at Clusterstock trumpetss, "Yesterday's Bloodshed Sent The VIX Soaring 20%, Which Means Today Markets Will Rebound."

But the Greece problem exposes several fracture lines. The most immediate is the strain on the euro. The monetary union left a lot of critical issues and mechanisms in the "to be sorted out later" category, and "later" has arrived. One long-noted problem is the limits on member nations in using fiscal and monetary policy, and the expected large differences in economic performance have resulted. The immediate problem for Greece is its interest rates have spiked up in the last few days based on the belief that its government debt burden is unmanageable; the only ways out look to be a rescue, either from the IMF (presumably on draconian terms) or the EU (which also looks set to keep Greece on a short leash), or the other choice, to abandon the euro, devalue its currency, and default. Gillian Tett points out that the dramatic increase in yields on Greek government bonds isn't entirely the result of shifting investor perceptions; some ECB collateral rules played a role:

Back in the autumn of 2008,...the ECB loosened the rules which govern how banks can get central bank funds. In particular, it let banks use government bonds rated BBB or above in ECB money market operations, instead of merely accepting bonds rated A-, or more.

This was initially presented as a "temporary" policy, slated to last until late 2009. But last year the ECB extended the policy until the end of 2010. Thus, during 2009, banks which were holding Greek bonds have been merrily exchanging these for other assets via the ECB. This, in turn, has helped to support Greek bond prices (and, by extension, Greek banks that hold a large chunk of outstanding Greek bonds).

Until recently, many observers thought - or hoped - that this policy would be extended again, perhaps until 2011 or beyond. For although Greek debt currently has a credit rating that meets the old ECB rules, there is a good chance the debt will be downgraded this year. This creates the risk that Greek bonds will be excluded from any newly tightened ECB regime.

Earlier this year, senior ECB officials indicated that they intended to "normalise" the policy, as planned, at the end of 2010, as part of their exit strategy. That has removed one key source of support for Greek debt (and spooked investors, such as German insurance companies, which also hold large chunks of bonds.)