The idea of a Greek default is no longer unthinkable, as Europe's leaders once argued. In fact, unless you're the sort of person who's happy to get back £5 on every tenner you lend out, you can easily argue that Greece has already defaulted on its debts.
For now, however, the hope is that private debt holders will agree to a 'voluntary' deal where they take a big 'haircut' on the Greek debt they hold, rather than losing the lot. The next tranche of money from the IMF, which Greece needs fast to pay off a group of bonds that are maturing in March, depends on a deal being reached.
But with the talks going nowhere fast, the big question is: what happens if Greece officially defaults?
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If the country can't roll over its debt, it could default and try to stay in the euro, or default and leave. If either event happens, it would have a serious impact on the markets, of course. And it would increase the pressure on the other heavily indebted European economies, particularly Portugal, to follow suit. Interest rates on three-year Portuguese debt, for example, are now an astronomical 19.4%.
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So, what are the worst-case scenarios and how can you protect yourself?
Scenario 1: Greece leaves the euro
Although it is technically possible for Greece and other countries to remain in the euro in the event of a formal default, the failure to reach a deal that has the backing of creditors, and the subsequent loss of EU/IMF payments, would almost certainly force a euro exit.
Leaving the euro is a drastic move, but there are benefits. Ditching the single currency would allow the likes of Greece and other indebted countries to set their own monetary policy, rather than having to put up with interest rates best suited to Germany. Any new currency would also fall sharply, making the country potentially more attractive to foreign employers and tourists.
However, it would also involve significant costs. A new currency would have to be printed. Firms would have to spend time and money adjusting to the new currency. And companies whose operations went beyond national borders could be hit by the capital controls and forced currency conversions that are likely to accompany devaluation.
There is also the strong possibility of a country-wide run on the banking system, as citizens rushed to take their wealth out of the country before it was devalued. Already the Italian and Greek governments have made cash transactions above a certain level illegal. This is ostensibly to prevent tax evasion, but it's also to discourage people taking their money out of the country.
Yet, overall, devaluation may be the only viable medium-term option for these countries, given their high levels of debt to GDP, chronic government deficits and recessionary economies.
Even if Greece stays within the euro, a default by the country could still be very disruptive. A key reason why banks and financial institutions are reluctant to agree a deal is that many took out insurance, in the form of credit default swaps (CDS), against a Greek default.
Most legal experts believe that these policies will not pay out in the event of a 'voluntary' default even if bondholders have to take substantial losses in the form of a principal write-down and a lower rate of interest. Given that there is now a great deal of pressure on private sector holders to take even greater losses than originally proposed, you can see why some institutions might prefer to have Greece formally declare bankruptcy at least then their CDS insurance should pay out.
That would hit the banks that sold CDS hard. Although many of the institutions involved will have made offsetting trades, the latest figures from the Bank of International Settlements suggest that guarantees by US lenders on public and private debt to the PIIGS totalled $518bn in the first half of 2011.
How Ryanair could profit from a Greek default
Obviously, a Greek default would be bad news for the banking system. Central banks around the globe seem prepared to step in and do what it takes to prevent a 2008-style crash, but the consequences would still be painful. So we'd certainly avoid European financials.
But one slightly leftfield and longer-term way to profit from a wave of sovereign eurozone credit defaults might be to buy Ryanair (LSE: RYA). As an airline focused on short-haul trips, the company could be well placed to take advantage of any tourism boom that would be likely to follow a Greek or Portuguese exit from the euro.
A riskier option although one that would pay out in the shorter term would be to short US financial stocks based on their potential exposure to a formal default. Even if there is no technical default, they risk being on the receiving end of CDS-related litigation from those hoping to argue that any agreement was in fact, involuntary.
On top of that, this year's US presidential election is likely to mean the banking sector comes under political pressure, as both parties compete to 'sound tough on Wall Street'. Already Barack Obama has outlined a new committee to investigate the role that fraud played in the subprime crises.
Shorting bank shares is not for the faint-hearted, especially with the Federal Reserve underlining its commitment to money printing. However, if you are looking for a way to do so that doesn't involve spread betting, you could consider an exchange-traded fund that rises as the banking sector falls, such as the Proshares Short Financials (US: SEF). Do understand though, that your timing matters with these funds. They rebalance daily, which means they are only suitable for short-term trades you need to keep a close eye on their performance.
