Essentially, the ECB decided Greece would default, but it wouldn't trigger Credit Default Swaps. As in it's a default but we aren't going to call it a default. Credit Default Swaps, by the way, are simply insurance issued by one private party to another. If Greece defaults, and you have a CDS on Greece, the insurance pays out.
Only this time it didn't. Because when your investment went up in smoke, the ECB redefined the meaning of the word "fire". There really is no direct reason for the ECB should do this. When a sovereign like Greece defaults the people who issued the swaps lose money, and the people who bought them gain. And it's not clear why one should be favored over the other. Presumably the ECB is trying to save some at risk institutions that issued insurance they can't pay out, but there are also many European institutions that bought the swaps.
This is incredibly harmful in that it prevents anyone thinking of buying European debt from hedging against the possibility of default. Demand for European debt will sink, and the interest rates on European debt will go up even more. And when the ECB changes the rules mid-game, it creates uncertainty about investing in Europe and people don't want to play anymore. This lack of trust in European institutions is now a structural problem.
The question here is why would these Eurocrats be so daft? Are they being daft?
Personally, I hope they are. The idea that the ECB is playing favorites is less worrying than a Europe that can't handle the default of even a relatively minor player. I don't think the ECB worries that a Greek default would be catastrophic, but rather that it might be catastrophic. Its worth remembering how little the people overseeing these financial crises really know about what is going on, and exactly what the result of triggering these Credit Default Swaps would be. It's hard to figure out what the full extent of liabilities across European institutions to a Greek default are, before it happens.
In the back of their minds is the fear that there is another AIG waiting to go off. And Europe may not have the tools to quickly rescue a collapsing bank if the sovereign country lacks either the will or the resources to do so. And I'm sure that in this fear ridden environment, a European bank with exposure in the case of Greece technically defaulting could get out of its commitments by jacking up the doom in private conversations with the central bankers.
