Satyajit Das: The Year of Wishful Thinking

By Satyajit Das, a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2010, FT-Prentice Hall).

A year of wishful thinking …

The period from March 2009 was the year of wishful thinking. Central banks cut interest rates and governments opened their cheque books providing a flood of cheap money that gave the illusion of recovery and a normal functioning economy. By pouring a lot of water into a bucket with a large hole, the world sustained the impression that the receptacle was almost full. As Norman Cousins, an American political journalist, noted: “Hope is independent of the apparatus of logic.”

Cognitive dissonance ensured that excessive debt levels and the unsustainable nature of debt fuelled growth was ignored. Governments merely transferred the debt from private sector balances sheets onto public balance sheets. The Global Financial Crisis (“GFC”) has morphed into a Global Sovereign Crisis (“GSC”) as sovereign governments now face difficulty in raising money. Stock markets and asset prices have tumbled. Credit markets are exhibiting an anxiety not seen since late 2008/ early 2009. The year of wishful thinking has run its course.

Cradle of debt…

If sub-prime was the Patient Zero of the GFC, then Greece, the cradle of Western civilisation, was the equivalent of the GSC. As historian Arnold Toynbee observed: “An autopsy of history would show that all great nations commit suicide.”

Greece’s significance is not its economic size (around 0.5% of global Gross Domestic Product (“GDP”)) but its significant debts. Greece currently has around Euro 270 billion (113% of GDP), projected to rise by 2014 to around Euro 340 billion (150% of GDP)). In addition, Greece’s budget deficit was around 12-13%, at least that was the best guess. Profligate public spending, a large public sector, generous welfare systems particularly for public servants, low productivity, an inadequate tax base, rampant corruption and successive poor governments were responsible for the parlous state of public finances.

Several events focused attention on the problems. Greece needed to borrow around Euro 50 billion in 2010 to refinance maturing debt and fund its budget deficit. There were damaging disclosures that Greece, like many other European countries, had used derivatives to manipulate its debt figures. Greece bungled attempts to mask its increasing difficulties in refinancing maturing debt, including statements about a large purchase by China of its debt which was denied by the supposed buyer.

The revelations focused attention on underlying problems setting off alarm bells. Smelling blood in the water, markets began shorting Greece, pushing up the cost of Greek debt, both in the physical and derivative (credit default swaps (“CDS”) or credit insurance) markets. The Greek stock market fell sharply by around 30%. Gradually, the ability of the country, as well as Greek banks and companies, to raise money ground to a halt.

Greece was also the “canary in the coal mine”, highlighting similar problems in the PIGS (Portugal, Ireland, Greece and Spain) as well as some Eastern European countries. These countries alone have around Euro 2 trillion of debt outstanding. Larger countries – the FIBS (France, Italy, Britain and the ‘States) – also have similar problems of large public debt, unsustainable budget deficits and (in most cases) unfavourable current account deficits (both in absolute terms and relative to GDP). This does not take into account the long term massive problems of aging populations and unfunded social welfare schemes (pensions and health systems).

Greece’s problem highlighted that such debt may be unsustainable and investors may not continue to finance it, certainly not at current rates and perhaps not at all. It was a problem that had been there all along.

Going Nuclear …

Will Durant, an American historian, advised that: “One of the lessons of history is that nothing is often a good thing to do and always a clever thing to say.” Initially, European politicians and bureaucrats, who suffer from delusions of adequacy, did nothing, but wouldn’t shut up about it. The oft repeated battle cry was “no default, no bail-out, no exit”. Germany remained especially hostile to any financial “bailout”. Repeated invocations of the no “bailout” clause underlying the Euro-zone drew attention to the risks of Greece’s debt.

The major problem was “contagion” – the consequences if Greece was to unable to raise money from commercial sources. Much of Greece’s debt is owed to investors outside the country, mainly banks and investors in other European countries. If Greece defaulted on this debt, then the resulting losses would have serious consequences for the affected banks and banking systems.

Countries, such as Portugal, Spain and Ireland, with similar economic problems would inevitably be scrutinised and targeted. If a sovereign experienced funding problems, then banks and other borrowers in that country would also be affected. For example, Greek banks were increasingly unable to fund themselves in international markets, relying on the Greek and European Central Bank (“ECB”). The Euro had become increasingly volatile and had started to fall in value. There were concerns that the financial problems would affect the real economy – growth, jobs, investment etc. What happened in Athens was unlikely to stay in Greece.

By February 2010, the need for coordinated action by the Euro-zone countries and the European Union (“EU”) was evident. While pledging eternal support, the EU postponed action, waiting for Greece to agree to an austerity program to remedy its finances. The cause of European unity was not served by attacks by George Papandreou, the Greek Prime Minister, that the EU was creating a “psychology of looming collapse” and making Greece “a laboratory animal in the battle between Europe and the markets”.

In April 2010, as the market for Greek debt worsened (the additional interest rate that Greece had to pay reached 8.00% p.a. over that paid by Germany), after considerable prevarication, the EU proposed a highly conditional Euro 30 billion rescue package. The Haiku writing, Belgian Herman Van Rompuy, President of the European Council, hoped “it will reassure all the holders of Greek bonds that the Euro-zone will never let Greece fail … If there were any danger, the other members of the Euro-zone would intervene.”

Markets considered the proposal inadequate and unlikely to avoid a Greek default. Increasingly desperate as circumstances began to rapidly spiral out of control, the EU increased the package in early May 2010 to Euro 110 billion, including a Euro 30 billion contribution from the International Monetary Fund (“IMF”) who would supervise the package and the implementation of the economic “cure.”

About a week later, continued market scepticism and increasing pressure on Portugal, Spain and Ireland forced the EU to “go nuclear”. After months of slow and tortured discussions, the EU acted with surprising speed announcing a “stabilisation fund” to the value of Euro 750 billion to support Euro-zone countries, including an IMF contribution of (up to) Euro 250 billion. The actions were designed in no particular order to salvage the EU, the Euro and over indebted Euro-zone participants by stopping contagion and further spread of the crisis.

Struggling for a telling phrase, journalists spoke of financial “shock and awe”. A single word – panic – better summed up the actions. All constitutional doubts and concerns about the legality of any bailout were jettisoned. The new consensus was that the actions had always been possible under the “exceptional circumstances provision” (Article 122) to counter a systemic threat.

Initially, stock markets rose sharply, especially shares of banks exposed to Greece who would benefit from the rescue. The interest rates on Greek, Irish, Italian, Portuguese and Spanish bonds fell sharply. As the announcement over the weekend caught traders unawares, the rally was driven largely by covering of short positions.

“Shock and awe” quickly proved more shocking and less awe inspiring than the EU had hoped. Wiser commentators mused that if Euro 750 billion wasn’t going to do the trick, then what was?

Nicolas Sarkozy, the French President, turned the Euro zone’s sovereign-debt crisis into a personal triumph. The proposal, he let it be known, was 95% French. Le Figaro led the cheerleaders reporting Sarkozy’s comment that “in Greece they call me ‘the saviour’.”

Brussels, we are not receiving you….

Details of the “plan” remain sketchy. The entire package conveys the impression that the EU and ECB are hopeful that the announcement will suffice to bring stability to markets and the facilities won’t ever have to be used.

A problem of too much debt was being solved with even more debt. Deeply troubled members of the Euro-zone were trying to bail out each other. Given that all have significant levels of existing debt, the ability to borrow additional amounts and finance the bailout remains uncertain.

The need for governments to raise the required amount risks “crowding out” other borrowers as well as increasing the cost of funding. In order to avoid the risk of inflation, the ECB proposes to sterilise payments by issuing bonds to soak up the additional liquidity created. The entire plan resembles a money shuffling exercise between European sovereigns.

The use of the SPV structure echoes the ill-fated Collateralised Debt Obligations (“CDOs”) and Structured Investment Vehicles (“SIV”) that proved problematic at the start of the GFC.

On 7 June 2010, the EU announced that the SPV will be backed by individual guarantees provided by all 16 members of the Euro-zone. The guarantees are individual rather than joint and several. This means that there is real doubt as to whether some of the weaker countries are in a position to actual to support or fund their share of the facility. There is a surplus “cushion” arrangements to ensure against the failure of any of the guarantors to supply their share of funds. The adequacy of this arrangement is questionable.

The structure obscures, perhaps deliberately, the real underlying risk of the borrower. The risk assumed by an investor is difficult to establish because of the conjoint liability and unspecified support arrangements. In the final analysis, this structure may be self defeating and unworkable.

The reality is that Germany, with its large pool of domestic savings, must be the corner stone of the rescue effort. The effect of the stabilisation fund is that stronger countries balance sheets are being contaminated by the bailout. Like sharing dirty needles, the risk of infection for all has drastically increased.

The IMF contribution to the Euro-zone rescue package also needs to be obtained from its members, many of whom would, in turn, have to borrow the money. The IMF’s 186 members have pre-assigned ‘quotas’ that equate to its maximum financial commitment. The quota is denominated in SDRs (Special Drawing Rights), an international reserve asset based on a basket comprised of the British pounds, the Euro, Japanese Yen and the U.S. dollar. The U.S., the largest member, has a quota of SDR37.1 billion (US$54.7 billion). Australia has a quota of SDR3.2 billion (US$4.7 billion).

The IMF finances any contribution from it quotas (25% of which is paid up), proceeds of sales of its gold holdings or borrowing from its members. The IMF’s ability to finance its activities is directly dependent on the member’s capacity and willingness to fund its activities.

Upon announcement of the US$700 billion TARP “bailout” package, Republican Senator Jim Bunning quipped: “When I picked up my newspaper yesterday… I thought I woke up in France. But no, it turned out it was socialism here in the United States…” Senator Bunning and his fellow Americans were perhaps equally bemused to find that they were now a part of the rescue plan for Greece and Europe.

Karl Dunninger, a trader, writing at www.seekingalpha.com captured the madness: “The most-amusing part of this is that nations seriously in debt and without a pot to piss in will be “contributing” some of the money to fund the debt. Spain, for instance, has pledged to do so. Where is Spain going to get the money from? Will they sell bonds at 8% to fund a loan at 5%? That’s a very nice idea…. let’s see, we lose 3% on those deals. That ought to help Spain’s fiscal situation, don’t you think?”

Solvency Not Liquidity, Stupid…

At best, the plan provides temporary liquidity to cover immediate financing needs, repaying maturing debt and financing deficit. In a striking parallel to the early stages of the GFC, the reality that it is a “solvency” problem not a “liquidity” problem remains unacknowledged.

Most of the countries in the firing line have unsustainable levels of debt. For example, beyond 2010, Greece needs to re-finance borrowings of around 7%-12% of its GDP (around Euro 16 billion to Euro 28 billion) each year till 2014. There are significant maturing borrowings in 2011 and 2012. In addition, Greece is currently running a budget deficit (currently over 12% but projected to decrease) that must be financed. As noted above, Greece’s total borrowing, currently around Euro 270 billion (113% of GDP), is forecast to increase to around Euro 340 billion (over 150% of GDP) by 2014.

The IMF’s publicly available economic analysis that its plan assumes that Greece is able to refinance long-term debt by early 2012 and short term debt even earlier. Given that Greece is expected to have a total debt burden of around 150% of GDP and total interest payment of 7.5% of GDP, the ability to raise funds and the assumed 5% cost of refinancing may be optimistic.

The IMF plan calls for a program of fiscal austerity and major structural reform. This would entail a sharp reduction in the budget deficit to less than 3% of GDP and public debt under 60% of GDP. It is unlikely that Greece, despite heroic speeches from politicians, will be able to meet these targets.

Temporary emergency funding will not solve fundamental problems of excessive debt and a weak economy. Government expenditure will need to be slashed and taxes raised to reduce its debt. But the government is too large a part of the economy and the suggested austerity measures will most likely cause a severe recession. In turn, this will drain tax revenues and increase expenditures making it difficult to reduce the budget deficit and funding needs.

The level of indebtedness may already be too high. Kenneth Rogoff and Carmen Reinhart in their survey of financial crises This Time It’s Different argue that sovereign debt above 60-90% of GDP restrains growth. Greece’s interest payment now total around 5% of GDP and are scheduled to rise over 8% by GDP. Rising interest costs will only worsen this problem.

The cure may not be feasible or will not help make it easier to meet future debt obligations. Ireland has already implemented austerity measures. The government debt as a percentage of GDP has increased to 64% from 44%. The budget deficit as a percentage of GDP has doubled to 14% from 7%. The nominal GDP of the country has fallen by 18%.

The plan may also make further liquidity problems inevitable. Instead of allowing Greece to raise funds normally, the bailout package is assisting investors to reduce exposure via repayment of maturing debt and the sale of illiquid longer-term securities.

The package also risks forcing other vulnerable countries to rely on the stabilisation fund. Investors are selling rather than purchasing Spanish, Portuguese and Irish debt to also lower exposure. The effect of the bailout package is that bondholders are subordinate to the IMF and the Euro-zone. This means that if the bailout fails, then the bond holders will be paid out after the IMF and the Euro-zone creating a disincentive for either holding existing debt or providing new debt.

This affects not only Greece but any country considered vulnerable and likely to access the bailout. Recent lack of support for Spanish debt issues may be evidence of the problem.

Sovereign debt problems have also affected the ability of European banks to raise money in wholesale markets.

These problems will increase the cost of debt for all affected countries. The increasing cost of market debt makes the cost of the bailout funding more attractive encouraging resort to the facility. If this pattern continues, then other countries may be forced to access the package and the Euro 750 billion will quickly be insufficient to meet the total liquidity needs.

As Woody Allen once observed: “More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly.”

Yves here. One quibble with Das’ piece. He does not make explicit the basis for sovereign default, which is that they have issued or guaranteed debt in a currency they do not control. Greece (like California) issues debt (in Greece’s case, in euros, in California’s in dollars) and it is not the sovereign issuer of that currency. Hence they have to worry about access to bond markets. Countries that are sovereign issuers are also exposed to default on foreign currency debts or guarantees. Argentina defaulted because it had dollarized its economy (effectively taking its own currency out of the equation). The UK is at risk of default because it has a very large banking sector with very big dollar liabilities. It cannot credibly backstop the dollar exposures of its banks. The US government is not at risk of default. It may create serious inflation if it “prints” too much, but with near 20% unemployment and low capacity utilization (and shrinkage in broader measures of money, a clear sign of contraction), that is simply not a real risk right now.