Satyajit Das: European Debt – Wrong Diagnosis, Wrong Treatment!

By Satyajit Das, the author of Extreme Money: The Masters of the Universe and the Cult of Risk (forthcoming August 2011) and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)

Executed with Northern European creativity, charm, flexibility and humility and Mediterranean organisation, leadership diligence and appetite for hard work, the European rescue plan – “the grand compact” – is failing.

Wrong Medicine

The EU response has relied on two mechanisms – the ECB and the European Financial Stability Fund (“EFSF”).

The ECB has financed the beleaguered countries by buying their bonds in the secondary market (around Euro 75 billion) and also by financing banks, against collateral of increasingly questionable quality such as Greek government bonds. There are allegations that the ECB and other European central banks have also used the Euro-zone payments system to lend money (around Euro 300 billion) to the crisis-stricken members. All this while the ECB has publicly been critical of banks, which are “addicted” to and substantially reliant on ECB financing.

The “temporary” EFSF due to terminate in 2013 proved poorly designed. Instead of the touted Euro 440 billion, the fund had only the ability to lend around Euro 250 billion, due to structural flaws. The EFSF is now to be replaced by the “permanent” European Stability Mechanism (“ESM”) which will have lending capacity of Euro 500 billion, the originally proposed level.

The Euro 500 billion ESM facility too has deep structural flaws. It relies on a similar mechanism to the original EFSF to achieve its AAA rating – a system of separate guarantees and capital. The Euro 500 billion fund is theoretically backed by Euro 80 billion in cash and Euro 620 billion in guarantees from Euro-zone members.

The Euro 80 billion will only be provided over 5 years starting in 2013. In part, this was a concession to member countries, including Germany, who were reluctantly politically to provide the cash except on deferred terms. There is provision for speeding up payments into the funds if required, for example, by the need for additional bailouts. The facility also provides for member countries to provide cash to support the ESM, where its credit rating falls below a specified threshold to reduce the performance risk.

As with the EFSF, the reliance on Euro-zone members guaranteeing each other is problematic. Some of the guarantors are themselves are vulnerable with the real and contingent liabilities. For example, every Euro 100 billion provided by the ESM increases Italy’s potential liabilities by Euro 18 billion, equivalent to 1% of the country’s GDP, and Germany’s potential liability by Euro 27 billion, also equivalent to 1% of GDP.

Drawings on the facility may result in a spiral of credit downgrades and cash calls. For weaker guarantors, their financial position may be undermined, potentially encouraging them to withdraw from the ESM itself. For stronger members, it places increased pressure on their support and weakens their credit rating and finances.

The position is made worse by the fact that non-common currency EU members may not be part of the new structure. The UK has indicated that it will not be part of the ESM, depriving the Euro-Zone members of a significant source of funding and support (around 14% of the EFSF).

The ESM perpetuates existing and introduces new problems. Access to the ESM funding requires unanimous agreement amongst the Euro-zone members. The ESM can provide loans only where the country agrees to accept EU/ IMF prescriptions for reformation of public finances and the economy. It will lend to the troubled country or purchase its bonds in the primary market, but not in the secondary market.

Unlike the EFSF arrangement, ESM funding would be senior to existing government debt (a standard feature of IMF rescues and bankruptcy financing, which was surprising excluded in the initial bailout condition). The ESM stipulates that restructuring is a requirement in the “unexpected” instance the government in question is determined to be “insolvent”. In addition, from 2013, all future government bonds issued by Euro-zone nations will need to include collective action clauses (“CACs”), designed to make restructuring mandatory under certain conditions.

If the current financing pressures on the troubled economies continue, then the existing support mechanisms may be inadequate. The countries, which have already sought bailouts, may need to seek additional support if commercial financing sources remain unavailable to them. Maturing debt and projected budget deficits for Greece, Ireland and Portugal will require around Euro 300 billion in new funding between 2011 and 2013. If Spain needs to resort to the EU Funding mechanism, then the ability to provide additional would be severely strained.

In reality, an EU support mechanism of something in the order of Euro 1.5-2.0 trillion would be needed to ensure a credible ability to bailout the embattled economies. Some European Finance Ministers have already called for an increase in the ESM to Euro 1.5 trillion. The political support for and economic viability of a facility of this size is unlikely.

At the same time, the terms of the ESM, especially the subordination of existing lenders to bailout funding and the mandatory Cas will increasingly force lenders and investors to avoid funding vulnerable countries. In effect, this will ensure that the peripheral economies becoming increasingly dependent on EU support, triggering the negative spiral described.

Skin in the Game

The EU bailouts have always primarily focused on protecting European banks from the effects of a default by borrowers such as Greece, Ireland and Portugal.

In total, banks in Germany, France and the UK have exposures of over Euro 500 billion to these three countries. If exposure to Spain and Italy is included, the global banking system’s total exposure increases to around Euro 2 trillion. The position is complicated by complex cross-lending arrangements. For example, banks in Spain, which may require support, have a Euro 70 billion exposure to Portugal and a Euro 13 billion exposure to Ireland.

Central to the European debt problems is the credit boom that took place following the introduction of the Euro. Prior to monetary union in 1999, interest rates charged on loans to individual countries better reflected risk of loss – from currency movements and ability to repay debt. The introduction of the Euro eliminated currency risk. Surprisingly, credit spreads fell sharply, reflecting a lack of differentiation between the credit quality of individual nations.

The mis-pricing of risk was driven by a belief that the entire Euro-zone was AAA rated because of the “implicit” support of Germany. An additional factor was the fact under Basel 1 and to a lesser extent under Basel 2 banking regulations, lending to sovereign nations attracted favourable capital treatment. The combination of these factors drove lending to the peripheral countries and their banks fuelling large credit booms which are now unwinding.

Much of this debt – in the form of sovereign debt, lending to banks and also structured securities based on mortgage and corporate loans – is held by smaller banks in France and Germany. If Greece, Ireland, Portugal and (ultimately) Spain have to restructure the debt, then these banks will suffer significant losses.

It is unclear whether banks, especially in Germany and France, have sufficient capital and reserves, to bear these losses. The IMF’s bi-annual Financial Stability Report has consistently argued that the Eur-zone banks have not been recognised losses adequately. The inadequate 2010 stress tests conducted by European central banks and the ECB did not countenance the prospect of a sovereign default in determining bank solvency. There are suggestions that the underlying position of some European banks, especially German Landesbanks, is highly problematic.

In June 2011, Moody’s changed its outlook on 13 mid-sized and smaller Italian banks to negative and warned it could downgrade the long-term debt ratings of 16 others. This followed its announcement that it had put Italy’s sovereign debt on review for possible downgrade. Italian banks were less affected by the financial crisis due to conservative lending culture and high levels of domestic retail deposits. Despite these strengths, concerns about possible contagion from the peripheral countries and the problems of Italy itself in bailing out these countries are now increasingly problematic.

Default or restructuring of European debt, in all probability, will require State involvement in recapitalising these institutions. In essence, attention will switch from bailouts of sovereign nations to bailing out affected national banks.

ECB Hurt Money

Default or restructuring would also affect the ECB, which holds around Euro 50 billion of Greek debt alone. The ECB’s total exposure to Greece, including lending to Greek banks and loans against Greek government bonds, is much higher – Euro 130-140 billion.

If Greece defaults, then the ECB could suffer losses as high as Euro 65-70 billion (say 50% of the amount advanced). The losses would almost certainly require recapitalisation of the ECB itself by Euro-zone members. As at 1 January 2011, the ECB had paid up capital of Euro 5.2 billion (due to be increased progressively to Euro 10.8 billion). The ECB is owned by the 17 euro-zone central banks with the combined capital of around Euro 80 billion.

The ECB’s position on whether peripheral countries like Greece should be allowed to default increasingly appears to be complicated by its own vulnerable financial position. When Lorenzo Bini Smaghi, an Italian board member, stated that a Greek debt restructuring would be “suicide” he may have been referring to the ECB. Statements about Anglo-Saxon “vested interests” seeking the restructuring of Greek debt are now matched by the ECB’s “self interest” in avoiding the same.

The effect on wider money markets of defaults is unpredictable. Depending on the quantum of losses and the recapitalisation requirements, the event could create concerns about affected Euro-zone banks, providing a channel for contagion in financial market. This could destabilise markets, transmitting the shock through high cost and reduced availability of financing, in a manner similar to what happened after the bankruptcy filing by Lehman Brothers in 2008.

Grand Confusions

The deeply flawed European strategy entailed providing financing to meet maturing debt and budget deficits at a time when markets were not open to the borrower or, at least, at reasonable rates. The EU/ ECB/ IMF funding would reduce borrowing costs to alleviate the pressure on public finances. The “temporary” measures would provide the country with the opportunity to reform its public finances and economy to make its debt burden more manageable. In time, the measures would allow the borrower to regain the confidence of commercial lenders and regain access to markets. As a corollary, banks would be able to build up reserves and capital against the possibility of some modest write-off as a result of some “minor” restructuring of debt, in the unlikely event that this was required.

Unfortunately, the premise that it was a “liquidity” rather than a “solvency” problem was incorrect. Breaking ranks, with other European central banks, Mervyn King, governor of the Bank of England, stated uncategorically that in his view it was an issue of solvency.

In reality, markets understood that the EU bailouts were a “get-out-of-jail” pass for poor lending decisions. There was no way that any of these nations would ever be able to service or repay current and projected levels of borrowing. The EU facility provided a means for the distressed nations to repay maturing debt and finance their deficits. In effect, the EU and official bodies have replaced commercial lenders as debt providers.

The bailout plan did not lower the nation’s interest costs or their access to markets. Interest rates on borrowing for Greece and Ireland are higher now than at the time of their bailouts. Despite the likelihood of EU support, Portugal’s cost of funds is unsustainably high. Spain and other countries, such Italy and Belgium, seen as vulnerable by investors have seen their borrowing costs rise inexorably.

The bailouts have made its less not more likely that these countries will regain access to markets in the near future. As existing debts mature, the funding provided official sources, the EU, ECB and IMF, is increasing. As these countries need additional financing, the absence of private financing will increase this proportion even further, leaving them to bear the bulk of losses in any restructuring.

The lack of confidence reflects the failure of the rehabilitation plans and the continued unsustainability of the debt levels of these countries. The lack of economic growth and deteriorating public finances is not likely to reversed soon.

Even in the most optimistic scenarios, gross public debt in the most troubled economies will continue to increase as continued budget deficits will require financing. Greece’s debt to GDP is likely to stabilise at around 160-180% around 2014/ 2015. Ireland, Portugal and Spain’s debt to GDP will reach 125-140%, 100-115% and 85-100% over the same period. Italy and Belgium already have debt to GDP ratios above 100%, but their budget deficits are lower and they are less dependent of foreign investors. Italy, burdened with very high levels of debt and low growth, has recently been placed on “negative” creditwatch by Rating agencies.

Even at subsidised interest rates, the debt burden for Greece, Ireland and Portugal looks unsustainable, rendering the countries insolvent. Spain’s position is better, but problems in the country’s banking sector as the property boom unwinds would strain its finances significantly. Slower than forecast global growth would place even greater pressure on all these countries.

These concerns about solvency will drive the lack of access to private financing, especially post 2013 because of the subordination provision and the mandatory inclusion of CACs. The failure of the grand compact will increase pressure to ultimately restructure debt in some form at some stage.

Backsliding

In the near term, the EU and Euro-zone members seem likely to persist with the failed strategy. Portugal’s bailout package will be financed by the EU, EFSF and IMF. Further funding needs will be accommodated as they emerge from the existing facilities as much as possible, until these are exhausted. The ECB will continue to support the bailout plans. German insistence on commercial lenders sharing some of the burden has wavered. Instead fuzzy ideas of a “voluntary” commitment of existing lenders to re-finance existing, maturing debt will gain traction.

Over time, the palpable failure of the bailout strategy – extend and pretend – will progressively be revealed. Pressure will emerge to improve the term of the bailout package.

Already, Greece has received reductions in interest rates on bailout funding and some extension in the terms of the financing. The need to provide additional funding to Greece of around Euro 120 billion is already under discussion. In all probability, some deal will be done to provide the funds, against Greek promises that cannot and will not be met. There will be more and more of the same, in a desperate effort to avoid default or restructuring.

In the end, default or restructuring will become inevitable. Initially, minor changes, such as lowering coupons and extending maturities, perhaps as part of debt swaps, will be sought to manage the problem. Ultimately, a major restructuring, involving a significant write off of outstanding debt is likely. This is the case for Greece and perhaps the other peripheral countries.

Such defaults would be the first by a developed country since 1948. As most of the debt is issued under local law, a swift restructuring is feasible by the agreement of a simple majority or super majority (say 2/3rd of lenders).

Based on history, a loss of around 30-70% of the face value of obligations is expected. The longer the time taken over the process, the greater the likely losses to holders of the obligations. The reason being that unless the debt burden is reduced early, continuing high servicing costs and deficits will continue to increase the level of write off necessitated to restore solvency.

A Matter of Political Classes

European decision making increasingly echoes Shakepeare’s Richard II’s lament: “I wasted time, and now doth time waste me.” The EU and major Euro-zone members, notably Germany and France, lack the political courage or will to tackle the problem. The absence of an “easy” and “painless” solution means that career politicians and Euro-crats see no benefit in advocating the complex and messy process of default and restructuring.

European leaders dissemble that the debt crisis was the result of traders and financial markets. Anders Borg, Sweden’s finance minister spoke of “wolf-pack markets”. José Luis Rodríguez Zapatero, Spain’s Prime Minister, blamed “cynical hedge funds”, “cocky credit-ratings agencies” and “neoconservative capitalism”. Greek Prime Minister George Papandreou accused traders of visiting “psychological terror” on his country. Michel Barnier, the European commissioner for the single market. accused financial institutions of “making money on the back of the unhappiness of the people”. Mr. Zapatero also found fault with a duplicitous Anglo-Saxon press. In short, it seems anybody but the Europeans are to blame. Cognitive dissonance looms large.

Increasingly, the trajectory of the crisis is driven by political considerations. The denouement to the European debt crisis, probably some way off, will come via by the “street” or the ballot box.

In the afflicted nations, public protests and disturbances are increasing as the populace rejects greater austerity. Populist politicians, willing to reject the need for further “sacrifice” and repudiate the country’s debt, hover in the wings. The argument that the country will be an international “financial pariah” don’t carry much weight when you are already one with no one likely to lend you money any time soon. It also has less weight when you don’t have a job and the country is on the brink of social breakdown.

For the countries that must provide the bulk of the bailout money, there is angst that the increased level of financing required by the problem borrowers has turned the EU into a “transfer union”. Karl Otto Pöhl, the former head of the Bundesbank, stated that: “The foundation of the euro has fundamentally changed as a result of the decision by euro-zone governments to transform themselves into a transfer union. That is a violation of every rule. In the treaties governing the functioning of the European Union, it explicitly states that no country is liable for the debts of any other. But what we are doing right now, is exactly that. Added to this is the fact that, against all its vows, and against an explicit ban within its own constitution, the European Central Bank (ECB) has become involved in financing states”.

The lack of decisive and timely action has allowed smaller political parties to gain momentum. Parties like Finland’s True Finns and France’s Far Right, rejuvenated under the leadership of Marine le Pen, have gained electorally on a policy platform of a mix of rejecting bailouts, nationalism, anti-immigration and other sundry forms of xenophobia.

Discontented and angry voters in Germany and other saving nations at some stage may also decide to call time on the fruitless and self-defeating support for the overly indebted Euro-zone members.

Having falsely linked the problem of over indebted states with the canards of the continuation of the Euro and the survival of the Euro-zone itself, Europe is increasingly drifting towards an inevitable, disastrous and destabilising debt crisis. Rather than amputating a gangrenous limb, European leaders risk poisoning the entire body fatally – weakening the financial positions of the stronger Euro-zone members and their economies, which are paying for the bailout and will suffer the losses when the inevitable defaults come.