Greece, Debt And The EU: Is The Day Of Financial Reckoning Finally Upon Us?

26th Oct '11 by Steven Dotsch

31 comments 16200 reads

If the leaders of the European Union cannot agree soon to some sort of 'master plan' that saves Greece, shields Spain and Italy from the contagion of wholesale investor selling, protects France from a fatal downgrade, avoids failure for the world's largest banks, and persuades German voters not to dump its government ... all hell will break loose in Europe, the UK, USA, etc. Portugal, Ireland, Italy, Greece, and Spain are more than 3.1 trillion Euros in debt. France — which, according to Moody's, is now in danger of suffering a fatal downgrade of its debt — owes another 1.6 trillion. Peripheral nations in Eastern Europe owe still more.

Europe's total ‘at-risk debts’ are estimated at nearly triple the size of Germany's entire economy.

How did we get to this stage?

Remember 2007 – 2009: the debt crisis and collapse of Lehman Brothers in 2008, with US and European countries pumping in massive sums to ward off a financial meltdown and save their largest banks from failure. The entire rationale of these giant bank bailouts in the U.S. and Europe was to contain the debt crisis — to prevent the contagion of fear from spreading to virtually every private-sector borrower in the Western world. But it all backfired, didn't it?

By 2010, instead of being contained, the contagion had begun to spread to major public-sector borrowers — the very same sovereign governments that had bailed out their banks in the years prior.

The banks were drowning in bad debts. But rather than lifting them from the brink, the sovereign governments themselves were dragged underwater.

And so here we are facing the most dangerous moment for savers, investors ... everybody actually, during the last 90 year or so, afflicting now not just individual banks and corporations, but entire countries:

the first to sink was Greece, as global investors dumped Greek debts in panic
soon after Greece received its first bailout from the European Union and the International Monetary Fund, investors began attacking Ireland and Portugal
after Ireland and Portugal were bailed out, the contagion hit Spain and Italy
and now, we have France on the chopping block, in danger of losing its triple-A rating

Rather than truly ending the 2007 - 2009 crisis, the United States and the European governments have merely set the stage for an even larger one.

Any prudent solutions in sight?

Any proposed "solutions"…

Unlock with Email

Unlock with Google

Already have an account?
Login here

Steven Dotsch

27th Oct '11

Eurozone Debt Deal: 10 Unanswered Questions - SkyNews, at: http://news.sky.com/home/business/article/16097619

Ed Conway, economics editor

Bank recapitalisation

European banks will have to raise a combined total of 106bn euros so they rebuild their balance sheets, specifically meeting capital ratio targets of 9%. In the first instance banks will be urged to raise that from private investors, but given they are likely to struggle to do so, governments are then permitted to step in and recapitalise them – which amounts to a semi-nationalisation of the sort Britain carried out with Northern Rock, RBS and Lloyds Banking Group.

According to the European Banking Authority, which regulates the health of banks across the continent, this will involve 70 banks raising shares, with Greece raising 30bn euros, Spain 26.2bn, Italy 14.7bn, France 8.8bn, Portugal 7.8bn and Germany 5.2bn.

Verdict:
This deal had, in all truth, been sewn up over the weekend. It is perhaps the most convincing part of the package, but there remain questions:

1. Is it big enough? The IMF referred to a shortfall of 200bn euros only a few weeks ago.

2. How can we be sure the banks will raise new capital rather than merely shrinking their balance sheets, lending out less and contributing to further economic woes throughout Europe?

3. Are the stress tests which underlie these big new numbers really plausible? Plenty of people would say they aren't.

Boosting the bail-out fund

The European Financial Stability Facility is an emergency fund set up to support countries struggling to raise money on the capital markets. It currently has around 440bn euros of high-quality bailout cash at its disposal – though some of that is already committed.

Under the new euro plan, the remaining 250bn euros will be leveraged up so it has the effective firepower of one trillion euros. There will be two parallel schemes to leverage up the fund, though both work on the principle of essentially committing to absorb the first 20% of losses investors would face in the event of a country defaulting. The idea is that with this commitment in place, investors will be far more willing to invest in, say Italian or Spanish debt.

The eurozone will also set up a special purpose investment vehicle, backed by the same commitments, which will aim to attract investment from around the world. Hence the fact that French president Nicolas Sarkozy is turning to China to seek an infusion of investment. However, the IMF will not be able to invest directly in the Fund – its remit only allows it to give money directly to countries, as, for instance, it has done with Greece.

Verdict:
While it is at least encouraging that there has been some kind of agreement on extending the EFSF there are serious questions about the EFSF:

4. Is it big enough? Most economists thought it would need to be worth two trillion euros if it were comfortably to support Italy or Spain. Even if you assume that the EFSF might not need to be used fully, is one trillion euros a big enough bazooka to convince investors to leap back into Europe's troubled bond markets? Unlikely.

5. Is it too complex? The schemes the eurozone is using to lever up the size of the fund look suspiciously similar to the kind of complex financial engineering carried out by American financiers in the sub-prime market. Anglo-Saxon capitalism, anyone?

6. The way the plan is structured makes it highly likely France, and perhaps other euro members, will suffer a credit rating downgrade, since it imposes extra likely fiscal burdens on them given they are now having to support Greece and other struggling euro economies.

7. Where is the ECB? Most economists agree that in order for the eurozone to get through the next few years, it will have to rely on the European Central Bank to keep monetary policy loose. However, the Germans insisted that the EFSF would be extended without the help of the ECB.

Bank haircuts

Private investors who own Greek debt agreed back in July to accept a 21% reduction in the value of their investments. They are now being asked to accept a 50% reduction. The aim is to reduce the total amount of Greek debt from around 180% of the country’s economic output to around 120% by 2020.

Verdict:
Where to begin with the issues?

8. This still doesn't leave the Greek public finances in what might be described as a sustainable position. Most studies have shown that when a country’s debt surpasses 100% of GDP, it is at the fiscal point of no return. Moreover, an ever-increasing proportion of Greek debt is owned not by the private sector but by institutions like the ECB and other governments – so a voluntary agreement from private sector investors can only make a diminishing difference to the overall debt-load.

9. We still don’t know whether it will work. The likelihood is that investors will be offered a selection of different restructuring deals, each of which will have the effect of reducing the nominal debt by 50%. However, unlike in July, we don’t yet know what the menu will look like. Moreover, we can’t be sure that it will actually be taken up by those investors. If the counterfactual is full-blown default where they would lose all their cash, there is an incentive to sign up. Just don't expect them to do so with much enthusiasm.

10. Although this deal will probably avoid a so-called "credit event" – a messy, disruptive, unplanned default – it will still be very painful for many blameless investors. Consider the plight of some investors who realised in recent years that their Greek bonds were likely to lose them money, and that the country could effectively default. They bought millions of dollars worth of credit default swaps – insurance policies which should pay out in the event of a Greek default. They are losing money on their Greek bonds (due to this haircut) but the insurance policy they thought would protect them (the CDS) will not pay out. So despite acting sensibly and rationally – despite them making the right investment call – they are being punished because of the peculiar contortions into which this deal has been manipulated.

emptyend

Who said I was farting around pitching tents and complaining?

Nobody - not even me!

However, whilst you are right to say that....

...taxing producing and growing sectors of the economy, to pay for unproductive and shrinking sectors is not the recipe for growth. It is the recipe for decline.
We can not borrow our way out of a debt problem increasing the burden on tax payers as it will destroy growth in the long run.

....the fact is that the other comments about "dipping the hands into taxpayers pockets" is the sort of populist tosh that stokes the anti-banker, anti-capitalist rhetoric ....which then gets parrotted round the world on the internet - thus neatly strangling any optimism or growth opportunities at birth.

The unfortunate reality is that it is ONLY by government action (using taxpayers' money to underwrite the financial system) that we are going to get the foundations of enough confidence to actually get the growth that the global economy needs. The actions of the protesters will achieve absolutely nothing.....save that they will contribute at the margin to a fall in GDP as a result of their disruptions!

Everyone in the world would now say that they would rather we weren't in this position - but we ARE, and we just have to get on with it! Using taxpayers' cash to underwrite the financial system is plain common sense - and, with luck, a big enough underwriting would mean that it won't get called on. The flipside of course is that the private sector should be forced into taking severe haircuts on its unwise lending......

....and here I fault all governments for having stoked the debt problem rather than headed it off - and then for compounding the problem by bailing out all and sundry lenders.

But we are where we are - and raising the level of forced haircut on the Greek lending is a modest step in the right direction....which requires a reduction in debt to more manageable levels.

macroeconomix

" get the foundations of enough confidence to actually get the growth that the global economy needs"

The foundation of a strong economy can not be based on the fickle sentiment of consumers who have already overspent, and over borrowed. This is Keynesian thinking, and a fallacy.

A strong economy is built upon savings and production, and the needs and wants of people who produce and make good spending decisions that don't destroy their wealth, or lead them to defaulting on debt they have used to live beyond their means.

If "confidence" leads people to spend money they don't have, and to borrow more than they can afford, then that can only stoke up more problems.

Of course the strategy of the central banks will be to destroy the value of their currencies as a means to forgive both private and public debt - unfortunately with so many dependent upon fixed incomes, this will only make problems worse, as the cost of living will rise destroying demand.

The solution is for the governments to do less, not more, for them to borrow less, not more, for them to tax less not more, for them to spend less, not more, and allow the productive parts of the private sector take up the slack. The sooner it is done, the less painful it will be. And it will be painful, no matter what the much derided (and with good reason) politicians and bankers choose to do.

The foundation of a strong economy can not be based on the fickle sentiment of consumers who have already overspent, and over borrowed. This is Keynesian thinking, and a fallacy.

Possibly. However, I said nothing whatsoever about CONSUMERS! There is more to "confidence" than mere consumer sentiment....notably in relation to the point that you make yourself that governments should be encouraging the productive parts of the private sector take up the slack.

AFAIAA this is precisely the policy being pursued by the UK government......but it DOES require a level of confidence within the private sector that will have to invest and hire people!

Wittering on and on and complaining about Governments using (but not necessarily SPENDING!) taxpayers' money - as they attempt to engender the confidence needed for investment - is simply unhelpful. That is why most journalists should be taken out and shot in present circumstances, because they are always focusing on the negative and the blame game - and simply making a bad economic problem rather worse!

The final day of reckoning avoided . . . postponed, I would say!

While markets soar after the announcement of the Eurozone debt deal, you may want to take a moment and wonder why?

The deal calls for private investors (banks and others) to accept 50 per cent losses on Greek debt and increases the firepower of the bail-out fund to about €1 trillion. While many banks are required to raise new capital, all at the same time.

The problem is, we don't actually know how they are planning to increase the bail-out fund size from €440bn to €1 trillion. On top of that, there remains the question as to whether €1 trillion in itself is enough. Nor where all the € billions are going to come from to prop up the banks.

All that Europe has done so far is to buy itself a bit more time to sort itself out. But for how long?

With many Eurozone countries teetering on recession and with high real inflation hurting we are not out of the woods yet.

Fangorn

Interesting to see that there will, in fact, be no "credit event",and thereby no CDS contracts triggered. A 50% haircut, essentially sees a restructuring of the debt, whatever the EU chooses to call it.

No suprises that the Eurozone worked hard to smudge this so as to prevent CDS contracts triggering, presumably because French banks and German ones are heavily on the wrong side of the insurance trade, It was always going to be so. Rather undermines the relevance of Credit Derivs in my view, which, no doubt, is the whole idea!

Have to feel sorry for all of those parties that sold Greece risk to hedge themselves (which was what Credit Derivs were invented for in the first place, rather than the trading instrument they have become)

A cynic.

I wouldn't lose much sleep if the CDS market disappeared up its own rear end. The CDS market was invented by banks so that they could pass on some of their gross exposures to counterparties who were less financially literate than they were......such as insurance companies and others.

As a result of the CDS market, those who were responsible for the actual lending decisions took less interest in the well-being of those they were lending to - because they were passing the risk on and not retaining it.

The CDS market was an important tool in facilitating the massive increases in leverage over the last 10 years or so - and if it doesn't actually do what was expected by the banks then they have only got themselves to blame! Much better that the contagion effect of CDSs (not working as expected) should be contained within those institutions that thought they had bought protection against default - because they shouldn't have lent in the first place.

Incidentally, the CDS market has only been in existence since about 1997-8.....and we all managed perfectly well then without it!

That has been the whole problem with the CDS market yes - what was envisaged as a hedging tool, quickly morphed into a leveraged speculative tool - If only it had been used properly.

As to if it doesn't actually do what was expected they've only got themselves to blame, have to disagree. One can never fully take into account political interference and that is exactly what we have here. Greece has defaulted, and will do so again, as their debt, even after the haircut, is unsustainable(120% of GDP post haircut was it not?) It's likely other Euro nations will follow, their debts are just so large.

Yep I was there when the first CDS trades went through. What a palaver that was - 30 page documents having to be faxed (with the alterations being faxed backwards and forwards!) No email back then! Agree we managed perfectly well before it but that was because risk managers at banks had a more hands on approach (as did local branch managers who actually knew their customers inside out!)

what was envisaged as a hedging tool, quickly morphed into a leveraged speculative tool - If only it had been used properly.

....mmmm....I really don't think that it was viewed that way by the banks! It was a way to reduce their own exposure whilst retaining the ability to do more lending to particular corporate clients. In order to hedge their own exposure, they had to sell the CDS on to protection-writers who were happy to take the credit risk (usually insurance companies that were active bond buyers, for whom a CDS offered a diversification in their credit portfolio.

As to if it doesn't actually do what was expected they've only got themselves to blame, have to disagree.....
Yep I was there when the first CDS trades went through. What a palaver that was - 30 page documents

The reason I said they have only themselves to blame was that it was the banks themselves who wrote those 30 page documents. If they didn't make them watertight, then it was their own fault! There were a few trades being done in the mid 1990s, but it didn't start to get properly organised as a market until 1998-2000. That might be a coincidence of timing re the growth of debt - but I doubt it!

dodge1664

28th Oct '11

Maybe the CDS market should never have existed, but there must be some consequences to effectively declaring that all previously written contracts are null and void. Won't large writedowns of Greek debt without any compensating CDS payout appear somewhere in the system?

Surely reducing their own exposure to loans made to corporate clients (whether that was to free up credit limits to enable them to loan more, whilst not impacting their client relationship negatively as selling on the loan to a third party would do) whilst still maintaining the loan on their book is hedging their risk position? By buying the CDS from writers of protection their synthetic short effectively cancelled out their long position in the underlying if things went tits up? Is this not hedging?

I do agree that many institutions, such as Bear Stearns , went overboard and aggressively traded such products. One of the reasons they were so exposed when the final call came in and they had nowhere to hide.

The marvel of CDS was that it both allowed hedging,and a cheap way to gain exposure to credits/time horizons that might not have been available in the underlying cash markets for some institutions.eg Those Life Insurers/Insurance companies that you mention.

I don't think there was anyway they could have been made watertight given that we are dealing with political interference. How often do we see governments change the "rules!" One simply can't document for that potential eventuality in my view.

It's a pity that the CDS market has morphed into its present form. It had the potential to be so useful but as many have commented, it has now become a leveraged gamblers tool.

With skepticism setting in, following yeaterday's furore, some interesting follow-up articles from Bloomberg:

"Greece Will Eventually Leave Euro, Rogoff says", at http://www.bloomberg.com/news/2011-10-27/rogoff-europe-pact-only-buys-time.html and, "Focus Swings to Italy Debt as Greece Wins Reprieve", at http://www.bloomberg.com/news/2011-10-28/focus-swings-to-italy-debt-as-greece-wins-reprieve.html

Is this not hedging?

Yes - which is why I said In order to hedge their own exposure, they had to sell the CDS

However, for every hedger there was a speculator...or, as you correctly put it, a cheap way to gain exposure to credits/time horizons that might not have been available in the underlying cash markets for some institutions.eg Those Life Insurers/Insurance companies that you mention.

The weakness would seem to be that not every eventuality was covered in the documentation (though I would argue that the spectre of a legal default hasn't been magicked away by the sleight of hand over the bond swap concept .....there will still be some original bonds out there - and I'd guess some will default and trigger defaults that the CDS will recognise as such*).........so it isn't the case that, as dodge suggests "there must be some consequences to effectively declaring that all previously written contracts are null and void".....because the contracts will have been adhered to - to the letter!

* this is the weakness of the plan for a bond swap AIUI (albeit on only the most superficial of inspections)

.so it isn't the case that, as dodge suggests "there must be some consequences to effectively declaring that all previously written contracts are null and void".....because the contracts will have been adhered to - to the letter!

ok, let me re-phrase: there must be some financial institutions who were relying on a CDS payout in this situation, and who now won't get one. There must also be question marks regarding the value of CDS contracts for other sovereigns as well. Perhaps some insurance companies or hedge funds could now run into trouble?

29th Oct '11

ok, let me re-phrase: there must be some financial institutions who were relying on a CDS payout in this situation, and who now won't get one.

Oh yes - that is certainly correct. But IMO the institutions that are out of pocket are most likely to be the banks which originated the loans that underpinned the CDS. That is certainly the way the CDS market started, though I guess there will be others on both sides, especially when it comes to sovereign debt rather than corporate.

Perhaps some insurance companies or hedge funds could now run into trouble?

It is a possibility, given that we are dealing with sov debt. There may well be some insurers who had loaded up on Eurozone debt and then taken CDS protection as the situation deteriorated. However (as Equitable Life showed with their inaction over falling rates and their outstanding guarantees), insurers often haven't been good at mitigating problems (and taking trading losses as a result).

Hedge funds could easily be on either side (but are generally pretty fleet-footed and street-smart)

I guess we'll see in due course....

31st Oct '11

some more on this topic:

http://www.bondvigilantes.com/2011/10/28/if-sovereign-cds-is-no-longer-an-effective-hedge-then-whos-in-trouble/

So the guys most at risk of sovereign CDS losing its credibility as a hedge are in all likelihood the large European banks. It’s the last thing these banks need right now. What will be really interesting is whether or not the banks’ use of sovereign CDS as an effective hedge in accounting definitions remains allowable now that politicians have made a default without a credit event possible. And of course the EFSF/Eurozone rescue is also in trouble if CDS isn’t an effective hedge, since the EFSF is going to attempt to sell protection on new issues of sovereign bonds in order to get their new issue spreads down!

Yes - that is a good point about designated hedge accounting treatments....though I'm not sure about the idea of the EFSF selling protection. Sometimes a bond buyer just has to take a properly-judged risk for himself, rather than being spoonfed the full hedgie package....

extrader

Hi all,

Mauldin's take on this, in his inimitably folksy style....

"..........I've always had a soft spot for Bunker Hunt. Yes, I know, he was a voracious manipulator who tried (and did) corner the silver market back in 1980, but boys will be boys. Maybe it's a fellow-Texan thing. He went bankrupt because they changed the rules on him. Lesson for all of us: Never assumes the rules are what you think they are just because they are written down, if someone else can change them. You can only push so far and then the peasants revolt.

And that is the final thing that happened at the summit. The banks "voluntarily" took a 50% haircut. Voluntary in that Merkel, Sarkozy, et al. told them that the alternative was a 100% haircut. "That's the offer, guys. Take it or leave it." Cue the theme from The Godfather.

And because the write-off was voluntary, there would be no triggering of credit default swaps clauses. Because if it's voluntary it's not a default – capiche?

And that smooth move, dear reader, triggered a rather significant unintended consequence, which resulted in the market "melt-up." Let me see if I can walk you through this rather bizarre world of derivative exposure without exposing too much of my own ignorance.

Let's say you bought credit default swaps on a certain bank's debt (let's use JPMorgan, but it could be any bank) because you think that Morgan is exposed to too much credit default swap risk. Just in case. Now, if (say) Goldman sold you the CDS, they could and would in turn hedge their risk by shorting some quantity of Morgan stock, or perhaps if the risk was sizeable enough, the S&P as a whole. It would depend on what their risk models suggested.

But as of yesterday, the risk evaporated: there would be no CDS event. So why buy CDS? Time to cover. And then the shorts get covered.

Further, the risk to financials was cut by a large, somewhat murky amount. But it was definitely cut, so buy some risk assets. Which puts any long/short hedge fund in a squeeze, especially those with an anti-financial-sector bias. But because of the nature of the hedge, the whole market moves. It involves rather arcane concepts that traders call delta and gamma. (Remember that the recent rogue traders had been at delta trading desks?) Guys at those desks can calculate that risk in a nanosecond. You and I take a day just to wrap our head around the concepts.

And it just cascades. The high-frequency-trading algo computers notice the movement and jump in, followed quickly by momentum traders, and the market melts up. Because a significant risk was removed. But not without cost.

Let's go back to where I noted that Italian interest rates are rising even as the ECB is supposedly buying. What gives? It is clearly the lack of private buyers, and a lot of selling. Because now you can't hedge your sovereign debt. If you ever need that insurance, they will just change the rules on you, so why take the risk?

Destroying the credit default swap market will make it harder to sell sovereign debt, not easier. Those "shorts" were not the cause of Greek financial problems; the Greeks did it all to themselves. As did the Portuguese, and on and on. Now admittedly, rising CDS spreads called attention to the problem, much as rising rates did in eras long past. And that did annoy politicians. And clearly, banks that had exposure to that market got the "fix" in to make their problems go away.

(OK, this is just my conjecture; but I have speculated before – with reason – that a major writer of sovereign CDS were German Landesbanks. Think Merkel didn't have that report? As did Sarkozy, on French exposure? It was a very high-stakes poker game they were playing this week. But one side of the table could rewrite the rules.).........

Another illustration of the law of unintended consequences !

GLA

Andrew Butter

Exactly - taxing winners to bail out losers is insane.

7th Nov '11

“Greece is free to leave the Euro” while “Merkozy have lost credibility"

In the Wall Street Journal, Simon Nixon writes . . .

The significance of Ms. Merkel and Mr. Sarkozy's Cannes declaration is immense. At a stroke, they have introduced foreign-exchange risk into a sovereign-debt market still grappling with the realization that euro-zone government bonds contain unexpected credit risk. Worse, throughout the crisis, the two leaders said they will do whatever it takes to save the euro. Yet the assurances they've given haven't been worth the paper they were written on: First, there were to be no sovereign defaults; then the first Greek haircut was a "unique situation;" the second Greek haircut followed 12 weeks later; now euro-zone exits are possible. No wonder the markets won't lend and China won't invest in Europe's bailout funds. Nothing these leaders say any longer carries any credibility.

More at http://online.wsj.com/article/SB10001424052970204554204577022222367756042.html

Greece, Debt and the EU: Is the day of financial reckoning finally upon us?

Unlock the rest of this article with a 14 day trial

About the Author

Steven Dotsch

31 comments

Unlock the metrics for all these stocks and more...

Unlock the metrics for all these stocks and more...