Collateral damage. Unintended consequences. Friendly fire. Certainly no one intended to have a global banking meltdown when they let Lehman Bros. go under.
Now we’re watching another Greek drama that could have significant unintended consequences – far beyond anything the market has priced in today. Then again, maybe not. Maybe the market is right this time. When we enter unknown territory, who knows what we will find? Fertile valleys and treasure, or deserts and devastation? Today we look at the situation in Europe and ponder what we don’t know. Greece provides a wonderful learning opportunity.
At the end of this letter I’ll mention our Strategic Investment Conference, which will be in San Diego, April 30–May 2. This week we have confirmations from George Friedman of Stratfor and Bill White, former chief economist at the Bank for International Settlements. The conference is shaping up to be the best ever. You can see the rest of the speakers at the end of the letter.
Greece in a Nutshell
Let’s see if we can briefly summarize the situation in Greece. When Greece plunged into crisis three to four years ago, its debt-to-GDP ratio was about 120%. Greek interest rates rose precipitously as investors began to be concerned as to whether they would actually get their money back. The interest rate on the Greek 10-year bond went to 48.6%.
Everybody agreed that Greece couldn’t actually pay that debt; and since so much of it was owed to French and German banks (with not an insubstantial amount owed to Italian banks and those in other countries), the Eurozone decided to bail out Greece, which was a backdoor way of bailing out their own banks. (Seriously, you can go to the IMF minutes, in which they admit that the bailout was about saving the banks and the rest of Europe, not about Greece. Cyprus was cut loose when it would have been a rounding error for the EU to save it – but there were no European banks involved. (The lesson every politician should learn from this is that if you think you’re going to need a bailout someday, make sure your banks owe everybody else a lot of money.)
Everyone breathed a sigh of relief, and Greek interest rates fell to even lower levels than before the crisis, as you can see on the chart above. Meanwhile, because the solution forced Greece into a depression that reduced GDP by 25%, saw unemployment rise to 25% (nearly 60% among youth), forced Greeks (at least some of them) pay their taxes, and obliged the Greek government to try to balance its budget (kind of, sort of), the debt simply got worse. Now debt-to-GDP is 175%. If the Greeks couldn’t pay their debt at 120%, they have zero chance of paying it at 175%.
Eventually, Greek voters noticed that the agreement with the Troika (the ECB, the IMF, and the European Commission) didn’t seem to be working for them, so last month they voted in a new government that promised to change the agreement. The party that won the election, Syriza, had made lots and lots of promises about how they would make those mean old Germans back down and fork over the money. If we threaten to not pay the debt, the new government assured its citizens, the Europeans will give us more money, and we can even make them change the agreement. Of course, if the Greeks don’t get more money their system will be completely bankrupt, and their economy will collapse even further. (The technical economics term is that their economy will be screwed.)
This threat is somewhat like holding a gun to your own head and threatening to commit suicide if you don’t get your way. This is generally not a workable strategy when you are asking the politicians of other countries to pay a lot of money to keep you alive, especially when you are not very popular with the voters who elected those politicians. However, the new Greek government seems to think this is a perfectly reasonable bargaining tactic. Their new finance minister has written five books on game theory. It seems he has negotiating theory down pat, but in practice things are not working out according to his theory.
Because the Greeks agreed as a condition of their bailout to do something that is impossible – to pay off their debt – the rest of the Eurozone (led by Germany) actually wants them to continue to commit to doing the impossible in order that they might be given even more money, so that their debt, which they can’t possibly pay, can rise even further. (Yes, I know you may have to read that sentence three or four times to make sense out of it. That’s because the Eurozone’s position doesn’t make any sense.) The rest of Europe seems to be just fine with Greece’s going further into debt that it can’t pay, as long as they at least promise to pay it. The fact that their doing so will mean a permanent depression in Greece doesn’t really rank very high on their list of concerns.
Greek Finance Minister Yanis Varoufakis (until recently a professor at the University of Texas and as fine, or maybe more to the point, as typical a socialist as you will find at a US university) went on a tour of Europe to drum up support for the idea that, far from wanting more bailout money, Greece just wanted to buy time, via a “bridge agreement,” to work out a better plan. He came back home with a big fat nothing. He did elicit a little sympathy here and there, but no one offered any money or promises. And after he met with ECB President Mario Draghi, in what was at first thought to have been a cordial meeting, Draghi simply cut Greece off at the knees. From the Financial Times:
The French president said he supported the newly elected Syriza government in its efforts to secure a better deal from its international bailout creditors – possibly through an extension of debt maturities – as long as Greece committed to remaining in the euro, reforming its economy and honouring its debts.
Mr. Hollande also backed the European Central Bank’s surprise decision on Wednesday night to ban Greek lenders from using their country’s debt as collateral to access cheap liquidity. The move has been widely interpreted as a warning from the ECB to dissuade Athens from following through with a promise to abandon its EU bailout when it expires on February 28.
“The European Central Bank’s decision forces Greece and Europeans to sit at the same table to outline a new programme,” the French president said. “It’s legitimate.”
As the saying goes, with friends like this, who needs enemies? Greece is essentially isolated. As I understand it, the offer on the table is to extend the term of the debt, reduce the interest payments, and lighten up a little on austerity measures.
There is considerable debate as to whether the ECB actually had the authority to take the (highly political) action of declaring that Greek government debt is no longer acceptable collateral. The entire Greek finance program expires on February 28. Until that time, Greek banks can get Emergency Liquidity Assistance (ELA), which will cost them a great deal more. But ELA is available only to solvent banks with acceptable collateral. Further, the ECB has kept ELA for Greece limited to €60 billion. Ambrose Evans-Pritchard estimates that an amount closer to €100 billion will be needed, and very quickly. It is highly questionable whether the board of the ECB will grant any increase in the ELA program to Greece, absent an agreement. (You can find out more about Greece and the ELA here.)
Not only can Greek banks use only certain types of debt to access the ELA, that debt has to be free and unencumbered; and it’s not clear how much unencumbered collateral Greek banks actually have. Their consolidated balance sheet suggests they held close to €293 billion in loans and bonds as of the end of the December. Only €12.4 billion was actually Greek government debt. But €42 billion was in government-guaranteed bonds, which are not eligible to serve as collateral. Greek banks are already using €50 billion of ECB funding. Further, Greek banks had almost €40 billion in funding from non-Greek banks in the interbank market. It is highly likely that some of their assets, probably of the highest quality available, are pledged against that commercial paper. Further, 35% of Greek bank loans are nonperforming loans that are not eligible for ELA, and the rest would be subject to a severe haircut for collateral purposes (Davies).
The problem is compounded by the fact that money is beginning to leave Greek banks. “Flying out the door” might be a more accurate way to put it. Honestly, I can’t imagine leaving any significant assets in a Greek bank beyond what I would need for basic business transactions. Almost €14 billion were withdrawn from Greek banks in January, which was equivalent to the peak monthly outflow during the crisis of the last few years. You can bet the outflow did not turn around when Varoufakis came back empty-handed from his trip.
Essentially, Draghi told both the Greeks and the rest of the Eurozone that they needed to come to an agreement and do it fast. ECB collateral rules are arbitrary, and Draghi has arbitrarily put a time limit on the decision process. The total amount of time left is under three weeks, but there are interim deadlines that are even more important. The Greeks are to submit their financing proposals to the Eurozone finance ministers at their meeting on February 11 (next Wednesday).
Greece can probably fund itself into March by stretching out payments and engaging in a few bits of financial chicanery. But if the ECB does not extend their financing past February 28, the Greek banks are finished as solvent institutions. The ECB is basically saying that unless Greece agrees to continue to honor its agreements, funding will not be renewed or extended. At that point, Varoufakis would essentially have to issue Greek “scrip” in order to allow the banks to continue to function, but who would want that paper?
Things may come to a head even sooner than February 28:
Continue reading: http://www.mauldineconomics.com/frontlinethoughts/the-eurozone-collateral-damage
