Tuesday, May 11, 2010

An American Package for Germany

In 2008 in the midst of the financial crisis. Hank Paulson gave the term bazooka financial significance. The idea was that if you announce a package large enough you will not have to deploy it because the market will step in front of you and finance whatever you want financed.

Back in those days China, the US, the UK, Brazil, among others, announced large fiscal packages to stimulate their economies. The Europeans, on the other hand, claimed they didn't need to because of the automatic stabilizing effects of their wide and generous social safety net.

Then, in the beginning of 2010, the world discovered that Greece had borrowed too much money and lied about it. Not only that, but Portugal, Ireland, Spain, Italy and others (nobody talks about Austrian banks and Eastern Europe anymore) had more or less done the same (ok, maybe except for lying).

So the Germans, stingy and hardworking as they are, complained that they shouldn't bailout the lying spendthrift Greeks who retire at 50 and do not work too hard. In addition, the law clearly states that bailouts are not allowed in Europe. True said the Greeks, but we owe 300 billion euros and, guess what, most of it to your banks and those of your new friends the French. So, you either bail us out or we blow up your financial system.

At that time, Merkel and Sarkozy went looking for the bazooka. Could it be a declaration of solidarity? the market said no and the Greek curve became inverted. Could it be 10 billion? same response. What if we call the (gulp) IMF? short lived rally. What if we promised over 100 billion which could finance Greece for several years? That should do it. Except nobody would buy the bonds from their banks and they already own a lot. What could we do?

Enter Tim Geithner, an experienced member of the Rubin/Greenspan/Bernanke team of anything for the banks. You have to make the package large enough to ignite short covering by the speculators in Chi...Frankfurt. If you set up a special purpose vehicle (we have AIG, Fannie, Freddie, etc) you do not have to show it as national debt. You can finance it over 30 years and kick the can down the road. Maybe in a couple of years they will discover spontaneous nuclear fusion in Thessaloniki and the market will rally saving the banks. In the meantime, they can put all the Greek, Spanish, Irish, AIG, Fannie, Italian, and Dubai bonds in the investment account and keep them at par.

In the Lexus and the Olive Tree, Thomas Friedman describes the world alternative models (circa 1999) as the five gas stations. In the 2010 version, everyone has become an American financial engineer. A financial alchemist can turn any solvency crisis into a liquidity crisis. Thus, no bank ever needs to write down any investment because they can always count on a government guarantee and a friendly regulator. In this context, why would Bank of America or Wells Fargo lend to anyone if they can buy Greek bonds yielding 8% with a German guarantee and finance them at 0%?

The fact is that no country has ever cut 10% of its GDP in spending without a devaluation and Greece cannot devalue without leaving the euro and, as a consequence, defaulting on its debt to the German and French banks. Nobody in their right mind would finance this with his/her own money even if it meant losing monies already sunk into such a project. Of course, other people's money gets a different treatment.

This situation is unsustainable and it may blow up with the next German election, IMF audit, or Greek strike, but it could work and, hopefully, by then I'll be gone and You'll be gone. So, party on Garth! Party on Tim, Angela, Nick, George...

Wednesday, May 5, 2010

Why Is The Greek Bailout Not Working?

Although Greek debt problems did not appear overnight it is obvious that something has radically changed in the last 30 days. In a world used to thinking that policy makers can fix markets at will just by deploying their balance sheets it is disconcerting to see the lack of market reaction to the ongoing efforts by the IMF and the EU to avoid a Greek default. The question is why isn't anything working? Is it because the money won't come, because the Greeks won't deliver on the conditions, or are there other factors?

Although the Greek debt/deficit problems have been known for some time they did not seem to have any market impact until late last year. In fact, as late as October 2009, the Greek government didn't seem to have any trouble getting financing as Greek bond yields were around 2.3% for 2 years. During the first quarter of 2010, in the midst of shocking discoveries about off-balance sheet debt and accounting irregularities the yield on 2-year paper soared to 6.6%. By then, conversations about a European bailout began to appear on a daily basis in the financial press. After much dithering by the German government, European commitment to Greece was firmly declared and the IMF was enlisted in the rescue. The process should have climaxed last Sunday with the announcement of a gigantic package of more than 100 million euros which should be sufficient to keep Greece out of the public markets for, at least 18 months.

Under the Hank Paulson description of TARP ("If you have a bazooka in your pocket you won't need to use it") large amounts of public money commitments do their work without ever being deployed as private financing usually steps in to capture, in this case, the Greek spread for the German guarantee. After markets sold off yesterday, the consensus (if after the fact) opinion was that the markets either did not believe the monies will be forthcoming or that they process will fail over Greek intransigence. Although Ms. Merkel's speeches do not betray any conspiracy, the 48-hour Greek strike does give this theory some credence. In my opinion, however, there is something completely different and perhaps unavoidable at play.

Last Sunday, the NY Times published a useful diagram to show why Europe is so concerned about Greece ("Europe's Web of Debt"). In simple terms, the German and French banks have too much Greek debt much in the SAME way many banks own too much real estate and/or toxic assets (they still do, by the way).

Consider the case of a risk manager at a large German bank. You have been told, very recently, that owning so much Greek debt is bad banking and that you should have never accumulated so much. As luck will have it, you, your boss, and the regulator, agree that you will get a chance to get out either through bond maturities or by selling your risk as Germany will not allow Greece to go bankrupt. You are just waiting for the bonds to rally from the low 80's to something closer to par, where you have them marked as investments held to maturity often are, to cut your exposure.

Under the scenario above, every announcement meets the aggregate of all banks who have been natural buyers of Greek debt over the past n-years as better sellers and NOT as buyers as the bazooka deployers would want. In other words, the EU tried to bluff the market into financing Greece for a while longer and the market, unbeknown to its individual components, is calling the bluff.

Markets are about mass psychology. What policy makers fail to understand, is that the same participants who had no trouble accumulating Greek bonds at 150bps over German credit are unlikely to be enticed to resume financing at 14.5% over 2 years because they already own too much Greek debt. This, in my opinion, is why the Greek curve has stayed inverted in the face of positive announcements and why it is likely to stay that way. In other words, even if Germany would somehow agree to underwrite Greek risk no matter what for 3 years, which is very unlikely, the curve will stay inverted from 4 years forward (i.e. beyond the German guarantee) until all the excess Greek debt (that over what banks really think is too much) matures.

Like our sub prime borrowers, Greece borrowed too much over many years. The banks who bought this debt are now chocking on the risk and there aren't any new risk takers to take the balance. No amount of austerity from the Greeks will change the fact that 120% debt to GDP is now perceived as too high. Debt binges usually work themselves out over time or through defaults and this time is...the same.

Tuesday, May 4, 2010

Is TARP Greek for "Save the Bank(er)s?

There was a time when we thought that the biggest problem with bailouts was moral hazard. Like with so many things in life, the only loss is to one's innocence and only the first time.

As it is well known, the Greek government is on the receiving end of an ever increasing bailout package. In exchange, for such a ridiculous amount of money and the invaluable tutelage of the IMF, which by the way will become a super-senior creditor ahead of ALL bondholders, the Greek government promises to produce what amounts to a balanced budget.

As we know, balanced budgets are as rare as honest politicians as nobody likes to pay taxes and everyone is rather attached to their salaries and/or entitlements. In my opinion, the Greeks are as likely to deliver a balanced budget in 2013 as anyone else in Europe and beyond, which means not at all. How does anyone think that raising taxes and cutting salaries will deliver short term growth in the presence of higher rates is a mystery to me. More importantly, the market for Greek bonds seems to agree with my assessment as the curve is still inverted from 2 years onward signaling concern about default.

Yet, we still get comments from various analysts and politicians to the effect that the situation is under control and it has a fair chance of getting better (if only the market would finance Greek debt at "reasonable" prices).

In this context, it is interesting to find out that the money from the package seems to be following a familiar script. In other words, just like our TARP, the Greek package is already mutating from "fund the government" (or pay the debt, which is equivalent) to "stabilize the banking system" which means the banks will get the money and decide what to do. Maybe even pay bonuses.

The problem with this (global) crisis is that it is destroying whatever credibility we may still have on the financial/political system. Enormous amounts of public money are being doled out on an attempt to keep the party going. The tragedy is not that, if History is any guide, it will not work, but that people will feel cheated out of their hard earned taxes. Money comes and goes, however, credibility is easy to lose and hard to get back.