A Member of the European Parliament Loses It On the EU Leadership

I am now a big fan of Nigel Farage:

Thoughts on the latest and greatest Greek bailout

I'm still trying to digest the reported bailout of Greece.  On the surface it seems like a very strong plan, with Greece being bailed out and the European Financial Stability Facility (EFSF) being authorized to buy bonds in the secondary market in order to help keep yields from going crazy.  In some ways, it's the European version of our own TARP plan.  The European markets seem to especially like it.  However, as always, I've found the devil is in the details and there are a few that are making me a bit skeptical:

1. This is the third "solution" to the Greek crisis that European leaders have announced in the last 14 months (previous ones were in May and September 2010).  European leaders seem to like to do just enough to calm investors for a few months, but not actually do anything to solve the problem. 
   
2. Even with the reported 21% haircut on Greek debt, which puts Greece in default, Greece still has a debt-to-GDP ratio of 130%, which is still an unsustainable debt level for a country like Greece.  It would be one thing if Greece had a balanced budget as the terms of the EFSF gives Greece debt at extremely attractive terms (Supposedly minimum 15 year terms at 3.5-4.5%).  But the Greek economy is in shambles and will only get worse following their austerity plan, which could cause tax revenues to miss targets.    If tax revenues miss targets, it's possible that the current austerity plan won't be enough to satisfy the IMF and the EU (especially the Germans).  Remember, they previously passed an austerity plan last year, which worked so poorly that the IMF was holding up a tranche from their original bailout, requiring them to pass another austerity plan.
3. The EFSF was just empowered to do a lot more than it has been doing but there was no mention of more funds going into the EFSF.  Given the size of the markets we are dealing with, this could create a major problem.  My guess is that any increase in the EFSF would need parliamentary approval from the member states that contribute to it and that is definitely not a certainty.  Governments might be brought down by such a vote and the EU politicians know it.
4. It's been made clear that Greece is getting a unique deal and that governments in Ireland, Spain, Portugal and Italy can't expect the same.  My guess is that their first question is "why not?".  It's not like Greece is in this position through no fault of their own.  It's actually completely and utterly their fault (they even purposely lied about their level of debt on a regular basis, and may be still doing so), so from a moral and ethical standpoint it doesn't seem to make sense to put Greece in a special category.  Though the idea of private investor haircuts across Euroland is very scary.
5. What happens to all the credit default swap (CDS) insurance on Greek debt?  With a 21% haircut, can't they be triggered?  What happens then?  US banks have about $34 billion in CDS exposure to Greece, does that mean US banks are on the hook for billions now?  The potential seems to exist for some sort of unintended consequence from the haircut causing massive problems somewhere (though we don't know for sure where). 
   
6. Because the US is a major contributor to the IMF, we are probably on the hook for $15-20 billion on this bailout.  Won't this appropriation have to pass Congress?  I think an argument can be made for us not to approve that additional funding.  After all, we have to issue debt to pay this money (assuming the debt ceiling is raised) so does it make sense for us to mortgage our children's future for the sake of people thousands of miles away in another country who have been living well beyond their means for years (and retiring 5-10 years ahead of the average American)?  Also, wasn't the Euro created, at least partially, to challenge US Dollar hegemony.  So why are we bailing them out?  I can definitely see us balking at this.    

Anyway, those are my key concerns with this whole bailout.  We'll see how long this keeps things calm.  Some people are already predicting trouble coming in the fourth quarter of this year, so after all that work, they might have only bought themselves a few months.  There really are only two permanent solutions to this problem, in my opinion.  The first one is that there will be a Euro fiscal union so that everyone has the same fiscal policies.  I don't think this is really workable as the Greeks don't want to be told what to do by the Germans and vice versa.  The second one is you just allow countries who want to, to leave the Euro.  I've mentioned before that I think it's in Greece's self interest to go back to the Drachma and I still think so.  I think their pain would be of a much shorter duration if they did that.

Let's see how long the band-aid stays on this time.

Why Doesn't Greece Just Default?

Courtesy of ZeroHedge, here are some of the austerity measures that will be coming up for a vote tomorrow in Greece (originally compiled by the BBC) with a focus on the taxation portion:

• Taxes will increase by 2.32bn euros this year, with additional taxes of 3.38bn euros in 2012, 152m euros in 2013 and 699m euros in 2014.
• A solidarity levy of between 1% and 5% of income will be levied on households to raise 1.38bn euros.
• The tax-free threshold for income tax will be lowered from 12,000 to 8,000 euros.
• There will be higher property taxes
• VAT rates are to rise: the 19% rate will increase to 23%, 11% becomes 13%, and 5.5% will increase to 6.5%.
• The VAT rate for restaurants and bars will rise to 23% from 13%.
• Luxury levies will be introduced on yachts, pools and cars.
• Some tax exemptions will be scrapped
• Excise taxes on fuel, cigarettes and alcohol will rise by one third.
• Special levies on profitable firms, high-value properties and people with high incomes will be introduced.

This kind of reads like "how to crash an economy in 10 easy steps".  Greece is currently in the midst of a deep recession/depression with GDP falling about 5.5% this year and while people are already having a tough time paying the bills you are going to make it even harder by increasing taxes on both your income AND your purchases (through the VAT)?  Also, people who are pretty much living under the poverty line will be required to start paying income taxes, thanks to a reduction of the tax free threshold from 12,000 to 8,000 Euros. 

So from Greece's point of view, why aren't they simply defaulting and going to the Drachma.  I know why the international community wants them to not default and stay with the Euro.  Greece defaulting would cause an international financial crisis similar to or even bigger than Lehman.  It wasn't that long ago that Greek debt was considered to be just about as safe as German debt, thanks to its inclusion in the Euro, and so you have Greek debt just about everywhere, as well as that of key banks.  But at this point, what does Greece get out of it?  The low interest rates that Greece enjoyed following inclusion in the Euro are gone, nobody but the EU/ECB is lending to them right now anyway.  And this austerity budget will make sure that the Greek economy does not recover for a long, long time.  Between wage cuts and across-the-board tax increases nobody will have a spare dime to spend on anything but necessities.  And that massive increase in the VAT rate on restaurants and bars will make it that much more expensive for tourists to go to Greece and maybe they will go somewhere else, like Turkey, which has similar scenery but is cheaper.

If Greece decides to default and return to their old currency, things won't be rosy but my guess is that they will recover faster than if they take another hit of heroin from the EU.  Yes, they will be cut off from extrernal funding sources for years but they will be in charge of their own monetary policy for a change.  They will likely start printing more drachmas as a way to both boost the economy and pay debts and then the Drachma will fall in value rather quickly.  This will cause massive inflation of any imported goods but on the positive side it will make all Greek products relatively cheap.  This will help to boost both tourism from abroad as well as the purchase of Greek products (think about it, thanks to both having the same currency, Greek products are about as expensive as German ones, which one would you rather buy?).  You might also see some more foreign direct investment as Greek labor just got much cheaper than the rest of Europe.

It seems like the choice for Greece is either a) continue in this economic death spiral, mainly for the benefit of non-Greeks or b) take a quick hit and all its immediate consequences but build the groundwork for an economic recovery.  Neither choice is ideal, but after years over fiscal mismanagement they are the only choices that seem to be available and it seems like default and an exit from the Euro is the better choice for Greece.

Are We Heading Towards Another Financial Crisis?

Definitely maybe.

It's always hard to predict the future (as the saying goes, those who live by a crystal ball shall eat crushed glass) but I will say that all there are signs that we are approaching another leg of the financial crisis.  One possible sign is that despite being in an environment where they should be making money, hand over fist, bank stocks are underperforming.  In fact, the KBW bank index is down 10.1% this year.  Stocks moving up or down 10% are usually not a reason to worry as equities are notoriously volatile, but the weird thing is that they are underperforming like this with a steep yield curve.  A steep yield curve simply means that banks can perform short term borrowing for very little and then loan out that money for quite a bit more.  When you add leverage into the equation, this is when banks are supposed to shine.  It is when a yield curve flattens or inverts that things usually get dicey as there is almost no way to make money borrowing in the near term and then lending for the long term as those rates might be the same, or might even be lower longer term.

So the question people have been asking lately is why have they been underperforming like they have been when they should be doing really well in this environment.  One answer is like a phoenix rising out of our memories of the last crisis, mortgage backed securities.  Yes, banks still have them, and while they might have been able to get rid of some of them, they seem to still own hundreds of billions of dollars worth.  And as you can see from the chart below, showing the index for 20 AAA CDO's,, they are starting to nosedive.  You can see a bunch of related charts here.

Another issue with banks seem to be their exposure to the Euro crisis.  It's been my understanding that it was European banks who were selling a lot of the insurance on Greek sovereign debt.  According to the Bank for International Settlements data, as waded through by The Street Light blog, that understanding was wrong.

US institutions have sold approximately $34.1 billion in insurance on Greek sovereign debt, about 56.3% of the total!  It's as if we learned nothing from AIG!  Of course, our exposure doesn't end there, we've sold $54 billion in default insurance on Ireland and another $41.2 billion on Portugal.  So if a Greek default, starts some sort of cascade, the numbers add up quickly, to the tune of $129.3 billion for those 3 countries alone.  Given these totals don't include any insurance sold on bank debt in those three countries, our true exposure to defaults is probably much greater.  Are we going to have to bailout our banks again???  You just have to cringe at the thought.

So when could a default happen?  It depends, it might not happen until next year, or it can happen this year if Greece is bailed out and as one of the conditions for the bailout is "private sector participation".  Any private sector participation would be considered a default by the ratings agencies and at that point, our banks will be on the hook.  And things don't look good, S&P downgraded Greece debt to CCC today, the cost of sovereign bond insurance is at record levels, and the Bundesbank President just said that the Euro will remain stable in the case of a Greek default (a little pregame damage control?). 

Cash may turn out to be king, once again.

A Greek Bailout Still Doesn't Seem Plausible

Last Thursday there was a rumor that a Greek bailout was agreed to "in principle", something vehemently denied by the powers that be.  This Thursday we are getting some color of what the bailout might look like.  60 billion Euros from the EU and IMF (which means US taxpayers will be on the hook for billions), 30 billion coming from Greek privatizations (oh yeah, I'm sure they'll be able to raise that money quickly as the country is throwing molotov cocktails on all the assets) and 30 billion from the private sector (bondholders). 

This proposal seems so not serious that I almost suspect that it was leaked to deflect attention from the Troika Report on Greece which said that Greek reforms were at a "standstill".  Why is the proposal not serious you ask?  I dealt with some of the issues last week, but in short trying to get 30 billion from bondholders through some sort of restructuring will be impossible without Greece being in technical default on their debt.  This default of a sovereign nation in the Euro region will have dire consequences, some that can be foreseen and some that can't.  Remember how AIG got into so much trouble selling default insurance on mortgage debt?  Guess who sold tons of insurance on Greek sovereign debt?  European banks.  Also, guess who tends to hold the most Greek sovereign debt?  European banks.  And don't forget that many of them also hold the debt of Greek banks who will almost immediately become insolvent on a Greek default.

Another issue which could put a kabosh on the whole process is that there is a July 5th hearing at the German constitutional court as to whether a German bailout of Greece is a violation of European and German Basic Law.  Officially, bailouts are banned by the EU treaties, which Germany has signed, so there is a not insignificant chance that the court may rule that the bailouts are illegal.  We shall have to see.  Given that European politicians have a history of bending the rules when it suits them, especially EU rules (remember the 3% deficit limit in the Maastricht treaty?) which limit their freedom to do whatever they want to do.

Another Greek Bailout? I'll believe it When I See It

This story has the Euro rallying right now:

The Economic and Financial Committee (EFC) of deputy ministers and senior officials of the 17-nation currency zone approved the Greek programme in principle in talks in Vienna that ended after midnight, the source said.
The second programme for Greece, which will effectively supersede the 110 billion euro ($160 billion) bailout agreed in May 2010, will involve some participation of private sector investors but limited to avoid triggering a credit event, the source said.
Details of that involvement, and the apportionment of the additional official international funding, remain to be worked out in time for a June 20 meeting of euro zone finance ministers, the source said.

Those are some pretty big details left to be sorted out.  Considering it's often difficult for the US House and Senate to come to agreement about slightly different versions that pass both houses, getting 17 nations, with sometimes diametrically opposed interests, to agree on details of ANOTHER Greek bailout is going to be tough.  You have some northern European countries that basically don't really care what happens to Greece because their houses are in order.  Others, like Germany, have their houses in order but their banks have lots of exposure to Greek sovereign and bank debt. The trick is with them is that the populace doesn't necessarily care about the banks that much and will likely kick out any government that agrees to bailout a country that has a history of cooking their books (they were only able to join the Euro after all by including prostitution in GDP). Then of course, you have the southern European countries who probably just want Greece to be bailed out once and for all, probably with the least stringent terms possible, as they might be next. 

The biggest issue to deal with is "private sector participation" which is an Orwellian euphemism for saying that bond investors won't get the money they were promised, when they were promised it, i.e. default (they have also tried to use the phrase "reprofiling the debt" but that one didn't stick).  Note the line about how they want to "avoid triggering a credit event".  That is something that would happen in the case of a default, which would a financial crisis as bad or even worse than what happened when Lehman went bust.  Greek sovereign debt and bank debt is in so many places in Europe that a default would eat into their capital ratios and cause loads of unintended consequences (remember when the Lehman bust caused a run on money market funds after one of them "broke the buck" because they were holding Lehman debt?).  Also, according to this article, European banks have been net sellers of Credit Default Swaps (CDS) which are insurance against default.  In other words, they will not only get hit on the bonds they own, but have to pay out on the insurance to the North American investors who bought the CDS'.   Essentially, they need to figure out a way to default without actually defaulting. 

Good luck with that.