Author : John E. Charalambakis
Date : May 29, 2011
In the last several days, the markets’ focus has been back on the Euro-zone crisis. In a nutshell this is the chain reaction that the markets are afraid of:
Now, the events of the last couple of days could be summarized in the following: The IMF is not very pleased with the implementation and the progress of the measures taken by the Greek government. It has threatened to withhold its part of the fifth tranche of the rescue package which along with the EU’s contribution is estimated at €12 billion. The EU has stated that it cannot replace IMF’s funds and the Eurogroup’s chairman has also threatened to withhold the rest of the contribution. If that happens, then Greek state will not be able to pay its bills or the upcoming maturing bonds and hence default will be inevitable. Such default will be perceived as Greek insolvency and the postman by that time, will have rung the bell the second time, not just for Greece, but possibly for the global economy initiating a dangerous credit event.
Against that possibility it was proposed that Greek bonds be re-profiled, meaning that their maturities would be extended. While this might be considered a viable option and part of a soft re-structuring the ECB’s rules and bylaws prohibit re-structured bonds from being used as collateral. In that case, the ECB won’t be able to take Greek public and private (bank) bonds as collateral, and hence Greek banks will suffer a liquidity squeeze through by what at that time will be their naked exposure to the ECB and the EU banks, which is estimated at close to €92 billion, i.e. close to one-third of Greek GDP.
However, the problem lies in the domino/chain reaction that such an event will initiate and which may even prove that the ECB is without clothes. In basic estimates as shown below, the first couple of rounds this chain reaction could affect close to €2 trillion or close to $3 trillion worth of securities. If that were to happen it could be the start of the mother of all crises where all bond “assets” will be affected, affirming our point that we cannot safely call something an asset that is actually only a piece paper which represents someone else’s liability.
Here is how this chain reaction may evolve: The devaluation of Greek paper (public and private) will start a domino for Irish paper, Portugal’s bonds, and probably Spain’s too, in the first round. As the bonds (public and private) from those countries are affected, German, French, Dutch, Italian, Belgian, etc. banks which are exposed to these bonds will start feeling the bleeding and the squeeze. At that point the ECB’s balance sheet will feel the heat (see graphs above), since it has taken in lots of paper of questionable value, as the figures show.
Once the EU banks and even the ECB’s balance sheet start bleeding they will dump US bonds which will suffer tremendous losses interest rates will skyrocket, devastating paper currency and affect the Fed’s own balance sheet. As we wrote above, this might occur at the time when the US is facing the need to increase its debt ceiling.
From an asset management perspective, this may not be the time to be in “assets” a.k.a. bonds that represent others’ obligations and liabilities. At the same time, allow us to reiterate our position that the above are nothing but a symptom of the greater cause called collateralization and securitization of paper whose value is at least questionable, and which in turn became the endogenous forces of over-extension of credit.
We are of the opinion that there is a solution, and could start from the country that is at the focus of the Euro-zone crisis i.e. from Greece. The solution that we envision, suggests a suspension/seisachtia/sabbatical of interest payments on the debt, for at least the next five years.
The markets are fearful, because they do not know where the bottom is and which shoe will fall next. A suspension of interest payments, assures the creditors that they will get all their monies/capital back, and hence there is no need to record any capital losses on the books.
Moreover, it stops the uncertainty as to whether another round of bailout will be needed. Such suspension relieves the EU and the other transnational organizations such as the IMF from any fears that they would need to come out with more funds in a few months, or that eventually a haircut will be imposed on private investors. The balance sheets of the banks will only be affected by the non-accrued interest, but this is minor in the face of what we described above.
Furthermore, such action relieves the burden/trap of debt and truly liberates the country, allowing her to take advantage of her natural endowments and competitive positions (agricultural, tourism, energy, shipping, etc.). If things start working out, then after five years, the country can start paying interest at a rate of at least 200 bps below its growth rate. In addition, the proposed solution does not trigger a downgrade or redemptions of the Credit Default Swaps. On the contrary, it may well improve the rating given that a viable solution that does not involve restructuring/default/haircut will be implemented and which actually creates primary budget surplus immediately.
The numbers work out because the more than €20 billion that Greece pays in interest every year will be used to write down the principal of her debt, which along with the principal payments it makes every year can enable her to pay off her debt within 10 years. Of course, such a proposal implies that the public and private sector restructuring/modernization that Greece has undertaken will continue. Additionally, measures of incentivizing capital formation (e.g. free trade zones, taxation, etc.) will also be implemented which will awaken dormant assets to the benefit of Greece.
Such a proposal rules out once and for all any talk about restructuring and default, and potentially can rescue the global economy from a catastrophe, if implemented prudently for other countries too.
Of course, it requires the presence of an international figure who commands authority and respect, and as we wrote before, (see our commentary dated Dec. 13, 2010) we believe that the current circumstances call for Chairman Paul Volcker to step in and coordinate the global rescue.
Ode to the best Chairman the Fed ever saw!