Bailing out the bail outs
What’s at stake This week marks the anniversary of the May 9th 2010 announcement of the creation of the EFSF, which was seen by many as the beginning of the end of the European debt crisis. A year later, the crisis lives on despite repeated initiatives – remember the “grand bargain”? – to bring it […]
What’s at stake
This week marks the anniversary of the May 9th 2010 announcement of the creation of the EFSF, which was seen by many as the beginning of the end of the European debt crisis. A year later, the crisis lives on despite repeated initiatives – remember the “grand bargain”? – to bring it to an end and could well enter a new phase where policymakers need to increase their financial commitments and continue to disentangle the feedback loops between sovereign debt and a still fragile financial system. All in all, there is an apparently strong willingness by European policymakers to provide more liquidity but also a growing sense of fatigue about the lack of burden sharing best illustrated by this heavily debated column by Morgan Kelly in the Irish Times and that of Timo Soini, the leader of True Finns in the WSJ. In a year, the policy debate has shifted from whether policymakers would find the political and financial resources to support countries in need to whether and how burden sharing with the financial system should be arranged to return to solvency.
Hardly a calm-smooth sailing week: rumours, lies and denials
Last week did not end smoothly in Europe to say the least. Real Time Brussels reports that just before 6 p.m., German news magazine Der Spiegel Online distributed a report claiming that euro-zone finance ministers were convening in a secret, emergency meeting in Luxembourg that to discuss a Greek plan to exit the euro zone. Calls from reporters flooded in to Guy Schuller – the spokesman for Jean-Claude Juncker – who repeatedly denied the meeting until it became clear that the Ministers of Finance of France, Greece, Spain, Germany and Italy were indeed meeting along with the ECFIN Commissioner and the ECB President.
Charlemagne writes that the confusion created by a secret meeting held in Luxembourg last Friday forced European policymakers to deny vigorously the possibility of a euro area exit for Greece and to rule out any form of restructuring thereby increasing the chance that more public money will be arranged for Greece.
Wolfgang Münchau says it loud: he no longer believes any statement by any EU officials in respect of this crisis. We are in the stage of the crisis where officials are lying all the time.
Martin Wolf does the math on Greece and argues that if one takes seriously the view – advanced by ECB board member Lorenzo Bini Smaghi – that any debt restructuring must be ruled out, official sources must finance Greece indefinitely. Moreover, they must be willing to do so on terms sufficiently generous to make a long-term reduction in the debt burden feasible. That is possible. But it is a political nightmare.
Ryan Avent wonders why Europe is delaying action if all of this is so blindingly obvious. The charitable explanation is that leaders are working frantically behind the scenes to make sure they have their procedural ducks in a row before announcing anything official. The less hopeful explanation is that Europe’s leaders recognize the need for restructuring but can’t reach a political agreement on how to handle the associated costs. And the really unsettling explanation that Europe is just hoping to put things off as long as possible in the hope that something good happens. But bad things can also happen while you wait.
In a recent briefing on the position of the different German stakeholders, Eurointelligence argues that the debate inside Germany is how and when the restructuring should happen. Some officials have expressed the hope that a combination of interest rate cuts and maturity extension would suffice, and that a haircut would not be necessary. But Germany rejects a haircut, for now, out of a fear of a repeat of an Argentine-style situation, but most importantly, Angela Merkel has famously pledged to protect existing bondholders until 2013 – known also as the Deauville, a promise she feels she cannot easily abandon. Where there is consensus among German government officials is that any decision on debt restructuring should wait until the autumn.
Squaring the Greek circle with no restructuring
Real Time Brussels points to two possible outcomes that would not involve a restructuring: (i) Modify, wait and hope which is essentially tweaking the current program in order to reduce the interest rate, give Greece more time for the measures to take hold and deliver results, and increase the privatisation effort, (ii) Give Greece more money in order to meet the roll-over risk and additional deficit.
Jacob Funk Kirkegaard argues also that Greece will receive more financial support but that it will require a couple of political tokens in return: (i) Greece will have to take firm privatisation commitments and effectively to engage in a real battle to break the coercive power of the unions. (ii) There seems likely to be a limited and strictly “voluntary” private sector participation which does not seem likely that the “voluntary” private sector participation will be big enough to make a difference to the sustainability of Greek debt. Such “voluntary” participation will thus likely serve as a symbol to assuage taxpayers that they are not the only ones extending help.
The Brady temptation
Barry Eichengreen notes that the head of the Paris Club at the time of the Brady Plan – which oversaw the Mexican debt reduction strategy organised by the G10 countries – was none other than Jean-Claude Trichet. It is hard to think of a better legacy for an outgoing ECB president than to dust off his notes and explain to other European policymakers how the lessons of the Brady Plan might now be applied. Peter Allen and Gary Evans – both veterans of the Brady plan – present in that goal what they refer to as the “Trichet plan”.
Nouriel Roubini has a nice table summarizing the 6 different restructuring options and sub-cases being discussed with their associated pros and cons for Greece, the creditors and the official sector. He concludes that of all options, the best approach for all stakeholders is akin to a Brady par bond option, an exchange offer in 2011 with potentially significant maturity extension, no face-value reduction and moderately reduced coupons.
Harold James argues that there is a good reason why the Brady plan occurred a mere seven years after the inception of the Mexican crisis. At an earlier stage, the banks simply could not have afforded to take such losses on their capital. They needed to fake it for seven years in order to build up adequate reserves against losses. As it stands today, the preconditions that made the Brady plan work are not in Europe: policymakers are too pre-occupied by the real problems posed by too-big-to-fail banks, and too terrified by the potential collapse of weaker banks, to allow such a solution. The recapitalization has not yet reached the point where there are enough strong banks to take the lead.
Peter Allen and Gary Evans argue that credit enhancements could allow EU banks to limit the losses that they must realise, spread them over the life of the new instruments, and bolster their balance sheets with new credits partially guaranteed by the EFSF or ESM. Barry Eichengreen argues that the new bonds could be structured so that haircuts incurred by the banks count as tax losses, reducing the hit to their profits. Eichengreen notes that regulation could also be used to reconcile Greece’s need to restructure now with the banks’ wish to wait until their balance sheets are stronger. Under the Brady Plan, an accounting rule called FASB 15 allowed restructured loans to continue to be booked at their original face value, so long as the sum of interest and principal payments on the restructured instrument at least equaled that on the original credit. New bonds, on which interest was back-loaded, could be given the same accounting value as old ones on which interest was paid earlier. This special accounting treatment could then be phased out over time, requiring banks to acknowledge their losses, but only once they were able to do so.
JP Morgan’s Peter Elwin has more on the specifics of how accounting tricks could be used to minimise bank losses arising from a restructuring. The idea essentially is that bonds held in Hold To Maturity (HTM) accounts could benefit from the impairment calculation if the coupons remain constant and the recovery value improves which is likely in this context. In this case, the NPV loss and impairment would be minimal. The last stress test suggests that some 80% of all bonds are held under HTM. However, bonds previously held under Available For Sale (AFS). The key though, is that only bonds which were originally classified as HTM would benefit — bonds that have been transferred from available-for-sale (AFS) into HTM would not.
Lee Buccheit and Mitu Gulati contrast the debt management technique being used in Europe in 2010-2011 with that of the Brady episode. The debt management technique adopted by Secretary Baker and his official sector colleagues in 1982 had the effect of grabbing the commercial bank creditors by their noses and holding them in place as the lenders of record until a more durable solution to the problem could be implemented. The concession made to the bank lenders at the time was a restructuring technique that avoided accounting losses while the banks were provisioning their loan loss reserves. This time around, the official sector players are not holding the original lenders by the nose; the official sector is actually buying out the original lenders in full and on time as each existing bond matures and is paid by drawing down an official sector credit lines. If the sword of a debt restructuring must eventually fall, that sword will fall principally on the neck of the official sector lenders.
Euro area break-up amuse bouche
Discussions of a potential break-up of the euro area have resurfaced on the blogosphere since the release of the Der Spiegel report, which claimed that Greece actually proposed such an idea – a false claim according to Eurointelligence. Instead of providing an extensive summary of these discussions, we’ll provide a few links worth mentioning. Paul Krugman still finds it hard to see any European government making a solemn, deliberate decision to leave the euro – for reasons best summarized in a recent report by John Llewellyn and Peter Westaway. But Krugman can now easily see how events could lead to a situation in which euro exit becomes the least bad option. FT Alphaville has also a noteworthy entry on the legal aspects of an exit.
Bruegel Economic Blogs Review is an information service that surveys external blogs. It does not survey Bruegel’s own publications, nor does it include comments by Bruegel authors.
Republishing and referencing
Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.