Friday, November 26, 2010

Waiting for the Euro default: Write down, Rescue and Restructuring

In the final analysis, why should citizens take the full burden of rescuing banks, while the bond holders take no punishment at all?

That, in essence is why I now expect to see the next step in the Euro crisis being a debt default- or as it will probably be termed, "debt restructuring". The rescue of the Irish banks was really only supposed to be about the depositors- who are generally businesses and individuals in Ireland, not the bond holders who are generally governments and financial institutions from overseas. The sovereign guarantee to the banks that was so thoughtlessly extended by the Irish government has turned into a black hole, and the price is beyond Irish means to pay it. The market understands this, and is increasingly sceptical of the ability even of the ECB and the IMF acting in tandem to secure the position. Since this assistance largely comes in the form of new loans, then essentially Ireland is solving the problem of too much indebtedness... by increasing its indebtedness still further.

No, it is quite clear that bond holders could, indeed probably should, be taking a haircut on their exposure. The market certainly thinks so, which is why they are pushing yields on the most problematic economies up so sharply. These yields are justified when one considers the ever increasing chance of a debt restructuring which will indeed force at least some bondholders to take a haircut, and others will see their paper rescheduled to a longer maturity. That is what the market believes is now most probable.

A default is not the same as the collapse of the Eurozone, which is fraught with danger for any economy that took that step. Indeed the default would be instead of the Eurozone collapse. A country that enters a restructuring process will keep the currency, but inevitably will be forced to borrow at higher rates over the longer term, as bondholders become far more discriminating between Eurozone credits, including Sovereign ones. In the short run this creates further pressure on economies as they incorporate higher borrowing costs into their system, but over time it will encourage the radical restructuring that is still necessary, especially in Portugal, Greece and Spain.

In fact the process of restructuring,would crystallise what is already happening with the ad hoc rescue measures that are being attempted at the moment. The supposedly temporary measures are already been developed into permanent fund, which looks to me very much like the permanent Euro Treasury in embryo that was missing from the Euro equation from the outset. Of course the fact is that the German government will not wish to become the blank cheque for the profligate economies to draw upon, which is why I believe that- more or less whatever happens- there will be significant restructuring/default special measures imposed on creditors.

One way or another the process of painful government retrenchment in the PIIGS is going to have to happen. Better that this takes place within the context of the orderly framework of the Eurozone than in a blizzard of newly re-created national currencies, most of which will have so little confidence behind them that they will be worthless.

Yes, yields will spike in the short term, but since that is already happening now, it is hardly a worse option. In the medium term, the restructuring process brings state finances under control and growth can resume. We can, I think, learn a lesson from the Baltic here. Latvia maintained their peg to the Euro, avoiding a devaluation of the Lats, by a slash and burn budget way beyond what any of the PIIGS are contemplating now. At the same time they have also restructured their position in the rescued Parex Bank group which has involved drastic write-offs. These are write-offs that mostly damaged the Latvian state, which held the equity, but several more "unusual" creditors took the pain as well.

The result is that Latvia has returned to a more normal risk environment, with the local RIGIBOR now trading inside EURIBOR. The crisis in the Baltic is now essentially over. The flexibility of the Baltic model has been proven, and the low levels of debt- in Estonia, negative government debt- provide comfort for the future, as pension funds and investments begin to swell.

The slash and burn tactics of the Baltic are not likely to be politically acceptable in the PIIGS, but a combination of write down, rescue and restructuring may yet help create more competitive economies for the future.

Of course it means that PIIGS borrowing will be more expensive than the more disciplined Balts, but then, that would be the rational free market in action.

It is certainly worth a try.


Lord Blagger said...

A haircut in the market is a technical term. Its the amount of money you have to put up if you want to repo a bond. If its current value is 100, and the haircut is 5%, you need to deposit 5% to trade on margin.

When you are talking about a haircut, you are talking about taking a loss because the borrower is partially defaulting on their promises.

No, it is quite clear that bond holders could, indeed probably should, be taking a haircut on their exposure.

OK, so in the UK, pension funds running annuity businesses are forced to invest in Gilts, post Maxwell. Are you saying that these naughty pensioners speculating in government bonds have to take a 20% hit in their incomes? That's what your proposing for the equivalents in the countries that partially default.

A default is not the same as the collapse of the Eurozone, which is fraught with danger for any economy that took that step.

No its not. That's the myth put out. We have two recent examples, Russia and Argentina. Are they complete basket cases? No.

Next, lets set up a choice. Ireland verus Greece. Greece struggles on, Ireland defaults. You have a choice. Do you lend to Greece up to its neck in debt, or that naughty Ireland with no debt? Which has the lower risk? The lowest risk has the lowest interest rate. It's Ireland, even with a premium for doing the default.

Lord Blagger said...