Most days come and go, but a few leave behind an after-image that stays in our field of vision for years to come. For Wall Street traders like me, the afternoon of September 29, 2008, was such a day. Just a few weeks after runs on Lehman Brothers and Bear Stearns, the House was to vote on the Troubled Asset Relief Program, or TARP, the first of many efforts by the U.S. government to inject liquidity into the banking system and arrest the panic then cascading through the credit markets.I walked to work that morning in Manhattan expecting the day to be uneventful. The overriding sentiment on the floor was that White House and Congressional leadership would not allow a vote without first securing the pre-requisite number of “Yeas.” Though we considered it a foregone conclusion, there was little trading before the vote, as is usual before a big economic indicator or newsflash; running to grab pennies in front of a steamroller is not a sustainable strategy, and this was a particularly large steamroller. We passed the time arguing over what government intervention meant for our industry and the economy. Some thought it wise to let the weaker banks fail, citing moral hazard and the inefficiencies inherent in a government takeover. Others argued that an extended credit run inevitably takes down strong and weak banks alike; they welcomed any efforts to improve liquidity and provide a floor for asset prices.The day didn’t turn out to be a quiet one. The oxygen suddenly left the room as the televisions tuned to C-Span revealed that the first vote had failed. Our desk heads disappeared in unison, headed to conference rooms devoted to emergency planning. The morning’s academic debates were over. Our world was now soaked in a fear oozing from our monitors, Bloomberg terminals and phones. The Dow dropped about 7 percent that day and traded down another 16 percent over the next two weeks, despite the fact that TARP passed the second time around.The markets didn’t hit bottom until March next year, driving our debates and discussions from the superficial to the fundamental. We reassessed our views on the robustness of a credit-driven modern economy and the ability of an interlinked financial system to handle leveraged losses by one or more of its major players. As credit structurers and traders for a major European bank, my immediate colleagues and I were forced to make some of the hardest professional and personal reassessments of our lives. The hubris of our industry melted away. The names in our beloved Bloomberg chat lists became electronic tombstones: The small green lights next to our colleagues’ names blinked out, one by one, as more jobs were eliminated with each passing day.Greek MythologyNow there is another crisis, again revolving around debt and raising questions about bank health, fiscal sovereignty and, more fundamentally, our collective belief in institutions once considered sacred. Since we work for a European bank in New York City, the curious often approach my colleagues and I with questions connecting the events in Greece and the European Union today to the events in the United States in 2008: “Is the world economy headed for another collapse? Bailouts saved you; will they also save Greece and the eurozone beyond? Did your derivatives cause this, too?”To briefly recap, 2008 began with four interconnected parts: unwise credit policy driven ultimately by East Asia’s savings glut; America’s political willingness, notably through the government sponsored entities of Fannie Mae and Freddie Mac, to subsidize credit to the less well off; the ease with which new financial products allowed credit originators to distance themselves from risk; and improper risk management decisions within a highly integrated financial system. In combination, these factors created a devastating global recession, which, at the very least, should have taught us that a 21st-century credit run looks very different from the 1930s-era stock image of long lines of customers queuing outside savings banks. The 2008 credit run didn’t readily produce such iconic imagery; the real action was mostly electronic. Uncertainty led to capital hoarding and the collapse of short-term financing markets that struck down all sorts of banks, corporations, asset managers and hedge funds—sick ones and healthy ones alike.Though vigorous debate continues as to whether direct government capital injections were the right response to the crisis, it is an empirical fact that, after years of unprecedented intervention, asset prices have normalized, bank runs have stopped, and our economy has recovered. Of course, matching cause to effect can be tricky; we’re still not sure precisely which decisions led to which results. But that hasn’t stopped traders, politicians and the media from attempting to apply the supposed lessons learned from the 2008 crisis to the slow-moving Greek tragedy unfolding in Europe. Despite superficial similarities, however, the two crises are fundamentally different, and attempts to link the two are distracting and even damaging to European recovery efforts now afoot.At first glance, we have a similar cast of characters and terminology: banks, bailouts, credit default swaps, and governments. Financial and political journalists have breathlessly speculated on election results, recall efforts, and what they mean for a bailout. European debt traders especially have made a cottage industry out of political speculation and punditry, sending out routine updates about the fortunes and inclinations of the governments of German Chancellor Angela Merkel and Greek Prime Minister George Papandreou, and the financial philosophies of the European Central Bank (ECB) and the International Monetary Fund (IMF).The temptation to draw parallels between the U.S. and European crises has injected several major myths into the public debate. These myths will lead to disaster if they end up generating policy. They have the capacity to leave Europe fiscally insolvent, damage the credibility of the institutions acting on them, and accelerate the decline of Europe’s global relevance. In short, these myths will result in an overestimation of short-term systemic risk and an underestimation of long-term systemic risk.Myth 1: The European crisis is a bank crisis, and private investors can play a key role in assuming losses in lieu of government intervention.Reinforced by our memories of that fateful Monday in 2008, credit traders have become keen spectators of the European political scene. Like many, we are worried that the only certainty often appears to be uncertainty. As a result of this apparent uncertainty, the more prudent banks have sought to minimize exposure to the debt of the PIIGS (Portugal, Italy, Ireland, Greece, Spain). They have done this not to engage in speculation over the chances of, or even to accelerate, a default or a bailout, as the more paranoid opponents of derivatives have claimed; it is instead a way for the banks to admit surrender in the struggle to predict the consequences of politicians’ unwillingness to face economic reality.The major U.S.-based banks, and many in Europe as well (especially those located outside of Spain, France and Germany) have negligible direct or derivative exposure to peripheral Europe. According to the International Swaps and Derivatives Association, the current net payout related to Greek credit default swaps is only $5 billion. JPMorgan has announced that its collective exposure to the governments of Portugal, Ireland, Greece and Spain, as well as companies located inside those territories, is $15 billion and shrinking. Bank of America puts its Greek exposure at just $692 million. It is a similar story of small numbers for many major non-peripheral European banks such as Barclays, Credit Suisse or UBS, whose governments have applied less behind-the-scenes pressure on them to remain committed financially.It was inevitable in an integrated Europe, however, that a significant number of financial institutions would have massive exposure to distressed sovereign debt. Notably, French and German banks, as well as the IMF and the ECB itself, hold the lion’s share of Greek debt. Of the $260 billion in Greek government bonds held outside of Greece, the IMF and ECB hold $98 billion. European banks reporting to the European Banking Authority hold another $40 billion. Nonetheless, European politicians eager to appease their constituencies have spoken of the need for the private sector to shoulder some of the burden.Unfortunately, debate over a possible ECB effort to force debtholders to “voluntarily” roll over Greek debt, beyond being inherently contradictory, is progressively becoming an internal conversation. As non-conflicted banks and asset managers exit the PIIGS, the remaining major bondholders are increasingly government-guaranteed European banks, either explicitly or implicitly. Among traders the suspicion runs deep that European leaders are acutely aware of this fact, and their eagerness to avoid technical default (default as defined by the ratings agencies or the credit default swap markets) is driven as much by the understanding that this would trigger direct losses for their own governments as their stated fear of systemic credit infection.Regardless of whether a default is technical or not, someone must take a loss. Greece is insolvent, and it is insolvent for the basic reason that it consumes vastly more than it produces. Therefore, even if the ECB were able to strongarm banks into refinancing Greek debt at thirty-year maturities, as Nicolas Sarkozy recently suggested, there is no chance the Greek government could afford to borrow at the near 20 percent yields demanded by the market. If banks refinance at a significant below-market rate, they face the prospect of an enormous loss on the investment, and this loss increases proportionally with the size and duration of the subsidy.Currently, the European Union is requesting that banks extend new credit to Greece at a 5.5 percent rate, tantamount to a 30-40 percent loss on tens of billions of dollars. We can be certain that governments have made promises of subsidy and pledges to tolerate creative accounting, but these promises have been concealed from the public for obvious reasons. Loath to be seen as providing bailouts to banks or indolent neighbors, European politicians have tried to sell the economically and mathematically impossible story that the private sector will subsidize Greece’s future out of a sense of solidarity and responsibility.What is really happening is that the EU leadership is weakening many of its largest banks and increasing systemic risk in order to avoid taking a richly deserved direct financial hit in the near term. There is already short-term consequence; Moody’s has downgraded Portugal’s debt rating to junk. Along with the obvious economic concerns, the agency accurately points to an increased reluctance for private investors to invest in sovereign European debt after witnessing the “voluntary” Greek rollover strategy.Myth 2: A Greek default will likely lead to systemic collapse and “runs” on peripheral Europe.Consistent with this political strategy of refusing to trade short-term distress for diffuse but significant long-term gains, EU governments have avoided talking about structural changes like a breakup of the eurozone or a speedy but orderly Greek default. Instead, they have offered the red herring that avoiding default is the key to preventing a repeat of the 2008 banking crisis.Unfortunately, it’s not accurate to draw parallels between that crisis and this one. Europe faces a structural dilemma, not a situational one. Its problem is not cash and credit flow disruptions; rather it is that major parts of the eurozone have anemic productivity growth, massive deficits from unreformed welfare-state obligations, and considerable domestic turmoil. The 2008 American bailouts had a fundamental foundation: The government would act as a lender of last resort and purchase distressed assets from banks that had economic value but were trading at prices that reflected a breakdown in traditional credit markets. In Europe, governments are already in hock up to their nostrils (Germany holds 27 percent of the European Central Bank’s equity, and France 22 percent, for example) and the distressed assets to be bought are being priced in well-functioning markets.It is therefore difficult to see what a bailout of the Greek economy can accomplish. It temporarily prevents default, true, but it does nothing to rescue the Greek government from unsustainable deficits. This is why, despite the fact that German and Central European banks are shipping hundreds of billions of euros to Greece, the bailout is having no effect on Greek bond yields. Investors understand that hardly anything has changed in the long-term Greek outlook. Even after multiple rounds of austerity votes and successful bailout packages, two-year Greek yields are trading at 28 percent, and ten-year yields are at 17 percent, as of July 6.These yields reflect the market’s near certain expectation of default. This situation is what many in finance refer to as a “known unknown”, meaning that, while we’re unsure when and exactly how a default will happen, we’ve known for years that it would happen. We think we have a handle on which banks are exposed, and as previously mentioned, we know that those banks that are not being restrained by their governments have already either pared down their risk or increased capital to offset inevitable losses. A telegraphed Greek default would be a contained event: The markets expect it, and there is no reason to think it will cause contagion.It’s noteworthy that many banks were wiped out overnight in 2008 not primarily due to trading losses but because long-term assets were funded with short-term financing. When short-term financing evaporated, banks literally had to shutter their doors. If Bank of America was unable to borrow overnight, there was good reason to believe that Morgan Stanley would not be able to do so as well. In contrast, Greece’s immediate inability to raise private capital or service its debt is mostly unconnected with, say, Spain’s situation.Greece could even survive being shut out of the debt markets for a few years. Its government has a tax base, however weak, it has assets to sell, and its neighbors have an incentive to see it avoid depression. Remember, too, that Greece’s GDP in 2010 was tiny, barely outpacing Maryland’s and less than 2 percent of the European Union’s GDP (though its debt is an order of magnitude larger, of course).This is not to say that a disorderly Greek default would not roil the markets. If, over the course of a weekend, Prime Minister Papandreou succumbed to increasingly violent protests, a new leader announced that Greece would immediately stop covering its obligations, and solidarity riots broke out in Spain and Italy, then the markets certainly would be thrown into turmoil. Were something like that to happen, banks with minimal exposure to Greece would have accordingly minimal losses, and the entire financial world would then proceed to re-evaluate the likelihood that Spain and Italy would go into a disorderly default as well. No one at present expects such an event to happen, so the instantaneous re-pricing of risk would be quite large. But even this scenario would largely be contained if the European Union were willing to support the more heavily exposed French and German banks and Spain and Italy remained solvent.Traders of short-term systemic risk currently find little to panic about, however. Our Counterparty Valuation Adjustment desks are calm, and LIBOR-OIS spreads—which measure the gap between short-term rates at which banks can borrow and risk free rates—remain low. Though the sky is about to fall in Greece, its fall will unlikely lead to the same in Spain, Italy or the rest of Europe.Myth 3: The breakup of the eurozone would benefit Greece but is unnecessary. The euro has not collapsed against the dollar, and therefore the markets still consider the eurozone viable.Though a flash default is unlikely, it is plausible that politicians will continue to be unable to address the problems of long-term deficits and the sputtering economic engines of Spain and Italy. This scenario would be a true disaster as these countries together have a GDP more than ten times the size of Greece’s and their bankruptcies could not be arrested by bailouts. Nonetheless, the political focus remains on Greece.A common suggestion for supporting Greece’s economy is to force peripheral Europe to leave the eurozone. Many economists have noted that the reintroduction of the drachma would allow Greece to depreciate its currency, thereby making Greek exports more attractive relative to countries still inside the eurozone. Sweden, currently enjoying one of the healthiest economies in Europe, partially owes its rapid recovery to its status as an export-driven economy that was able to drastically depreciate the krona from 9.2 SEK per Euro to 11.6 SEK per euro from August 2008 to March 2009.Unfortunately, the Swedish solution won’t work for Greece. Greece has anemic exports; it relies heavily on tourism. It is therefore poorly positioned to economically grow out of its fiscal hole. Additionally, if the peripheral states left the euro instead of the stronger states, they would continue to have euro-denominated debt. A depreciated currency would raise the cost of holding foreign-denominated debt and would result in near instantaneous default. The only way of avoiding this scenario would be for northern Europe to leave the euro, instead of Greece, Ireland, Portugal and other distressed countries. This is highly unlikely.Despite the fact that currency depreciation would be a far greater shock for Greece than receiving handouts from the rest of Europe, a broader breakup of the eurozone is still worth pursuing, because it would increase financial flexibility for the entire European continent. Spain and Italy are far better positioned to benefit from the freedom to pursue their own currency policy. Until then, the only option for any eurozone country seeking to make its products more competitive is to mimic Ireland’s wage deflation policy—a far slower, less flexible and less sustainable strategy than currency depreciation.Eurozone defenders have pointed to the only moderate decline of the euro relative to the dollar since 2008 as a sign of its strength, but this is hardly a strong argument in its favor. The U.S. government has pursued an extraordinarily aggressive easy money policy and has negative real interest rates. A more proper comparison would be to the Swiss franc, against which the euro has lost nearly 25 percent in a near continual decline since 2008.Of course, if the euro is strong for some countries in the zone, it is weak for others, like Germany. Germany has been taking advantage of the artificially low rate by creating a robust export-based economy at the expense of its would-be lower-wage competitors in peripheral Europe. In a multi-currency zone, exchange rates would adjust so that German products and labor costs were comparatively more expensive, but the euro prohibits this from happening.A Financial Crisis?Each of these three myths has gained widespread traction and could lead to (and in some cases is already leading to) exceedingly dangerous policy. While the European crisis is currently a sovereign risk crisis, mismanagement could ironically turn it into a bank crisis as well. Apart from being dishonest, it is risky business to discourage European banks from recognizing their losses. Instead of strongarming them to rollover debt at below-market rates and promising them the opportunity for creative accounting, these banks should be raising as much capital as possible and de-risking. Credit agencies have recently pointed out the obvious, that forcing private investors into new financing at a loss constitutes a default.By buying into the mythology of the need to delay Greek default at all costs, the European Union is not only suppressing and delaying its banks’ ability to protect themselves; it is actively “volunteering” them to take on even more peripheral risk. Any Greek bailout policy that refuses to address the medium-term risks of Spain, Portugal and Italy will increase bank exposure to peripheral debt and dangerously run the risk of precipitating another systemic failure.Despite Germany’s frequently and clearly expressed reluctance to subsidize peripheral Europe, there has been remarkably little discussion about the fact that the euro functions as a subsidy for German manufacturing. Most observers therefore severely underestimate German reluctance to allow any type of eurozone breakup, regardless of the festering resentment of its citizenry and challenges in the German courts. The euro’s rise as an alternative reserve currency to the dollar has also led many around the world to exert pressure to keep the eurozone to whole. It is plausible then, that there will be no reformation of the eurozone for the immediate future, given the role in all of these diverse short-term incentives in blocking such reforms. It should come as no surprise that politicians have chosen the easy but doomed path: muddle through, provide temporary bailouts and hope for the best.Though my colleagues and I will always live in some fear of sudden and unanticipated unknowns, we are less concerned about immediate credit infection in Europe than many believe. However, the ECB, IMF and major members of the European Union’s wholehearted investment in preventing a Greek technical default is already weakening the EU banking system. In the long run, this strategy, as well as the inability to discuss eurozone reform raises the chance that economic disaster in Spain and Italy would create another credit pandemic. The simple truth is that it would be much wiser to face reality and take the inevitable losses now, before they fester and infect other parts of the European economy.Fortunately, the path to ruin in this case is known and avoidable. With enlightened leadership and a continued economic recovery, Europe’s crisis can be contained and shortened, but this will require European leaders to be willing to lead—beginning with telling themselves and their people the truth about what is, and is not, happening. Though this may seem like a straightforward wish, the political reaction to the July 5 Portugese debt downgrade has been telling. Almost immediately, the response has been of denial, rather than acceptance of the facts. Jose Manuel Barroso, president of the European Commission, tried to claim Moody’s report was “mistakes and exaggerations.” German Finance Minister Wolfgang Schaeuble announced that “the influence of the ratings agencies” must be curbed and broken. In the meantime, fiscal imbalances continue to build, and we continue to hope that European leaders come around to reality.
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Published on: July 1, 2011Greek to Me
Three myths about the Greek crisis.