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July 22, 2011

Europe Declares Euro Too Big To Fail; Germany Becomes, Essentially, Manager of Greece

This seems ill-advised.

Germany now becomes the one-nation Marshall Plan for the debtor nations of Europe. This only works if it works. When you strap yourself to a drowning man, there's a very good chance you will be dragged under, rather than holding the drowning man afloat.

In addition, democracy is effectively suspended in Greece as European Union technocrats will be managing its affairs.

It’s not quite what some are portraying it as – the day that Europe signed up to the creation of a superstate – but it’s another big step in that direction...

By creating extreme moral hazard through ultra low interest rates for the afflicted nations, it also threatens to sow the seeds for an even worse eurozone debt crisis at some stage in the future.

Agreement on the package is one thing, deliverability is quite another. Once Germans realise that what is being proposed is a transfer union by stealth, you have to wonder what political future there is for the leaders who agreed it. Angela Merkel is staring election defeat in the face, rather in the way that agreeing to German participation in the euro was arguably what did for Chancellor Helmut Kohl back in the late 1990s.

...

The agreement refers to a “European Marshall Plan” to restore competitiveness to Greece. This doesn’t appear to mean money. Instead it seems to refer to the provision of “exceptional technical assistance to help Greece implement its reforms”. In other words, someone else will be running Greece’s affairs. That might be regarded as a positive development. Greece has, after all, proved quite incapable of running them for itself. Democracy has nevertheless been suspended.

Monty calls this a default by Greece. I believe he means this: Credit rating firms have stated previously that any failure of Greece to pay its obligations would be charged as a "default," even if the creditors agreed "voluntarily" to take a haircut. (No one really "volunteers" for a haircut; this is done just to get some money out of a bad investment.)

I think the theory is that more and more of Greece's debt is held by the European Central Bank and by lending them vast amounts of money at low interest rates (which they clearly haven't earned), this is as a much as a "default" as simply not paying up.

This all seems very bad.

Oh: Monty now explains. Apparently the bondholders did take a haircut:

It's a default because bondholders have to take haircuts -- willingly or not, it's still coercive. (I.e., if I read the deal correctly, getting their bonds at par with the full coupon is not an option.)

It's a legalism, though, as I explained in my solvency article. [This will be posted later -- ace.] "Default" is a legalism, and one that sovereigns (especially the ECB) play a lot of tricks to avoid.

An extension of term is still a haircut even if the par value is retained. A bond is a contract, and if I buy, say, a 1-year Greek bond with a 2% coupon, that's a contract. An extension of term means my principal remains "locked up" for longer than I wish, and I may or may not get the agreed-upon coupon rate at the end of the renegotiated term. (Just because the sovereign *promises* a higher coupon -- interest rate -- on the extended bond doesn't mean they'll actually pay it. After all, the previous defaulted bond was a promise too.) In other words, I'm incurring an opportunity cost (not getting my principal plus original interest back) without being properly compensated for it. And there is the reality that there will be a sure-enough bond default not long from now because this whole "voluntary" thing won't have enough takers, I'm betting -- Greece would need to impose haircuts of at least 50%-70% on outstanding debt to even have a *chance* of paying it back. This whole "Brady Bond" approach is yet another delaying action, not a real solution.

Nevertheless, it is also a technical default on bonds -- the only reason markets aren't freaking out about it is that they priced in default a long time ago. (The Euro actually got a small bump on the
news.)



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posted by Ace at 02:43 PM

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