Follow by Email

Saturday, December 31, 2011

Closing 2011 with a minority view

The clear majority view seems to have become that the involvement of private banks in the debt crisis has been the greatest mistake so far. Furthermore, that the refusal so far to issue Eurobonds is the major reason why the crisis has seemingly drifted out of control.

Those who have been following my blog know that I take a different view and the approaching year-end is a good point to summarize it. Most of what I say below falls into the category of what "should have been done". I am not sure that what "should have been done" can still be done at this advanced stage of the crisis but perhaps my arguments stimulate thought.

What should have been done?

1) Above all, the possibility of a Euro-exit on the part of Greece should not have even be brought into discussion, at least not until some future time when stability has returned. A Euro-exit would bring along unpredictable political turmoil in Greek society.

2) The Greek external payments crisis should have been treated as quite a normal thing from the start. "Normal" in the sense that an external payments crisis is the most natural thing to happen when a country runs enormous current account deficits (financed with debt) for an extended period of time, and "normal" in the sense that this has happened innumerable times with other countries before so that Greece was neither a surprise nor an exception.

3) Under no circumstances should the Greek external payment crisis have been defined as a life-and-death issue for the Eurozone, not to mention for the EU. One should have reacted to this normal crisis in the normal way.

4) The normal way would have been for Greece to ask her lenders to reschedule debt as soon as it became apparent that a confidence run had started against the country. Looking back, that would have been at the latest by early 2010.

5) If Greece had not taken that initiative, then the EU should have prompted Greece to do so. Under no circumstances should the EU have given any signals that it was going to stand up for Greece's existing debt.

6) The rescheduling should have encompassed not only the sovereign debt but all other foreign debt of the country (i. e. including the foreign debt of the banking and other sectors). The debt to be rescheduled should have been split into separate categories with different terms for each category (i. e. better terms for government-to-government and short-term trade debt than for long-term bonds).

7) The general principle would have had to be: the existing debt will be rescheduled with existing debt holders ("risk takers remain risk carriers") and the needed Fresh Money (i. e. for the budget deficit) comes from the EU.

8) Banks' participation in the debt rescheduling would have been the "private sector participation". Nothing more required of banks. Under no circumstances should a haircut have been considered.

9) A haircut has disastrous consequences for both the international markets as well as for Greece. The long-term consequences on financial markets of the precedent of a haircut for a first-world country after only 2 years of crisis cannot be foreseen. The long-term consequences for Greece of having needed a haircut cannot be foreseen, either.

10) It was wrong to consider it as the foremost question how much sovereign debt Greece can handle (100% of GDP, 150% of GDP; more?). The only question which matters is how much interest Greece can reasonably be expected to pay on her sovereign debt.

11)  The interest rate on the rescheduled debt should have been split into 2 portions: (a) interest paid in cash and (b) interest capitalized.

12) The total cash interest should have been put on a variable basis (i. e. a percentage of total government expenditures). Interest exceeding that amount should have been capitalized.

13) The sovereign debt should have been split into 2 portions: (a) the amount within Maastricht-limits (60% of GDP) and (b) the rest. The Maastricht-portion should have been rescheduled at normal terms (maturities up to 20 years). The rest of the debt should have been structured as "evergreen bonds" (maturities up to 99 years).

14) A condition precedent for the rescheduling should have been that the EU provides the Fresh Money and negotiates with Greece the implementation of deficit reduction measures and reforms.

15) The deficit reduction measures should have focused almost entirely on revenue-raising to increase the government revenues from an unacceptable 38% of GDP to the more common level within the EU of 46-48%. Only little should have come from existing tax payers. The bulk should have come from those who have never paid (or underpaid) taxes. If Greece had needed EU-support for that, the EU should have sent legions of experts to Greece. The Greek population at large would certainly have applauded that.

16) Since Greek government expenditures were not at all out of line with EU-averages (around 50% of GDP), they should have only been reduced minimally in order to avoid too much of an ecnomic slump. However, they would have had to be restructured dramatically along the principles of fairness and utility ("stop taking money from the living so that pensions can be paid to the dead").

17) Parallel to the debt rescheduling, an investment program for the private sector would have had to be initiated, to be financed with foreign investment. Initial focus should have been import substitution products. Special Economic Zones with an internationally competitive business framework should have beeen established to attract foreign investment. Compliance with the respective new law(s) should have been guaranteed by the EU to provide security to foreign investors.

18) Temporary protective measures ("infant industry protection") should have been implemented to stimulate new domestic production (special taxes on imports) and to stop capital flight (capital controls).

19) A long-term economic development plan for the Greek economy should have been developed with the focus on getting the current account deficit under control by emphasizing domestic value generation and, thereby, reducing the dependence on imports.

20) Finally, the possible impact of the rescheduling on the stability of foreign banks should not have been an issue for Greece. If foreign banks had experienced problems, their respective governments would have needed to bail them out directly (instead of using Greece's balance sheet to bail them out indirectly). The same logic would have applied to any disturbances caused by the CDS-market.

So, here you have it. "Should have have been"; "could have been"; etc. An American manager might say: "I don't pay you for telling me what should have been done in the past. I pay you for proposing to me what should be done in the future!" One can only hope that 2012 will be the year in which Greece manages to do something about her future on her own!

Friday, December 30, 2011

Bond financing versus loan financing

Very little discussion has taken place so far on the difference between bank loans and bonds as instruments for raising public financing. In times of difficulties, it makes a huge difference whether a borrower's debt takes the form of loans or bonds.

Loans 
A loan is a private contract negotiated between lender and borrower. All conditions in the loan agreement can be "tailor-made" to suit the needs of both lender and borrower. Above all, the interest rate can be negotiated freely between borrower and lender (i. e. it is not forced upon them by “market conditions”). The loan agreement stipulates the conditions which must be fulfilled prior to disbursement of the loan as well as the conditions which must be fulfilled during the life of the loan. It also stipulates what happens if those conditions are not fulfilled. There are no "automatic bankruptcies". Before default occurs, both lender and borrower have it under their control to take measures to cure it. Even if default has already occurred, the lender can chose to delay declaring it until the borrower has cured it. If a default cannot be cured but if neither lender nor borrower seek bankruptcy, they will consensually amend the terms of the loan agreement.

Bonds
A bond is a public debt instrument designed to be sold to institutional or private investors and, as a general rule, it can subsequently be traded. Thus, the terms of a bond are dictated by what potential investors require and they can only be minimally "tailor-made" to the needs of the borrower. This applies to documentation and, particularly, to the interest rate. The terms of a bond are worked out between the borrower and the manager of the bond (or a group of managers; typically investment or commercial banks) based on what they deem the "investors' appetite" to be. If their assessment of investors' appetite is correct, the bond will sell well. If they are mistaken, they will sit on the bonds: their role changes from "arrangers of financing" to "investors". 

Once a bond is sold to investors, what began as a relationship between borrower and manager turns into a relationship between borrower and investors (i. e. the bond holders) and it becomes anonymous. Even though the bond managers know who the investors are (because they transfer interest to them), they are not allowed to reveal their names to third parties. The terms of the bond cannot be amended later on because there is no one with whom an amendment could be negotiated.

If all of Greece's debt had been loans...
... then it would have been the most natural thing in the world for Greece to call all her lenders to a bankers' meeting and to present the need for an amendment to loan agreements (i. e. a rescheduling of maturities and a resetting of interest rates to levels affordable by Greece). Most likely, one would not have rescheduled all of Greece's debt but, for instance, only the maturities of the next 3-5 years; possibly by disbursing a new loan to refinance those maturing loans. The lenders would have elected among themselves a Steering Committee with which Greece would have negotiated. If handled well (i. e. keeping up the appearance of voluntariness and consensuality), the banks would not have needed to write-down any of their loans (not to even mention a haircut). 

Who should be the purchasers of bonds? 
Contrary to popular belief, it is NOT one of the principal roles of banks' to finance governments; least of all foreign governments. The principal role of banks' is to finance the real economy. Regrettably, banking regulations (Basel-II) have incentivated bank lending to governments (because they were deemed to be risk-free and required no reserves) over bank lending to the real economy (which is not risk-free and requires reserves).

Sovereign debt tends to take the form of bonds because the idea is not for the managing banks to hold them on their books but, instead, to sell them to investors (and make money through the arranging and selling fees). Banks should be lenders and not investors. Potential investors for bonds are private individuals and those institutions which manage funds for long-term returns (insurance companies, pensions funds, etc.).

Banking regulations (Basel-II) have turned this principle upside down!

Why do governments prefer bonds as debt instruments?
Because bonds are - in good times - an easy way to raise funds in large amounts and with bullet repayments: invite banks to make pitches; award the mandate to one manager or to a group of managers; negotiate more or less standard documentation and pricing with few people; and --- off you go and, before you know it, you have perhaps half a billion Euro in your bank account repayable in one sum at some distant point in the future. No further dealings with your "lenders" until maturity (provided that interest is paid on time). 

One bank alone will hardly make a loan in the large amount of a bond. Thus, a syndicate of banks must be formed which means that documentation and pricing must suit the needs of many lenders. Also, once the syndicated loan is closed, the assets have to stay on the banks' books. Loans are usually structured with instalments (instead of one bullet maturity) which means that there is a more frequent need to refinance maturities. Most importantly, banks who make loans want to "stay in touch" with their borrower during the life of the loan. The borrower is continuously "bothered" by wishes from his lenders "to stay in touch".

What are disadvantages of bonds?
Like with any other public debt instrument which is traded, a bond is a rather standardized "product" which has rather standardized features (tenor, interest) so that it can be traded easily. Consequently, there is virtually no flexibility during the life of the bond: either its conditions are complied with or it goes into automatic default. 

In times of difficulty, a borrower might publicly invite all bondholders to a meeting but the smart ones will stay home because they have nothing to gain from it. The very large bondholders (banks, insurance companies, etc.) can, of course, be "forced" to identify themselves and they may not have a choice but to agree to attend a meeting to renegotiate terms as the case of Greece has shown but no one can be forced to agree to new terms. And a small family office which holds, say, 1 MEUR of Greek bonds will completely ignore any such moves. They will simply hold on to their bonds knowing that with their piece of paper they could trigger default and cross default on the whole sovereign debt of a country if they didn't get paid on maturity.

What are possible conclusions from the above?
While it is the most natural thing in the world for banks to sit down with the borrowers of their loans in times of difficulty to renegotiate the terms of the loans, when they hold bonds they can "hide" behind the structure of that debt instrument. They can argue that, while they would be happy to renegotiate the terms, they legally can't because it would be construed as a default. That threat of uncontrolled default puts banks in a position where they can argue that "someone else" should make sure that the bonds get paid. 

When "danger is at hand" (like in the case of AIG when commitments fell due within days), that "someone else" has virtually no alternative but to succumb to that blackmailing.

With sovereign bonds, there is never "danger at hand" because one knows way beforehand when they mature, and they don't mature as frequently as commitments of players in money markets. Thus, one has plenty of time to exercise pressure. Should "danger at hand" come up (because, for instance, some maturities come up), the "someone else" can decide to cover those maturities, but only those, until an overall solution is found.

The overall solution must be guided by the principal of lending, i. e. "risk takers must remain risk carriers". Large institutions can be held accountable for adhering to that principle. Smaller institutions (like, for instance, the family office of a private investor) may have to be given preferential treatment as the price for keeping the overall problem under control.

What are counter-arguments to the above?
The principal counter-argument is that sovereign bonds have to be risk-free because otherwise the existence of the bond markets might be threatened. Anyone making this argument in Economics 101 will flunk the course!

The only sovereign bonds which are risk free are the bonds of sovereign nations which can print the currency in which their bonds are denominated and where the bonds are subject to their laws (i. e. US Treasuries). Every other sovereign bond has some form of risk (credit risk, currency risk, or otherwise).

When Joseph Ackermann stated in a CNBC-interview that "measures must be taken that sovereign loans are made risk-free again, which is what they should be!", the journalist should not have nodded understandingly but, instead, returned the following question to Mr. Ackermann: "If that is so, Sir, why are sovereign bonds rated differently in the first place?"

This has nothing to do with the Euro-structure, with a central fiscal policy (or not) or whatever. Federal States of the USA do not borrow at the same rates because they represent different risks. When California can't pay her bills any longer, she has to do something about it because she can't print US dollars. Only bonds of the US Federal Government are risk-free because it can print the currency in which they are denominated. There is no Eurozone government which can print Euros!

Things get out of control in capital markets when the reallocators of funds take unwise decisions on a massive scale. The solution to that is not to have those reallocators take even more unwise decisions. Instead, they - and their funders - have to take losses so that they learn from the experience. That is not a "destruction of markets" but, instead, a "readjustment of markets to reality" which assures that, going forward, markets will act more wisely. In the long run, markets cannot ignore reality!

Thursday, December 29, 2011

A devastating verdict!

Below is a letter which the Ekathimerini published recently. It devastates all those who have taken advantage of the Euro-party of the last 10 years and concludes with the sentence: "But I do feel sorry for Greeks at the bottom of the pile. They have been exploited by the greedy Greeks and continue to pay the price". The letter is very worth reading!

----------------------------------------------------------------------------------------------------------------------

Greek nouveau riche are mocking me

When I left Greece in the 1970s I did so to escape a relatively poor, corrupt state.

In Britain I worked hard and became prosperous.

Today, my Greek friends and relatives have better standards of living than I do, bigger homes, smarter cars, newer computers; they take more holidays to exotic locations, and their children go to expensive private schools and foreign universities.

My Greek friends and relatives continue to moan and groan about their future.

I am sick of my Greek friends and relatives. They are spoiled beyond belief, living off my taxes, and more corrupt and arrogant than ever.

So arrogant, indeed, that they repeat to me the sayings of Karatzaferis, that if Greece doesn't receive trillions in our taxes, the country will become the Cuba of the Eastern Mediterranean.

Let them become Cuba, I say.

I'm sick of my arrogant Greek friends and relatives, who think everyone owes them a living.

Today, I trust Turkish politicians more when they talk about Greek-Turkish issues than I trust the pompous Greeks. I have also started to listen carefuly to the arguments of the Skopje Macedonians and the Albanians and Bulgarians.

I no longer think that Greece is a victim. I believe it is a bully. It has also become a coward, ready to enjoy the rewards of the Western alliance but too frightened to accept the responsibilities of such membership.

I've told my greedy friends and relatives that I will no longer be bringing them gifts from abroad as they are rich enough today to buy their own things.

But I do feel sorry for Greeks at the bottom of the pile. They have been exploited by the greedy Greeks and continue to pay the price.

Fanis Koliopoulos
Hamstead, London
----------------------------------------------------------------------------------------------------------------------

And here is my comment on the letter.

You recently published a letter by Fanis Koliopoulos from the UK under the above title. That was a rather brilliant description of those Greeks who could benefit from the euro-party of the last 10 years. Correctly, it also pointed out that there are other Greeks who didn't benefit much. It think it is important to differentiate between these two prototypes.

Clearly, a large part of the Greek population is suffering terribly these days. Nothing which I say below should belittle in any form or fashion that fact.

I must comment, however, on the other Greeks who are not suffering at all. We spend about half the year in Greece. Given the location of our apartment and our circle of friends, we would see nothing of a crisis if we didn't watch TV or read papers (or talked about it). On the contrary, I see a lifestyle and living standard which exceeds that of Austria (where we spend the other half of the year).

We shop at the nearby Gran Masoutis which is more impressive than what we have in Austria. Some of the products are also more expensive than in Austria. And yet, the place is full with shoppers all the time.

When we go to places like IKEA or Hondos, we see crowds of shoppers who are actually buying things. When we go to the huge Mediterranean Cosmos Mall, we see something which has no parallel in Austria. We also find it hard to find parking even though they have hundreds if not thousands of parking lots.

The streets of Thessaloniki are jammed with SUVs when gasoline costs about 20% more than in Austria. The cafes and bars are full with people of all ages during daytime. It seems like everyone has at least one smartphone. The coffee costs as much as in Munich and a small glass of ouzo sells between 5-10 euros. We eat quite normal meals in quite normal restaurants and hardly every pay less than 15 euro per person (drinking only water). When we go to the movies, we pay 9-10 euros per ticket.

I knew Greece before money started flowing into the country as EU-subsidies and/or cheap euro-loans. It was a relatively poor country and quite cheap. If a poor man hits a jackpot and decides to spend it all on consumption, he may live well for, say, 10 years. When the money is spent, he has to return to the standard of living of 10 years ago. Much worse for the Greeks because they did not hit a jackpot but took up debt instead and that debt is still there.

Sorry, I miswrote. It is not much worse for all Greeks. It is very, very much worse for those Greeks who had little fun at the euro-party and who now have to foot the bill for it. And the other Greeks who have their money stashed away (tax-free!) will continue to live very well, much better than tax payers in Central Europe can ever imagine to live.

Greeks like to play the victim role. Yes, Greeks have been victims but they have not been victims of foreigners taking advantage of Greeks.

Greeks who are truly victims today are the victims of other Greeks who have taken advantage of society for individual benefit in dimensions which remind me of nobility and peasants in the Middle Ages. In dimensions which one might expect to find in some third world banana republic but not in the EU.

All this stuff about Hellenic grandeur and Classic Greece is for the birds if a large portion of today's Greeks act and behave like people in a third world banana republic. And, I might add, it is also insult and injury to those Greeks who are not like that. To those Greeks whom Central Europeans remember as the guest workers with the best reputation. To those Greeks whom we meet in Greece today who are decent, industrious, most friendly and open-hearted people. I would guess that the latter still are the majority. Even if not, it is about time that they stand up against the other Greeks and be counted!

Wednesday, December 28, 2011

The race to lend Greece

Prof. Yanis Varoufakis published in his blog my recent tale about how Greece might have built up so much foreign debt. There were many comments to it and below is my response to them.



After reviewing the comments to my tale (thanks to Yanis for distribution), I would like to comment on comments.

My tale was about BEHAVIOR of banks and bankers and not about technicalities of banking. Having spent some of my banking years as “overpaid wine-taster” and some others as “narrow-minded domestic banker”, I can assure everyone that my description reflects quite accurately the behavior of large banks with international activities.

I did not want to attribute blame to anyone. While I took Greece as an example, the tale applies universally and I would guess that it is timeless.

One reaction was that I didn’t talk about the betting among banks against, say, Greece. That is correct. I could have easily concocted a couple of very biting paragraphs about that but, then, there are other aspects which I didn’t cover either. The tale had become longer than intended already.

Regarding the mean bankers/speculators who are allegedly out to “kill” countries and economies, I have never met any person fitting that description. However, there are many bankers/speculators out there who are chasing high financial returns, preferably short-term gains, and they can definitely destroy real values. Theoretically, if economies/markets were in complete balance (not possible in practice), these people would be out of a job. They thrive on imbalances and they have an amazing ability to detect imbalances. Oftentimes they can even create them. But they are out to (profitably) transact business and they are not out to (unprofitably) wage geopolitical campaigns.

The word “parasites” was mentioned and I find that very interesting. In the Middle Ages, that term was used against people who were deemed to take advantage of real economies without contributing to them. What we have today are entire industries who take advantage of real economies without contributing to them (other than recycling the financial wealth which they generate for themselves).

Even today, most banks (the medium-sized and smaller ones) understand that banks are not an end per se but a means towards an end. That their end is to support customers in the real economy so that there can be real wealth generation. Despite their quantitative majority, these banks really cannot influence large international capital markets. Instead, they are influenced by them. The much fewer large players have developed a mindset where the bank is an end per se and where it is the customers who become the means towards that end. They think less of “customers” and more of “counterparties”. Instead of visiting customers, their top executives visit institutional investors, attend analysts’ meetings, talk to consultants, etc. “Real” customers often, and rightfully, criticize them for speaking a language which no “real” customer understands. However, without a real economy somewhere out there, they could not transact any business. From that standpoint, to use the word “parasites” to describe them is mean but not false.

For individual banks/bankers caught up in the midst of the herd behavior, it is next to impossible to break out. Horst would have been fired if he had fallen too far behind Jean-Pierre and Charlotte (and replaced by someone who could successfully compete with them). Even a CEO like Josef Ackermann would have gotten into serious personal trouble if Deutsche Bank had fallen far below the 25% ROE which he had promised his investors. And he promised that return to investors to safeguard his job in the first place. A notable exception would be Warren Buffett who has built such a myth around himself that he does not really need to report to anyone (and, so far, no one has dared to question him); they all trust him blindly. When Warren Buffett decided not to take part in the IT-bonanza/bubble because he didn’t understand it, he could do so. Most everyone else would have lost his job for “not understanding” such (perceived) enormous profit opportunities.

Goldman Sachs was cited as the villain. Actually, G+S is the epitome of perfection in this game. Not only do they often profit the most from being in the herd. As “leading steers”, they push the herd onwards but they are smart enough to leave the herd before it goes over the cliff (and sometimes they even save themselves by driving others over the cliff). It is the nature of the game which needs to be criticized. If one justifies the nature of the game, one should not criticize its most successful (albeit reckless) performer.

G+S was criticized for advising Greece how to “cheat” with the level of her debt and for collecting high fees for that. The reality is that every major player in international finance employs entire divisions of supremely intelligent people who spend their time developing new products/ideas for making money. Regulations are a great opportunity for them because for every regulation there are possible ways around it. Maastricht is a case in point. The fee income earned so far by bankers, lawyers, accountants, etc. through advising governments how they can legally circumvent these regulations is probably beyond imagination. Some of the better known circumventions are: cross-border leasings; private-public partnerships; outplacing debt into SPVs; or – as in the case of Greece – cross-currency swaps. I cannot imagine that G+S got the mandate for Greece’s cross-currency swaps because they conspired with the Greek government how to cheat the EU. Instead, I would suspect that every major player had pitched for that mandate and G+S got it because they were the best. As far as I know, there was nothing illegal about the structure of the cross-currency swaps and Greece is definitely not the only country which is “optimizing” its sovereign debt for the purpose of reporting it (Austria’s reported sovereign debt would be about 20% higher without “optimization”).

These are some of the behavioral aspects which I tried to bring across and I appreciate the feedback from those who understood this. I attach a video below which came out almost 4 years ago. Not all of you may know it yet. It is priceless for its humor, and --- quite reflective of reality!



Tuesday, December 27, 2011

The bazooka revisited

This interesting article by Avery Goodman makes the recent ECB-bazooka (LTRO) look like it were the best thing since sliced bread. I had taken quite a different view in my recent posting but I had concluded that posting by saying that one may have to be prepared to accept new wisdoms if the bazooka works.

There are some embarrassing mistakes in Goodman's calculations when he suggests that a bank, after 1 year of participating in bimonthly LTROs, can earn about 30% in spread interest. His (wrong) conclusion is based on the assumption that banks can borrow from the ECB at 1% and buy Italian bonds yielding 6%. Yes, that is a 5% spread but doing that 6 times per year does not increase the spread; in only increases the volume to which the 5% spread applies. And, by the same logic, there certainly is not a 90% return on investment after 3 years!

Sadly, Goodman is perfectly right in saying the following: "If a bank participates to the fullest extent possible in the back door money printing, its executives will have collected fat bonus checks from big profits made on sovereign debt".

The LTROs are a way of providing banks with below-market-rate funding so that banks can increase their spreads leading to higher profits. If such profits were retained, they would strengthen the capital base of the banks which would be one way to justify this kind of subsidy (or slow-motion bail-out). If such profits are paid out as bonuses for executives and/or dividends, the ECB would be subsidizing executives' and/or shareholders' incomes.

What is left out of all these considerations is the issue of risk. So far, auditors have allowed banks to carry their sovereign risk assets at nominal value. Regulators have even called for that (Basel-II). However, even if all the sovereign debt will eventually return to full value again (a highly optimistic assumption), it is quite likely that banks will be required to make some risk provisions for these assets sooner or later. A bank which has to make a 10% risk provision on, say, Italian bonds has just wiped out 2 years' of spread interest through active utilization of the LTRO.

Tuesday, December 20, 2011

Zum Thema "Leistungsbilanzen"

Die Zeiten des mehr oder weniger uneingeschränkten freien Welthandels nähern sich einer gewissen Zeitenwende. Die Weltfinanz tut sich zunehmend schwer, die strukturellen Ungleichgewichte in den Handels- und Leistungsbilanzen zu finanzieren.

Im Welthandel haben sich "have's" und "have-not's" herauskristallisiert. China und Deutschland sind klassische "have's"; die USA und EU-Südländer sind klassische "have-not's".

Die "have's" sind Exportweltmeister, bauen Geldreserven auf und ziehen Produktionsjobs an sich. Die"have-not's" sind Importweltmeister, bauen externe Verschuldung auf und verlieren Produktionsjobs. Die "have-not's" dürfen stolz darauf sein, dass sie Arbeitsplätze anderswo schaffen. Die "have's" müssen feststellen, dass sie die "have-not's" finanzieren müssen, damit ihr eigenes Wirtschaftswachstum nicht einbricht.

Natürlich ist der freie Welthandel prinzipiell nur zu begrüßen, weil er "Wealth of Nations" schafft (Hebelwirkung der jeweiligen Wettbewerbsvorteile eines Landes und Effizienzsteigerung durch rasant expandierende Arbeitsteilung). Dieses System funktioniert allerdings nur solange für alle Beteiligten gut, solange der Welthandel über den Wirtschaftszyklus hinweg mehr oder weniger strukturell ausgeglichen ist. Ansonsten werden die Einen auf Dauer reicher und die Anderen ärmer.

Beispiel USA: seit nunmehr 2005 haben die USA jedes Jahr 2.000 Mrd. USD (und mehr!) importiert und deren Exporte decken gerade einmal 75-80% der Importe. Dienstleistungen und Sonstige Transfers hatten eine gewisse positive Auswirkung, aber dennoch betrug das Leistungsbilanzdefizit der letzten 10 Jahre im Jahresdurchschnitt 578 Mrd. USD!

Ein Leistungsbilanzdefizit stellt den Vermögenstransfer eines Landes zum Rest der Welt dar. So betrachtet haben die USA in den letzten 10 Jahren jährlich 578 Mrd. USD (netto!) an Vermögen ins Ausland transferiert.

Man vergleiche die USA mit beispielsweise Italien und Griechenland. Das "gebeutelte" Italien deckt mit seinen Exporten immer noch 90-95% seiner Importe ab. Griechenland hingegen erscheint hoffnungslos mit einer Export-/Importdeckung von nur 40-45%.

Im Interesse einer ausgewogeneren Weltwirtschaft wird man wahrscheinlich dazu übergehen müssen, die Leistungsbilanzen der einzelnen Länder genauer unter die Lupe zu nehmen. Eine mögliche Kennziffer wäre "Leistungsbilanzsaldo in % vom Bruttonationalprodukt".

Wenn beispielsweise eine Leistungsbilanzdefizitquote von 3% überschritten wird, könnte beispielsweise der IWF diesem Land signalisieren "aufpassen; es könnte sein, dass etwas mit Eurer Wettbewerbsfähigkeit nicht mehr stimmt!"

Wenn sie beispielsweise 5% überschreitet, dann sollte das Signal sein "Vorsicht! Sie bewegen sich auf dünnem Eis! Korrekturmaßnahmen sind erforderlich!"

Im Umkehrschluß müsste man ähnliche Signale für die Länder mit großen Leistungsbilanzüberschüssen entwickeln. Kein Land hat einen Nutzen daraus, strukturelle und dauerhafte, sehr hohe Leistungsbilanzüberschüsse zu haben, weil das bedeutet, dass dieses Land sehr viel Kapital exportieren muss (mit dem damit verbundenen Risiko).

Die Politik wird dieses Thema wahrscheinlich von selbst nicht aufgreifen wollen, weil jedwede "Steuerung" des Welthandels sofort als "Eingriff in die Marktwirtschaft" wahrgenommen werden wird (und kein Politiker wird sich diesen Vorwurf gefallen lassen wollen). Deswegen müssen die freien Märkte von sich aus die Politik auf dieses Thema hinweisen, damit sie auf Dauer die Vorteile des freien Welthandels für sich nutzen können.

Fall-out from the crisis of Greece (and the Southern Periphery)

A very dangerous process is under way: with the European debt problem assuming ever increasing dimensions, a mindset seems to gain foothold that all the problems are in the "sick" South and all the answers have to come from the "healthy" North.

After 3 months in Greece, I have now been back to Austria for 2 weeks. Austrian tax payers subsidize their national railways to the tune of 7 BN EUR a year, I just read, so that the national railways can send their employees into retirement at an average age of less than 55. Sounds familiar? I remember the comment of a Greek politician that it would be less costly to have all train riders be transported by taxi rather than by the national railways and, if I recall correctly, Greek tax payers subsidize their national railways with less than 7 billion EUR annually.

The same goes for tax payers' subsidies of pension payments, social and health security payments, etc. etc. Except that it is not today's tax payers who are doing the subsidizing but, instead, today's tax payers transfer the burden to future tax payers (in fact: future generations).

Can Austria afford that? Of course not! The famous ratio of sovereign debt to GDP already stands at around 80%. But Austrians are more clever than Greeks, it appears. Some of the sovereign debt is not even included in this calculation because it is transferred to special purpose companies (do you remember Enron?). All told, the sovereign debt of Austria might be in excess of 100% of GDP.

Is the Austrian government concerned about this? Yes, they were --- until other countries (like Greece) came along with even worse ratios of sovereign debt... And here is the great problem!

Does anyone in the South of Europe realize that Central Europe (with the notable exception of Switzerland) has built up welfare states which by no possible imagination can be financed in the long term? Particularly not with the demographic development is most Central European states?

Are the one-eyed leading the blind here? It appears that way but the one eye is not going to be open for so much longer!

One of the Austrian governing parties just published their own 24-point "savings plan" for the cure of the enormous budget deficit (mind you: an enormous budget deficit at a time of economic boom!). A savings plan? It consisted of 24 points of how to raise taxes. And that in a country where government expenditures already represent 53% of GDP ("only" 50% in Greece). Good luck!

Austria has the advantage over Greece of having a well-functioning private sector which, so it seems, will forever finance all the government's follies. Or will it not forever? And Austria's private sector has the advantage of having other countries buying its exports. Or will they not forever?

By the way, Germany is not all that different!

The present crisis is only superficially a crisis of the South. Sure, in the South the crisis blew all imaginable proportions but that is not to say that the North is "out of the water". It isn't. Instead, it is heading for the same waters which the South is already in!

Europeans altogether (with the possible exceptions of Switzerland and Scandinavia) have become accustomed to the fact that there may be such a thing as a free lunch. And with globalization, there now comes the surprise that "there ain't such a thing!"

Here is a 10-point paper written over 15 years ago. It was awarded a prize from the former Nobel Prize Winner Gary S. Becker. It's simple thesis is that there is no such thing as a free lunch.

The rest of the world outside Europe knows that, anyway. We Europeans are just about to find out.

Monday, December 19, 2011

Money makes the world go 'round...

A lot of blame is being thrashed around these days. Blame on the part of borrowers against lenders (and vice versa). Blame on the part of importers against foreign exporters (and vice versa). Blame on the part of the South against the North (and vice versa).

I will not introduce another blame-theory but I want to focus on how the process starts.

An individual gets into financial trouble the moment he pushes the "transfer" button on his PC paying for something which isn't worth the amount of money which he is transferring (or which loses value afterwards). If he has transferred his own money, the trouble is his and his alone. If he has transferred money which he borrowed from someone else, that someone else may have to share in his trouble.

An economy gets into financial trouble when those who dispose over the economy's money transfer that money into poor investments and/or to weak borrowers. If the financial intermediaries make good reallocation-of-financial-assets-decisions, the economy will grow. If they make bad (or even silly) decisions, disaster may strike the economy.

Regardless how weak and/or irresponsible a borrower is, he cannot waste other people's money before it is lent to him!

So one could blame financial intermediaries for having made such reckless loans to governments? Would that be fair? Probably not quite, because governments represent probably the most difficult challenge for a risk analysis: there is no balance sheet; there is no revenue base from the sale of products; there is no marketable collateral; there are no market shares;  actually - a sovereign state as a borrower isn't really much of anything other than the government's political will to keep its house in order. And that political will can change from one government to another (or even within one and the same government). From that, I derive the following question: who is best suited to lend money to governments?

What if regulations stipulated that governments can take up debt for their ordinary course of business (regular budget) only from investors residing in their respective country? A government's revenues/expenses are generally domestic. Why should its borrowing not also be domestic?

It is government spending which triggers the need for taxes (tax laws are not the original cause of taxes; they only become necessary when there is government spending and the government has no other revenues like Monte Carlo does). If expenses exceed revenues, a deficit occurs which needs to be financed through debt. Such debt represents nothing other than "insufficient taxes paid" by current beneficiaries of government expenditures. The debt is the instrument which defers such tax payments to tax payers of the future (perhaps even future generations).

If all government debt were owed to domestic investors, debtor and lender would - in sum - be one and the same. Quite possibly, with today's levels of sovereign debt, it could well be that only few countries have enough domestic savings to finance the sovereign debt but it doesn't have to be accomplished overnight. It would be sufficient to start working towards that goal.

Extraordinary government expenditures (such as large infrastructure or other investments) should be exempted from those regulations. They are typically of a magnitude which would exceed the capacities of domestic capital markets in smaller countries. At the same time, they are typically project-oriented, thereby making it easier for foreign lenders to analyze the risk and make wise lending decisions.

The private sector (including banks) should not be prohibited from borrowing abroad. First, the private sector has expenses abroad which justifies borrowing abroad. Secondly, private sector borrowers are much more suited for a risk analysis by foreign lenders than a government is and wiser lending decisions can be expected. Finally, the private sector's investments should not be slowed down by any "crowding-out" of the domestic capital markets through the government's borrowing.

An economy's borrowing abroad means using the savings of other countries. Particularly in fast growing and/or still developing economies, those savings of other countries are absolutely necessary to finance domestic growth. The critical aspect is that those savings of other countries are invested wisely and not wasted foolishly. As explained above, when those savings of other countries are lent to the government, there is a greater risk that they are not invested wisely (or rather: that they are wasted foolishly).

And the more money goes 'round prudently and is invested wisely, the more living standard we will all be able to enjoy.

Saturday, December 17, 2011

A misdirected bazooka!

Christian Noyer, Governor of the Banque de France, allegedly said the following in an interview with French news channel LCI: "What we decided yesterday in the governing council of the ECB was to use our bazooka ... so that banks can continue to do their job ... buy sovereign debt".

Headlines in other reports read like:  "Noyer – ECBs big bazooka will work through banks; ECB liquidity will encourage them to buy states’ debt”.

One of the more exciting aspects of these times is that one learns so many new things about the role of banks and the role of a Central Bank!

Perhaps not a very sophisticated but certainly an easy to understand description of the role of banks would be: they are intermediaries between those who have financial assets and those who need them. In this process, their role is to transform risks and tenors. 

Perhaps one of the more classic descriptions of the role of a Central Bank is that it is, among other things, a lender of last resort to the banking system. When it lends to the banking system as a lender of last resort, it requires first-class collateral such as highly-rated government securities. 

Traditionally, banks held highly-rated government securities in their portfolio for 3 reasons: (a) so that they always had enough collateral should last resort funding from the Central Bank be required; (b) for distribution to their customers who want to save in government bonds and/or for trading; and (c) for parking extra liquidity.

As a long-term investment per se, highly-rated government securities are not really that attractive for banks when the yield curve is flat (as it is now) because they have the lowest yield of all asset categories (see German bonds today). Even though they are freed from reserve requirements, they still blow up the balance sheet.

If I recall correctly, not so much time has passed since banks were accused for having done "reckless lending" to governments, thereby contributing massively to the current debt crisis in Europe. Some banks are already having to pay for that "sin" by having to voluntarily participate in the PSI for Greece.  

And now the ECB expects the banks to do more of that "sinning"? 

One ECB-logic could be the following: we give banks funding a near-zero interest rates so that they buy Greek bonds with high yields. In the process, they generate high margins and high profits which will strengthen their equity base. Somehow, I am reminded of a type of sub-prime logic.

Obviously, ECB funding is critically important to those national banking systems which are presently losing deposits in the billions. But if a, say, Greek bank takes funding from the ECB to buy Greek bonds which it subsequently pledges to the ECB as collateral, the funding base of that Greek bank has not changed a bit. The Greek bank may have contributed to the stabilization of prices for Greek bonds but --- is that the major role and/or responsibility of a Greek bank?

It will be interesting to see how Mr. Noyer's strategy plays out. It is certainly an interesting contrarian move: at a time when every bank tries to unload sovereign paper of deficit countries, the ECB offers banks incentives to buy even more of that. 

A traditional banker would say that this can never work but who knows? Many things in finance have been turned upside-down in the last couple of years. Perhaps it will work out, which would force the traditional banker to accept new wisdoms.

Friday, December 16, 2011

How Greece could build up so much foreign debt - a purely fictional short story

Greece’s foreign debt was 399 BN EUR by mid-2011. It was composed of 174 BN EUR in the central government; 208 BN EUR in the banking sector and 17 BN EUR in other sectors.

Many people ask these days how foreigners could lend so much money to Greece. Let me tell a tale how this could have happened. Any similarities with actual persons and/or banks are strictly coincidental.

Imagine that there are 3 major banks in Europe: the Merkel-Bank AG; the Sarkozy-Bank S. A.; and the Cameron-Bank Ltd. Each of them has a country-desk for Greece headed by Horst at the Merkel-Bank, Jean-Pierre at the Sarkozy-Bank and the charming Charlotte at the Cameron-Bank. All three of them feel very important because, after all, the entire Greek exposure of their respective banks is under their responsibility. They also know each other from meetings, presentations, road shows, etc. where all international bankers having an interest in Greece get together.

Their colleagues responsible for domestic lending operations in each of their banks think of them as “overpaid wine-tasters” because in their view, Horst, Jean-Pierre and Charlotte spend their time like diplomats who mingle amongst their own kind and who feel like being above the dirty day-to-day business of a normal bank.

Let’s take Horst as an example. He is in touch with his Greek customers (mostly bankers like himself) almost daily via phone or email. But two or three, or even four times a year he takes a trip to Greece to meet with all of them personally. They call that “relationship management”.

So, as Horst prepares for his next trip to Greece, he gathers information from all marketing departments within the Merkel-Bank as to what their business activities with Greek customers are and what their business development interests would be. His Syndications Group might complain that they are being left out of good Greek deals because the Sarkozy-Bank and the Cameron-Bank take a much more aggressive posture. His Trade Department might tell him that they would like to transact a lot more documentary business with Greek banks but that they are always told that such business is allocated to the lending banks according to their exposure and that the Merkel-Bank is not quite up to where the others are.

Horst also requests input from his Risk Management Department. They send him the latest summary of the Merkel-Bank’s country limit and actual usage thereof as well as an economic analysis of Greece. Horst studies all the input from the marketing departments as he prepares for his trip. The input from the Risk Management Department he leaves on the side, to be read on the plane and/or in the hotel room once he has arrived in Athens.

By the time Horst has reviewed all the input from his marketing departments, it is clear to him that he cannot return from his trip with empty hands. Instead, he has got to come up with some more business in order not to fall too much behind the Sarkozy-Bank and the Cameron-Bank.

On the plane to Athens, Horst starts flipping through the reports of his Risk Management Department. He doesn’t get very far because, great surprise, Charlotte from the Cameron-Bank is on the same plane. So he postpones the reading until later on in his hotel room and chats with Charlotte about the big picture of Greece.

Horst reads the report of his Risk Management Department in his hotel room. He doesn’t quite get it. These bean-counters write at length about Greece’s budget deficit which seems to be heading out of control; about Greece’s current account deficit which seems to blow all conceivable proportions; about the staggering growth in Greece’s foreign debt. Horst remembers that Charlotte had told him completely different things on the plane and he puts the report to the side.

The next day, Horst has appointments with 3 Greek banks: a breakfast meeting in the morning; then a luncheon; and the third one for late afternoon to be continued with a dinner at Mikrolimano. Since Horst doesn’t speak Greek, he is most impressed by the fluency in English of his Greek counterparts and by the way they handle themselves. He often thinks that if only his primitive domestic banking colleagues could see the type of top-notch internationalist people he is dealing with and how he can handle himself with them. And how well he speaks English!

His counterparts do not request any new loans from Horst. Instead, they talk about how great the Greek economy is developing and how other banks recognize this by increasing their Greek exposures. They express their full understanding that the Merkel-Bank is not quite up to the Sarkozy-Bank and the Cameron-Bank but, somewhat sadly, they say that, because of this, the Merkel-Bank should not be surprised if it gets less documentary business and/or capital markets business from them.

The lunch takes place at the executive dining room of the bank. The dinner in Mikrolimano lasts until the early morning hours and, by the time they all go home, they have promised each other to be best friends for the rest of their lives. Horst wonders if the Chairman of the Merkel-Bank ever has such business experiences.

The next days of his business trip unfold in similar fashion. None of Horst’s counterparts requests credit. All they do is to point out how much market share the Merkel-Bank is losing by not being a bit more aggressive as regards lending to Greece.

In one of the meetings, Horst hears that Jean-Pierre from the Sarkozy-Bank had recently had a personal meeting with the Minister of Finance. Embarrassingly, Horst has to admit that he has never had the opportunity to meet with the Minister. His hosts say that they could arrange such a meeting but they point out that the Minister does not like to waste time. If he agrees to a meeting, he would like to know beforehand that there will be some outcome.

By that time, Horst is convinced that he is running far behind Jean-Pierre and Charlotte. He better do something to convince his Greek counterparts that the Merkel-Bank is in no way junior to the other banks. As he looks forward to the meeting with the Minister, he briefly does remember that his Risk Management Department was very concerned about taking on more Greek risk but he quickly dispels this thought. After all, those bean-counters are acting from ivory towers and he, the Country Desk Manager of the Merkel-Bank, was truly “in the field” and could assess what the risk really was.

The Minister tells him at the meeting that Greece was about to give the mandate for a new bond issue. The Sarkozy-Bank and the Cameron-Bank had already made their pitches and both looked really good. But if the Merkel-Bank really wanted to improve their standing with the Greek government, this would be the chance to show colors. But they would have to do that soon. The Minister assumes a fatherly role and promises Horst that if his bank made an interesting proposal, he would personally favor it over other offers. Horst leaves the meeting convinced that he now has the chance to really put the Merkel-Bank on the map in Greece.

Waiting for his return flight at the Athens airport, Horst runs into Jean-Pierre who has just arrived and who is in great spirits. Jean-Pierre tells Horst that he would be having meetings at the Ministry of Finance to discuss an upcoming bond issue. At this point, Horst knows that the race was on.

On his flight back, Horst organizes all his papers and starts preparing his upcoming Committee Presentation mentally. When putting together the numbers, he sees that, with the new Greek deal, he would exceed his annual budget quite substantially. He starts making some first bonus calculations in his mind.

Back at Head Office, Horst finalizes his Committee Presentation. One small hurdle is that the Merkel-Bank’s Risk Manager wants to have a conversation with him about the presentation.

That conversation turns out to be less pleasant than the dinner at Mikrolimano. The Risk Manager wants to know of Horst why he recommends such a substantial increase in exposure when the economic analysis of Greece was not favorable at all. Horst has to control his temper. In his mind, the Risk Manager is the epitome of a bean-counter. Horst argues that, regardless of what the economic analysis said, Greece was rated A/A-1/Stable by S&P which made it investment grade. Also, Basel-II did not require any reserves to be held against sovereign bonds of Greece because sovereign bonds were considered risk-free.

The Risk Manager asks why Horst is going for approval of such a large amount. Horst explains that they first had to subscribe the full bond but that they were expecting a large sell-down to end-investors with only a reasonable final take. Who will be the takers, the Risk Manager wants to know. Horst answers that, above all, the Sarkozy-Bank and the Cameron-Bank would take large amounts. He had just recently had discussions with each of them and they were bullish on Greece.

The Risk Manager insists on the question of why a bond and not a loan. He argues that with a loan the bank would have much more direct influence on the borrower whereas with a bond the bank had virtually none. He points out to Horst that he had argued on previous deals that there would be large sell-down’s and at the end of the day they ended up with most of the deals on their books. Horst has 3 answers to that: first, the Syndications Group had messed up the distribution of the previous bonds; secondly, the bank was earning good margins on those risk-free assets so that they were very well off holding them; and, finally, the bank should be guided by what the customer’s interests are and not only by its own. And the customer wanted a bond.

Risk Management adds a critical view to the Committee Presentation but no one takes serious note of it given the investment grade rating of Greece and the new business potential. The deal gets approved and Horst is praised for his accomplishment. And the Minister of Finance accepts the proposal by the Merkel-Bank.

Once the deal is closed, Horst passes it on to the Syndications Group with specific instructions to start the down-selling with the Sarkozy-Bank and the Cameron-Bank. Much to his surprise, he receives feedback that neither of these two banks wanted to take any part of the bond. Horst is confused and places calls to Jean-Pierre and to Charlotte.

Both answer him the same way. Yes, they say, they still had plenty of Greek exposure available but their policy was to reserve that exposure for deals which they had generated themselves. Also, each of them say, they had just arranged a major bond for Greece and they didn’t want to go back to their committees with a new request so soon thereafter. That comes as a bit of a shock to Horst because, until that time, he thought that Greece had only done one deal and that he had outmaneuvered both the Sarkozy-Bank and the Merkel-Bank.

Horst then has a brainstorming meeting with the Syndications Group to plan a new strategy for down-selling. At the end of the day, they can place some portions of the bond with German Landesbanken and second-tier banks of other countries but the bulk of the bond stays on the books of the Merkel-Bank.

During this time, Horst once runs into a colleague from the domestic lending operations of the Merkel-Bank in the bank’s cafeteria. Horst proudly explains what a large deal he had just concluded with Greece. His colleague from the domestic lending operations inquires what the purpose of that financing was. Specifically, what Greece was going to use the money for. Horst doesn’t even reward that petty question with an answer. Such petty questions could obviously only come out of the narrow minds of domestic lenders.

By the time 2008 comes around, the Merkel-Bank, the Sarkozy-Bank and the Cameron-Bank (and many other banks) have gone through this process several times. With the crisis of 2008, the banks’ liquidity comes under pressure and their appetite to increase bond volumes on their books declines. Also, by mid-2009, the foreign debt of Greece surpasses the 400 BN EUR mark and it begins to look substantial. An election campaign is under way in Greece and the banks want to await the outcome of the election.

Shortly after coming to office, the new Greek government shocks the world with revised budget deficit figures. Hectic breaks out among board members of the Merkel-Bank. They urgently request presentations of the bank’s total exposure to Greece. Horst as well as his Risk Management Department are busy compiling all the information.

The Board Committee expresses surprise at how large the total Greek exposure is. The Risk Manager points out that they had reviewed and approved the frequent exposure increases themselves. The Committee feels that action must be taken. The first action will be to reduce the exposure limit to current outstandings so that at least no further money would go out the door. Then they want to hear proposals as to how the current outstandings could be reduced.

As it turns out, most of the outstandings are bonds which the Merkel-Bank holds on its books and the Syndications Group informs that there aren’t really any buyers offering reasonable prices in the market. So they turn to the loan outstandings which represent short-term lines of credits to Greek banks for the purpose of trade financing. These lines are so-called “internal lines”; there are no written loan agreements and, thus, they can be cancelled any day. Horst is assigned to “run down” those short-term internal lines of credit.

Horst then calls one Greek bank after another to inform them of the Merkel-Bank’s new policy. The Greek banks are shocked. They remind Horst of the dinner at Mikrolimano where they had promised each other to be friends for the rest of their lives. That, at that time, they were doing him the favor of giving him business which other banks had wanted as well; that they now had the impression like Horst was selling umbrellas when the sun was out and was now running away as soon as the first raindrops fell. Horst has no better explanation than to say that he is instructed to implement the bank’s new policy.

Billions and billions of Euros are called back by the Merkel-Bank and by all other banks during this period. Had the Greek banks not been able to get refinancing from the ECB, they would have gone under.

Meanwhile, there are new developments at the Head Office of the Merkel-Bank. Their chairman, one of the most prominent bankers in the world and a key advisor to the German government, had convinced policy makers that the ECB should buy Greek bonds. Otherwise, the markets would collapse. Eventually, the ECB agreed to do this and the Merkel-Bank manages to sell off, at near-par rates, a large part of its Greek bonds.

Horst received a very good bonus twice. The first bonus he received when he had successfully run up the Greek exposure and the second bonus he received for successfully calling back the short-term lines for Greek banks and for unloading such a large amount of bonds to the ECB. Unfortunately, he lost a few “eternal friends” in Greece, but Horst is happy.

A year later, a new challenge comes up for Horst. The bank’s chairman had to grudgingly agree to a socalled “voluntary debt forgiveness” in the order of 21%. That is not good news for Horst. However, the basis for calculating this 21% had not been clearly established. “Forgiving 21%” means that the Merkel-Bank will receive a new bond with EU-risk for the other 79%. Horst is now charged to come up with proposals as to how a formula could be implemented which would assure that the damage to the Merkel-Bank would be as small as possible.

Horst comes up with a net-present-value calculation (NPV). An NPV-calculation is routine work for Horst. Essentially, it means adding up all future cash flows from a loan (interest, principal) and transforming them into a net present value applying a discount rate. The higher the future cash flows and the lower the discount rate, the higher is the amount to which the 79% will be applied.

Horst is very clever and he constructs long tables of numbers using certain assumptions. At the end of this exercise, it turns out that the Merkel-Bank’s voluntary participation in the debt forgiveness will be less than 10% of the nominal value of the bonds which it has on its books.

This is when Horst is awarded his third bonus.