Wednesday, December 14, 2011

European debt problem --- Time for a Fresh Start?

Since all current rescue efforts are treading in troubled waters (Greek PSI, IMF's funding by ECB, paid-in capital of ESM and EFSF leveraging), I revert to a proposal which I had first made in the beginning of the year. At that time, it was meant only for Greece. At this time, one might as well consider it for all banks.

All Eurozone-countries must clean up their banks' balance sheets at all cost. Financial institutions must be forced to write-down the value of their sovereign risk assets to realistic market prices. That would be a one-time shock which probably many (if not most) financial institutions could not absorb at once. Thus, the governments of the home countries of each financial institution must recapitalize their banks with preferred stock. When the dust has settled on all of this, perhaps even within 10 years, each government would have very significant privatization potential (and, hopefully, privatization gains). 

This would not only apply to private banks but to all holders of sovereign risk assets (including the ECB, insurance companies, etc.).

No haircuts and/or PSIs! Only a write-down to realistic market prices (a provision for loan losses) which should be uniformly prescribed by the ECB for each country. For instance: down to 50% of nominal (or even less) for Greece; 80% for Italy; 70% for Spain; 70% for Portugal; 60% for Ireland. These are only suggestions. The actual percentages would have to be discussed in detail (but they have to represent a mark-to-market!).

All that is required to implement this is a directive from each country's Financial Institutions Supervisory Authority to all of its members (in coordination with the ECB). Financial institutions should be given a period of 30 days to comply with the directive. 

Based on figures published in the past, total write-downs would be in the range of 1-2 trillion EUR and they would wipe-out the capital & reserves of most financial institutions. Thus, these financial institutions would be required to go to their respective governments to request a bail-out.

In the case of public financial institutions (e. g. ECB), the governments would have to make direct capital increases. In the case of private financial institutions, the most appropriate instrument - frequently applied by Warren Buffett - would appear to be the issuance of preferred stock.

Governments should establish special budgets for this purpose so that the respective principal amounts and revenues/expenses can be segregated. Whether or not they should be Maastricht-relevant would need to be discussed.

The funding of this excercise should be handled by each country's National Central Bank. Since the liquidity needed for these capital increases and purchases of preferred stock would need to be neutralized simultaneously, there would be not net increase in money supply.

At this point, nothing has changed for the borrowing countries because they still owe 100 Eurocents for each Euro of nominal debt and the nominal debt is still 100% of the original emission. The financial institutions, too, still have a 100% claim on the borrowing countries but they show less than that on their balance sheet because of the write-downs.

As a second step, the borrowing countries and their respective creditors negotiate directly a rescheduling of the existing debt. The creditors must elect amongst themselves a Steering Committee which is empowered to negotiate on their behalf. All agreements will eventually required the approval of all creditors. I will now continue my proposal using Greece as an example (the same procedure would apply to all countries). 

1. The sovereign debt must be segregated into different categories, for example: debt equivalent to the amount of loan loss provisions already made, other long-term debt, short-term debt. Each of the categories will have seperate rescheduling terms.
2. The debt equivalent to the amount of loan loss provisions already made should be rescheduled into "Evergreen Bonds" (with a maturity of, say, 31.12.2099) carrying a fixed interest rate. How much of that interest is payable in cash and how much is to be capitalized depends on the "all-interest-formula" (see below).
3. The other long-term debt should be rescheduled into Regular Bonds with maturities between 20-30 years carrying a fixed interest rate. How much of that interest is payable in cash and how much is to be capitalized depends on the "all-interest-formula" (see below).
4. The short-term debt should be rescheduled into Regular Bonds with a 10-year maturity carrying a fixed interest rate. How much of that interest is payable in cash and how much is to be capitalized depends on the "all-interest-formula" (see below).
5. All-interest-formula: Greece must be assured that her budget is charged only with "tolerable" amounts of interest. Thus, the interest to be paid in cash must be variable during at least the first 10 years. I recommend a "percentage of total government expenditures" formula. If such expenditures go up, so does the interest payable in cash. Vice versa if they go down. Economists should discuss what that "percentage of total government expenditures for a tolerable interest expense" should be. If it were 5%, it would be very low. If it were 10%, it would be high but not as high as the 15% of government expenditures which Greece must presently allocate to interest. The portion of interest which is not paid in cash must be capitalized and payable at maturity of each bond.
6. Allocation of interest to different categories of debt: more important than the overall interest rate per category is the allocation of cash interest to each category. It will be particularly important to make sure that the Evergreen Bonds receive an adequate cash interest payment because that is what will determine their value in the secondary market (no one alive today will live to see their maturity) and there must be an active secondary market for Evergreen Bonds. They may trade at only 10% of nominal at first (or even less) but, going forward, their prices in the secondary market will be an indicator if confidence into the Greek economy develops or not. 

What will all of this cost eventually? Theoretically nothing because no creditor forgoes any of his claims and there is a possibility (perhaps with only a 1% probability) that all these bonds return to 100% face value in the secondary market. In the final analysis, the total cost will be the difference between face value and market value of these bonds at some future date of reckoning. If that cost exceeds the amount of loan loss provisions, governments will have to, again, invest money. If it is less than the loan loss provisions, governments will get money back.  

Who will pay for this cost? The tax payers of the countries where the creditors are located. Should a country be overcharged with that burden, solidarity within the Eurozone would be called for. 

Why would the financial institutions - via the Steering Committee - be willing to agree to a rescheduling as described above? Because they have already recognized their losses through the write-downs and loan loss provisions. Thus, the rescheduling no longer affects the value at which they show these assets on their books. Also, governments are now their major shareholders and can determine the direction of the rescheduling.

Necessary collateral measures
1. The EU must gurantee all savings deposits and retirement plans until the dust has settled on this rescheduling.
2. The EU must permit capital controls, if necessary, in those countries which may be affected by capital flight.
3. The foreign debt of the banking sector of each country must also be integrated into the above rescheduling (above all: existing providers of trade credit must commit to keep their trade financing lines available). 

On a Friday evening, a 1-week bank holiday through the Eurozone is declared. All necessary legislation is implemented in the week following. 

Net effects/benefits for all concerned
Effect 1: no Euro-exit for any country.
Effect 2: the debt maturities of existing debt are taken care of via the above rescheduling. Risk takers remain risk carriers.
Effect 3: Fresh Money is required only for the financing of budget deficits (thus: much more manageable amounts).
Effect 4: it becomes justifiable for tax payers in surplus countries to underwrite the Fresh Money via guarantees because (a) the amounts involved are now manageable and (b) they serve a meaningful purpose.

1 comment:

  1. Jetzt verstehe ich Ihre Überlegungen etwas besser: Beim "Rescheduling" geht es wohl nur um zeitliche Verlängerung?

    Aber Fragen:

    1)Wie beschaffen sich die Länder (Griechenland!) unter solchen Bedingungen frische Kredite am Markt???

    2) Glauben Sie nicht, dass, wenn die Banken die Anleihen sowieso schon teilabschreiben mussten, der Anreiz für die Schuldnerländer sehr gering sein wird, die alten Anleihen auch wirklich voll zu bezahlen? Da wird prompt das Argument kommen: "Die Anleihen sind ja sowieso nicht mehr vollwertig".
    So jetzt schon bei Yanis Varoufakis, der es für eine Zumutung hält, wenn Griechenland der EZB volle Rückzahlung für mit Abschlag angekaufte Bonds leisten soll: "This new loan [from the EFSF] boosted Greece’s debt substantially but netted the ECB a profit of around 840 million (courtesy of the 20% discount at which the ECB had purchased these bonds)." -

    Sie sind gewiss ein kluger Mann, aber ich fürchte, Ihnen fehlt die kriminelle Phantasie, um die Listen unserer südländischen Bruderländer zu durchschauen! :-)