Friday, January 25, 2013

"Sudden stop", "FIFO", "pari passu" - and Cyprus

'Sudden stop' is the term which defines the sudden slowdown of voluntary capital flows to a borrower, be the borrower a company or country. In the case of Greece, this phenomenon occurred probably in the first quarter of 2010.

Actually, it is seldom a sudden stop because a sudden stop would imply that only new capital no longer flows voluntarily. In reality, a sudden stop very quickly transforms itself into a run on a borrower. It's like shooting a bullet straight up into the air. It climbs at enormous speed until it runs out of speed; then it comes to a halt in mid-air for a split second, only to fall back at high speed.

In consequence, one can endlessly philosophize about 'debt capacity' without being able to say what exactly a borrower's debt capacity is. Instead, one finds out what the debt capacity was after one has reached it because once it has become public knowledge that it has been reached, every creditor will try to get his money back.

Are banks or creditors in general bad people? Not necessarily. They are just attempting to always protect their own interests, which is their responsibility. The accounting equivalent of bankers' behavior is called the FIFO method (first-in, first-out). Every banker wants to be the first into the door when a good lending opportunity presents itself and every banker wants to be the first out the door, hopefully before the door closes, when problems surface.

'Pari passu' is the instrument which attempts to neutralize the downsides of the sudden stop and FIFO phenomena. As long as lenders know that, at the end of the day, they will be exactly in the same risk position as they were before the sudden stop, they won't try to play tricks like FIFO.

Which brings me to Cyprus. The lending countries (above all Germany) are voicing reservations about the Eurozone's bailing out Cyprus' banks because their research has told them that this would be tantamount to bailing out Russian oligarchs. This is a correct position and it should be held up, if --- if only the Eurozone had not violated the principle of pari passu from the beginning.

'Pari passu from the beginning' would have meant, to illustrate it with Greece as an example, that the official Greek rescue packages would not have been allocated to each country based on its share in ECB-owernship but, instead, based on its exposure to Greece. If Germany, for example, had held 40% of Greece's debt, then Germany would have carried 40% of the rescue packages (and not 27% as per its ECB-ownership). This was not done, leading to the unsatisfactory consequence that some countries now have an overproportional exposure to Greece whereas other countries (I suspect the UK, Switzerland and the US would be good examples) could walk away free of charge.

Applied to Cyprus, this would mean that if the existing Cyprus exposure were hald 50% by the Eurozone and 50% by Russia, then 50% of the rescue package would have to be carried by Russia.

'Would have'; 'should have' --- it's too late now because the wrong precendents have been set a long time ago. With Cyprus, the Eurozone is finding out what it can mean when one sets the wrong precedents.


  1. Applied to Cyprus, this would mean that if the existing Cyprus exposure were held 50% by the Eurozone and 50% by Russia, then 50% of the rescue package would have to be carried by Russian TAXPAYERS and 50% by Eurozone TAYPAYERS.

    The rescue packages might be paid back eventually, once inflation has devalued their worth to a fraction of face value. By which time the original Taxpayer-lenders will be dead and buried. And their children would have foregone the benefits they might have enjoyed; had their parents tax payments not been used to bailout yet another Club Med country that either never knew or has forgotten the meaning of THRIFT.

    This nonsense has to stop, let Cyprus default, let it exit the Euro, dust of the Young Plan and apply it to Cyprus. This would give the plan the chance that it never got in Germany. Then historians might be able to form a view as to whether or not the original might have worked in Germany, had the Crash of October 1929 never happened.

    A Young Plan for Cyprus would even have one of the same objectives as the original, blocking Russian expansion.


    1. I have to take issue with this comment. Accusing by implication the Cypriots of being lazy is propaganda. I agree that several population segments in Greece (and elsewhere in the south eg Sicily) were used to easy money, but generalizing is a pernicious lie. I do business both in Greece and Cyprus and the difference is striking. The Cypriots are efficient, punctual and the job gets done. The Cyprus state apparatus works, as opposed to the Greek one. They can be seriously devious and wily but that hardly makes them lazy.
      Thrift? As the English upper classes that have created most tax evasion tools in the world? Beneficial owners in companies for owners to hide, crown dependancies that the UK government "can do nothing about" with 0% tax,money in trust so no tax is paid, strange laws in the various islands around the UK allowing unstable mass media owners to live their baronetcy fantasies, the scandal of non-resident tax status and so on.Or the Dutch tax authorities that allow US companies to evade tax and have regulations that allow Swedish tycoons to pretend that their vast holdings are charity foundations. Or Delaware. Or....I guess the lower classes must be thrifty to subsidize the powers' that be tax evasion.
      Block the Russians? Why not block the British imperial delusions and kick the British bases out of Cyprus? Because of the treaties? Well they can make a treaty with the Russians. It is their right.Or do you believe that they must obtain British permission?
      From the name, command of English and the tone of the above comment I believe you are English. I have to say this: from LIBOR manipulation to Kenya brutality the English lost the right to lecture anybody. Grow up, the empire is gone and nobody cares. If my guess is wrong my apologies.
      Herr Kastner sorry for getting personal but some preaching is getting to me.

  2. Perhaps I should explain my reasoning in a bit more detail.

    The allocation of rescue packages to ‘countries’ (i. e. tax payers) in proportion to each country’s existing exposure is actually the second step. Regrettably, the EU jumped over the first step since the beginning.

    The first step would begin with individual creditors, the original ‘risk takers’. The principle is that risk takers must remain risk carriers.

    Suppose Deutsche Bank holds 5% of the total Greek debt at the determined cut-off date (which is typically set at a couple of months before the run started), then Deutsche’s share of whatever happens would be 5%; and so forth with other creditors. If a new loan is to be made to repay existing loans, then Deutsche would have 5% of that. If maturities are to be rescheduled in longer terms, then Deutsche would have 5% of whatever the new structure is. And if the First National Bank of Saigon were to hold 1% of the debt, then that bank, too, would take part in rescue loans with 1% even though Vietnam has nothing to do with the Eurozone.

    In short, pari passu means that no one can make the run for the exit door and no one can improve his position relative to others (pari passu also means a few other things, like equal collateral, etc., but that is not the issue here).

    Tax payers should come in at the very, very end. Existing creditors should handle the rescheduling of the existing debt between them. When there is a need for Fresh Money, existing creditors should, again, be put on the spot first. After all, it is in their interest to protect their existing assets. Only when existing creditors have really lived up to their responsibilities, would the time be ripe for tax payers to assume part of the burden. That’s when Germany’s share of the rescue package would be calculated on the basis of total German exposure to Greece.

    EU-elites, in their great wisdom, decided to have tax payers come first instead of last. That’s a precedent from which they will not get out of for a long time (forever is such a long time…).

    1. This is pretty good. IN actual fact this is how is should be done. But there is a number of pertinent questions:
      a) How do you enforce it? What happens if Deutsche Bank simply says no and does not pay up? Then it seems that we will end up with a political negotiation between the banks and the authorities. And when the elephants are fighting the grass (taxpayer) gets all the blows.
      b) Second how do you know the precise composition of Deutsche Bank's portfolio? What happens for example if Deutsche Bank has insured the Greek bond risk but holds no paper itself? More generally who is a creditor?The one that holds the risk or holds the paper or some strange combination of derivative paper?
      c) What happens if Deutsche Bank has sold all or most its Greek holdings between the cutoff point and the run point? Or the bank had substantial Greek debt for a few days around the cutoff point? Then the bank will have taken a loss(low prices appear before the run) and can claim that it suffered enough. In any case the bank is not a creditor any more. Then back to political negotiation.IN any case, after LIBOR and the UK gas market price quotation mess, can anybody trust these guys?
      I suggest that pari passu requires substantial changes in the way the markets work, the most basic one being that licensed financial institutions (banks,insurance companies, brokerages) must stop operating in OTC markets, so that rule enforcement and price quotation can be made completely independent of the participants. It is also necessary to use some pretty brutal regulation on bonuses to make sure that traders etc don't apply the take the money and run principle.

    2. 1 of 3

      Let me try to answer your questions.

      First, one has to understand that such a restructuring process is a very delicate process which builds on mutual contingencies among multiple parties where everyone says ‘I will do this, provided that others do that’. The key instrument is ‘persuasive coercion’; in plain English: blackmail. All parties know that they hold the nuke which they could let go off but they also know that no one wants the nuke to go off.

      The private creditors know that they can never impose measures on sovereign governments, that only official bodies like the IMF can do that. So their principal condition is that the IMF must be involved with some form of a base financing which allows the IMF to negotiate a memorandum which stipulates not only what the IMF but also what all the private creditors want. So the private creditors say ‘we will do this, provided the IMF comes in’ and the IMF says ‘we will only come in if private creditors agree to that’. At the same time, Greece as the borrower has to play both sides in parallel fashion.

      It begins with Greece’s inviting all its private creditors to a creditors’ meeting. The principal purpose of such a meeting is to have all creditors select a Steering Committee which has a mandate from the creditors and with which Greece can negotiate. Typically, that is a group of about a dozen players with an executive committee of perhaps 3 of them. The latter would typically be large global players who have a reputation to defend and who can’t pull fast ones like saying ‘you pay us back or else…’ (and if they still said that, they would feel enormous pressure coming down on them from official bodies like the IMF, Central Banks and also from politics. That answers your question about what would happen if Deutsche simply said ‘no’. Deutsche could not simply say ‘no’, believe me! And that’s why you want to have Deutsche in the executive committee because, that way, they have to persuade others to do something which they on their own would not do quite voluntarily).

      The Steering Committee creditors are typically not the 12 largest creditors. Instead, the Steering Committee is usually balanced in such a way that every creditor group finds a representation of its interests. For example: if there were only a few American banks involved but with a relatively large exposure in sum, they would likely want to have a representation. Hedge funds might want one. Insurance companies, etc. etc. Again, it has to be a balanced representation of hopefully all creditors’ interests.

      Suppose the Steering Committee has its first meeting in March and they see that everything was more or less ok until December of the previous year but beginning in January, the run on Greece had started and private creditors had pulled massive funds out of Greece since then. They would likely agree to set the ‘rescheduling date’ as December 31, and they would approach, in the name of the Steering Committee, all the creditors which had mandated them to report their exposures as per December 31. The Steering Committee reconciles these numbers with the numbers on record at the Central Bank of Greece (or the Ministry of Finance). That can be a very tedious process where everyone tries to ‘bend numbers’ to his favor but eventually one agrees on a total exposure break-down per December 31. That total exposure becomes the 100% and every creditor’s share thereof is calculated. If one has already pulled out money since January, he has to replenish. If one refuses to do so, all the others will fall all over him.

    3. 2 of 3

      Now, there will always be players who play hard ball and refuse to go along. Typically, they will be players who feel that they are not vulnerable to any pressure being enforced against them; that they have nothing at stake. Perhaps a hedge fund. Perhaps a family office in Switzerland. Perhaps the First National Bank of Saigon. If such players have the nerve to carry through their hard ball, they might get away with it if the total sum is not too large (i. e. the remaining creditors will decide to pay them out just to get them off their backs). Whether or not they will have to pay a price for that, they will find out in the future. Vietnam might see that the exports to Greece which the First National Bank of Saigon had financed come to a halt, and the customers of that First National Bank might not be too happy about that…

      What happens if Deutsche has insured its Greek exposure? That would be a tough one because in all likelihood they would risk losing that insurance if they voluntarily agree to a rescheduling (the insurance pays only in case of default). I don’t know how that problem would be solved because, in my time, there were no CDS’. My sense is that Deutsche would have to negotiate something with their insurers but under no circumstances could Deutsche afford to walk away from the rescheduling. A guarantee is always a risky thing because circumstances might happen where the guarantor has a right not to honor his guarantee. Deutsche knows that because there were a lot of guarantees which they had issued (back-up lines for commercial paper) which they had not honored after Lehman.

      Greece would then make a proposal to the Steering Committee. Greece would have excellent advisors who know exactly what the paramaters for a ‘reasonable proposal’ are. Typically, the paramaters would be a very significant stretching of the debt service period, i. e. rescheduling maturities way into the future; an interest rate structure which provides relief in the short term; etc. etc.

      When it comes to Fresh Money, the creditors could play tough and say ‘we have already done more than could have been expected from us; the Fresh Money has to be taken care of by official creditors (IMF, EU, etc.)’. They would likely get away with that, but not necessarily.

    4. 3 of 3

      The whole process only works if the official bodies and politicians do what they actually get paid for: exercise every pressure and leverage they have to make sure that private creditors live up to their responsibilities. As soon as official bodies show a weakness (like saying ‘we will defend the Euro at all cost!’ Or like showing concern that a Deutsche could fail), then they have lost. What they have to signal Greece is that ‘if you don’t play ball, you will go bankrupt’ and what they have to signal to private creditors is that ‘if you don’t play ball, you will regret it’. Basically, the official bodies have to argue like the Godfather…

      Everyone needs to save face in the process. Greece must be able to say to it electorate that it got very reasonable terms from its creditors. The creditors should be able to say to their shareholders that they did not forgive Greece ‘one cent of debt or interest’. And the official bodies must be able to say that they fulfilled their responsibilities admirably.

      If the creditors refinance all existing debt with a new 30-year bond, Greece has de facto a grace period of 30 years on principal. If the creditors charge a fair market interest rate but capitalize interest for the first 10 years, Greece has de facto an interest moratorium for 10 years. But no one has forgiven anything. You understand?

      The sad point for Greece is that, however flexible the creditors are, it won’t be able to avoid a memorandum with the IMF (or Troika) whichever way you slice it. The terms might be a bit more favorable if the entire restructuring process is managed very smoothly (sort of as a reward for that) but they will still be painful. Not because of Greece but because that’s how the IMF has played this game for ages.

    5. theAthensdog left the below comment which I had erroneously deleted.

      “Very good. I suggest you give seminars with the title: How the world really works. Not only to Greeks, but to others as well. Somebody may disagree with several details but the basic thrust is indisputably correct. However, one last question:the whole process requires an overall political policeman. This is obvious especially in the third part, where you mention political failure. Until about 1990 the boss was the US, helped by the fear of the Cold War turning hot. Now there seems to be no overall political boss to enforce some discipline. Hence my suggestion about Deutsche saying no:if the German government is, for some reason, weak a no may be forthcoming and only the German government can control them. Postwar the US government was so powerful that even a weak one (like say Nixon near the end) could enforce discipline. Now? Is this lack of a political overlord connected with this peculiar admission of error in Greece by the IMF? Any ideas are welcomed.”

      And here is my response.

      Actually, there already exists that ‘policeman’ whom you desire – it’s the IMF. The IMF has no cozy relationships with banks and they are in a position to interfere with cozy relationships between national banks and their governments. The IMF is supranational and somewhat anonymous, so when ‘austerity victims’ get mad, they get mad at something supranational and/or anonymous (instead of, say, the Germans).

      Greece should have gone to the IMF from the start (which, I believe, is what Mr. Papandreou had wanted to do but then he allowed himself to be bullied out of it by his friends in Paris and Berlin). The IMF would have, behind the scenes, quarterbacked the kind of private creditor negotiation which I described above.

      Now suppose that the IMF, together with Central Banks, Banking Supervisory Authorities and whoever else represents official bodies, would have come to the conclusion that, in the interest of balance sheet transparency, all private creditors would have to make loan loss provision of 50% (or even 75%) of their Greek exposure. A loan loss provision is not a debt forgiveness; it only adjusts the internal book value of the loans through a charge against the P+L statement. That would have driven a lot of banks into deep trouble (and most banks if, after Greece, they had done the same for Portugal, Spain, Italy, etc.).

      That would have led to a situation where Deutsche & Co., instead of arrogantly telling governments that it is their duty to pay 100% value on Greek loans, well, Deutsche would have had to walk, with hat in hand, over to the government and request very politely a bail-out. The government would happily have obliged but only for its pound of flesh. The latter being equity. Perhaps the amount which tax payers would have had to come up with would have been similar to the amounts wasted in rescue loans but now tax payers would have gotten something in exchange – equity in those banks which they bailed out. And when the government later exited from those banks by selling their equity, they might even have made a profit just like the US tax payers made a profit on bailing-out AIG.