The Setting Sun – Japan’s Coming Debt Crisis

Japan’s Nikkei 225 stock average rose by around 23% in 2012 and has continued to rise in early 2013. Much of the increase was since the announcement of the election in late 2012, when the index rose by around 20%, outperforming 92 of 94 equity benchmarks around the world. Foreigners increased holding of Japanese equities by a net US$21 billion in the six weeks before Christmas.

The increase reflects faith in the reflation strategy of second time Prime Minster Shinzo Abe to increase growth through an additional US$120 billion of public spending and create inflation to reduce the debt to GDP ratio.

In the post war period, Japan enjoyed decades of strong economic growth – around 9.5% per annum between 1955 and 1970 and around 3.8% per annum between1971 and 1990. Since the collapse of the Japanese debt bubble in 1990, Japanese growth has been sluggish, averaging around 0.8% per annum. Nominal gross domestic product (“GDP”) has been largely stagnant since 1992. Japan’s economy operates far below capacity, with the difference between actual and potential GDP being 5- 7%.

The Japanese stock market is around 70-80% below its highs at the end of 1989. The Nikkei Index fell from its peak of 38,957.44 at the end of 1989 to a low of 7,607.88 in 2003. It now trades around 8,000-12,000. Japanese real estate prices are at the same levels as 1981. Short term interest rates are around zero, under the Bank of Japan’s (“BoJ”) Zero Interest Rate (“ZIRP”). 10 year Japanese government bonds yield around 1.00% per annum.

Since 1990, public finances have deteriorated significantly. Government spending to stimulate economic activity has outstripped tax revenues, resulting in a sharp increase in government debt. Japan’s total tax revenue is at a 24 year low. Corporate tax receipts have fallen to 50 year lows. Japan spends more than 200 Yen for every 100 Yen of tax revenue received.

Japanese government gross debt is now around 240% of GDP. Net debt (which excludes debt held by the government itself for monetary, pension and other reasons) is about 135%. Total gross debt (government, non financial corporation and consumer) is over 450% of GDP.

Japan’s large pool of savings, low interest rates and a large current account surplus has allowed the build-up of this large government debt.

Japan has a large pool of savings globally, estimated at around US$19 trillion. In recent years, household savings were complemented by strong corporate savings, around 8% of GDP. Around 90% of all Japanese Government Bonds (“JGBs”) are held domestically. Low interest rates make servicing the high levels of debt manageable.

If Japan continues to run large budget deficits, as is likely, then the falling saving rate and reversal in its current account will make it more difficult for the government to borrow, at least at current low rates.

Japanese household savings rates have declined from between 15% and 25% in the 1980s and 1990s to under 3%, reflecting decreasing income and the aging population. As more Japanese retire, inflows into JGBs will decrease making domestic funding of the deficit more difficult. Insurance companies and pension funds are increasingly selling their holdings or reducing purchases to fund the increase in payouts to people eligible for retirement benefits.

Since 2007, the Japanese trade account surplus has fallen sharply, turning into a deficit in 2012 due to an appreciating Yen, slower global growth and higher cost of energy imports. But Japan’s large portfolio of foreign assets (US$4 trillion, including US Treasury bonds of US$1 trillion) will cushion the effects for a time. But even if net income from foreign assets stays constant, Japan’s overall current account may move into deficit as soon as 2015.

As the drawdown on financial assets to finance retirement accelerates, Japan will initially run down its overseas investments, losing its net foreign asset position. Unless public finances improve, Japan ultimately will be forced to finance its budget deficit by borrowing overseas. Where the marginal buyers of JGBs are foreign investors rather than domestic Japanese investors, interest rates may increase, perhaps significantly.

Even at current low interest rates, Japan spends around 25-30% of its tax revenues on interest payments. At borrowing costs of 2.50% to 3.50% per annum, two to three times current rates, Japan’s interest payments will be an unsustainable proportion of tax receipts.

Higher borrowing costs will also trigger problems for Japanese banks, Japanese pension funds and insurance companies, which also have large holdings of JGBs.

To avoid the identified chain of events, Japan must address the core problems. Reductions in the budget deficit are difficult. Spending on social security accounts and interest expense now totals a major part of government spending. An aging population and shrinking workforce will continue to drive slower growth and lower tax revenues. Tax increases are politically unpopular. Reductions in the budget deficit are likely to reduce already weak economic activity, compounding the problems.

Japanese policy makers can maintain its zero rate policy and monetise debt to finance the government. Japan can try to inflate away their debt. But ultimately, Japan may have no option other than a de facto domestic default or restructuring to reduce its debt levels.

Investors and traders have repeatedly bet on a Japanese crisis, usually by short selling JGBs to benefit from higher rates. But the bet has failed each time, giving the strategy its name – the widow maker.

Economist Rudiger Dornbush once observed: “The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought”. Japan’s toxic combination of weak economic performance, large budget deficits, high and increasing levels of government debt, declining household savings and looming current account deficits is increasingly unsustainable.

© 2013 Satyajit Das

Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money

Greece Lives To Default Another Day!

Following protracted negotiations, the Greek government has agreed on a new Greek austerity package. The bond exchange is likely to proceed with bond holders’ suffering losses of over 70-75%.

The Troika – the European Union (“EU”), European Central Bank (“ECB”), the International Monetary Fund (“IMF”) - needs to reduce the level of Greek debt to a “sustainable” 120% of gross domestic product (“GDP”) by 2020. The bond deal and the latest budget cuts are designed to achieve this paving the way for a second financing package for Greece to enabling Greece to repay a Euro 14.5 billion bond on 20 March 2012. Deterioration in Greece’s finances required the bigger writedowns and greater budget cuts.

But even the greater austerity and larger losses to lenders will probably leave Greek debt above the target level, requiring delicate financial engineering to at least cosmetically reach the target. In the end, even with a dollop of wishful thinking and economic gymnastics, the projected debt figure came in at 120.5% in 2020.

The 120% level is largely meaningless, being a political construct designed to avoid drawing unwelcome attention to Italy whose debt levels are around this level.

There is no certainty that the agreement reached can be implemented. The IIF represents around 50% of banks and investors. The deeper losses will increase resistance to the deal, especially from hedge funds who may prefer to take their chances in a default.

One option is to unilaterally insert collective action clauses (“CACs”) into existing bond contracts, allowing a supermajority of lenders to bind the minority. A complicating factor is the ECB’s refusal to take losses. With direct holdings of Greek bonds of Euro 40 billion as well as additional loans to banks secured over Greek bonds, the ECB’s capital of Euro 5 billion (scheduled to increase to Euro 10 billion) is insufficient to absorb losses. As the CAC would force the ECB to share in losses, a special arrangement will exempt them from the effects of any CAC to the further detriment of already resistant private lenders.

Any agreement is also likely to face legal challenges from lenders, which would complicate proceedings.

Another complication is the extremely tight timetable that must be followed to ensure the arrangements are implemented in time. Greece must undertake certain actions to qualify for the funding. Parliaments in Euro-Zone members must approve the package. The European Financial Stability Facility (“EFSF”), the current main European bailout facility, must raise around Euro 70 billion to finance the bond exchange. Of course, the EFSF is guaranteed around 30% by Spain and Italy! There is little margin for error.

This agreement is unlikely to be the definitive resolution everyone seeks. Greece has consistently failed to meet economic forecasts.

Despite measures by the Greek government, debt continues to increase. According to the EU statistics office, Greece's debt reached 159.1% of GDP in the third quarter of 2011, up from 138.8% a year earlier and 154.7% in the previous quarter.

Greece may get through the March 2012 maturity but the arbitrary 120% debt to GDP ratio, the best case under the plan, is unsustainable, even in the unlikely case that it is met. The Greek economy, which has been in recession for years, shrank by 7% in later part of 2011. Budget revenues for January 2012 fell 7% from the same time last year, a fall of Euro 1 billion. This compares to a budget target for an 8.9% annual increase. Value-added tax receipts decreased by 18.7% in the same period compared to January 2011.

Greece’s financial position will deteriorate and it will miss key milestones – debt levels, budget deficits, asset sales and structural reforms.

In the end, Greece may live to default another day. History suggests that a write-down of debt for distressed borrowers is frequently followed by others.

With Greece increasingly doomed, the real significance of the negotiations is that they provide a template for future European sovereign restructurings. No one buys the oft-stated European leaders’ position that Greece’s position is unique or exceptional. Portugal is first in the line of fire, with the Irish, Spanish and Italians watching anxiously.

© 2012 Satyajit Das All Rights reserved.

Satyajit Das is the author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011)

Europe's Seemingly Inevitable Slide Towards Financial Disaster

At best, European plans to resolve the continent’s debt crisis have been to provide funds to tide over the immediate funding problems of weaker Euro-zone members. It does little to deal with the euro-zone’s structural problems. There is still the risk that Europe enters a prolonged period of low growth or recession. There has been no attempt to address the economic divergences that exist within the Euro-zone or ease the painful adjustment processes that weaker members will still have to undergo within the constraints of the single currency.

A crucial element of the plan is the ability of Spain and Italy to take action to improve their finances and maintain access to funding at reasonable cost. The EU communique specifically refers to the need for actions by these two members at some length. There is considerable doubt as to whether this will occur.

Spain’s economy is weak, with low growth, low productivity and high reliance on debt. As the country has sought to bring its finances under control, Spain’s growth has slowed with an increase in the unemployment rate to 21% and youth unemployment above 40%. Spain’s banking sector remains heavily heavily exposed to the real estate with the likelihood of further losses. It is difficult to see Italy, weakened by internal political strife, making rapid progress to making required structural changes to its economy and cutting public debt.

The austerity and balanced budget measures, reinforced and reiterated in the plan, cannot deal with the primary problem - the deflation of the debt-fuelled bubble. Strict enforcement of limits on deficits and level of debt would prevent counter cyclical spending by Governments undermining economic recovery and lock the Euro-zone into a death spiral of budget deficits, further budget cuts and low growth.

The problem is compounded by the competitiveness gap between Northern and Southern countries, estimated at 30% difference in costs. For many of the weaker countries, the best option would be to devalue its currency in the same way that the US and Britain are debasing dollars and sterling respectively. The EU’s refusal to contemplate a break-up or restructuring of the Euro makes dealing with this problem difficult.

Unable to devalue or control interest rates, these weaker countries are trapped in a vicious and ultimately self-defeating cycle of cost reduction.

An additional problem is the internal imbalances exemplified by Germany’s large intra-Euro-Zone trade surplus at the expense of deficit states, especially the Club Med countries like Greece, Portugal, Spain and Italy. German reluctance to boosting spending and imports makes any chance of resolving the crisis even more remote.

German banks lent money to many countries to finance exports, which benefited Germany. Germany also gained export competitiveness from a weaker. Reluctance to confront these problems makes a comprehensive resolution of the crisis difficult.

The latest plan has bought time, though far less than generally assumed. The European debt endgame remains the same: fiscal union (greater integration of finances where Germany and the stronger economies subsidise the weaker economies); debt monetisation (the ECB prints money); or sovereign defaults.

The key element of the 27 October Plan was the unwillingness or inability of Germany and France to increase the size of their commitments. Germany is increasingly unwilling to increase its commitments. It is restricted by the German Constitutional Court’s decision, which makes it difficult to increase support for bailouts without a new constitution.

For the moment, Germany cannot or will not go above Euro 211 billion in guarantees for the bailout funds already committed –about 7% of its GDP. Fiscal integration would have a higher cost than Germany is willing to pay or can sustain without affecting the country’s creditworthiness. France is at the limit of its financial capacity. France’s GDP is around US$2 trillion and its debt to GDP around 82%. Following the assumption of the liabilities of the failed Franco-Belgium financier Dexia, the rating agencies have indicated that France faces a rating downgrade.

Netherlands, Finland and Luxembourg are too small to make much difference. Fragile coalition governments in Netherlands and Finland are increasingly reluctant to increase its commitments to the bailout process.

The ECB is not allowed and seemingly unwilling to print money. Theoretically, it would need a change in European Treaties although the ECB has stretched its operational limits. Germany’s Bundesbank opposes debt monetisation. There would be deep-seated unease about printing money in Germany, which is still haunted by the memory of hyperinflation in the Weimar period.

The accepted view is that, in the final analysis, Germany will embrace fiscal integration or allow printing money. This assumes that a cost-benefit analysis indicate that this would be less costly than a disorderly break-up of the Euro-zone and an integrated European monetary system. This ignores a deep-seated German mistrust of modern finance as well as a strong belief in a hard currency and stable money. Based on their own history, Germans believe that this is essential to economic and social stability. It would be unsurprising to see Germany refuse the type of monetary accommodation and open-ended commitment necessary to resolve the crisis by either fiscal union or debt monetisation.

Unless restructuring of the Euro, fiscal union or debt monetisation can be considered, sovereign defaults may be the only option available.

© 2011 Satyajit Das All Rights Reserved. Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (November 2011)

Europe's Plan to Have A Plan to Have A Plan etc

The most recent EU plan was too little, too late and involves too much wishful thinking. Even if the plan could be implemented then there’s no reason to believe that it would work. This summit will not be the last and the prospects for a resolution remain slim, with Italy and Spain and increasingly France and other stronger core countries looking increasingly vulnerable.

Countries like Greece need to restructure its debt to reduce the amount owed – an euphemism for default. Banks suffering large losses as a result of these debt write-downs need to be stabilised by injecting new capital and ensuring access to funding to avoid insolvency. A firewall needs to be erected to quarantine Spain and Italy as well as, increasingly, Belgium, France and Germany from the further spread of the debt crisis. Steps must be taken to return Europe to sustainable growth as soon as possible.

On 27 October 2011, banks and investors holding Greek bonds, agreed to a 50% haircut. At best, the reduction of Euro 100 billion is less than 30% of outstanding debt, as only private investors were covered. A leaked assessment by the “Troika” (The European Union (“EU”), ECB and International Monetary Fund (“IMF”)) indicated that a 50% haircut reduces debt to 120% of GDP and funding requirements to Euro 114 billion through 2020. While the write-downs were needed, it is unclear whether the quantum is sufficient and whether Greece’s residual debt burden is sustainable.

The EU, to date, has carefully confined discussions about debt restructuring to Greece. The attention of financial markets will inevitably turn to Ireland and Portugal. The Greek write-downs may create speculation for Ireland and Portugal to follow suit, especially if economic condition deteriorate.

The EU plans calls for Euro 106 billion in recapitalisation of European banks, primarily to cover losses on holdings of sovereign debt such as Greece, by June 2012. The amount is at the low end of what is required. The amount of recapitalisation focuses on losses from holding of Greek bonds. Taking into account possible losses on Irish, Portuguese, Spanish and Italians bonds, the required recapitalisation is around Euro 200-250 billion. The write-offs, covering the cost of recapitalisation and the general de-leveraging (reduction in debt) is likely to reduce economic growth resulting in increasing credit losses that must also be covered.

It is not clear where the additional capital is coming from. Banks must try to raise the capital privately through equity raising or restructuring and conversion of existing instruments into equity. Banks should also reduce dividends and bonus payments to improve their capital position. If this is insufficient or unsuccessful, national governments are required to provide support. Recapitalisation funded via a loan from the European Financial Stability Fund (“EFSF”), the European bailout fund, is the last resort.

An enhanced EFSF is the cornerstone of efforts to quarantine Spain and Italy as well as, increasingly, Belgium, France and Germany from the further spread of the debt crisis. The EFSF will provide loans to or purchase bonds in order to support market access for Euro-Zone Member States faced with market pressures and to ensure that their cost of borrowing does not rise to levels that threatens solvency.

With available resources of only around Euro 250 billion, the EFSF does not have adequate resources to perform its functions. The amount available can be compared to the financing requirements of beleaguered European countries. Over the next 3 years, Spain and Italy will need to find around Euro 1 trillion to meet their financing requirements. After accounting for existing commitments to Greece, Ireland and Portugal, the fund’s available capacity is around Euro 200-250 billion.

In order to enhance the capacity of the EFSF, the EU proposes to leverage the fund. In the absence of details, it is widely assumed that this will entail the EFSF guaranteeing against losses on bond holdings, up to an unconfirmed amount of around 20%. It is unlikely that the insurance scheme will achieve its intended objectives to support market access for and the lowering of borrowing costs of countries like Spain and Italy.

A second option proposed is to enhance the EFSF using resources from private and public financial institutions and investors through Special Purpose Vehicles (“SPV”).

The idea seems to be to raise money from emerging nations with large foreign exchange reserves, such as China, or sovereign wealth funds. Support for the idea amongst potential investors is uncertain. The Chinese position to date has been that Europe must get its house in order first and then China will assist. The current European position is different – China must give money to Europe to get its house in order.

China has considerable “skin in this game”. Europe is China’s biggest trading partner. China has around US$800-1,000 billion invested in Euros and European government bonds. Continuation of the European debt problems will have serious effects on China’s economy and its investments. It is not clear that the EU proposal has sufficient chances of success to encourage China increasing its exposure to Europe, especially as relatively wealthy European countries, like Germany and France, are unwilling to put up more money and are seeking to limit their exposure.

More worryingly the EFSF’s attempts to raise money to meet existing commitments has run into problems, meeting lack lustre support and a sharp increase in costs. Increasingly, the EFSF looks irrelevant.

Time will determine whether the plan creates “confidence” or is just a “con”. But the early signs are not promising.

© 2011 Satyajit Das All Rights Reserved.

Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (November 2011)

Euro-Zone’s Leveraged Solution to Leverage

If as Albert Einstein observed insanity is “doing the same thing over and over again and expecting different results”, then the latest proposals for resolving the Euro-zone debt crisis requires psychiatric rather than financial assessment.

The sketchy plan entails Greece restructuring its debt with writedowns around 50% and recapitalisation of the affected banks. The European Financial Stability Funds (“EFSF”) would increase its size to a proposed Euro 2-3 billion from its current Euro 440 billion. This would enable the fund to inject capital into banks and also support Spain and Italy’s financing needs to reduce further contagion risks.

On proposal under consideration entails the EFSF using leverage to increase its size and enhance its ability to intervene effectively. Attributed to US Treasury Secretary Tim Geithner, the proposal is similar to the 2007 Master Liquidity Enhancement Conduit (“MLEC”) super conduit which was ultimately abandoned.

The EFSF would apparently bear the first 20% of losses on sovereign bonds and perhaps its investment in banks. This resembles the equity tranche in a CDO (Collateralised Debt Obligations), which assumes the risk of the initial losses on loans or bond portfolios. Assuming the EFSF contributes Euro 400 billion, the total bailout resources would be around Euro 2,000 billion. Higher leverage, a lower first loss piece, say 10%, would increase available funds to Euro 4 trillion. The European Central Bank (“ECB”) would supply the “protected” debt component to leverage the EFSF’s contribution, bearing losses only above the first loss piece size.

The proposal has a number of problems.

The EFSF does not have Euro 440 billion. After existing commitments to Greece, Ireland and Portugal, its theoretical resources are at best around Euro 250 billion, assuming that the increase to Euro 440 billion is ratified by European parliaments.

The EFSF must borrow money from the markets, relying on its own CDO like structure, backed by a cash first loss cushion and guarantees from Euro-zone countries. In fact, some investors actually value and analyse EFSF bonds as a type of highly rated CDO security known as a super senior tranche. This means that the new arrangement has features of a CDO of a CDO (CDO2), a highly leveraged security which proved toxic in 2007/ 2008.

The ECB, the provider of protected debt, has capital of about Euro 5 billion (to be raised to Euro 10 billion), supporting around Euro 140 billion in bonds issued by beleaguered Euro-zone nations, purchased as part of market operations to reduce their borrowing cost. The ECB has also lent substantial sums (market estimates suggest more than Euro 400 billion) to European banks without access to money markets at acceptable cost, secured over similar bonds. While the Euro-zone central banking system has capital of around Euro 80 billion that could be available to support the ECB’s operations, this adds to the incremental leverage of the arrangements.

The 20% first loss position may be too low. Unlike typical diversified CDO portfolios, the highly concentrated nature of the underlying investments (distressed sovereign debt and equity in distressed banks exposed to the very same sovereigns) and the high default correlation (reflecting the interrelated nature of the exposures) means potential losses could be much higher. Actual losses in sovereign debt restructuring are also variable and could be as high as 75% of the face value of bonds.

The circular nature of the scheme is surreal. Highly leveraged vehicles, in part backed by weakened nations like Spain and Italy, are to undertake the “rescue” of the same countries and their banks. Levering the EFSF merely highlights circularity in the entire European strategy of bailouts, drawing attention to the correlated default risks between the guarantor pool and the asset portfolio of the bailout fund. This is akin to an entity selling insurance against its own default. This only works if all commitments are fully backed by real cash and savings, which of course nobody actually has, requiring resort to familiar “confidence tricks”.

The proposal assumes that it will not need to be used, avoiding exposing its technical shortcomings. The EFSF too was never meant to be used, relying on the “shock and awe” of the proposal, especially its size and government backing, to resolve the crisis.

The proposal is driven, in reality, by political imperatives - avoiding seeking national parliamentary approval at a time when sentiment is against further bailouts and lack of support for an increase in the size and scope of the EFSF.

It is also designed to reduce the increasing risk to the credit ratings of France and Germany. This last factor is increasingly important given concerns raised by rating agencies about the quantum of contingent liabilities being assumed by these countries. For example, after the increase in the size of the EFSF to Euro 440 billion, Germany’s commitment to the EFSF is over Euro 200 billion.

The scheme may also facilitate the ECB covertly monetising debt, “printing money”; to generate the protected debt to leverage the structure and also to cover the losses on its own exposures to distressed sovereign debt. It is simply another means of allowing the imply another way of requesting that the ECB to expands its balance sheet to absorb increased credit risk.

It now looks like the proposal to leverage the EFSF via the ECB are unlikely to be pursued - but as this is Europe nothing should be discounted. Instead, different forms of leverage are under consideration - EFSF to enter into credit default swaps to protect holders of bonds issued by weak European sovereign borrowers; EFSF to guarantee the first 10% or 20% or 40% of losses to bondholders; EFSF to act as bond re-insurer.

Unfortunately, all these new schemes like previous proposals are unlikely to succeed. The unpalatable fact remains that Europe may not have the capacity to rescue everybody that now seems to need rescuing without imperilling the financial health and ratings of stronger countries such as France and Germany.

As Sigmund Freud’s observed: “Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.”

© Satyajit Das 2011

Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011)

A shorter version of this article was first published in the Financial Times

Nowhere to Run, Nowhere to Hide

The crisis threatening to engulf world financial markets has been brewing since 2008. Until recently, markets were Dancing in the Streets. Increasingly, another Holland-Dozier-Holland standard also made famous by Martha and the Vandellas is relevant: “Nowhere to run to, baby/ Nowhere to hide.”

The recovery from the first phase of the crisis was based on “botox economics”. Clostridium botulinum – “botox”- is commonly used to improve a person’s appearance, but its effects are temporary with toxic side effects. “Financial botox”, money from central banks and governments to prop up demand, temporarily covered up deep-seated problems, rather than resolving the real issues. As chastened individuals and companies reduced debt, governments increased their borrowing to limit the effects of the crisis on the broader economy.

The new phase of the crisis is different to 2008 and the “Lehman moment”. Then, governments had the financial capacity to backstop the private sector, especially affected financial institutions, and support the wider economy.

The crisis now involves entire nations and the ability of sovereigns to finance themselves is in question. Ultimately, there is no one to backstop the governments themselves. Contagion from sovereign debt crisis is especially pernicious and very different to that of 2008.

Europe’s debt problems provide an insight into the problem. While smaller nations can be bailed out by other stronger nations, the financial commitment required weaken the saviours and threatens their own survival. Saving Greece, Ireland, Portugal, Spain and Italy would probably require a facility of at least Euro 3.0 trillion with an effective lending capacity of around Euro 2 trillion dictated by the fact that maximum lending capacity is limited by the guarantee commitments of AAA rated countries.

As more countries need support, the burden of the guarantees becomes concentrated on stronger Euro-zone members - German, France and the Netherlands. In effect, the creditor nations rapidly become debtors themselves, ultimately affecting their credit ratings, cost of funds and causing financial problems if the contingent liabilities are triggered.

International Monetary Fund (“IMF”) support may spread the potential contagion to other countries. In effect, rather then containing risk, support for weaker nations spreads the crisis to the stronger countries.

Government bonds are traditionally safe-havens as well as the preferred form of collateral used very widely to secure borrowing and other obligations. If the quality of stronger government issuers were to be contaminated, then this would lead to far reaching effects on financial activities.

Most banks have substantial holdings of government bonds, which have increased since 2008 as they have increased levels of liquidity. Any fall in the value of these holdings would affect the solvency of the affected banks.

For some European banks, lack of access to commercial funding has forced reliance on money from their central banks and the European Central Bank (“ECB”), generally against government bond collateral. Credit rating downgrades or fall in the value of government bonds would create liquidity problems, as banks are unable to finance themselves. If the banks need government support, then this further weakens the government. If individual national governments require external support, then this weakens the ultimate guarantors.

Falls in the value of government bonds or a loss of confidence in their value as surety would lead initially to a global “margin call”, as the value of the collateral is marked down setting off a “dash for cash”. In an extreme case, where governments bonds are not accepted as collateral, it would lead to a contraction of liquidity and financial activity generally.

Central banks, sovereign wealth funds, pension funds and insurers have significant investment in government bonds. A significant proportion of China’s substantial foreign exchange reserves (over $3 trillion) are invested in US and European government bonds. A loss in value in these holdings would reduce China’s wealth and financial flexibility, ultimately affecting its economic performance.

In reality, the crisis has returned to its starting point –debt levels and the reliance of the global economy on borrowing to fuel growth. The level of debt depends on the value of the assets or investment that supports it and the income or cash flows available to service the interest and principal. Many nations have debt that is above the level that can be sustained in a lower growth world – the “new normal”.

The new crisis is part of the de-leveraging with governments now joining individuals and companies in being forced to reduce levels of debt. But if not managed properly, sovereign debt problems may escalate rapidly with the risk of a major disruption in financial markets.

In his pamphlet Gravity – Our Enemy Number One, investment analyst Roger Babson, who anticipated the 1929 stock market crash, argued that gravity was an evil force. In the credit boom, prices rose, defying gravity. At the commencement of the crisis, governments flooded the system with money to the keep the game going for a little longer. Now, financial gravity is reasserting its malevolent power.

An earlier version was published in the Financial Times

Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (published in August/ September 2011)

French Connections - The Greek Bond Exchange

The proposal in July 2011 for the extension of the maturity of Greek bonds emanating from the Élysée Palace reflects French strengths first identified by Napoleon III: “We do not make reforms in France; we make revolution.”

Structured to meet a German requirement that private creditors contribute to the Greek bailout, the proposal falls short of what is actually required. After initial rejection, the proposal miraculously re-appeared in the European Union's "Grand Plan" to resolve the debt problems of some Euro-zone countries. The analysis below shows that neither the original plan nor its cousin now being contemplated are likely to be viable.

Under the original sketchy proposal, for every Euro 100 of maturing bonds, the banks will subscribe to new 30 year securities, but only equal to Euro 70 (70%). Of the Euro 70, the banks, in turn, will only give Greece Euro 50 (50%) and invest the other Euro 20 (20%) in 30 year high quality zero coupon bonds (via a special purpose vehicle) to secure repayment of the new bonds. The new 30 year Greek debt will carry an interest rate of 5.5% per annum with a bonus element linked to Greek growth of up to an additional 2.5% per annum.

Of the Euro 340 billion in outstanding Greek bonds, banks hold 27%, institutional and retail investors hold 43% and the International Monetary Fund (“IMF”) and the European Central Bank (“ECB”) hold 30%. It is not clear whether non-bank investors are willing to participate in the arrangements.

As not all Greek debt trades at the same price in the secondary market, if all bonds maturing are not rolled over, then banks could arbitrage the offer exchanging bonds trading at a deep discount, holding on to those trading at better prices.

The Euro 20 invested in high quality collateral will need to earn around 4.26% per annum to accrete in value to Euro 70 to cover the principal of the new 30 year bonds. German 30 year bunds currently yield around 3.75% per annum, less than the required rate. Other AAA rated bonds, such as the European Financial Stability Fund (“EFSF”) bonds, might be used to provide the extra return. Given that the EFSF is backed by guarantees from countries with questionable long-term credit quality, the security afforded by such a guarantee is unproven.

Greece must find Euro 50 for every Euro 100 debt exchanged under the proposal. Given it has no access to commercial funding, this would have to come from the EU, IMF, EFSF or ECB.

Greece’s cost would be between 7.7% and 11.20% per annum, as it only receives Euro 50 of the Euro 70 face value of the new bonds. Assuming the remaining funding is at 6%, then Greece’s blended rate for every Euro 100 of finance would 6.85-8.60% per annum, compared to the 7-8% per annum considered sustainable by markets. The new EU proposal does at least address this and lowers the cost to the bailout receipients.

Most importantly, the overall level of debt, considered unsustainable, of Greece would remain unchanged.

Almost all of the issues identified are present, to different degrees, in the latest version of the debt exchange now being contemplated.

The exchange scheme seems designed primarily to allow banks to avoid or minimise recognising losses on holdings of Greek bond. Even if the principal of the 30 year bonds is “risk free”, the interest on the bonds remains dependent on Greece’s ability to pay. Valued at a rate of 12 % per annum for 30 year Greek risk (a not unreasonable estimate), this would mean that the new bonds are only worth around 64% of face value, equivalent to a mark-to-market loss of around 36%. The new proposals sugegst a lower of loss of 21%. It is not clear if the authorities will require the true loss to be recognised.

Other proposed alternatives -an exchange of maturing bonds for new longer dated bonds- is even worse as it defers the problem for an even shorter period of time.

Thankfully, the proposed tax on all banks to raise Euro 30 billion over 3 years to provide the pretence of private participation has been abandonded for now. Why banks which have no exposure to Greece should bear the cost is not clear? How this helps Greece is also far from obvious?

A more logical solution would be either a full debt restructuring where Greek, Irish and Potuguese debt is written down by 25-50%, acknowledging the reality that the current debt burden is simple unsustainable. Alternatively, Greece can repurchase some its outstanding debt at current market prices, well below the face value of the bonds. The deby buyback is not without its problems. Both proposals would reduce Greece’s debt level. It would also result in the bank’s sustaining losses.

According to the Bank for International Settlements, French banks have exposures to Greece, including of around Euros 50-60 billion. German banks have exposures of around Euro 30-35 billion. These banks might result require new capital to absorb the writedowns.

If necessary, then the French and German governments would need to provide this capital. In effect, rather than lending to Greece, it would have to use the funds to recapitalise its own institutions. This would, in the final analysis, be more sensible than continuing with the farce that Greece is solvent and the bank’s holding of Greek debt are worth the face value of the securities. It would be the first logical step in addressing the problem of over indebted European nations.

History records that in August 2001, the IMF oversaw a debt exchange for Argentina in an unsuccessful, last ditch effort to avoid default. Indecisive and confused action by European authorities seems doomed to ensure that this restructuring, if it eventuates, will be followed by others and an eventual messy, disorderly and expensive default.

The French proposal perpetuates the lack of acknowledgment that Greece has a “solvency” rather than a “liquidity” problem. Like the EFSF whose structure has been criticised as nothing more than a collateralised debt obligation (“CDO”), it uses financial engineering techniques to defer or disguise losses in an unending game of “extend and pretend”.

© 2011 Satyajit Das

Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (FT Press, forthcoming August 2011).