Greece’s financial problems and their implications for the world banking system

After the action of the previous days one might reasonably think that we were due a quieter day yesterday. Well so much for reason! It turned out that Tuesday the 27th April was the day where contagion fears in the euro zone were fleshed out and started to become reality. The situation in Greece was already deteriorating and was sucking particularly Portugal into its tailwash when we saw the ratings agency Standard and Poors make an intervention. I was only explaining yesterday that  equity markets often react to events like these with a delay of 3/4 months when the downgrade of Portugal and then Greece turned out to be a bit of a trigger for them and we saw heavy worldwide falls ( and perhaps moved with such a timetable again). As an aside I would like to point out the illogic of a downgrade from what should be a virtually discredited ratings agency  being a trigger, and as one of the commentators on here has pointed out it is also analysis by the rear view mirror.

What did Standard and Poors actually do?

First it cut Portugal’s long-term rating to A- and its short-term rating to A-2 from A+ and A-1 respectively. The outlook is also negative. Also Standard and Poors give a quite damning assessment of Portugal’s position.  

“Under our revised base case economic growth scenario, we expect the Portuguese government could struggle to stabilize its relatively high debt ratio over the outlook horizon until 2013. Portugal’s public finances in our view remain structurally weak, notwithstanding the government’s substantial public sector reforms of recent years.”

 Then on what was clearly a day of action for them Standard and Poors downgraded Greece too by three notches.  

We are lowering our ratings on Greece to ‘BB+/B’ from ‘BBB+/A-2′ and assigning a negative outlook. The negative outlook reflects the possibility of a further downgrade if the Greek government’s ability to implement its fiscal and structural reform program materially weakens in our view, undermined by domestic political opposition at home or by even weaker economic conditions than we currently assume.

In case you were wondering this is indeed junk status for Greece. Also it leaves the ratings agencies as like party guests who turn up just as you are clearing up afterwards.If they were schoolchildren I would suggest maybe 1000 lines, “I must be more pro-active in future”. I notice one or two suggestions starting to circle that they should be nationalised, my view on that is that the situation is already bad enough…..

A Serious Problem for the European Central Bank (ECB)

The downgrade for Greece immediately made me think of the ECB’s collateral rules. For those who are not regular readers I have written on the implications of these rules before particularly on the 29th March. But as a quick summary the ECB recently relaxed its rules to try to include Greece as from 2011 onwards it was looking likely that Greece would be excluded from the game.This is important because it is a system which provides plenty of profits for euro zone banks by allowing them to borrow at 1% from the ECB and depositing assets which have a higher yield, which has proved rather profitable for them to say the least for example for Greek banks it was  worth around 3/4 billion euros last year. If you like this system has performed the role of moving economists theories of free money into reality.  

The move by S&P took Greece below even the new relaxed (easy) framework. Now she still has a fingerhold because only one of the three ratings agencies have to give her a rating which allows her government bonds to qualify under the ECB’s collateral rules and there are two left (Fitch and Moodys). It will not be reassuring for Greek readers of this to see the next few words, ratings agencies tend to travel in packs.

Comment  

The ECB has a terrible choice in this area and it is really quite simple does it wish to help Greece or does it wish to be a credible central bank? Sadly you can only relax your rules so many times. I also gave my views yesterday on the so-called nuclear option of the ECB buying euro zone members government debt in the comments section in a reply to Mr.Kowalski. The true reason that the ECB finds itself in this position is because of the dithering of the euro zones politicians and it would not surprise me if right now they were applying enormous pressure on the ECB to in effect to try and bail out the effects of their failures. In my view it must stand firm as you must think beyond the current panic and maelstrom to the follow on effects and implications of your actions. 

Speculators  

I see that this morning that there has been another effort to blame speculators for this crisis. 

The Hellenic Capital Market Commission, after taking into account the conditions prevailing in the Greek market has decided today to ban short selling of shares listed in the Athens Exchange. The ban becomes effective today 28 April 2010 and remains in force until 28 June 2010.

I wrote on this subject on the 16th April and since then I have not changed my views. If there are guilty parties in this they are three groups of people. There are those politicians who set up the Euro with a constitution which was badly flawed, there is a different group of European politicians who have dithered over the Greek crisis, and of course there is the previous Greek government which misrepresented her economic statistics. Markets are by no means perfect and sometimes they are not even rational and they do include “vultures” but in this crisis they are actually a force which is making politicians finally realise the implications and consequences of their errors and mistakes. The alternative would have been to continue with the mistakes which would if you think about it only have led to even bigger problems and an even bigger crash.  

The World, European and Greek Banking Sector 

As this crisis has been progressing I have been wondering more and more about the stability of the world’s banks and the impact of this crisis about them. The credit crunch led to in general terms the worlds governments (via their taxpayers) bailing out the worlds banks often in many ways that are not well understood (see my “free money” above) but as some governments hit trouble my thoughts turn back to the implications for the worlds banks. I have made a recommendation that a haircut of 20% (originally 15% but as things got worse…) should be applied to Greece’s government debt as part of my suggested repair mechanism for her current crisis. One of the reasons behind my trying to keep any haircut as low as possible is my fear for the Greek and also the European banking sector which could also hit the world banking sector. It is by no means impossible that even my level of haircut could make banks insolvent. Larger ones will virtually guarantee it in my view. I notice that as part of its report yesterday S&P had this in its report “indicating our expectation of “average” (30%-50%) recovery for debt holders in the event of a debt restructuring or payment default”. Such a move would drive banks insolvent and we would be in danger of going back to the collapse of Lehman Bros and all that implies.  

Who?

I am grateful to one of my tutors at the LSE (Willem Buiter) for the chart in his report yesterday which gave some clues on this subject. The banks most exposed  are French and they had an exposure of 79 billion euros at the end of 2009. This explains why the French authorities have been making rather gratuitous statements about the French government bond market being fine and her central bank governor stating that France had “relatively little” exposure to Greece. Well we now know what he means by relatively little and it begs the thought of what he thinks a large amount is. I was expecting German exposure to be higher than the 45 billion euros stated in the report so perhaps this is a contributing factor in their tougher line with Greece.  

Rather disturbingly tucked down the list but with significant amounts we find Portugal with an exposure of 9.8 billion euros and Ireland with 8.6 billion euros. These are very significant for several reasons. One is that they are comparatively large when compared with their economies and of course it is not as if they do not already have problems od their own. In particular the Irish banking system has only just been bailed out and Bank of Ireland only announced details of its right issue plans this week. So clear problems and remember one of the lessons of what happened with Lehman Bros was that financial crises often have implications in unexpected places, what I was taught as “the serially uncorrelated error term”

 Market Reaction  

This was in two camps as we saw government bond yield rise in the affected countries often quite substantially. Greece’s ten-year government bond yield closed at 9.54% but the real impact was felt in Portugal where her ten-year bonds now yield 5.61% and Ireland where her equivalent yields 5.25%. Comparing these with the German benchmark gives us +2.68% and +2.31% respectively.However German ten-year bund yields actually fell to 2.93% in what is called a flight to quality. As UK ten-year government bond yields also fell (to 3.95%) perhaps a better phrase is risk aversion!  

How does this work?Having pointed out yesterday in my later update a flaw in the EU rescue plan I wish to repeat it for the benefit of earlier readers.  

Portuguese three-year government bond yields have now risen above 5% partly because she has just been downgraded. The significance of this will not be lost on people who understand that she will be expected to provide funds to Greece at 5%…….. 

Germany might be able to subsidise Portugal’s position from her “windfall” but not if her Constitutional Court had anything to do with it.

Conclusion  

The crisis is continuing and contagion may now not only be from country to country but I fear that it could hit banking systems too. As I wrote yesterday I believe that there is a brief window of hope still for countries such as Portugal if they were to take the advice I gave immediately, but time is now running very short. Markets do ebb and flow and they may be able to take decisive action and benefit from an ebbing. As to my wider thoughts on implications for the euro zone I am reminded of my conclusion on the 23rd February’

 

  

Solutions  

Of this there are two and they are the two polar extremes. The Euro zone can drive forward political and fiscal integration to put it into the position it should always have been or it can break up. It does not have to break up entirely as an inner core could remain. I believe that Europe’s politicians will drive for further integration but will fail. In essence I think that the German taxpayer will be unwilling to shoulder the implied burdens of it and as this crisis develops they will become clearer on what the costs will be. 

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18 thoughts on “Greece’s financial problems and their implications for the world banking system

  1. I would very much apreciate a more UK centric angle on all these developments. Whilst the Greek Tragedy has indeed been fasinating to see unfold, if not a bit scary, more concerning is what this all implies for the UK.

    Any chance you can continue to at least every fea days write up your thoughts on how it is likely to impact UKPLC and by extension the UK taxpayer.

    Thanks

    Anand

    • Whilst some of the posts may not be directly UK related I think we can be certain that the events in greece (and thus Europe, the ECB etc) will be of monumental importance in the future.

      Just look how the international markets reacted to the downgrading of the Greek rating (and how UK government bond yields reacted as some fled to a “safe haven”)

      If we don’t try to understand and keep abreast of the Greece issue now, we’ll only be looking back in 6-12 months time and be asking “how did this happen?”

      Plus I’m due to go on holiday to Corfu this summer and appreciate the insight that’s provided on this blog!

  2. Another press opportunity where Merkel and the IMF stress how much there is to lose if a ‘solution’ cannot be arrived at quickly.

    I presume they are actually communicating to identical counterparts in an alternate universe?Why do you need a press release to tell yourself something? I know I need to cut the grass but telling you on this blog won’t get the job done.

    Turning to the UK,the assumption is that a rating downgrade is on hold until after the election.Presumably the illustrious analysts at S&P et al have scrutinised the manifestos of the 3 major parties and concluded that none of them are serious about eradicating the structural deficit.So what are they waiting for?

    • Hi Andy
      I was discussing this very point at the weekend with my father. Who exactly do they think they are talking too? We came to the conclusion that such official pronouncements are for those who are either not aware of international finance and how it operates, have no great interest in it or simply have blind faith in authority. In some respects it sounds disturbingly Orwellian the way that language is perverted. For example President Obama and Chancellor Merkel have said tonight that Greece requires “timely” measures which of course is the exact opposite of Chancellor Merkel’s strategy so far, accordingly it reminds me of the Ministry of Peace in fact being the Ministry of War.

  3. Shaun,

    A naive question perhaps.
    Is it possible and/or desirable for EU/IMF to pay off Greece’s debts as they come due? And provide no additional funds. This should address the bank losses and insolvency issue (does it?).

    The reason I am wondering is that the Greek government is resisting additional austerity measures. But there is no clarification whether the pressure for additional austerity measures is for Greece to live within its means or to pay off some of the debt that is coming due. It might also go some way towards addressing the political situation in Greece.

    Any thoughts?

    js

    • Hi John
      I had spotted that Greek Ministers have been saying such things. I think the day before Greece formally applied for aid the Finance Minister said that there would be no more austerity measures this year. I thought at the time it was an unwise statement to make and seeing as he must have known by then that they were going to call in the IMF (as we know now) it was worse than unwise. If you look at statements like that and you were the EU,IMF or indeed the ECB -there has been talk of the ECB buying up government debt of Greece, Portugal, Ireland etc.- then if you have any sense you would conclude that it would be a mistake to pay off Greece’s debts in the manner you suggest.

      Otherwise there is an enormous moral hazard because what incentive would there be for Greece to carry out her austerity plans? The usual IMF pattern is to dole out money in stages in return for (austerity) targets being achieved, in a way analagous to how you would pay a builder.

      So my conclusion is that it is possible but it is not desirable as if Greece does not make reforms then the problem is only moved into the future when it will be on an even bigger scale.

  4. Hi Shaun,

    Interesting series of posts – may we live in interesting times.

    Can I ask for your thoughts on an alternative scenario? Many holders of Greek debt in the Eurozone are banks in public or semi-public ownership. What response would you foresee if, instead of bailing Greece’s government out, Eurozone governments were to write down Greek debt by 25%-33%?

    Thanks,

    • At times like this I am reminded of the supposed Chinese proverb “it is a curse to live in interesting times”. If so we are in danger of a curse aren’t we?

      As to a haircut of 25/33% on its own it would not be enough. There would also have to be austerity measures and I expect them to be made tougher by the IMF than Greece plans at present, probably centering on a tougher 2011. Would they be enough together? Not really because if you look at the interest rates Greece is looking like she would have to borrow at from the markets she would be back in trouble fairly quickly.

      As to the impact on the banks it is hard to say. I hope but do not absolutely know that my own figure of 20% for a haircut would not make any bank insolvent and I have looked at the published figures for likely liabilities. But I have seen examples in the past where published figures have proved inaccurate ( this was the UK and not Greece) and at best they are lagging indicators. So even on my lower haircut there could be trouble and if you raise it the chances get higher. One other policy response would be for the ECB to make sure that the markets have plenty of cheap cash so that there is liquidity. This would not end the possibility of insolvency but it would buy time and a little respite would help Greece.

  5. Standard & Poor’s has just lowered its rating on Spain’s public debt to from AA+ to AA, precipitating possible further financial chaos. The US has now admitted that this crisis is of great concern.

    In addition the IMF has now stated that bailing-out Greece may cost billions more than formerly assumed! Looks like the contagion is spreading now faster, as fear begins to rule? How much longer will the UK remain unaffected?

  6. Are we really seeing “contagion”? The problems in Greece aren’t CAUSING the problems in Spain, Portugal etc. It’s merely that all the PIIGS chickens are coming home to roost at the same time.

  7. Dear Sir,

    Firstly I would like to thank you for your comments and insight concerning the imminent Hellenic tragedy.

    Secondly, following up on yesterday’s comments and being a greek taxpayer – working for the wider public sector – myself (one who has already lost 2/14 of his extremely high annual income of 14,000 Euro per annum and is on the verge of loosing his job) I would like to stress out that defaulting on our external debt is not an option. It is un-ethical (strangely enough the greek word “ethos-virtue” is no longer part of the Hellenic “ruling class’ ” vocabulary) and conforms neither with our history nor with the views and thoughts of the majority of the educated greek population.

    However, given that the decision-making process in Greece is somehow “disconnected” from the general population’s aspirations and thoughts, what would be, in your opinion and according to past experience, the consequences of a technical (or any other kind there might be) default on our debt both for the greek citizens/Greek economy and the Eurozone?

    • Hi Thanos

      Thank you for your comment and wellcome. I have found it helpful to read the comments of those actually in Greece as they do sometimes give views which are different to those provided by the media in the UK.
      Firstly as I have explained today in my analysis of the UK I believe that disconnection from their voters is a common feature of elected politicians at this period in time and is true in the UK and Germany where with elections due soon reality is being denied. However Greece is a more severe example. For example last night two previous finance ministers spoke at the London School of Economics and denied any deliberate falsification of economic statistics, what they made of the outbreaks of laughter which followed this I do not know.

      As to a technical default I think two things
      1. It now looks unavoidable
      2. It could set Greece on a much better path than it is on now and after some economic pain (which I do not want to hide will involve several years of adjustment) if it is combined with the measures I have also outlined Greece and her citizens will then face a much better future.

      One alternative which I haven’t seen much talk of is of a technical default of a certain percentage followed by leaving the Euro and devaluing by the same amount.Forgive me for thinking of this as I type I will now go away and plot the implications of it…..

      Also I am sorry to hear of the personal impact of this crisis on you. It is with regret that I say that I expect to hear more such news.

    • Hello,

      I’ll give you an update of the ‘planned measures’ to be taken, however I will give it on today’s post, so that you, and your readers, can be informed about what happens when ‘things go down the drain’, especially considering you have an economy-centered debate tonight. 🙂

  8. The discussion in mainland Europe is radicalising as well.

    Basically a portion of the population (I do not have stats on how much) has concluded that the Greece politicians can not be trusted now or in the future, and they really want Greece to go bust. The argument being: They cannot and therefore will not change, giving them money now will lead to them wanting more later. Let us take the hit now and save our own banks and let Greece to sort out its own after their people “feel” what their politicians did instead of us. You should remember that many nations took measures comparable to the austarity measurement, pension cuts, pay cits, education cuts, hospital cuts, public transport cuts, to keep theit own nations afloat. Seeing Greece population resisting is just oil on the fire of people viewing the Greecs as lazy honourless freeloaders. Actually those people hold the actions of the government against the entire greece population, feeling they should have voted wisely and elect reliable realistic leaders. Voting in fantasy politics is their own mistake and they should take the hit. Those comments actually seem vindictive.

    The other school of thought is we should bail them out wathever the cost as a bankrupty is more costly in the end. Not social thinking, just calculus. We will deal with their political “elite” later and that wont be pretty. People regard them as kind of a maffia crime sindicate, bleeding their savings accounts from Athens by stealth, and people demand “blood”, and expect those Greece finance ministers and companions to be haunted with wathever legal case or other people can trow at them. Geven the what I read, if I was them I would not speak in public in mainland Europe for now and the near future.

    The last and final option being discussed is to copy Brittain and the USA and shift the pain to the future…. Again… It is called go “Nuclear”. And let the ECB buy up the toxic Greece debt. And hope we can come up with something before that debt bubble comes back to hount us, as it will the USA and the UK. This is a hot potato not only in Germany, but also in other nordic nations. Because this heavily undermines the long term strength of the currency. So from the ECB perspective I don’t see it happen, for polliticians it is perfect. The next 2 governments are save. After that, we don’t know.

    As for me. I don’t know anymore what to think. So many artcles have freezed my brain on this issue. But I do know more and more people angrily demant accountability of the Greece politicians at wathever rescue they are made to pay by their own politicians.

    • Some brief comments:
      -As if Greek electorate had choices. All parties said more or less the same apart from the Greek communists who still worship Stalin. Do you get the picture? Accusing the common people is preposterous.
      -If north Europeans think that Greece and its inherent problems is the source of all economic evil, they are naive to say the least. Greece is just the weakest link (because they indeed overborrowed, but this is still happening by some countries and they are quoted saying we are no Greece!).
      – There is no common fiscal policy as it should in a common market. I predict collapse of Eurozone for not identifying the inherent problem of the Euro and they just use Greece as scapegoat. I think the Eurozone will sooner or later collapse. Bailing out Greece or not is irrelevant, it just postpones the inevitable. The very fact that north Europeans think that Greece is the real proble for Eurozone and EU (Greeks are screwed anyway) gives me great confidence in the prediction that the whole Eurozone will collapse and perhaps some other EU countries. I think that it is in front of their eyes but they can only have Greeks eating souvlaki in their mind and they are blind! Let’s see…

      • I can imagine your view. But what the greece population does not seem to, or wishes to, understand is that what is called austarity measurements is common place in Nordic nations. I was asked to up my pension to 67 last year to produce the money needed to safe the banks in the Netherlands. Simple as that. Grudgingly we the populus agreed. Now I am asked to shuf up 30 Billion in cuts this year to pay off future debt to meet the Maastrich criteria. On top of that we are now asked to cuff up somewhere inbetween 5 to 10 Billion imediately (current estemate in the media here is 150 Billion plan for Greece) to bailout Greece. We could have used that 10 Billion ourselves to offset that 30 Billion. There is already talk about upping the pension age again. Since the Greek pension age is 53 you can imagine the anger, baout us having to pay for their 14 year holliday.

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