Greece just got a debt jubilee. Who’s next?

CDS in general were called weapons of financial mass destruction for a reason. We see it here with Greece. I am sympathetic to the concept of neutering them in the way the Europeans have. However, as I indicated, in the CDS post yesterday, doing so will have negative unintended consequences i.e. raising the yield on other euro zone sovereign bonds – as we are already seeing in Italy. Moreover, trying to call this a non-default and then having the private sector take a loss voluntarily but the Troika and ECB not really subverts the rule of law. I can understand trying to do this if no principal writedown was taken as in the July 21 deal. (You will see my thoughts on this in a May passage below.) But now we are seeing a loss of principal. It’s a farce to say this is not a default. You have to respect existing financial contracts.

The best way to get rid of CDS is to regulate them tightly and make margin requirements right. We saw the same problem with AIG and those margin requirements. Clearly, the fact that bond yields will go up now that CDS has been undermined tells you implicitly that there is not enough margin.

And this is not an argument in favour of sovereign CDS as a market. The AIG affair shows you that some systemic player will get into trouble and be forced to post collateral that bankrupts it and ripples throughout the system. CDS are an inherently defective product with perverse incentives. See my 2009 piece CDS contracts and the implosion of several Eastern European economies for why. I say make all OTC CDS exchange-traded with no exceptions, ban naked CDS, ban future sovereign CDS and slowly strangle the market until existing contracts expire.

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As an aside, I should mention that a friend wrote me how the CDS might have been related to the huge rally yesterday:

One story doing the rounds today is that the fact that the holders of Greek credit default swaps won’t receive a penny has indirectly contributed to the massive gains yesterday. The logic is the following: CDS issuers are assuming that if Greece doesn’t qualify then none of the other European sovereigns will ever qualify, and that is causing them to cover their shorts on European equities which have acted as a hedge against their CDS exposure.

So, yesterday could have been the mother of all short-covering rallies. This would make sense as the banks rallied the most, both in Europe and the US. I have heard people suggesting that Geithner’s pressure on the Europeans earlier in the Fall was really about US banks having written CDS contracts and that now that the CDS is less problematic, this is good for not just European banks but US banks too. See here for speculation on these issues from early in 2010: “Is AIG the main CDS insurer for Greek government debt?”. Price action in AIG yesterday doesn’t say this rally was necessarily about CDS.

I like Marc Chandler’s angle on the deal we just saw proposed for Greece’s default. He writes “To Forgive is Divine”:

Another irony is by playing loose with the "voluntary" nature of haircut, they may have undermined the credit default swaps market, and contrary to its intent and interest, and will make it even more of a speculative market, even if they can effectively ban naked positions. ISDA says that the voluntaristic aspect is sufficient to prevent it from triggering the CDS. Therefore hedge/insurance function of the CDS market is questionable at best.

While undermining the legitimate function of the CDS market, there might be something to learn from the gaming of the haircut/default distinction. A voluntary haircut is nothing more than debt forgiveness. Banks, insurance companies, pension funds lent money to the Greek government. Recognizing Greece cannot pay it all back, they have said they will forgive half of the debt. While entirely self-serving, as mark-to-market would require even deeper losses, and there is the implicit and explicit threat of a hard restructuring, the forgiveness is noble.

Many investors/creditors scoff at the "voluntary" participation, but perhaps they would be better served by take the lesson of forgiveness to heart. Forgiveness of some part of the principle of US mortgages that are under water would go along way toward addressing the debt overhang of US households. With the help of creative officials, holders of US mortgages, including of course Fannie and Freddie, can help create incentives where forgiveness of part of the principle is in their interest.

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I see this deal as a quid pro quo for the banks getting recaps in exchange for writedowns. Because it is a negotiated agreement of a sort of payment in kind, it isn’t really clear if the banks are being made whole (as compared to a CDS-triggering default) as a result. Marc Chandler is saying this was really debt forgiveness, meaning that the banks have done a debt jubilee for Greece in exchange for recapitalisation backstops. I like that angle. But both Marc and i think larger haircuts are coming.

Debt forgiveness is something that Stephen Roach is banging on about for the US a lot these days.

The over-indebted American consumer will be hard pressed to simultaneously reduce debt and maintain levels of consumption that support economic growth. On CNBC today, Stephen Roach of Morgan Stanley says, we need “ways to forgive the excesses of mortgage, installment and revolving credit, as what was done in the 1930s, that will help consumers get through the pain of deleveraging sooner rather than later.”

Stephen Roach: Consumers need debt jubilee, Aug 2011

Will the debt jubilee in Greece move on to Portugal or Ireland? Could do. Is the American consumer next?  I doubt it. Remember, this is really about apportioning the losses on debt contracts between creditors (i.e. investors and taxpayers) and debtors. In the case of Portugal, if they can’t make the grade on austerity, the Greek deal shows them one way forward. In the US, there are tens of millions of mortgage contracts. Many of these homeowners are underwater. Most will repay, however as they can. As soon as you start offering principal reduction, you have a problem because not only will the people who can’t pay and need a break take you up on the offer, so will the people who can pay and will. So you get a really adverse event for creditors in terms of apportioned losses. I don’t see it happening for just this reason.

As an aside, I was thinking about just this point from a different angle yesterday. I asked myself what if we forgot about the debt for a second and just wiped the slate clean, what would the global economy look like? The answer I came up with is that we would see a hugely productive economy. Think about all of the built up infrastructure, plant and equipment, and people in the developed and developing economies. it’s immense. Without the debt, with a clean slate, companies now cautious, would hire people like crazy and starting making stuff. The economy would sprint forward like a lion.

That mental exercise confirmed to me how much this is a debt crisis. Now clearly there is the issue of equity. You can’t just wipe the slate clean and void millions of legal contracts if you want to respect the rule of law. After all, that is the problem with the Greek CDS deal.

Here’s a passage from a May post “Greece will eventually restructure” in which I predicted this hard restructuring that we eventually got that references the CDS:

Yesterday, I had the pleasure of talking on CNBC along with Marc Chandler of Brown Brothers Harriman about the European sovereign debt crisis. I also wrote a piece in the New York Times about the same issue, concentrated on Greece. While Marc and I differ somewhat in tone, we are both clear that eventually a restructuring of principal will happen.

Here’s the background to what we said:

  • Greece needs a strategic plan. At a minimum, a soft restructuring – that is to say, a voluntary reduction of interest rates and an extension of maturities – will happen sooner than later under the EFSF facility. While this is necessary, it will certainly not be enough. Eventually, principal reduction will occur.
  • Bank capital must be protected from immediate losses. Principal reduction has to be done with timing and in a way that considers the stress to Greek and foreign bank balance sheets. The problem with an involuntary default is that it would trigger immediate losses and panic. Europe’s banks are still undercapitalised; so such a default must be avoided at all costs.
  • It is unclear whether the move to principal reduction will be messy. An involuntary default would clearly be messy. I don’t see this scenario as likely, and it certainly won’t happen in 2011. Instead, I anticipate a soft restructuring followed by a certain amount of political dithering, which will create contagion that forces a hard restructuring (aka ‘soft default’) down the line. This will be “somewhat messy”.
  • Neither Marc nor I mentioned a euro zone break-up. My view is still that some combination of monetisation and a voluntary default, hard restructuring package is the most likely scenario for Europe. When I handicapped scenarios after the Irish stress tests in late March, I felt this way. I still do now. This means that when you look at the three options for the euro zone, monetisation, default, or break-up, I see break-up as by far the least likely. Again, a hard restructuring/soft default is much more likely.
  • Credit default swaps triggers can be avoided. My view is that a restructuring that involves maturity extension, interest rate and principal reduction via an exchange of bonds or a roll off of maturing issues does not necessarily have to involve a technical default that triggers credit default swap payments. If a strategic plan is properly conceived via bond exchanges, investors will lose money but actual default can be avoided. Obviously, a reduction of principal is still a loss of money for investors. But, it is key that this loss take place with as little unwanted negative consequences for other euro zone debtors and the banking system.

Note, I now think a euro zone breakup will eventually happen. But, I think that post shows you that all of the issues we see now were foreseeable: the bank recapitalisation, the attempt at a soft restructuring, the eventual writedown of debt and the attempt to avoid a CDS trigger were all known in May. It’s not rocket science. The fact that it took us five months to get to this point tells you that the markets are leading the politics and that this crisis has been one of political will first and foremost.

But, on the debt and CDS issue, the passage goes to the real problem, which is not just debt but the interwoven nature of our financial system. Nicolas Sarzoky made the point in his TV interview last night that Lehman Brothers was a financial Armageddon that all policy makers are now looking to avoid repeating. The holy grail of dealing with this crisis is about unravelling these interlocking relationships and writing unpayable debt down as quickly as possible while apportioning the losses between creditors and debtors as fairly as possible. We still have a long way to go.

Source: Jubilee – Wikipedia

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10 Comments
  1. john haskell says

    your 2009 piece discusses how nice little BTA was put into bankruptcy because the meanies at Morgan Stanley (who may have been smart enough to buy some credit insurance) refused to accept a workout plan.

    In the intervening three years we have learned that BTA was a scam of almost Madoff proportions.

    Maybe BTA’s bankruptcy is not the best example to illustrate how CDS’s are bad.

    1. Edward Harrison says

      Fair enough.

  2. wagdog says

    EH: “I asked myself what if we forgot about the debt for a second and just wiped the slate clean, what would the global economy look like?”

    According to David Graeber in “Debt: The First 5,000 Years”, Mesopotamia periodically carried out your mental exercise for real, protecting debtors by “wiping the tablets clean”. This reluctance to countenance programmes of widespread debt-forgiveness seems to be unique to modern western governments.

    http://www.ft.com/cms/s/2/04e44606-d9a0-11e0-b16a-00144feabdc0.html

    1. john haskell says

      1. please give me the following information: a) date of next jubilee, b) your bank account details. I’ll send you a loan agreement, I will expect you to send it back executed with a wire transfer to my benefit. Best regards

  3. spirit of jubilee says

    I think it’s too early to call this a jubilee. Jubilee is not the same as writing off debts. Jubilee is returning to inheritance, taking back what has been lost. Debts that can’t be paid won’t be paid. A good start for bankers to recognize this basic fact. However,this is far from a jubilee. A jubilee will be when the debt is written off AND there is a return to sane economic and monetary policies AND when there is celebration in the streets. There is no celebrating in the streets in Athens. Austerity is still being imposed. The crisis will continue to get worse… No this is not a jubilee… this is not a party…. this is not a return to an economic recovery… This is not a jubilee…

  4. Max Shifrin says

    EH: “I asked myself what if we forgot about the debt for a second and just wiped the slate clean, what would the global economy look like?”

    One point you’re forgetting here is that if we wipe out all the debt we also wipe out all the savings in the world and also those companies who were cautious enough not to lever up as much as possible with debt. For every dollar of debt there is eventually a dollar of savings – and any debt forgiveness at all is actually a prize to the less cautious part of the deal.

    Personally I can’t comprehend that “voluntary” debt forgiveness, in the scheme which is supposedly going to be carried out, won’t trigger CDS contracts. It actually voids the purpose of the CDS in that case.

    1. Edward Harrison says

      Just to be clear, it was a mental exercise. I was not saying you want to write the slate clean. I was asking myself what would happen to productive assets if you did.

      1. Max Shifrin says

        I understand that. What I’m saying is that even if we set aside all the moral hazards etc.. This still won’t cause any growth to the economy, in my opinion, as every dollar of debt is actually matched by a dollar of savings. Hence while those who have their debts erased in such a scenario would seemingly benefit from it, everyone else will lose and it’s a zero sum game.

        1. Edward Harrison says

          On savings and debt, even in this stylized example, if you wiped out ALL debts, there are still a ton net financial assets in the private sector so you are not wiping out all accumulated savings.

          But the point is irrelevant. Again, I am asking what would happen to productive assets, not to growth. The productive assets still have their utility irrespective of the financing used to purchase or make them. this is why people in leveraged finance spend so much time worrying about EBITDA in order to strip away the financing of assets and focus purely on the income stream that assets can throw off. So, again, I am not talking about growth but of the accumulated productive capacity available irrespective of how it is financed.

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