Archive for the 'bailout' Category


November 1, 2011

The Greek Prime Minister wants to hold a referendum on the new bailout deal to be signed with the Europeans. It appears that this was an unexpected move which has caused anger throughout the Eurozone (also here). The details are not yet available, but it seems that Greece will negotiate the rescue plan first, and then will put the proposal to a vote. The Greek people will decide if they agree or not.

To be honest, I thought that this was the best piece of news (for Greece) to come out recently. Negotiations thus far were a two-party game, which has now been forcibly turned into a three-part asymmetric game:

  1. The Greek Government who are on one side of the negotiating table,
  2. The EU, ECB, bankers, IMF, etc. who are on the other side of the negotiating table, and
  3. The Greek people who are voting on the outcome when negotiations are complete.

Now one has to only think: whose negotiating power increased immensely and whose negotiating power took a dive, when the third party entered the game. Yes, it is the Greek government who now drive the process.

Also, it is worth remembering that what Eurocrats fear most is democracy. The history of referenda on EU policies is not stellar, and I suspect that they really don’t want to lose this one. It will not surprise me if Greeks get away with an 80% uniform haircut including the ECB, and bank recapitalisation for free.

Unlike what Greek commentators keep repeating, Greeks have the option to say No: a standard EU policy is to keep having referenda until a Yes vote is won, giving more and more sweeteners in the process.

PS: All is not clear sailing though. A requirement is that the Greek government will maintain its slim majority until January, which is not certain. Another Greek MP resigned today, most probably because of the referendum proposal itself. The opposition leader does not want to hold a trump in his hands, and promises to stop the referendum at all costs.

The chance of Greece descending into a chaotic horde of witch hunters has gone up by another notch.

adverse efsf

October 24, 2011

There is a widespread view that the EU will attempt to lever up the EFSF capital to achieve an insurance capacity of EUR2-3tr, by turning it into the equity tranche of a sovereign CDO. Others put forward a TARP-like structure which will buy back bad sovereign debt.

A Special Purpose Vehicle (SPV) will be the financial entity that will implement this endeavour, where whatever is left of the initial EUR440bn EFSF money will serve as the capital. This is certaily a big number, which is bound to catch the headlines and trigger a stock market rally. But is there any meat on this bone?

How do you value that crap?

Although yet unknown, the bond buy-back structure will be probably similar to the TARP model which was implemented in the US to help banks offload their ‘misunderstood’ assets. The idea behind TARP was that the market for CDOs and other morgage backed instruments just dissappeared overnight. For that reason, if banks were to sell these assets they would receive very little, even though foreclosures at the time were not justifying such a severe price cut.

In order to implement the TARP, a price discovery mechanism was needed to gauge what a fair value would have been. An ‘inverse auction’ was put into place, where the holders of the assets posted the prices at which they were prepared to sell, and the lowest prices were filled first until capacity was reached. Therefore selling institutions had an incentive to post a low price to get rid of their assets, and losses were written down. To fill in the holes these sales punched in their capital, banks issued preferred shares that were bought by the same programme. A total of USD700bn were earmarked for this programme, of which about two-thirds were actually used.

How would that work in the context of the EFSF? Here Greek, Portugese and Irish bonds appear to be eligible at the moment, while Spanish and Italian bonds could become eligible in the future (if eligibility is defined as being bailed out). Banks that hold periphery bonds will post a selling price, and the cheapest ones would be filled first. One does not know yet the exact mechanics, but it is safe to assume that Greek bonds will be the first ones to go. Obviously, the current market price serves as a lower bound, but if enough banks try to get rid of the bonds, then the price might not be too far away.

The main driver behind the TARP was that households were not defaulting on their mortgages at a rate that would justify the market prices, and that if these ‘misunderstood’ securities were kept for a while then the market would resume and reasonable price levels would be restored. The current situation is markedly different: the problems facing Greece (and other periphery countries) are not due to the lack of liquidity but lack of solvency. The low price of Greek debt is not unreasonable if one considers the fundamentls, and is in fact supported by the implicit or expected haircuts described in the various PSIs. If these PSIs were gone, the price of Greek debt would be arguable even lower. Pumping liquidity in the secondary market would do little good to the banks involved, and no good to the Greek state.

The related recapitalisation would be welcome though. Banks gain some immunity against sovereign default if the bonds are off their balance sheets. This also takes the burden to recapitalise the banking sector off the sovereign, but causes a moral hazard issue which invalidates the whole idea.

Survival of the fastest

As it stands the EUR440bn are not sufficient to provide a decent backstop. Already nearly half of the money has been spent, but let’s say that there is another EUR250bn left in the fund, and the liabilities of the larger periphery countries easily exceed that. An argument is to use the magic of leverage to turn these EUR250bn into EUR2tr or even more. I think that this argument is flawed, if one considers the incentives of the countries involved.

The size of the Greek default is constantly being debated in the financial press over the lat few weeks. The initial PSI of 21% has grown into a PSI+ of 50-60%, with some commentators advocating levels of 90-100%. There is a valid argument that the costs of recapitalising the Greek banking sector do not go away. Every Euro that a Greek bank loses through a haircut is a Euro that Greece has to borrow in order to recapitalise the bank. This means that the true impact of a 50% haircut might be actually less than the 21% that was originally proposed.

In the TARP world the default of a household was disconnected from the profit or loss that the MBS realised. But in the EFSF case this does not hold: if Portugal defaults then the Portugese state will need funds to recapitalise Portugese banks; if the EUR250bn have run dry because Greece and Ireland have already tapped the fund, then Portugal will be left exposed. It matters little that EUR2tr were insured, if the equity tranche is wiped out. The incentive for Portugal is to default before everyone else, just to make sure that her banks take advantage of the EFSF rescue funds.

The size of the default is now subject to adverse selection too. If Portugal need not worry about the impact of a default on her own banking system, then she might opt for a much larger haircut. As her banks are recapitalised externally, why not give them a helping hand?

Obviously moral hazard becomes an even more important issue for Spain and Italy, where the money involved would be stretched in the better of scenarios. If they want to have any chance of protecting their financial system, then they have to rush to the EFSF gates early in the day.

What this leverage will create, as the crisis deteriorates, is the equivalent of a good old bank run. A leveraged institution might not have enough capital, and everyone eligible rushes to get the most out of it. It also resembles the good old CDO: if CDOs underestimated tail dependence and systemic correlations, European politicians are making sure that a cluster of sovereign defaults will happen in the EU sooner rather than later.

As if there is not enough contagion as it is…

consequences of a euro break-up (ubs analysis)

September 6, 2011

UBS economists published today a research piece on a possible breakup of the Eurozone. They contrast feasible solutions like Greece leaving the currency union or Germany doing the same. They also explain why other alternatives (like expelling Greece) are not feasible.

They estimate that Greece leaving the Euro will incur a one-off cost of about EUR10,000 per person during the first year, and about EUR4,000 each year after that. There are obviously severe social costs that cannot be monetized. The one-off figure for the Germans (should they choose to leave instead) is somewhat lower at about EUR8,000.

Contrast that to the cost of bailing out Greece, Portugal and Ireland simultaneously, which is about EUR1,000 for each German taxpayer. It seems clear that the only viable solution at this stage is a default within the Eurozone, even though this could eventually take us to the same point in a few years’ time.

fair markets

August 24, 2011

Some are still talking about it:

ATHENS (AFP) – Greece will hasten its efforts in the next four months to check a runaway public deficit that threatens recovery goals agreed with its creditors, the finance minister said on Tuesday.

Some have actually done it:

Ireland’s trade surplus hit a record in June, rising by 8 per cent to €4.08 billion, new data from the Central Statistics Office said.

And the results are here for everyone to see…

Greek 2Y bond index

Greek 2Y bond index

Irish 2Y bond index

Irish 2Y bond index

Who said that markets are unfair?

They told us that they told them to lend

April 1, 2009

James Hamilton in a brilliant post discusses the recent expansion of the monetary base.

As it stands, the Fed has bought an array of securities from the banks, of a varying degree of toxicity. They did not go to the bank headquarters with a truckload of money, they, sort of, wrote a check or an IOU.

Every bank is required to keep some reserves with the central bank. In that way they force banks to keep some of their assets in cash form, thereby reducing the risk of banks over-leveraging themselves (or at least that was the principle). In order to buy these dodgy assets, the Fed did not actually pay for them, they just extended the reserves of the corresponding banks, without the banks putting any money themselves.

To make things more concrete, say that Pitibank is required to keep USD50 with the Fed as reserve. Also, say that the Fed decided to buy from them a bunch of mortgages (of face value USD300), but which they agree to buy at USD200. These are “toxic” because if the bank sold them in the market, then at the moment they cannot find a buyer that will pay more than USD30.

The Fed gets these mortgages from Pitibank, and instead of paying in cash, they just increase Pitibank’s reserve to USD250. It is essentially the same thing, since Pitibank can draw from these reserves if they want to (down to the requirement of USD50). The Fed will then essentially “print” money to give Pitibank when asked.

What politicians are telling us, is that they want banks to start lending again. This essentially means that they want Pitibank to ask for these reserves and lend the money to individuals, small businesses and each other.

But banks don’t appear to be doing that. They prefer to let the money in their reserves with the Fed. Why do they do that? Are they keeping good money idle? Well not really, because the Fed has decided to actually pay interest on these reserves. This increases the opportunity cost of lending the money to you and me, and acts as a dis-incentive for Pitibank.

Does that make sense? Well, no matter what the politicians are saying, central banks are having nightmares of all that money reaching the consumers and sparking inflation. As J Hamilton points out, doubling the monetary base will eventually translate into 100% inflation: all prices will double.

It seems to me that with that interest rate on the reserves, the Fed is trying to control how fast this huge amount of money reaches the real economy. And they don’t seem to be very keen for this to happen.

Already below the adverse scenarios

March 31, 2009

The Federal Deposit Insurance Corporation (FDIC) is an agency “created by the Congress that maintains the stability and public confidence in the nation’s financial system by insuring deposits, examining and supervising financial institutions, and managing receiverships.” They were heavily involved in the bailout of Citi and have been active in the so called “Legacy Loans Program”, which is the vehicle via which the US taxpayer is buying all those dodgy “toxic” mortgages.

A few months ago, the FDIC released this FAQ, outlining how they would determine if financial institutions “have sufficient capital buffers”. To do that, they devised two scenarios: a “baseline” and an “adverse” one. The baseline scenario is some sort of expert expectation, while the adverse is a stress that is “unlikely”, but “cannot be ruled out”, as their document explains.

House price scenarios used by the FDIC

House price scenarios used by the FDIC

The index they use is the Case-Shiller index of house prices in 10 US cities. This index is reported monthly with a two-month lag. The average index value over the 3rd quarter of 2008 is 165.92 which is the base of the figure above. Today we got the index value for January 2009, which was 158.04 or a drop of 4.75%. This is the first month of the scenarios that the FDIC constructed, and it seems to me that we are already covered the baseline scenario for the whole quarter. We are also en route to go through the adverse scenario pretty soon.

Well it is only one month, but certainly not an encouraging one. The US taxpayer must be delighted with the guys that buy loans for her…

the great slump of 1930

December 18, 2008

<< The world has been slow to realize that we are living this year in the shadow of one of the greatest economic catastrophes of modern history. But now that the man in the street has become aware of what is happening, he, not knowing the why and wherefore, is as full to-day of what may prove excessive fears as, previously, when the trouble was first coming on, he was lacking in what would have been a reasonable anxiety. He begins to doubt the future. Is he now awakening from a pleasant dream to face the darkness of facts? Or dropping off into a nightmare which will pass away? >>

ProjectGutenberg (in Canada) has put the short essay “The Great Slump of 1930” by J. M. Kaynes on the net. Scary reading.

thanks for saving my royal ass

December 18, 2008

What a pleasure to watch the CNBC interview of the Saudi Prince Alwaleed. The prince is the largest shareholder of Citi, which is the latest institution to be bailed out.

It is a pleasure to watch his highness, in sexy scarves and sunglasses and surrounded by racing horses, blaming the FDIC for not giving Wachovia away, and the government for not taking the risky assets away from Citi via TARP. Apparently they didn’t give Citigroup and “the banking industry” a “vote of confidence”, and that caused the share price to slide. Now how arrogant is that!

And on the scandalous bailout that leaves the existing management in place and underwrites all of Citi’s crappy assets, the prince finds that the government should be “commended”. What a surprise…

(You can read the transcript of the interview here.)