Posts Tagged ‘regulatory arbitrage’

always in your debt

December 24, 2009

This is how the Greek debt looks like for the next thirty years. EUR349bn is due, of which EUR95bn (or 27%) is interest and the remaining EUR254bn is the face value.

Distribution of the Greek national debt. Principal and interest in million euros. Source: Bloomberg, Dec09

Greece would typically issue 5- and 10-year bonds. As an example, the notional due in 2012 (approx EUR30bn) would consist of 5-year bonds issued in 2007 and 10-year bonds issued in 2002 (perhaps EUR15bn each). There are also some smaller notional from longer issues, but the bulk of the debt expires before 2019 (the weighted maturity is actually 2017 or thereabouts). This means that in 2010 the government can issue bonds that expire in 2015 and 2020, say EUR15bn each. Then, the notional for 2015 will increase to something around EUR28bn, and a new notional of EUR15bn will be added for 2020. There is a suspiciously large peak in 2019, but I did not have time to investigate its origin. I will collect some more information on each issue and come back with the breakdown.

The bonds Greece issues have typically fixed coupons, that is to say they pay fixed interest. Only a very small number of the issues in the chart pay floating or variable coupons, meaning that the whole current debate on interest rates is irrelevant to Greece’s current exposure. But they will affect the forthcoming issues, as investors will demand higher coupon rates in order to lend to the Greeks. Also, given that Greece might need to borrow money just to pay off the interest of previously issues bonds, there will be a refinancing cost as new coupons will be added. The new orange bars will be a bit larger than they would have been if debt was issued three months ago, and since Greece borrows at fixed rates they will remain higher for the duration of the debt.

Interest rates are close to historic lows, so even with this extra premium the actual amount will not be that different from what it was before: the new orange bars will not be a lot bigger than the existing ones in the chart. It is more of an opportunity missed: other EU countries will take advantage of the low rates to either improve their balance sheets or spend their way out of recession, Greece can do neither. The recession will bite harder, as there will be insufficient fiscal stimulus given the higher cost of money. Moreover, Greece is missing all infrastructure improvements that take place elsewhere in the name of fiscal stimulus. And when interest rates finally pick up, Greece will find herself in the back seat: she did not invest when money was cheap, but still has the same debt burden as if she did.

So who are the immoral bankers that pile up Greek debt, taking advantage of the high spreads that has driven the whole country in despair? Hugh Edwards brings forward some analysis by Goldman Sachs on Greek banks making extensive use of the ECB liquidity facility (which allows institutions to draw funds from the ECB using rated bonds or ABS structures as collateral). This facility was put in place in order to provide liquidity to the holders of highly rated but ‘misunderstood’ securities, and certainly not to provide cheap funding for speculative activities. For some reason Greek banks are always there asking for more, even though they do not appear to be liquidity drained under any measure. In fact, it appears that Greek banks have overdone that to the point where the Central Bank of Greece had to tell them off (presumably under instructions from a pissed off ECB). What do Greek banks do with all that money?

[…] the current spreads on Greek government bonds […] offer Greek banks an exceptional arbitrage opportunity, since by taking advantage of the uniform ECB liquidity rate Greek banks can buy higher Greek government bonds with a much higher yield than the government bonds which their French or German counterparts buy. Regardless of the risk implied through by the Greek CDS spread, Greek government bonds carry a zero risk weighting when calculating riskweighted assets for capital purposes. So for Greek banks this arbitrage carries no capital impact whatsoever. That is to say the Greek banks have been doing very nicely indeed out of the Greek sovereign embarassment, than you very much. Hence it is not difficult to understand the ECB’s growing sense of outrage with the situation.

This means that essentially ECB money is given to Greek banks at very low interest rates, under a scheme designed to help banks that are genuinely in distress. Greek banks use these funds to buy Greek government bonds, which offer a substantially higher rate of return. As far as ECB rules are concerned, these are risk free bonds and Greek banks are not penalized for holding vast amounts of them. The end result is that Greece ends up paying through the nose for funding that comes from the ECB printers via a Greek bank, and Greek banks make huge profits for just taking advantage of a loophole in the rules. One might say that Greek banks are taking on sovereign risk (at the end of the day there is a non-zero probability that Greece will default), but the fates of the Greek state and large Greek banks are so highly intelinked, that a Greek default will wipe them out anyway.

Surely, Greek banks must feel embarassed of employing a regulatory arbitrage scheme that many in Europe see as immoral, especially when the purpetrators are state-owned institutions. Enter Apostolos Tamvakakis, the newly appointed (by the newly elected government) CEO of the National Bank of Greece, the country’s biggest banking institution. Even befor Moody’s decided to let Greece go with a slap on the wrist, he made the bank’s intentions clear:

A downgrade by Moody’s would not affect our decision to fund the Greek state

Enough said.