Deja Vu

The EU looks set to celebrate the one year anniversary of the Greek bailout by... giving it another bailout.

The fact that a second bailout for Greece is even being considered almost defies belief. Greece’s credit rating got downgraded again yesterday by S&P, solidifying its position as junk and highlighting the fact that a debt restructuring is by almost all accounts, except the EU powers that be, unavoidable. On top of this, there is also talk of further relaxing the original rescue conditions and reducing the interest rate. At some point one has to ask, to what end?

Not only has the EU failed to grasp the public opinion spreading across Europe (no more bailouts), they’ve also completely lost sight of the end game – finding a solution to the eurozone crisis.

Both the Greek and Irish bailouts failed to achieve anything, except maybe buying time as BBC’s Stephanie Flanders suggests (that’s some expensive time by the way). Both countries have seen their cost of borrowing skyrocket and continue to have massive debt and deficit levels. Furthermore, Greece has ultimately failed to meet the conditions laid down in the first bailout agreement, rewarding it with another bailout as well as relaxing those conditions seems to supercharge the moral hazard created by the original bailout. Combine this with the ongoing resistance to imposing losses on bondholders and it becomes clear just what perverse incentives these actions could be creating.

Relaxing the bailout conditions doesn’t really help anyone, least of all Greece, because the deficit/debt cutting and labour market reforms are vitally important for the future of the Greek economy. Some relief might sound good right now but ultimately these reforms will need to be made if Greece is ever to have a chance of becoming competitive again.

It’s becoming increasingly clear that eurozone leaders are just trying to put off dealing with the situation until 2013, when the new permanent bailout fund (ESM) comes into force, for both political (its after some important core eurozone elections) and economic (Germany thinks its banks will be in better shape then) reasons. Reaching that date seems to be the new end above all else, no matter the cost (restructuring will only get more costly as debt continues to increase) or the futility of their actions.

Unfortunately, we feel like we've made all these arguments before, but at least we feel less alone this time... ( for example see here, here and here but there are countless others)

Wrestling with a Greek restructuring

The talk of a Greek restructuring has resurfaced again, following Wolfgang Schauble’s seeming acceptance that one might be necessary in the near future. It looks like he’s back tracked today, claiming he was ‘misinterpreted’, but the damage was already done - Greek cost of borrowing has already hit new highs and the euro weakened significantly.

As we’ve noted on this blog many times (here and here, for example) and in our Greece paper, a debt restructuring is unavoidable, Greece is essentially insolvent. It’s been trying hard to enact the necessary austerity but the evidence is against the government – tax revenues have barely increased, spending cuts are proving hard to enact and the population is already fed up with austerity in all its forms.

There are a couple of points which have been raised with us recently on the negatives of a Greek debt restructuring: it will take down the Greek banking sector and there is significant moral hazard. Undoubtedly, it is a risky proposal but from what we can see, there are few other options to tackle the long term (and in this case short term) problems.

On the risk to the banking sector, there is no doubt that Greek banks hold huge amounts of Greek sovereign debt but that just serves to underline that they’re unsustainable. All the large Greek banks need to be restructured and recapitalised. Combining this with a sovereign debt restructuring is just good sense. They may need some capital injection and a lot of ECB help, they may even need to be nationalised while all this takes place but in the end the newly streamlined banks will serve the economy far better than the bloated inefficient current ones ever could.

As for the moral hazard, it is a valid concern that it could encourage other nations to seek debt relief but unfortunately we’re now in the realm of lesser evils. With bailouts or fiscal transfers you get a double moral hazard – firstly to the governments, who are not being reprimanded for their profligacy, and secondly to banks, who took huge risks which they could not cover – at least a restructuring shares the burden between the two.

It looks like Greece is coming to the end of the road, a decision needs to be made otherwise a chaotic default could be on the cards before 2013 and nobody wants that. Greece is priced out of the markets for the foreseeable future, the public is fed up with austerity and taxpayers across Europe are tired of paying to support ailing economies; what more is there to lose from a debt restructuring?

Performance problems

The problems facing German banks (and banks as a whole) have been slightly under reported in recent months. This week, though, has seen a spate of reports which pick up on just that issue.

The IMF Global Financial Stability Report pinpointed the Irish and German banks as the ones with the most "acute" need to rollover debt. Both banking sectors have about half of their outstanding debt due in the next couple of years. So expect a refinancing rush in the not too distant future (although the more immediate concern for most German banks is whether they can raise enough capital to make sure they pass the next round of stress tests).

Interestingly (and commendably), the IMF takes a much higher threshold for capital requirements than the EBA (8% compared to 5%). According to the report, a third of all European banks don't meet the IMF core capital requirements. This highlights just how lax the EBA is being in its assessments, and how precarious the position of many banks is.

According to PWC, German banks are holding €225bn in "non performing loans" - these are loans which are unlikely to be repaid (to compare: UK banks hold €175bn. Irish and Spanish banks hold €110bn and €100bn respectively). The sheer volume of risky loans held by German banks is surprising, especially considering that they hold more than the UK banking sector which is far larger. These figures are only going to increase as well, thanks to poor economic growth and the looming ECB rate rises. Once these losses start being realised they could pose a serious problem for the smaller German banks, who already have capitalisation issues.

(Yesterday it emerged that the German state of Lower Saxony will pump a further €600m of capital into regional bank NordLB, in which it holds the biggest share, aiming to help it pass EU stress tests. We're sure the Lower Saxony taxpayers are thrilled with that!)

On the surface this may seem like it detracts from the problems of the periphery and could even reduce the 'piousness' which many have accused Germany of. However, this is probably far from the truth. Unfortunately, these banking problems are systemic and not enough is being done to tackle them (or even root out their full extent).

So what needs to be done?

Well, (not that we like harping on about it) effective and transparent stress tests would be a good place to start. Combining some peripheral debt restructuring with a widespread recapitalisation programme for European banks should be the ultimate goal. This might be a painful process but it would finally deal with the issues that have been hanging around since the start of the financial crisis. There also needs to be a plan for winding down insolvent and inefficient banks (to be fair there is a 2001 directive which outlines one, but it needs updating and some political will to enforce it).

European leaders continue to turn a blind eye to the dire state of European banks and in this instance Germany is as, if not more, guilty. The level of non-performing loans, huge exposure to peripheral economies and large amounts of debt maturing highlight the trifecta of problems which European banks face; shouldn't EU leaders at least try and deal with one of them?

A bridge to nowhere

There’s been a lot of talk over the last couple of days about Portugal getting bridge loans from somewhere (the European Commission, bilateral loans, the ECB) to hold them over until a new government comes to power.

If the objective is to deal with the sovereign debt crisis, such a solution would really be the worst of both worlds.

Not only would this small bailout have to be condition-free (since there is no government to enact or negotiate the conditions) but it would be nothing more than a precursor to a larger bailout to be negotiated with the new government. Neither of these bailouts will solve anything (as we pointed out in our Portugal paper); the country is basically insolvent and uncompetitive within the eurozone and beyond.

Regardless, no one seems to have any idea where a condition free loan would actually come from. As FT Alphaville points out, EFSM, IMF and even bilateral loans come with conditions (although we agree that the latter is currently the most likely option). The ECB has been eerily silent during the back and forth on this issue, suggesting that it is strongly opposed to expanding its government bond buying to fund Portugal (although we already knew that).

Oh, and just for good measure the caretaker government continues its line of denying that any talks with the EU over short term loans, or otherwise, exist.

Meanwhile, back at the fort, Portugal held another short term bond auction, which raised €1bn but at 5.9% for a one year loan (at that interest rate you could get a €70bn bailout from the EU/IMF). To add insult to injury Portuguese banks announced they would stop buying Portuguese government bonds (because even they have accepted that the debt will be restructured). In case you were wondering, it looks like the Portuguese social security fund bought most of the debt on offer today, meaning that when it gets restructured a large chunk of the populations’ retirement capital will be wiped out.

Clearly, a bridge doesn’t help if you’ve already sunk.

Is the ECB becoming a bad bank?

Its common knowledge that the ECB has been providing massive amounts of liquidity to eurozone governments both directly (through the purchase of government bonds) and indirectly (by taking on large amount of government debt as collateral for lending to banks). The extent of this – and therefore also the implications – are less clear, mostly thanks to the ECB’s reluctance to publish any data on its holdings of collateral or government debt.

FT Alphaville highlights a note from JP Morgan, which suggests that the indirect exposure of the ECB to the Greek state is massive - and then we mean massive. JPM estimates that Greek banks have posted almost €140bn in state related collateral with the ECB (€85bn of state guaranteed bank paper, €45bn of Greek government bonds owned by Greek banks and €8bn of zero-coupon bonds which the Greek government had lent to Greek banks in 2008). Combining this with the direct holdings of government debt (thought to be around €60bn, as we noted in our paper on Greece) you get total exposure of the ECB to the Greek state of around €200bn.

That is a phenomenal amount.

Though these amounts are slightly speculative at the moment, there are some interesting and possibly disturbing implications here, particularly for those of us who believe that Greece will need to restructure its debt at some point soon (not that we’re alone, this group includes nearly all investors and apparently the IMF). This exposure to the Greek state is in the direct firing line if a restructuring occurs. First, there are likely to be large write downs on the direct holdings of Greek government bonds (at least 35% to have any significant impact on the debt burden) and secondly, the state backed paper could become close to worthless. Potential losses are still hard to quantify but would easily be upwards of €40bn.

Comparing this loss to the capital and reserves which the ECB holds, around €79bn, shows the potentially difficult situation which the ECB could find itself in following a Greek restructuring. Essentially the ECB would either have to ask eurozone governments for an injection of capital or or try to print their way back to an acceptable level of capital and reserves.

Therefore, following a Greek restructuring the ECB may have may face a difficult choice: completely ignore its primary mission (i.e. price stability) and print money or go hand in cap to governments - like the bad banks in the financial crisis - and ask for cash (almost like a bail-out).

Two questions: how in the world did the ECB allow itself to get so deep into this mess? And do German politicans/economists/opinion formers understand how incredibly exposed the ECB - once dubbed the world's strongest central bank - actually is?

Splitting the difference between the BBC and the tabloids

There have been lots of numbers floating around on what a bailout of Portugal would mean for the UK. The tabloids today reported a figure of €6.8 billion, while on the BBC Today programme, Robert Peston argued that Britain would only contribute through the IMF, and possibly nothing at all.

Please bear with us as we're trying to break down what's going on here.

First, any bailout would NOT be a direct cost imposed on the UK, apart from the cash contributions the country is making to the IMF. The UK would be liable for a possible bail-out under the the so-called European Financial Stabilisation Mechanism, which the Labour government signed up to in the dying hours of its administration. The mechanism involves the European Commission borrowing money on the markets and then lending it to struggling eurozone countries, using the EU budget as collateral. So far, only Ireland has tapped this fund (Greece only recieved money from the IMF and the bail-out fund that only eurozone members contribute to, the EFSF). Since the UK contributes to the EU budget, it guarantees a certain portion of the loans given to any bailout recipient under the EFSM (the UK's share is around 13.6%). However, this is still significant for UK taxpayers, as it effectively requires them to underwrite the debt of peripheral eurozone economies. It's a bit like if you were to underwrite the mortgage of your neighbours house.

Secondly, in terms of the size of these liabilities, we expect a bailout of Portugal to be in the region of 60-€70bn - though we've seen figures of up to €100bn floating around(clearly its a moving target which makes it difficult to predict). If Portugal needs a €70bn bail-out and the rescue operation is structured in the same way as the loans to Ireland were - one third each from the EFSM, EFSF and IMF - the UK’s liabilities would be €3.2bn (13.6% of the total) under the EFSM and €1.05bn under the IMF. This gives a total UK liability of €4.25bn (if the bail-out is restricted to €60bn, then the UK's liabilities will be in the region of €3.7bn).

Are you with us? Pardon all the acronyms - but this is EU policy, remember.

Thirdly, this is assuming that the EFSM - which, again, the UK is partially underwriting - is in fact activated and used. If EU leaders decide to only look to the IMF and the EFSF, we're looking at a different scenario.

So, the question is, will the EFSM be used in a Portuguese bail-out? The BBC's Robert Peston gave no explanation on the Today programme for his assertion that the UK wouldn't be implicated in a rescue operation on the Iberian peninsula. However, on his blog, he seems to suggest that the EFSM will only be used once the eurozone-only fund, the EFSF, has been exhausted (which it won't be in the case of Portugal).

This is a possible scenario (as we explain in our Portugal briefing) - which will clearly limit the UK's liabilities - but it involves some pretty heroic assumptions. EU leaders are currently bogged down in hugely complicated talks over how to boost the fire power of the EFSF (the fund is currently worth €440bn on paper, but a lot less in reality) in order to convince markets that the eurozone has what it takes to save the euro. A deal is currently being blocked by Finland, due to domestic opposition to underwrite the debt liabilities of other countries, with Finnish national elections looming.

Only involving the EFSF and IMF in a bail-out would leave the EFSF almost completely tapped out. And if markets suspect that the EFSF is runing dry, the euro might be in for an even bumpier ride. Therefore, there will be many EU leaders out there who will want to use a large chunk from the EU-wide EFSM (which still have €37.5bn in it).

In addition, the EFSM is much faster to get off the ground as, unlike the EFSF, it's decided by majority voting. The case of Finland (and also Slovakia which refused to take part in the Greek bail-out), shows why this matters. Ergo, there is a very strong case for suspecting that the EFSM will be used, and therefore, that the UK will become indirectly liable.

That Peston seems to be omitting this discussion - which touches on so many important aspects of the ongoing eurozone crisis - is surprising.

Fourthly, the UK tabloids today featured pieces on what would happen if the EFSM was tapped completely (i.e. if it used all the remaining funds). Well, there is currently €37.5bn left, of which the UK is liable for €5.17bn. However, it's very unlikely that this entire amount will used in a Portugal bailout, since the cost will be shared with first, the IMF and most likely also the EFSF. Our estimates that we set out above are far more likely.

So still lots of uncertainty. Time will tell.

Don't fear the R-word

The Portuguese Prime Minister Jose Socrates resigned last night, after failing to get his new austerity measures through the Portuguese Parliament. This has pushed Portugal into a political crisis, and forced them to the brink of asking for a bailout.

As our new briefing on Portugal’s economic situation shows, a bailout could amount to €60bn - €70bn. Based on the structures of previous bailouts, the UK’s contribution could amount to as much as €4.26bn in liabilities (in the form of loan guarantees). That’s a big liability for taxpayers.

That’s why we argue for a combination of a restructuring and bailout. This would shift some of the burden onto investors; it would also help put Portugal on the road to debt sustainability rather than just recycling more debt around the EU.

For you restructuring-phobes out there, we are aware of the risk of contagion, but we believe there are many factors in this instance which make this a viable course of action:

- The bailouts of Greece and Ireland have solved little, they still have no market access to fund themselves and face ever increasing debt burdens.
- Markets are already boycotting peripheral eurozone debt, how much worse can things get (if it wasn't for the ECB, Portugal would have gone bust long ago)!
- Portugal’s debt burden, although large in GDP terms, is relatively small in nominal terms (given the size of other EU countries and banks).
- Exposure to this debt is spread around the EU and does not fall heavily on peripheral economies; the European banking sector will withstand the losses it may incur (although if it coincides with other negative banks may start to wobble - but that's an argument in favour of sorting out the banks!)
- The ‘Portugal goes, Spain goes’ assumption looks to be overstated (see positive market response to Spain despite Portuguese problems). In any case a limited bailout fund should help halt the spread of contagion from Portugal.
- Unfortunately, we’re in a crisis; difficult decisions need to be taken. A restructuring now is preferable to a more costly one later. The alternative is ongoing transfers of wealth to struggling eurozone economies - the sudden rise of the "True Finns" in Finland shows why this is politically very unlikely.

The question that now needs to be answered is when can or will any of this take place? That depends on what powers a caretaker Portuguese government has, but, in our view, the sooner the better. (The double standards displayed by the opposition in bringing down the government over austerity measures, then pledging to do a better job of managing the debt and deficit levels, doesn’t fill us with confidence though).

You can read our briefing here.