Tuesday, May 4, 2010

Greece and Insolvency

A financial crisis that is a result of the potential insolvency of a borrower is connected with the “true” value of the underlying assets held by the lender. In the case of the Greece bailout, the European Union (EU) and the International Monetary Fund (IMF) are working to keep the value of Greek bonds at 100% of face value.

Thus, the €110 billion (or $145 billion) package put together over the weekend is an effort to save the Euro by providing Greece with enough cash to meet its financial obligations over the next twelve months or so. Hopefully, at the end of this time Greece will be welcomed back into the capital markets so that it can raise its own cash, something it needs lots of.

Then, as is usually the assumption in insolvency situations like this, the debtor will grow out of its difficulties so that its debt will return to 100% of face value in the financial markets. The problem with this is that Greece is expected, at best, to return to the level of real GDP it achieved in 2009 in or around 2017. The austerity moves required by the IMF of the Greek government is not expected to contribute to a strong rebound in its economy.

Many analysts are contending that the bailout is really to protect the banks in Germany and France. The commercial banks in these two countries hold a massive amount of Greek debt. If one gives the Greek debt a haircut of 40% to 50%, several banks in these two countries will fail and require government support to keep the banking systems functioning. If this were to happen both nations would find themselves in deep economic trouble, threatening the recovery of all Europe.

But, note…”The European Central Bank (ECB) agreed to continue accepting as collateral any current or future Greek government bonds, no matter how much debt-rating companies downgraded them.” (See http://online.wsj.com/article/SB20001424052748703612804575222331434882588.html#mod=todays_us_page_one.)

By doing this, the ECB is attempting to prevent a liquidity crisis at Greek banks, because these banks can use the new collateral rule to get cash from the ECB by pledging their Greek bonds as collateral. Also, this rule will benefit euro-zone banks because it will mean that these banks can also get money from the ECB by pledging their Greek bonds as collateral.

There seems to be a special effort on the part of EU and IMF officials to take all discussions of losses on Greek debt “off-the-table.” The emphasis is upon ensuring that the banks that hold Greek debt and the financial markets that everyone will be “paid-in-full” over the next year or two. Anyone that talks differently will have his or her hand slapped!

The ultimate mechanism for insuring that debt is covered over the longer run is to produce an inflationary environment. And, in a severe financial crisis, the concern of the policy makers is to err on the side of providing too much liquidity. The policy makers do not want people, at some time in the future, to accuse them of not providing enough liquidity to the system which resulted in an even greater financial crisis.

Jean-Claude Trichet, the President of the European Central Bank certainly is adhering to this principle in the current situation. Trichet, the stern defender of central bank fight against inflation in 2007 and 2008, now seems to be putty in the hands of current circumstances.

Trichet, however, still seems to be a amateur when compared with his counterpart Ben Bernanke at the Board of Governors of the United States’ Federal Reserve System. When it comes to “throwing stuff against the wall to see if it sticks” Bernanke is the poster-child.

Inflation may be the ultimate tool that Europe uses to save the Euro and the European Union. The reason for this is the other nations that are on the brink of financial disaster: Spain, Portugal, Italy, and Ireland. Also, there is the U. K. sitting across the channel showing us the very real possibility of having a “hung” Parliament which would find it very difficult to do what it needs to do to get its own act in order. There may just be too much to do in the current state of affairs to overcome the lack of national discipline that has been exhibited in this the European region in the recent past.

The factor that might set this all off is the reaction of the government employees and the working classes in these nations to the austerity programs that are being forced down the throats of the governments in question. Europe has a long and proud history of labor movements and working class unrest. These movements have been relatively quiet in recent years. In Greece we are seeing a resurgence of protest that could fuel further unrest in other countries, especially in Italy.

It was fear of such unrest in Europe in the 1920s and 1930s that led to a philosophy of government policies that supported the creation of an inflationary environment to keep people employed with ever increasing wages. These policies were implemented in many countries once the disruptions created by World War II subsided. The history of labor movements in Europe in the twentieth century is long and rich. It is unlikely that the austerity programs will be easily accepted by the people being impacted by them.

Again, the problem we are seeing is that there are no attractive options to governments or governmental bodies after a long period in which financial discipline has been absent. As Carmen Reinhart and Ken Rogoff have shown in their book “This Time is Different”, every time that governments (or people, or, businesses) lose their fiscal discipline the time is never different.

The Piper eventually has to be paid.

The effort to prevent too much pain, however, is to bail out governments (and people, and, businesses) and then stimulate the economy to put businesses, and, people, and, governments, back where they were before the crisis began. This is done by inflating the economy through extensions of liquidity and programs to maintain asset prices. The goal: to get the economy back to where it was before the crisis began.

This is what the European Union, with the help of the International Monetary Fund, is attempting to do. Unfortunately, the underlying problem has not been solved. There are major amounts of assets on the books of financial institutions and other organizations that are substantially over valued. The question that lingers in an insolvency crisis relates to how long these financial institutions and other organizations can continue to hold onto the assets without marking them to a more realistic value or working the losses off through charges against other earnings?

1 comment:

Jay said...

Even in normal economic situations, insolvency amongst businesses is more common than we would like.

insolvency advice