May 31, 2011

Greek EMU Exit: More Pain than Gain

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 11:43 PM by Robert Barone

In a recent blog post, we argued that, despite her credentials, Ms. Lagarde may not be the best choice for heading the International Monetary Fund (IMF) because of her bias to protect the French, German and European banks from the losses they will have to take in a Greek default, and that she will pursue the same “extend and pretend” policies that were put in place a year ago rather than face up to the fact that we are dealing with insolvency, not temporary illiquidity.

The Moral Hazard Expectation

It is clear that Greece will never be able to repay its debt in today’s Euros, and European banks are clearly in jeopardy.  Yet the market has yawned, and European bank equity values have been untouched.    A comment received from a colleague regarding that blog post read, in part:

If she [Lagarde] gets into position and kicks the ball down the road a ways, it will only be to give these big banks a chance to off-load and write-off Greek credit over a few years which will make it more palatable when the time comes to restructure.

The market appears to have much the same attitude expecting the governmental institutions to save the “systemically” important financial institutions.  Moral Hazard is now the expectation.  Not only are all depositors implicitly protected, but so are the shareholders, bondholders and the managements.  We always thought that investing was a risk-reward business.  Investments that fail are supposed to penalize the investor through a monetary loss.  There isn’t supposed to be a floor of book or par value supported by public funds.

The Implications of Additional Austerity

We suspect the reason for the kid gloves treatment is that the alternatives inflict too much short-term pain.  As mentioned above, a Greek default significantly impacts most large European banks.  Rather than recognize the impairment of the investments in Greek debt, in exchange for additional monetary support, the European Central Bank (ECB) and IMF will likely impose even more stringent austerity measures on Greece than the ones that currently exist and cannot be met.  What isn’t factored in is the impact this will continue to have on the Greek economy and its population.

It was only 10 years ago (2001) that the government of Argentina was compelled by the IMF and other large institutional debt holders to apply more and more austere measures on their economy in order to pay back debt.  In the month of December, 2001, the austerity imposed was met by protests which quickly erupted into revolution, governmental overthrow, and eventually a tacit default.  Is this where we are heading again?

Given the resistance of the Greek populous to the existing imposed austerity, additional austerity could trigger a popular uprising and result in a Greek exit from the European Monetary Union (EMU), i.e., the Euro, or from the European Union (EU) itself.  The founding Maastricht Treaty (1992) and original amendments didn’t discuss provisions for a member’s exit from either the EMU or the EU.  The Treaty of Lisbon (2009) does allow for an exit from the EMU, but that appears to be predicated on a negotiated rather than unilateral withdrawal.  It is clear, however, that the EMU was meant to be an irreversible arrangement. (For a detailed discussion, see P. Athanassiou’s ECB working paper entitled “Withdrawal and Expulsion from the EU and EMU” at

The “New Drachma”

Putting aside the legal questions, an exit from the EMU and formation of a new Greek currency (call it the “New Drachma”) has its own set of troubling issues.  Once again, a look at the recent Argentine experience is enlightening.  A decision to leave the EMU would need to be done quietly, as public knowledge would cause a run on the banks to acquire Euros causing nearly instant failures in the banking system.  So, severe restrictions on Euro withdrawals would have to be imposed, like the much hated “corralito” that was imposed in Argentina in ’01. That government imposed policy restricted withdrawals to a nominal amount per week.  This was a key repression that led to the social unrest, riots, and the eventual toppling of the government.

Next, Greece would need to decide what to do with its debt.  Hard choices would have to be made on externally held debt. Any attempt on the part of the Greek government to convert externally held debt to the new currency on a 1:1 basis would be met with massive resistance.  Keeping external debt denominated in Euros would become crippling as the value of the “New Drachma” would immediately devalue in the forex markets.  And, all of the “extend and pretend” would be for naught, as the Greek sovereign assets on the balance sheets of the banks would be repaid in a devalued currency.

Impairment is Inevitable

Thus, the results of an imposed austerity likely leading to a Greek exit from the EMU are the same as a simple recognition on the part of those banks that hold Greek sovereign debt that those assets are impaired.  Facing up to this basic problem would seem to be a better than the current “extend and pretend” approach in which we ultimately end up in the same place, but without the social unrest and bloody carnage that accompanies it.

Recognizing today’s value of the Greek debt on financial institution balance sheets is called “transparency”.  Accounting standards, both in the U.S. and internationally, have been pushing for transparency for two decades.  Yet, now, governments are madly scrambling to cover up the true values of such assets on the books of their “systemically” important institutions.

There are also tens of billions of dollars of Credit Default Swaps (CDS) outstanding on Greek sovereign debt.  Regulators failed to deal with the capital issue in the CDS marketplace in the aftermath of the ’08-‘09 AIG meltdown, so it is impossible to predict the effects of a Greek default on this marketplace because there is no information on CDS counterparties and their capital positions. But we suspect these markets, being unregulated, continue to be over-levered.

“Extend and Pretend” Causes Stagnation

The interconnected nature of today’s global financial system implies that many other banks around the world face asset impairments and a need for more capital. Many banks could fail.  The stockholders and bondholders of these institutions should suffer losses, and not be recipients of the “moral hazard” of government protection.  There will be terrible short-term pain.  But, history shows that the pain of balance sheet depressions, while severe, is short-lived.  The system returns to health with huge lessons learned about risk.  “Extend and pretend” only imposes a long-term period of economic stagnation as the cancers on bank balance sheets fester.  Japan’s is a 20 year example of the impact of unrecognized bank losses on the economy.  In an interview given to Investors Business Daily (“Slow Growth Normal For Post-Fin’l Crisis Recoveries”, Norm Alster, 5/23/10) by Vincent Reinhart regarding the paper he recently wrote with his wife, Carmen, concerning the aftermath of 18 financial crises (see After the Fall, 8/17/10), in Japan, “the banks were allowed to carry bad assets on their books at inflated values.”  As a result, “property prices have declined for 20 year”.  As an overview, Reinhart concluded that “the government’s willingness to let banks carry bad debt rather than force them to take losses tends to stretch out the process of deleveraging.  When you let banks carry their assets at high values relative to their market values, it freezes that market”.  His prescription: “Recognize the losses … Take the hit”.  Since it appears that the inability to restart America’s economic engine is partly due to bank balance sheet impairment, why is Europe about to go down the same road?

Robert Barone, Ph.D.

Matt Marcewicz

May 31, 2011

Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A).  A copy of this Brochure may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

1 Comment »

  1. hemp said,

    How long will we support the governments Ponzi scheme that makes a mockery out of the monies we have annually contributed obediently to our Social Security and Medicare accounts? …..I have been writing extensively about the unregulated along with the that has resulted in an explosive market rally from the depths of the post financial crisis. Facts which can convince a jury of our peers that beyond a reasonable doubt we know how and by whom a crime was carried out.

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