Greece vs. Lehman? Look for the next AIG instead

Much of the discussion about how to restructure Greece’s debt has focused on the banks and other institutions that will take a hit when the unavoidable happens. It is in fact pretty simple. As a sovereign issuer, Greece of course knows precisely how much debt is outstanding. Regulators in other countries have a pretty good idea who own the debt, since they can force the banks to disclose their holdings. So when politicians are negotiating, they know who will lose. It is just not good style to tell.

The fact that 100’s of banks would take a hit has led to comparisons with Lehman. That is a wrong comparison. When Lehman blew up as a direct result of their own incompetence, the real surprise was that AIG blew up as well. The culprits were of course CDS’s.

Buyers of CDS’s buy insurance against a credit default – lyrically referred to as “protection”.  One does not need to have given credit, i.e. to hold bonds in order to buy CDS’s. Buying or selling CDS’s has become a simple speculation in a default with volumes of "protection" traded often massively exceeding the volume of underlying bonds. As the Lehman/AIG debacle showed, if too many have speculated in a default happening and on the other side we find only one major seller of CDS’s, the situation can become unmanageable.

A combination of gaping holes in the accounting rules, a complete lack of transparency, and plain incompetence and greed created a situation where the US government chose to simply pour billions of dollars into AIG. The purpose was to make sure that the buyers of CDS’s on Lehman debt did not end up in a situation where the “protection” they had bought did not vanish. It is by now a well-known story that a bank like Goldman Sachs received cash compensation to the tune of USD 14bn directly from the US government via AIG’s accounts.

Back to Greece. It is obvious that a debt restructuring is necessary, and Germany has suggested a voluntary maturity extension. It had to be “voluntary”, i.e. the holders of Greek debt would have to accept swapping short term debt for long term debt without saying: “hey, you are forcing me to do this, it means Greece has defaulted on the short term debt. That is a credit event”.

The important term here is “credit event”.  What constitutes a credit event is not defined by politicians but by ISDA, the International Swaps and Derivatives Association. It is a private organisation which serves as the financial market’s own watchdog over OTC transactions. In other words, even if European politicians were hoping to construe a maturity extension as voluntary, ISDA could simply say that they were having none of it and define it as a credit event.

In that case, all the CDS’s bought and sold on Greek government debt would have to be settled, the credit default protection would be activated. And here lies the rub.

Despite several well-meaning political efforts to force open the CDS market, it is still largely unknown how many CDS’s have been established on Greek debt. Nor do we know for certain who are the holders and who are the issuers.

Whereas holders of Greek government debt are relatively simple to identify, it is close enough to impossible to find out who is sitting with the CDS risk. It may be banks. It may be commercial companies. In other words, there is a sizeable risk that the holders of Greek debt will not be alone in taking a loss. Issuers of default protection will also take a hit, and they may or may not have enough capital to survive a credit event. This uncertainty could indeed create a new freeze in the money markets. We know what that leads to.

If that were to happen, it would be the second time in three years that the CDS market proved dysfunctional. Which leads me to my real point.

Since 2001 corporate bonds and particularly junk bonds (conveniently renamed “High yield bonds”) have been very strong performers across the world. This is partly due to the existence of CDS’s , which have allowed the treasurers of the corporate world to have the illusion of being able to manage the default risk on the issuer of the corporate bonds.

If Greece fails (as I believe it will), it could lead to a major blowout of CDS’s, where nobody would know who would be hit. And in the after math, it could lead to a major loss of confidence in a system which has blown itself up twice. The effect could very well be a visible widening of credit spreads worldwide.

I have earlier written that I believe risk is priced way too cheaply. It has become cheaper since back then. A “credit event” on Greece could be one step in the direction of normalising the price of risk. But it would not be pretty.

The value of implicit bank guarantees

In an event little noticed outside of Denmark, the Danish FSA and the finance ministry let the country’s former fifth largest bank, Amagerbanken, go bust . This happened after a couple of attempts at recapitalising the bank. Remarkably, the holders of Amagerbankens’s bond debt were told that they could line up with other creditors to get their money back.

It has created quite uproar in Denmark’s financial sector, where previous bank collapses had been handled with “due respect” for the interest of bond holders. 

As a direct consequence, the international (read: the US) rating agencies have downgraded Danish banks several times since then, most recently at the end of May.

Predictably, Danish banks are lamenting the fact that the government has shown its willingness NOT to compensate bond holders.

Their spin is that the lower ratings mean higher funding costs and thereby a competitive disadvantage for Danish banks. So we are to believe that the FSA and the finance ministry willingly have weakened the position of the country’s own banks?

One could look at it differently. I have several times wondered why simple capitalist principles were not applied when it came to the banking sector. The answer is that a) the banks were much weaker than anybody outside the sector had expected and b) the banks have been very good at making politicians believe that it would be the end of civilisation as we know it if banks and their owners/creditors were to shoulder the burden of their own greed and recklessness.

If we look at it this way, Denmark is the first country that has shown the way forward (well, Iceland sort of did, too). If banks cannot survive with the capital they have, they go under. Those who had lent them money should take the losses, since money lending inherently is a risky business. That seems a very healthy principle for “bank resolution”, i.e. dealing with dead banks. And by the way, it was exactly what Sweden did during its systemic banking crisis in the early ‘90s.

But what about the increased funding costs, stemming from the absence of a government guarantee to the lenders?? 

The right way to look at this is not to bemoan the situation of the Danish banks, but instead look at the difference in funding costs as the market value of the implicit government guarantees. We are in a situation where banks in other European countries have higher ratings than Danish banks, simply because the governments are expected to pick up the pieces if another bank blows up. It could hardly be unhealthier.

I quote former US Secretary of the Treasury and Chief Economic Advisor to President Obama, Larry Summers, who in 2000 said:

“While conditioned, precautionary financial support is constructive in some cases, the risk inherent in systematic availability of unconditional credit to countries can be summarized in two words: moral hazard. ... It is certain that a healthy financial system cannot be built on the expectation of bailouts.”

Summers later minced his words in a quite spectacular way and helped engineering the biggest giveaway of taxpayer money in modern history. But that does not make his statement of 11 years ago wrong.

Banks’ funding costs should not be based on implicit guarantees. They should be based on the availability of a capital base sufficient for their activities. Incredible that it is so difficult to get this simple message across to the banks.

Well, an implicit guarantee does not weigh on the balance. It allows a higher financial leverage. And it creates the possibility of higher return to the shareholders and fatter bonuses to the bank management. Go figure.