Portugal recently. It’s not a pretty story, but well worth reading. His
conclusion is that Portugal will follow Ireland very soon. AEP ends his
piece with:
Any better ideas out there?
I will give it a shot. But first let me say that I do not believe in
plans that push problems down the road. I think we would all be better
off to let nature rule on the economies. We have already had far too
much intervention. Between bailouts, dangerous fiscal policies and
downright whacky monetary policies it is hard to determine what is real
in the global economy. A good chunk seems to be on permanent life
support. That said:
To address the European sovereign debt problem a very big bazooka is
required. It is a trillion dollar (equivalent) problem (including Spain,
but excluding Italy). No one has that kind of money. For there to be a
“solution” to the EU debt problems there has to be a new Brady Plan. It
would require cooperation and involvement by all of the big global
players including the IMF, Switzerland and China. It would require
sacrifice by the countries affected; there would be costs to all EU
countries. Lenders and bondholders would have to pay a price.
The Brady Plan relied on zero coupon bonds to securitize the principal
of a sovereign borrowers debt. In 1989 Mexico restructured $50 billion
of external debt. Holders got a new instrument in exchange for their
un-payable old ones. The new bonds had an interest rate that was both
favorable to Mexico, but still profitable to the banks (Libor + 13/16th
or a fixed rate of 6.5%). The principal of the new bond was guaranteed
by a 30 year zero coupon bond issued by the US Treasury. Over a short
period of time Mexico’s problems went away and they prospered for many
years (so did Brazil and a number of others). Mexico was no longer faced
with any rollover risk. The principal had been defeased. They had a
stable/predictable debt service cost of the old debt.
It is very hard to recreate the Brady Plan in 2011. The simple reason is
that interest rates are too low and zero coupon securitization would
cost too much. Outside of the market rate restriction there is the
question of who would be the issuer of the new zeros? The USA is not the
right answer this time.
In 1989 30-year interest rates were 9+%. Using the miracle of compound
interest a 30-year Treasury zero cost only 9.5% of par. Mexico was able
to secure the principal on $50b of debt at a cost of only $4.5 billion.
Today that zero would cost closer to 30%. Two solutions. The zero must
be 40 years and the implicit interest rate must be at 6%. The present
value of that theoretical zero is $9.72 today. Using this number, $1
trillion of sovereign bonds could be secured with approximately $100b.
That is progress.
Who would be an acceptable issuer to the marketplace of the zeros? My
candidate is the IMF. The IMF would love to issue 40-year bonds at a
fixed rate of interest, but they most certainly would not be willing to
pay 6% to achieve it. A fair rate for this today would be 4.5% so there
is a cost of 1.5% that has to be addressed. The cost in the first year
comes to a manageable $1.5b (.01% of EU-GDP). But that miracle of
compound interest works in reverse as well. Over the 40-year period it
comes to a total of $81b. Who would pay this subsidy? In my opinion the
cost should be allocated among the EU members. I propose that it be done
annually, on pro-rata basis based on GDP. Yes, that implies that
Germany and France would carry the heaviest weight. But they also have
the most to win (and lose). Germany’s cost would be ~$500 mm in 2011,
~$30b over forty years. What would the alternative cost? Many multiples.
The next hurdle: Assume that Greece, Ireland Portugal and Spain are in
need of a $1T recap. Assume the percentages of that are Greece-10%
Ireland 10% Portugal 5% Spain-75%. Assume finally that the cost of the
zero is 10% of par. You get these capital requirements to initiate the
restructuring:
Greece=10b
Ireland=10b
Portugal=5b
Spain=75b
Total=100b
These are daunting numbers. Coming up with this much money is essential
to the transaction. This will prove to be the thorniest part of the
“fix”.
Each of the countries has reserves that could be used to fund a portion
of the capital required. For example, Spain has $25b of reserves
available. Reserves are necessary for any country to manage liquidity. A
trouble borrower like Spain must have adequate reserves, therefore the
amount that each country could come up with is limited. However, post
the proposed restructuring the countries will not have any maturities of
debt. Their re-financing of future maturities will have been largely
eliminated. Therefore they can manage with a lower net reserve position.
I believe that each of the countries have the capacity to fund 10% of
the required capital. That still leaves a very big hole.
$90b is not such a big number these days. This amount could come from
the big surplus countries in the EU. The problem that I see is that this
approach creates a political stumbling block. This money could also
come from the IMF. But again, I am concerned with the optics of over
reliance on the IMF. I would prefer to see that this money is raised
from sources outside of the EU/IMF. My two candidates for this are
Switzerland and China (the “S&C” loans).
Both countries have very deep pockets of reserves. Coming up with the
$90b is not an issue. They both have big stakes in the outcome. Yet,
selling this will be difficult. I point again to the fact that post a
restructuring the credit profile of the countries will be dramatically
improved. Their ability to service the S&C loans should not be in
doubt. Therefore the loans are “money-good”. That said, it may be
necessary for a broader EU guarantee on the S&C loans.
China would not want to do this. They have plenty of cash, but they may
require trade concessions as an inducement. Should something like this
happen China would ascend to the top of the list of global Kingmakers.
This would blunt some of the criticism that they face on the currency
issue. How much would they pay to buy some peace on this issue? Plenty.
Switzerland does not want to do this. Again, liquidity is not the issue;
it is politics. In my opinion it is high time that Switzerland step up
to the table. I do not want the Swiss (or the Chinese) to take risks on
their reserves. I want them to use them to facilitate a broader
solution. The Swiss have already spent massive amounts in an attempt to
stop the CHF from appreciating against the Euro. If the EU blows up the
CHF will soar. This outcome would be broadly negative to the Swiss
economy.
I want another role for Switzerland. I want them to be the fiduciary
that manages the financial paper work. There is no cost to this; they
might even make a buck. Their role would go a long way toward giving the
program the necessary respectability.
I feel very strongly that Switzerland must get involved and be part of a
solution. They have had a free ride for a decade. It is now time for
them to step up to the plate. If they resisted this responsibility I
would like to see the EU retaliate with a broad increase in tariffs. A
carrot and a stick.
Now the market side of this: I would propose that an exchange offer for
new Capital Protected Bonds (“CPBs”) be voluntary. Most of the debt is
held by banks. The fact that they would have no future capital risk
would mean they could leave the bonds on the shelf forever and never
face a write down. I would propose pricing on the CPBs to be close to
that of Germany. That concessionary rate is justified as there is no
principal risk.
If a holder of a sovereign Spanish bond chose not to participate in the
restructuring they would not get paid cash at maturity. They would get a
new 5-7 year bond (the “Exchange Bonds” or “EBs”) that have a yield set
at EURBOR plus 1. There would be a market price for the EB paper. The
holder of the original sovereign bond could sell the new EBs for cash.
This would probably imply a loss. Tough luck. If they want to avoid a
potential loss they have the alternative to participate in the CPBs.
This ties the knot on virtually all existing debt. Either it is rolled
into the CPBs or it is exchanged for the new EBs. Functionally this has
the effect of subordinating all of the existing debt. The countries
involved will have “clean” balance sheets. They should be able to fund
existing trade and current account imbalances from the market. Should
that prove to be a trouble spot I would consider that there be EU
guarantees on the new working capital debt. I do not think this step
will be necessary.
The banks will hate this plan. I say, “tough luck”. They are
collectively part of the problem and therefore should be part of the
solution. There is a silver lining for the banks. The new securities
(CPBs and EBs) will create a whole new trading opportunity for them.
Give them something new to trade and they will shut up. I would not
tolerate much opposition from the banks.
Summary
-This proposal avoids all losses to current holders of trouble sovereign
debt. It restructures liabilities for many years. It could eliminate a
substantial portion of the principal indebtedness of the borrowers. The
portion that was not exchanged for CPBs would also be automatically
pushed forward by a significant period of time. Debt service cost would
be stabilized. Rollover risk will be eliminated.
-There is no incremental cost to the IMF.
-China and Switzerland have to step up to the global stage and play
their role. They face little economic risk from this proposal, they
would benefit from the stability/trade deals that would follow.
-The troubled borrowers would still have to face up to the need to
reduce deficits. The amounts and pace of those adjustments will be less
draconian than those that the IMF has currently required. While I doubt
the countries involved would rejoice at this outcome it is far better
than any other alternative they are currently facing.
-Note that there is no role for the USA in this proposal. Very
deliberate by me. The US has no resources, no moral authority given its
debt profile and its involvement would likely prove counter productive
given the political gridlock that is soon to envelop D.C.
Exactly, Portugal SHOULD go first, but if Spain is smart, it will jump line. It's starting to be earliest in will get most help and emerge earlier than those that must follow . . . and almost ALL will follow in Western World.
While everyone is focused on the PIIGs, better keep your eye further east. Watch BRUHA - Bulgaria, Romania, Ukraine, Hungary and Austria. Doesn't matter that IMF is already in Hungary and Ukraine - not stable, and housing hasn't been accounted for with its currency issues in Hungary and the overreach in Ukraine is gonna have a domino effect.
Yes, banks need to take the hits. They did know what they were doing when they overleveraged and decided risk didn't matter in lending, packaging and investing. It was all yields and all fees all the time. Not asset/liability risk management or reasonable lending standards.
And, why should Switzerland have to bail out an organization and structure that it very intentionally did NOT join? Yes, they benefit from trade with the rest of Europe, but they have largely handled their own banking problems directly. The fiduciary role is a good suggestion as it does lend potential credibility at a time where we have no trust in any of these organizations anymore - IMF, EU, Fed, governments of almost every kind - but it is should be a Swiss decision, not a global demand.
My cheap, probably useless, 2 cents.
And Bruce omitted the thorny problem of the UK - part of the EU, but not in the Euro. However, a large GDP, just behind France. Would Blighty be requested to pay its share?
The UK does not have the resources to make a meaningful contribution to this.
Sell the queen's jewels.
No, seriously. Another option is to let themselves blow each other to pieces...for a Nth time. Then you can sell what's left to pay off the oil mullahs. They've been frothing at the idea of re-establishing their lost eurabia caliphate for over 500 years.
Hannusen saw the reichstag on fire. But who's to say what he saw was 2011 and not 1933?
Who does? Didn't France just have a pension change? Italy is a ticking time bomb. Seems like the only solvent member of the EU system is Germany and a few minors. Germany is already feeling a lot of internal pressure on this and their status as main funder of the EU. Pile this on them and might just see a rise of a breed of more nationalistic politicians who will call for disbanding the EU or at least leaving it.
And it's not like Germany is not action packed with problems. Look at their pension obligations going forward, it's better then most, but IIRC still insolvent.
Price it to 20 cents because of inflation...