As global financial markets ponder with trepidation the possibility of a Greek debt restructuring (or worse), it's worth remembering that cross-border lending has always been a shortcut to financial hell. The United States itself has defaulted no fewer than four times (though not since the Civil War); decorative but worthless Russian railway bonds paper the walls of banks across the globe; in the 1970s and 1980s the mania for LDC (less developed country) lending ended in bitter tears; Russia defaulted again at the end of the 1980s; and now, despite the supposed comfort and support provided by the EU and the IMF, the Eurozone's PIGS are in deep doo-doo, with Greece currently at the forefront of market concerns.
Banks seem to be unable to shake the habit of underestimating sovereign risks. During the LDC lending binge of the 1980s, loans to countries in the old "Warsaw Pact" countries of Eastern Europe were perceived to benefit from the "Soviet umbrella theory": loans to Poland were safe because the USSR would never allow its satellites to default. Three problems with that, of course: the USSR was never formally on the hook; it wasn't in a position to meet the obligations anyway; and it ended up falling apart itself.
In a similar vein, lenders have piled into Greece and the other PIGS partly because of the perception that these countries' membership of the EU and the Eurozone offered some kind of protection to lenders. At the time most of the bonds were sold, this support was as theoretical as the Soviet umbrella of yore. Although the EU has rushed to establish formal mechanisms since the crisis erupted, the sheer scale of the support that is likely to be needed is now triggering voter discontent, as recent election results in Germany and Finland attest.
In the specific case of Greece, assessment of the risks has not been helped by the fact that the country misrepresented its financial position in the runup to Eurozone accession. The so-called Maastricht criteria were intended to ensure that prospective new Eurozone members had "converged" to accepted inflation and fiscal standards before they were admitted. Since Greece appeared to be meeting the criteria, the perceived EU blessing encouraged private lenders to get involved in the country. It turns out, of course, that Greece had been massaging the data to ensure it was accepted into the Eurozone. It would be unfair to blame the banks for being taken in, when the due diligence failings appear to have been mainly on the part of the Eurozone authorities.
Not that this is the first time that borrowing countries have misled their lenders. If I may be allowed a personal anecdote here, in early 1980 I went to Rio de Janeiro to prepare the "information memo" for a loan my bank was planning to syndicate for Petrobras. The stated purpose of the loan was to finance the purchase of four offshore oil rigs. As a colleague and I sat in a hotel room overlooking Copacabana beach, working on the information memo, an oil rig was towed into the middle of the bay just in front of us. Petrobras admitted to us the next day that this was one of the rigs our loan was financing. They already owned it, but they knew that attaching the loan to an identifiable project would secure better terms than describing it as balance of payments financing, even though that's what it was. This was normal practice for Brazil, and the loan went ahead anyway (and was repaid on time).
So the road that's led to the edge of the precipice with Greece is one the banks have travelled before. But there are differences this time, and they're not reassuring. Back in the days of the LDC lending boom, loans were syndicated out to a small syndicate of lenders, who kept them on their own balance sheets. The information memo that I worked on in Rio was intended to help with risk assessment, but each participant had to assess the deal for itself. All banks had internal limits for how much exposure they would take to each sovereign risk.
Things are different today. Loans to Greece and the other PIGS have been packaged up and sold off to all comers. Most of the buyers have relied on the credit rating agencies for their risk assessment, and we all know how safe that's likely to be. The result of this process is that it's difficult to know in advance where the damage may be done if Greece were to reschedule its debts.
Uncertainty over where the risks lie is massively heightened by the extent to which banks and investors have relied on credit default swaps (CDS) and similar instruments to lay off some of the risks of their exposure in Greece and elsewhere. Recent data seem to suggest that the outstanding volume of CDS is far lower than it was in 2008, as deals have rolled off, but it remains far higher than the volume of actual debt outstanding. (Remind me again why CDS are not purely speculative instruments?)
Recall that in the 2008 financial crisis in the US, it turned out that the institution most exposed was not a bank but an insurer, AIG, almost entirely because of its insatiable appetite for CDS. The current belief is that the greatest exposure to Greek debt is held by the German Landesbanks, but it's impossible to be sure because CDS remain an over-the-counter product: nobody has a clear handle on who has bought what.
Some of the same people who said that it was a mistake to let Lehman collapse back in 2008 now seem to be suggesting that it was a mistake not to let Greece collapse as soon as the problems surfaced, because the costs of a rescue are even higher now, and are more likely to fall on the taxpayer, since the ECB has been hoovering up outstanding Greek debt for the past couple of years. (Good old Harry Hindsight, always at the fore in a financial crisis). The EU's strategy of muddling through seems to be reaching its limit. Whatever comes next, it's going to be messy.
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