France, Italy and the war's fluid front

China has stopped doing business with a number of French banks, and Siemens, for one company, has stopped as well. There is concern that the banks will be hit by a possible Greek default on public debt next month. A good amount of Greek debt will have to be paid or rolled over, the Greeks and the troika of EU, IMF and ECB have been at an impasse, and Germany has just announced that it can't possibly vote on new support until 2012. A default is coming, and the Chinese, who have excellent business acumen in these things, are pulling out.

The silver lining in this cloud is that they will probably be back, purchasing assets and shares at a bargain at a later date, but not before France is significantly weakened, and before the Chinese have strategic positions in French investment banks. Note that will come with political as well as economic influence.

Italy has also been downgraded, and the country is unable to find a replacement for the outgoing Berlusconi.

The war has extended beyond Greece, Portugal and Spain and is now rampaging in France and Italy. The Dutch and the Germans are retrenching budgets all the more to compensate and ringfencing themselves from the carnage. Spain seems to be holding the fort well enough.

This isn't the end of it. Indeed, because the Europeans will not support the economic stimulus plans that the US is proposing, there will be a downward spiral for the next decade in which employment, wages and general economic welfare in Europe will decline. The only people to benefit will be the ones with enough cash to buy in at a discount.

All of this assumes that a default doesn't happen, and/or that Greece remains in the euro. But leaving the common currency may not affect the other countries that are now in the midst of the war.

Assuming Greece stays, invest in emerging markets. Growth will not be happening in Europe for a while.

The European Systemic Risk Board and Default in Greece

Greece will default on its debt this year, whether Europe helps it or not. The only questions now are: how big will the default be; will the default take Europe down with Greece?

The answer to those questions will look far more positive in relative terms if the European Systemic Risk Board is used to figure out and manage the impact of a Greek default. The ESRB was designed for a different purpose: for preventing financial collapse when a private bank collapses. Now, if its members have any sense at all, it must start making contingency plans for a Greek default. It will have to run through a number of scenarios, from total and unregulated default, with uncontrolled consequences, to a negotiated, managed and partial default. Each will bring its own set of consequences for the rest of Europe, particularly for banks.

For that is the ESRB's job. It exists to plan what will happen when one or more banks collapses. It was not really designed for a country collapsing, but the job is the same, and it is of vital importance that they step up to the plate and do something.

There are reasons, however, due to the ESRB's institutional design, to believe that the ESRB will be a political cripple and not fulfil the role it needs to if it waits for a green light before forging ahead. First, the head of the Board is the European Central Bank, which is refusing to cooperate with anyone on the issue of a managed default. It may have a contingency plan for when Greece can't pay, but if it does, it isn't admitting it. Second, the Board lacks the political clout to make the deals that are required to make a rescue plan work. Its members are the ECB, the central banks of the EU member states and representatives of three European Authorities that regulate or advise the Commission on regulating banks, securities and insurance companies respectively. Unlike the Financial Stability Board in Basel or the Financial Stability Oversight Council in the United States, there are no representatives of national governments at the table.

These are the reasons why we are hearing so much from the European Commission, the European Central Bank and the European Council of Economics and Finance Ministers, but so little from the one institution that was created to ensure the stability of Europe's financial system, at the moment of its greatest peril.

The European Systemic Risk Board needs an explicit mandate to intervene and give much-needed advice on the implications for financial stability of full and partial defaults. It also needs to provide advice on how to manage a Greek exit from the euro. And it needs to start making contingency plans for propping up the European financial system when the Greek default comes. That means it will have to have specific information about bond holdings by banks, and model through who will need what, when and how, once Greek bonds implode and Greek private banks cease to exist. It may also have to consider how great the knock-on effects will be for pension and insurance companies who invest in such bonds, as well as capital requirements for banks. Banks need not set aside reserves for loans to governments, a policy that surely must end.

The Board has this mandate already, even if it is implicit. If it does not get it explicitly from the Commission, the Bank and the Finance Ministers, it should claim it directly for itself without asking permission. That is how the European Court of Justice established its position and the position of EU law in Europe. It claimed it. Right now, national governments are bickering, putting partisan plans forward and kicking the can down the road rather than facing the threat in the eye and dealing with it. That is catastrophic and will become Europe's demise if allowed to continue. If Europe is to be saved, the European Systemic Risk Board will have to assert itself, and others will have to accept a new, larger role for the Board than they originally envisaged. There are two advisory boards within the ESRB that can push for these developments where the key members may not: the Technical Advisory Board (which does the work of modelling the causes and impacts of defaults); and the Academic Advisory Board, which collects experts on a variety of issues related to financial system stability. These are the groups who must start doing some persuading and drawing contingency plans.

Europe's existence is hanging on a thread. Regardless of how long national governments take to agree on strategy, there is both a moral and existential imperative that the ESRB start acting like what it needs to be: Europe's best hope for averting catastrophe once the defaults start rolling. When the politicians look at the tsunami that starts rolling toward them, they will hopefully look at the Board and its plans, and say Yes.

Helping Greece Default

The EU governments, if they want to avert disaster, need to assist Greece, and other countries as well, in an orderly default of their debt. A default is never easy to propose, but as I indicated in my last post when referring to the assistance of the United States government to Mexico in defaulting through Brady Bonds, this assistance makes all the difference between making the debt load manageable and total collapse.

There will be a lot of bellyaching from Northern Europe. Indeed, the finance minister of the Netherlands' right-wing government, Jan-Kees de Jager, has declared he takes pride in taking the toughest stand of all European countries on the terms that Greece will have to meet. That could be a costly position to maintain.

There is a difference between rebuilding on terms everyone can figure out, and terms that no one can figure out because the plan won't be kept. Creditors in Europe may look at a 100% repayment plan as only fair, whilst Greek critics will look at it as imposing unrealistic demands. The only part that is important though is: can Greece really pay 100%? If it can't, then an orderly default is better than a European shit storm. 

Default, deception and European debt

Europe has economic and political problems that just won't quit. There is a stench of desperation in the air that has gotten so strong that the President of the EU Council, Herman van Rompuy, has effectively told heads of government to STFU, lest they freak out the markets and send investors fleeing unnecessarily. On the contrary, Europe is suffering from a deep psychosis.

It's unlikely to make much difference unless there are real reasons for investors to think that Europe has its act together. And Europe doesn't. Standard and Poors has already downgraded bonds from Greece and Portugal to within a breath of junk bond status earlier this year. Those bonds, as well as those of Spain and Italy, are under renewed pressure as S&P considers a further downgrade of Italy.

The only question that anyone cares about, but that the politicians haven't accepted yet, is which of these countries will default on their debt this year, and by how much. If no default were likely, the problem would take care of itself. Imagine raking in the high interest payments on debt that you just bought for a big discount. The markets aren't buying it. Literally and figuratively.

Europe, with the exception of the ECB, (For its part, the ECB is demanding that the Greeks and everyone else pay in full, and that Europe reject any talk  of default, under whatever deceptive label it might come .) sent a strong message last week that it wants to let Greece default without actually calling it a default. A partial default is called a restructuring and is pretty common. But no one wants to say that. Talk started to circulate of 'soft restructuring', as if this would make an difference to anyone. When it was clear that it wouldn't, European finance ministers started talk of 're-profiling' the debt, which did nothing but slap a new label on an old plan. Last week, realising that someone would have to do something, the EU Council asked banks holding bonds from these countries not to ask for the money back.

Why does Europe think that banks and other institutional financial investors would hold on to such a crappy investment? It's the state equivalent of a sub-prime mortgage. Sooner or later, you want to get rid of it. The less confidence you have in the ability of the borrower, the sooner you want to sell. And if it isn't clear by now, holding on to that debt in the hope that it will be repaid, or at least that markets will re-invest in it at some point out of speculation, is hoping that a new economic bubble will wash the problems away. Or at least onto someone else's balance sheet.

That is a really bad idea. It's like a serious alcoholic who's trying to hide the booze bottles rather than admit having a problem and taking on the pain and responsibility of rehab. But lies and delusion don't make a problem go away. They prolong the disease and the agony. And everyone turns their backs on you.

Under these conditions, when Europe is deliberately trying to mislead the world about the depth of its problems, there are serious reasons to object to Europe insisting on its right to head the IMF. It wants to hold on to its prestige and power by birthright rather than merit, a point that is both legitimate and gaining steam internationally. It's like the town drunk, insisting on running the liquor store. Unless Europe shows a change of heart, that is another really bad idea. Europe hasn't hit bottom yet, and still thinks its in control.

It's time to take away the keys.

Who pays when a country defaults?

Yesterday's deal to bail out Ireland rejected a long-standing German demand that investors holding Irish government bonds take a haircut in return for EU aid to the banks.

Accepting a haircut is financial market-speak for accepting a reduction in the value of the bonds you hold. The German government, which has been one of the most openly critical of the behaviour of investors during the crisis, has insisted that there is no reason to provide public insurance for private risk-taking. Investment is a rewarding business, but also a risky one, and when investments go bad, investors have to accept losses.
 
When a government like Ireland can't pay its debts, bondholders run the risk of receiving nothing in return for their scraps of paper. The alternative is that they collectively agree to avert total disaster by agreeing to take only a portion of what is owed them, and extending new loans to give the country extra time. This is what is known as restructuring a country's debt. Outside governments can increase the likelihood that they will agree by sweetening the deal with extra loans to the country that can't pay. This gives the group of private bondholders a bigger pie to distribute, it softens the blow for the country that can't pay, and it prevents the country from collapsing. This is why the most likely source of this outside funding is the country's most important trade and investment partners. This was the case for Mexico in the mid-1990s, when the United States helped bail it out. And it is the case for Ireland and Greece today. It's enlightened self-interest.

Except that the European Union, unlike the United States, asks nothing of bondholders in return. They are, unless anything changes, getting 100% of their investment guaranteed by the euro zone in the final instance. And they are using that money to wage a further war against other countries they have in their sights. This week, the first salvos were shot at Portugal and Spain.

This European attitude is something to watch. So far, Germany has been unable to convince its fellow member states to make bondholder haircuts a condition of EU aid. Instead, the message that the Irish and others, including the European Commission are sending out, is that they are terrified that bondholders will turn their backs on the country entirely.

Why watch this point if European countries are not united in their assessment of whether bondholders must share in the cost of the crisis? Because the war has only started. We have yet to see financial markets attack a large country. If and more likely, when that happens, the EU will have to make some very tough decisions about how much it is prepared to give now (and that is limited), how much, if any, it is prepared to borrow collectively to bail out its weakest states (which implies a radical re-thinking of European economic principles and law) and how much the bondholders must pay.

If European governments listen to Berlin and make bondholders share the burden, they will be doing nothing different than has happened many times before. International investment will not dry up as long as the crisis is used wisely to restructure the economy, improve corporate governance and improve the regulation of financial markets as Ireland rebuilds.