Euro-Zone Solution May Require Big Bank “Haircuts”

1 December 2010

Since the start of the euro crisis, Europe’s leaders have perfected two techniques:

scrambling to catch up with events, and playing them down.

Again and again, they have been forced to assemble bailout packages to prevent the euro zone from breaking apart.

And after each new one, they insist that the measures are purely psychological and will probably never be needed.

1 December 2010

Since the start of the euro crisis, Europe’s leaders have perfected two techniques:

scrambling to catch up with events, and playing them down.

Again and again, they have been forced to assemble bailout packages to prevent the euro zone from breaking apart.

And after each new one, they insist that the measures are purely psychological and will probably never be needed.

That’s what happened in the spring, when countries like Germany first refused to rush to the rescue of ailing Greece,

only to change their minds and bail it out a few weeks later.

And in May, when the European Commission, EU countries and the International Monetary Fund

stitched together a €750 billion ($978 billion) safety net that was never intended to be used — until Ireland jumped into it.

Until now, as might be inferred from these farcical scenarios,

the euro zone has had only one option in the fight against surging budget deficits:

if a state can no longer handle its debt obligations, the EU has to bail it out.

It is not an option, for example, for Greece to leave the euro zone.

“The result would be a run on the Greek banks.

Investors would withdraw their funds on a massive scale,

the Greek financial system would collapse and send shockwaves around the whole of Europe,”

says Christoph Weil, an economist at Commerzbank.

That could trigger a new financial crisis on the scale of the collapse of Lehman Brothers in September 2008.

Which is why Europe wants to create a second option for handling debt crises:

a mechanism for rescheduling the sovereign debt of an ailing member state.

On Sunday, the Euro Group of Finance Ministers from the 16 Euro-Zone member states approved the outlines for

a long-term European Stability Mechanism (ESM) to come into force in mid-2013.

It is intended to provide states with a broader arsenal of options to fight debt crises.

Now governments have come up with something they claim will end a crisis once and for all.

In an emergency, countries that have run up excessive debts are to have part of their debt waived,

and all creditors are to share the burden in equal measure — private investors, banks and investment funds.

According to the EU, the crisis mechanism is to work as follows:

A debt rescheduling clause is to be built into all government bonds issued by euro zone member countries from June 2013 onwards.

This legally binding clause defines what happens when a government can’t repay its debt.

If a country is only suffering from a short-term liquidity shortfall,

but is deemed capable by the European Central Bank and IMF of meetings its obligations,

it can draw on funds from the EU rescue fund.

And creditors will be encouraged to agree to delayed repayments to ease the burden on the indebted nation.

BUT if the country has a structural problem,

meaning that it may never be able to repay its debt,

a meeting of creditors is convened.

That meeting can decide with a qualified majority on what debt rescheduling measures to take.

It has not been decided yet what majority will be needed to reach a decision.

The private sector has thresholds of 66 or 75 percent in these cases.

What would a rescheduling look like?

There are three methods of helping a company to cope with its debt burden:

• Creditors can extend the maturities of the bonds they hold

• They can waive interest payments

• In the worst case, they could agree to write down the principal — a so-called haircut, as it’s known on Wall Street

The German government praised the crisis mechanism agreed with its EU partners.

But markets remain nervous.

The risk premiums on the sovereign bonds of high-debt nations have kept on rising since Sunday’s agreement.

Spain, for example, has to pay creditors an interest rate that is 2.9 points above the level for German bonds.

Italian 10-year bond yields also increased, reaching 2.05 percent on Tuesday.

Many analysts doubt whether this future crisis mechanism will calm current markets.

“The debt rescheduling clause only applies to government bonds that will be issued from June 2013 onwards,”

says Manfred Jäger-Ambrozewicz, an analyst of monetary policy and financial markets at the Institute of the German Economy in Cologne.

“The old bonds for which there are no provisions for orderly rescheduling will only be replaced gradually.”

That means the orderly debt rescheduling of a nation as envisaged by the new mechanism will only be possible from 2020 onwards.

So the possibility of dis-orderly rescheduling in the current context persists,

and it is quite feasible the following scenario might actually happen:

“The risk remains that Greece won’t be able to service its debt in the long term,” says Weil.

“In this case the EU would have to keep on supporting Athens for years to come —

or it would have to accept a rescheduling.”

But Europe’s banks say they would probably be unable to handle such a rescheduling —

which, of course, is what they’ve been saying in Japan since 1989, and the US since Black September 2008,

and precisely why re-scheduling — or taking a haircut — has been so strenuously avoided until now.

“If the banks waive part of the Greek government debt, Greece’s government bonds will lose part of their book value,” says Weil.

“At present, the equity capital ratios of many banks are simply to low to cope with that.”

So the new mechanism won’t solve the current crisis.

But analysts say the debt rescheduling clause makes sense in the long term.

“It finally gives the monetary union a measure that has a disciplining effect,” says Jäger-Ambrozewicz.

After the euro was introduced, interest rates on government bonds remained low because

creditors believed in the implicit guarantee that the EU would stand by troubled member states in a crisis.

“Now that will finally change,” says Weil.

The implicit guarantor will gradually disappear over the next decade.

This will have two consequences for the euro zone:

Risk premiums are unlikely ever to fall back to the levels they were at before the crisis.

And countries will have to maintain stricter budget discipline in future,

according to this useful article from Spiegel Online.

But that STILL won’t solve the current Euro-zone crisis …

UNLESS the “taking a haircut” principle is applied NOW to creditor banks.

That, however, requires a tremendous amount of POLITICAL vision / leadership / and guts,

because it forces the banks to actually pay for their own mistakes —

an outcome they have successfully resisted for decades in Japan, more than two years in the US, and so far in Europe.

So unless there’s a massive reversal in government indulgence

of the big TBTF banks and the rest of finance sector,

don’t expect the Euro-zone crisis to be “solved” anytime soon.

David Caploe PhD

Chief Political Economist

EconomyWatch.com

President / acalaha.com