Leaderless in Brussels
We’ve all had a “Eureka” moment, where the light shines bright and we finally are able to see our way through the confusion. Thanks to a friend, I had such a moment this week. It finally became clear why the Europeans are having such a difficult time finding an obvious solution to the Greek debt crisis.
In theory, the European Union (EU) has a mark-to-market rule. If it worked in practice as it is supposed to work in theory, there likely would be little opposition to a financial restructuring, and the EU would not be embroiled in a crisis that increasingly looks like a soap opera. The financial institutions holding the bulk of the Greek debt already would have written down the value of their outstanding holdings of this debt and recorded the capital losses. This in turn could have led to a rollover of the old debt into new debt with a much smaller face value, lower interest rates and longer terms to maturity. This financial restructuring would have greatly reduced Greece’s annual interest and principal payments, and thus greatly lessened the financial burden on the country, giving Greece more time to balance its books.
Of course, some opposition would have remained. A financial restructuring likely would have been interpreted as an event requiring the sellers of credit default swaps (CDS) on Greek debt to pay the buyers of these swaps, some of whom would have been simply gambling on the potential for such an event. Some of the buyers would have been the same financial institutions who should have incurred significant write-downs on the value of their holdings of Greek debt. (These institutions would have been buyers of Greek CDS in order to hedge against a possible default.) The recovery on the CDS would have boosted their capital (and generated larger bonuses for their senior executives, the same people who received large bonuses in the past because they did not record these losses).
But the practice is different from the theory. Yes, financial institutions in the EU are required to write down the value of their holdings of debt when market prices decline. HOWEVER, if the financial institutions believe that they will be paid in full and as originally scheduled, they do not have to write down the value. Hence, most financial institutions in the EU have not taken the hit on their holdings of Greek debt. Eureka!
Any financial restructuring, such as a rollover of the debt either directly or indirectly, would be treated as a default, requiring massive write-downs and losses. This would greatly reduce the capital of these institutions, possibly threatening the solvency of some, and definitely requiring that they all raise new capital – a difficult proposition at a time of large losses. Some of the losses might be offset by payouts on the CDS held by some of these institutions.
Nevertheless, in theory it looks like a simple exercise to figure out the net losses of the EU financial institutions, and devise a program to augment their capital. The US, under the leadership of Bernanke and Paulson, was able to create such a program in the midst of the financial crisis in 2008. (Fortunately, the world did not have to rely on the EU for leadership at that time.)
So why hasn’t this happened?
There are three reasons. There would still be a number of people who prefer to avoid any loss altogether – a loss would negatively impact their reputations, and more importantly, their bonuses.
Secondly, the EU and its many institutions probably do not know who the winners and losers might be and the magnitude of their gains and losses. This is a dreadful indictment of the regulatory morass in the EU. The regulators lack the data needed to regulate, and none of them are willing to admit their failure.
Finally, there is no leadership in the EU. The EU is managed by clowns and hypocrites.
Speaking of soap operas, perhaps Berlusconi can organize a grand party to deflect everyone’s attention from the Greek debt and the failure of the EU.
The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.