What is the problem with Greece?

This has been a topic at the helm of global finance that has taken all the markets on a roller coaster ride since the past year. Here I attempt to discuss some of the issues, the causes and the steps taken to avert a crisis as a result of its ballooning debt to GDP.

Why is Greece close to defaulting on its sovereign debt (government bonds)? Why cannot Greece use the monetary policy tools that traditionally states used to ease their debt burden, and what are some of these tools?

Even before the time they entered the EU, Greece has been on a spending spree on infrastructure, services and public sector wages. As Greeks reduced their tax payments, the vast gap between government income and expenditures was filled in by borrowing billions of dollars from other banks and nations. This enormous public deficit was exposed post the 2008 banking crisis and currently, with a 160% debt to GDP ratio, Greece is nowhere near able to pay off its debt. With the downgrade of Greek bonds to junk status no one is also willing to lend Greece and being on primary deficit it is further unable to meet its expenses without external monetary support.

Some of the monetary tools that governments use in such a situation are devaluation of currency, increasing the interest rates, controlling reserve requirements or printing new currency. Greece had been deploying many of these tools before its integration into the Euro. However, under the Maastricht criteria applicable to all EU members, all the EU states need to keep their inflation rates within stipulated limits and need to have a control over their government deficit and debt. In addition they need to follow the exchange rate mechanism under European Monetary System (EMS) and also need to keep a check on their long term interest rates. Since Greece is a part of the Euro it does not have enough flexibility with these policies to be able to come out of its debt crisis.

http://www.telegraph.co.uk/finance/financialcrisis/9098559/Whats-the-Greek-debt-crisis-all-about.html

http://en.wikipedia.org/wiki/Maastricht_Treaty

The Greek economy is small relative to the economy of other states in the EU – why would a Greek default significantly impact (i) the economy of other EU states; (ii) the stability of the Eurozone; (iii) the world economy?

Even though Greece has a relatively small economy, a Greek default can lead to a contagion the effect of which will be felt throughout the EU and also the world at large. It would send the yields on Portuguese, Irish and Italian bonds spiraling upwards and Portugal might have an incentive of defaulting as well. Subsequently the confidence in these countries will drop leading to a bank run and a severe credit crunch and EU will need to provide capital to the banking system for which there would be no collateral.

Such events would lead investors, and the world, to lose confidence in EU and hence growth can be hampered in the near future which can also lead to a drop in the euro. With the global financial system just out of a financial crisis, this contagion will be akin to rubbing salt on the wound that hasn’t even begun to heal yet and it would probably put Europe in a recession and would stall short term growth throughout the world.

Great efforts are expended to restructure the Greek debt so that it does not trigger CDSs written on Greek bonds. Who holds these CDSs?

The net value of CDS written on Greek debt is small as compared to the total debt. For instance, with a $300 billion of restructuring and $100 billion of wipeout, the outstanding CDS contracts net just about $3.2 billion ($70 billion overall).

These CDS are held by private entities that have invested in Greek debt over the years. Although this information is not publicly available, it is known that major European banks such as DB and BNP Paribas as well as some American banks such as JP Morgan, Citibank and Goldman Sachs hold Greek debt and have hedged it with CDS.

Recognizing that the situation evolves from day to day, what are the arrangements related to the Greek debt restructuring that are contemplated currently?

Of course Greece defaulted for non payment of the dues it owed on 20th March. Thankfully, to my utter surprise, it failed to shake the markets in a way I had imagined leaving it with just a nudge, maybe that was also the market's volatility itself. However, to ensure that financial markets are now immune to the fate of Greece a series of hard steps were taken and accepted, in some cases against the will of many. Here I lay down those steps and their magnitude.

There have already been four rounds of austerity packages involving about 100bn Euros in loan and a round of austerity measures being implemented by the government. Currently the Greece creditors have agreed to a 53% haircut on the Greece debt and EU has raised about $172 billion for support the remaining debt of Greece. Debt swap for coupon bonds (50% of face value as compared to original) have been initiated with a coupon of 3.7% bringing the total voluntary write-down to around 70%. Although it seems that even this huge bailout will not be enough and ECB reckons that Greece would need another 254bn Euro to meet its targets.

Under the terms of this bailout Greece is required to undergo reforms aimed at reducing its debt to 120% of GDP by 2020 from 170% currently. These include severe austerity measures as well as a 22% wage cut across the working population and a 35% for those under 25.

But this bailout has quite some risk associated to it especially because of the elections that are about to take place in Greece in April. The debt restructuring package is extremely demanding on the citizens and it is not surprise that there have been widespread demonstrations, sometimes violent, against it. This can be a crucial campaign agenda for politicians who can promise a renegotiation of the terms which casts uncertainty over Greek default. On the other hand the deal has been struck with the private sector representative, the IIF and needs the support of each of the private debt holder to go through which is a major process in itself. Now this debt restructuring has been accepted by a higher majority of the private creditors as against the alternative of losing their entire investment and face the ugly process of recovery from a default.

http://blogs.wsj.com/marketbeat/2012/02/07/whats-the-latest-on-greece/?KEYWORDS=greece+default

http://online.wsj.com/video/is-europe-preparing-for-a-greek-default/7ACA93BF-474E-4DCF-A9DE-248567E1E152.html

http://online.wsj.com/video/where-next-for-greece/DE35FF36-8253-4E67-90B8-637E849D7F7F.html

http://dealbook.nytimes.com/2012/02/21/greek-crisis-raises-new-fears-over-credit-default-swaps/

http://news.goldseek.com/UnionSecurities/1328198400.php

How CDS pulled AIG down

I have been wanting to talk about things relevant to my course but have just not been able to find any time to devote to writing. On the other hand, I have studied, researched and learnt quite a bit about the mechanics of financial instruments and I would like to share two such topics.
Note that I obtained the facts mentioned in the following lines from different credible sources and all I that have done is paraphrased the content and broken it into categories. I guess the jargon will be too much for some of you so shoot any questions that you have.

The following post is about investigating the reasons behind AIG's fallout:

Why did CDS contracts almost provoke the bankruptcy of AIG?

AIG had been a successful insurance provider until, seemingly, it started to venture out in the business of writing Credit Default Swaps. It began insuring debt obligations of lenders against a risk of counterparty default, thereby taking the credit risk of the counterparty on itself. At one stage, of the $60 trillion CDS market, AIG owned about $440 billion of notional, an enormous amount compared to its peak market value of about $240 billion, with the portfolio contributing over a quarter of AIG’s profits.

The problem was that CDS was designed in such a way that it didn’t require any capital requirements and hence it attracted pension funds, insurers, hedge funds and banks for they could reap on the credit risk without any capital to lend. Furthermore, the demand for such instruments rose as they added on to the profits on the income statements without a mention of the risk involved.

Most of these CDS were on asset backed securities pools, primarily mortgages, and when the housing market collapsed these mortgages that AIG had “indirectly” insured started falling in value. The losses began accruing in 2006 and by 2008 AIG had less equity than it needed to fulfill its obligations. This trapped it into a vicious cycle as its credit rating was downgraded and hence it was required to post an additional margin that further put strain on its financial resources.

Hence we see that AIG, due to its good credit rating and the nature of CDS, was able to stack up large quantities of such insurance on its books with being questioned about the risk involved. Since the notional value of these contracts exceeded the market value of AIG, the possibility of the underlying assets going sour raised a possibility of bankruptcy for AIG.

http://www.economist.com/node/12274070

http://www.economist.com/node/12552204

What saved AIG from bankruptcy?

AIG is one of the biggest insurance companies in US and during the crisis it held a huge amount of credit risk on its books. It started getting calls on that risk when the underlying assets began degrading in value but its capital stash was not enough to meet all the requirements. To avoid a contagion across those who had insured their risks as well as to avoid the mess that AIG’s default would create in its other space such as life insurance and annuities, the government decided to bail it out with taxpayer’s money.

When AIG reported the biggest quarterly loss of any company in American history, of $61.7 billion, the government proposed a bailout package of $85 billion and took a 79.9% stake in the company in return. It further provided up to $37.8 billion in capital and removed the coupon on a $40 billion equity that was injected by the government in Nov 2008. Although AIG quickly used up about $90 billion of the ~$120 billion credit line awarded, it was able to stabilize its margin requirements on its contracts and was able to fulfill its obligations

http://www.economist.com/blogs/freeexchange/2009/03/government_and_aig_together_fo

http://www.economist.com/blogs/freeexchange/2009/04/did_we_need_to_bail_out_aig

http://www.economist.com/node/13213322

What could be done, in terms of reorganizing the CDS market in order to diminish the impact of situations like the one that almost doomed AIG?

There seem to be quite a few fundamental flaws with the way a CDS contract is designed:

• With the exception of capital requirements, a CDS contract allowed smaller firms, such as hedge funds, which did not have huge capital to lend, to be able to take on the credit risk of a counterparty’s portfolio in exchange of insurance premium.
• The accounting policies did not require such companies to reflect such transactions on their financial statements and hence the risk of such instruments went unnoticed and what appeared on the balance sheets were the profits.
• Depending on their credit rating, the companies had to put aside minimal margin, relative to the loan, to cushion against possible defaults.
• The CDS contracts allowed speculative positions to be held in the market. Hence the CDS market was over inflated and peaked at about $62 trillion when the value of the underlying debt was just about $5 trillion. This in turn had an effect on the ability of a company to take on debt as its CDS spread in the market would determine its credit strength.
• The voting power that comes with a debt stays with the debt holder even when the risk has been passed on. This can result in a clash between the intentions of the lender and the insurer regarding the default of the borrower as the lender might not agree to a debt restructuring.

It seems that with a proper understanding of CDS and its implications its abuse, and hence what followed, could have been avoided.

• The regulations around CDS can be more stringent to provide evidence of “credit risk” against which the insurance is sought. This will avoid speculative positions that can overburden the market with possibility of a multiple losses over a single debt.
• The accounting regulations also need to be strengthened so that such risks are portrayed on the balance sheet and hence are accounted for in assessing the financial health of a firm.
• The firm selling such contracts should be required to reserve certain capital in the event it needs to meet its obligations under the contract. This would help restrict the amount of CDS a company can write based on its capital cushion and credit rating.
• The voting power that comes with taking on debt should be somehow shared with the CDS seller so they have a say in the debt restructuring of the defaulting firm.

http://moneymorning.com/2009/04/23/ban-credit-default-swaps/

http://moneymorning.com/2008/09/22/credit-default-swaps-2/