Streetwise Professor

February 15, 2010

Shocked! Shocked!

Filed under: Derivatives,Economics,Financial crisis,Politics — The Professor @ 9:49 pm

Like Claude Rains in Casablanca (which was on Turner Classic Movies yesterday), the Germans and others are Shocked! Shocked! that Greece used swaps priced off the market to borrow, for all intents and purposes.  For all purposes, that is, but one: accounting for the public debt to determine its adherence to European Monetary Union requirements.

Except that it wasn’t a secret at all.  Risk wrote about one of these deals back in 2003. S&P issued a note describing these types of deals in 2002.   The New York Times reports that there were many of these deals, from the very outset of the European experiment:

For all the benefits of uniting Europe with one currency, the birth of the euro came with an original sin: countries like Italy and Greece entered the monetary union with bigger deficits than the ones permitted under the treaty that created the currency. Rather than raise taxes or reduce spending, however, these governments artificially reduced their deficits with derivatives.

. . . .

But with the help of JPMorgan, Italy was able to do more than that. Despite persistently high deficits, a 1996 derivative helped bring Italy’s budget into line by swapping currency with JPMorgan at a favorable exchange rate, effectively putting more money in the government’s hands. In return, Italy committed to future payments that were not booked as liabilities.

The NYT also reports that these types of deals were a subject of fierce debate among European finance ministers going back to 2000.

In other words, nobody in government finance has any more reason to be shocked about these transactions than Captain Reynaud had to be shocked about gambling going on at Rick’s.

Some of the debates that are going on about the probity of these deals reminds me of discussions of who is to blame for drug addiction: the addict (Greece, for instance), or the pusher (e.g., Goldman, Morgan, Deutsche Bank, etc.):

“Politicians want to pass the ball forward, and if a banker can show them a way to pass a problem to the future, they will fall for it,” said Gikas A. Hardouvelis, an economist and former government official who helped write a recent report on Greece’s accounting policies.

In other words, politicians were being politicians, and bankers were being bankers, and they were engaged in mutually beneficial transactions.  The difference being, of course, that there are other people–millions of other people–who will pay costs.

If forced to choose, I guess I’m have a less favorable view of the politicians, for two reasons.  First, they never cease to tell us how morally superior they are, whereas bankers are for the most part (not universally) less sanctimonious.  Second, the politicians are ultimately violating a responsibility that they are entrusted with, whereas the bankers are actually carrying out their responsibilities to their principals.

But this is really all a side issue.  The central issue is what to do about Greece, and ultimately, the other countries that are at risk to following it over the edge.

I tend to lean towards what John Kemp writes in Reuters:

Most commentators have concentrated on the need for the EU to bail out Greece. But in reality any rescue would be another subsidy for excessive-risk taking by the country’s bankers and the institutions that have sold credit default swaps (CDS) on Greek debt.

Forcing the country into an austerity programme and arranging an emergency loan from other EU members or the IMF would ensure the bankers got their money back (again), but inflict years of misery on the country’s households and businesses.

If market discipline is ever to be re-established after the boom and bailouts of the last five years, it is imperative creditors face the real prospect of making losses if they extend large loans and fail to price the risk on them properly. The sellers of CDS insurance must face up to making real payouts in return for all the premiums they pocket.

Bailing out Greece would be wrong. Not because it would harm the eurozone’s credibility, but because it would reinforce the rampant moral hazard in financial markets. It would perpetuate the inequitable and politically unacceptable situation where structuring fees are retained by the banks as private profits while credit losses are socialised and passed onto taxpayers.

Greece would do everyone a favour by declaring a moratorium and forcing a rescheduling. The country faces years of misery in any case. The threat of being shut out of capital markets rings hollow. But by triggering losses on these derivative transactions and a credit events under the CDS it would help ensure a much more prudent approach in international banking markets.

Bailing out Greece so everyone can pretend the country can remain “current” on its loans when it patently cannot would simply deepen the moral-hazard crisis. If market discipline is ever to be re-established (something which everyone agrees is desirable) then at some point creditors must take a loss. Greece is a good place to start.

Yes.  As I discussed in an earlier post, it is the lenders–the creditors–that are ultimately the source of moral hazard.  If they are convinced that they will be bailed out, they will continue to feed the bad habits of profligate borrowers, including sovereigns.  Bailing out Greece, or others, will just increase expectations of future bailouts, and we’ll be in a sort of moral hazard Groundhog Day. Only it won’t be quite so funny.

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  1. My problems with bailouts is that they overwhelmingly are instances where political considerations dictate economic winners and losers and they do not let economic considerations determine the survival of viable institutions.

    Comment by Charles — February 16, 2010 @ 10:14 am

  2. Professor, I know a lot about Russia and zip about economics. So sorry for the stupid question I’m about to ask. Is your position that “too big to fail” shouldn’t exist? That we should have just let the biggies collapse? Could you link to a previous post (or posts) where you explain what you think should have been done?

    Comment by mossy — February 16, 2010 @ 1:08 pm

  3. Mossy–complicated question. Short answer: yes, I believe that letting biggies fail is preferable in most circumstances. The question always is: who bears the loss? The loss is there, the question is whether it is socialized, or left with those whom the defaulter owes money.

    The problem with bailing out big firms is that gives them the incentive to get too big. Fannie and Freddie grew bloated because of the expectation that if they get in trouble, they’d be bailed out.

    The problem is that governments have little credibility is saying they won’t bail out. The pressure to do so is immense. That’s why I made a half-joking reference to Dr. Strangelove and a doomsday machine in the past. If the governments can precommit not to bail out, via some mechanism, the need for a bailout will likely never arise.

    The ProfessorComment by The Professor — February 16, 2010 @ 5:14 pm

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