Barring some miraculous breakthrough over the next 24-48 hours, it would seem that time is running out for a pre-July 20 agreement and there are really only two choices left:
1) Negotiate a short term deal – bridge financing to clear the IMF arrears and make the July 20 ECB payment, and another month or two to allow time for a real agreement to be negotiated. The problem here is that all parties are sick of kicking the can further and a short term deal only makes sense if there is consensus on the broad outlines of a program and it’s just a matter of more time being needed to finalize the details. This is clearly not the case here.
2) Begin planning for an orderly Grexit. No one wants to go down this path, but if the only choices are to start planning for an orderly Grexit now or have an unplanned, disorderly Grexit in two weeks……..
Lots of criticism against shareholder value management and stock-based compensation for executives has appeared in the press recently.
There’s nothing wrong with shareholder value management, which simply states that when evaluating corporate investment decisions, a company’s management should A) ignore accounting fictions that have no bearing on cash flow and B) take into account their overall cost of capital, which includes both debt and equity.
Likewise, there’s nothing wrong with aligning management’s incentives with those of the owner’s of the firm via the issue of stock options or restricted shares.
As is often the case, the problem is with the execution of the above. The root cause is short-termism itself. Stock buybacks, one time dividends, and other financial engineering practices may drive the stock price higher in the short run but it does not lead to long run value creation, which was the whole point of shareholder value management. Likewise, the way we have structured stock grants to executives is not aligning their long term interests with shareholders, it’s incentivizing them to extract as much in the way of economic rents from the companies they run in as short a time as possible. The combination of these two factors is leading to disaster. The solution is to fix the implementation, not to scrap the fundamental ideas themselves.
US stock markets rallied 2-3% and crude oil jumped over 9% yesterday in reaction to the latest “plan to have a plan” and “agreement to agree on what has already been agreed” coming out of the EU.
I’m not convinced that this will amount to much more than another short term attempt to boost market confidence that rapidly deteriorates.
Everyone ought to just read the official statement (which is just slightly longer than one page in length) and ignore the speculation from the financial press.
Here are my key concerns:
- Debt subordination. The financial press keeps saying that the EU agreed that the Spanish bailout would be an exception that would not subordinate existing debt. That seems to be true, but if you read the actual statement, it’s an artifact of the EU simply re-affirming that any assistance provided by the EFSF and then transferred to the ESM will not involve subordination. This is an important point, for reasons that will become clear in a moment.
- ESM. I have a number of concerns here. First and foremost, the ESM was supposed to go into effect July 1. That’s tomorrow. It appears the new target date is July 9. Is that realistic? They need to get to a point where the countries providing 90% of capital contributions ratify it in order for it to become operational. Progress has been quite slow. Another concern is the size of the ESM – with approximately €500 billion in credit to be available it will not be nearly large enough.
- Direct injection of ESM funds into banks. This is the big one. The question, again, is timing. It can’t happen until the new single bank regulator is in place, currently targeted for January 1, 2013 (and we know how target dates slip in the EU). Furthermore, each individual ESM bank bailout will require UNANIMOUS approval. Is the thinking that no banks will get in trouble over the next 6 months, and that when they do get in trouble there will be ample time to get unanimous approval on terms?
Given the timing of the ESM itself as well as the timing of its power to provide direct assistance to banks along with the subordination issue, I think there is going to be enormous pressure over the next few months to expand both the duration and size of the EFSF while backburnering the ESM. Alternatively, some new “medium term solution” may emerge to fill the gap between the EFSF and ESM. It’s unlikely that matters will proceed along the lines currently proposed, with a smooth and seamless transition between the EFSF and ESM.
Yesterday, the EU agreed to provide Spain with a 100 billion Euro ($125 billion) rescue package.
The money will go into a fund called FROB (Fund for Orderly Bank Restructuring) modeled loosely after the US TARP prgram. The Spanish government will be responsible for paying back the loan, but they are constrained in how they can use the money; essentially, it has to be used to recapitalize their banks.
It appears this will calm the markets, but for how long?
Why is “calming the markets” always the proximate (and often the ultimate) goal? Spain has an overall unemployment rate over 24%, with unemployment levels hovering around 50% for the young. GDP growth was negative in 2009 and 2010, barely positive in 2011, and now has gone negative again for the first half of 2012 with consensus estimates for all of 2012 coming in around -1.5%. The housing market is in shambles after a boom and bust. Where are the plans to address crisis-level unemployment and jump start economic growth? Where are the plans to fix the housing market?
It’s interesting to note the similarities between Spain and Ireland, both of which pursued fiscally responsible policies prior to the financial crisis. Spain ran budget surpluses in 2006, 2007, and 2008. In 2009, Spain’s public debt was under 60% of GDP, well below the EU average. Even now, after the crisis, it only stands at around 68% of GDP. Like Ireland, Spain is not a tale of fiscal profligacy, it’s a story of a country that experienced the collapse of an asset price bubble followed by a banking crisis. Awhile back, Paul Krugman noted that Rogoff and Reinhart got the correlation between public debt as a % of GDP and economic crisis correct, but they had the causation reversed. An economic crisis causes public debt to skyrocket, not vice versa. Spain is a perfect example.
Where do we go from here? What will the political repercussions be, both in Spain and in the rest of the EU? Will Ireland and others demand a renegotiation of their bailouts to remove or reduce the austerity measures attached to them? What impact will this have on the Greek elections? Will the contagion spread to Italy next?
Forced debt to equity conversions have been proposed as a solution to make insolvent banks solvent again. The idea is that some portion of a bank’s outstanding debt is converted into equity in order to restore a positive net worth (assets – liabilities). There’s no reason why this same approach could not be taken with private homeowners.
Let’s look at a simplified example:
Home purchaser takes out a $100k bank loan to buy a $100k house.
Assets = $100k, liabilities = $100k, net worth = $0.
House price drops to $80k. Now:
Assets = $80k, liabilities = $100k, net worth = -$20.
Undertake the debt to equity conversion:
Loan reduced to house market value = $80k.
In exchange, bank gets $20k equity = ($20k/$80k) = 25% ownership stake in house.
The homeowner essentially gives up 25% of future increases in home value in order to not be underwater now.
At some point in the future, the house will be sold. When that happens, one of the following scenarios will play out.
Scenario 1 – House sells for <$80k. Bank gets fraction of its $80k loan back. Bank gets nothing on its equity. Homeowner gets nothing.
Scenario 2 – House sells for $80k. Bank gets all of its $80k loan back. Bank gets nothing on its equity. Homeowner gets nothing.
Scenario 3 – House sells for >$80k. Bank gets all of its $80k loan back. Bank gets 25%*(Home price – $80k) on its equity. Homeowner gets 75%*(Home price – $80k).
At a sale price of $160k, the bank recoups all of its initial loan ($80k modified loan + 25%*$80k = $100k). The bank makes a net profit on any final sale price over $160k.
The homeowner will also receive an option to buy out the bank’s equity at any point in the future for 25% * (Market value – $80k) plus some pre-determined premium.
This program would be open to all homeowners, banks would have no say in the matter. Obviously, homeowners who are not underwater would not have any reason to participate.
Is this solution perfect? No.
Is it preferable to a taxpayer-funded mortgage forgiveness program whereby the government pays banks to forgive a portion of underwater loans? Yes.
Is it preferable to doing nothing and having the debt overhang doom the economy to a decade or more of below-potential GDP and high unemployment? Yes.
I’m well aware of the difficulties involved. The loan writedowns would impair bank earnings for a period of time (though there would now be future upside). The impact on mortgage services, MBS, CDOs, and the holders of MBS and CDOs would be messy. There would be lawsuits. Again, it must be measured against the alternatives and not some utopian fantasy world where all debts will be eventually paid in full and no losses have to be taken.
What I’ve laid out above is a simplified, stylistic version. All sorts of modifications could be made to improve it. The percentage of debt converted could be increased to provide additional monthly payment relief. The equity structure could be modified to give the bank a bigger percentage claim on the first $20k in price appreciation. Other terms of the loan could be modified. The point here is just to lay out a set of guiding principles; the details can be hashed out later.
The Fed announced at 2:15 that it would hold the Federal Funds rate near zero for 2 years.
More significant was what it did NOT announce:
- It did not announce it would keep rolling over its bond portfolio for 2 years.
- It did not announce it would change the composition of its bond portfolio to longer maturity bonds.
- It did not announce it would cut the interest rate (0.25%) it pays on bank reserves.
- It certainly did not announce QE3.
The immediate market reaction was predictably negative – market consensus was for more action by the Fed.
However, that reaction was short-lived, and the market soon took off like a rocket. Very odd.
There’s a considerable amount of debate regarding the exposure of US banks to Greek sovereign default via their CDS protection sales to European banks. See:
Yet some policymakers and industry participants still aren’t convinced of the need to move CDS trading to exchanges and bring transparency to the market? Seriously? We really didn’t learn anything from the 2008-2009 crisis.
Some key stats:
- Debt-To-GDP of around 150%
- Budget Deficit >10% of GDP
- Current account deficit >10% of GDP.
- GDP growth for Q1 2011 -5.5%
- 15.9% unemployment rate
- 2-Yr hitting a high of 30% and the 10-Yr hitting a high of 18%
With average interest rates around 20%, and around a 150% Debt to GDP ratio, Greece needs a primary surplus (government budget net of interest) of 30% to service that debt. Yet tax revenues are falling at an alarming clip because of the decline in GDP.
What Greece needs, in order:
1. Economic growth
2. Lower interest rates
Austerity programs (lower spending, higher taxes) lead to lower economic growth in the short to medium term, with very little impact on interest rates over that time period.
The bailouts increased the debt to GDP ratio, and any softening effect they had on market interest rates was highly temporary.
Unfortunately for Greece, an absence of bailout funding means an almost immediate default on existing debt. I agree that this would be a highly destabilizing event for the entire Eurozone if not the world, BUT – the architects of the bailout have no credible explanation for how Greece is to sustain its debt service over the next 2-5 years apart from simply ASSUMING that austerity will somehow magically lead to both balanced budgets and robust economic growth, which is NONSENSE.
Meanwhile, EU/ECB/IMF leaders’ primary concern is how to get Greece’s creditors to rollover short term maturing debt in a manner that does not trigger a “credit event”. The fact that they are talking in CDS terms speaks volumes. This is silliness.
The Greek Parliament ought to outright REJECT the asuterity measures that European banks are attempting to impose on them. Tell the EU/ECB/IMF that they want to honor their debts but that the only way to do so is through economic growth, and ask for a plan that will increase economic growth to a level that makes current debt service sustainable. Make it clear that the only other option to the “growth plan” is immediate default, French and German banks be damned.
The more Greece tries to balance its budget by cutting spending and increasing taxes, the more the budget deficit will actually widen as the economy slows and tax receipts decline. Austerity is not the solution, it is a big part of the problem. Likewise, exchanging existing government debt for new government debt, while interest rates continue to rise, only makes future debt service more difficult. Stop the madness.
There’s a reason why we abolished debtor’s prisons a long time ago. They effectively make it impossible for the debtor to ever repay his debts, and thus are to the detriment of both debtor and creditor. Yet, what the European authorities have done is essentially put Greece into a debtor’s prison named Austerity. They should release Greece if they are to have any hopes of being paid anything back.
A number of bloggers are making their annual predictions on what’s in store for the economy in the coming year. Since I consider trying to forecast GDP, unemployment, and other macro measures a year out to be a fool’s errand, I will instead focus on what I consider to be the biggest threats to the US economy in 2011.
- Oil Prices. Crude is now over $91/bbl. That represents a 35% increase over where it stood early this past Summer. Rising oil prices act as a brake on economic growth. $100/bbl is an important psychological milestone, and if it goes much above that, we will certainly see an impact on auto sales, airline profits, and transportation industry profits, along with a general falloff in demand as disposable income is reduced.
- Real Estate Prices. Housing prices started falling again in July after appearing to stabilize. It appears that the temporary stabilization was largely a result of the homebuyer tax credit, and its expiration means housing is resuming its slide. This will mean more negative equity, more foreclosures, and more economic pain for almost everyone.
- Stimulus Wind Down. The growth rate of ARRA spending has already peaked. Many programs are winding down. There will almost certainly be many (misguided) calls for further austerity. State budgets are being cut back to the point where basic services like snow removal (as the recent Northeast blizzard demonstrated) are becoming a challenge. The 2% payroll tax cut and unemployment extension will provide some respite, but these are temporary measures.
- The European Debt Situation. The crisis that is continually contained, until it isn’t. It’s likely that we’ll continue to see flare ups followed by new emergency measures that bring about temporary calm repeated almost ad infinitum. My fear is that, for whatever reason, there will eventually be a “European Lehman” that fails and the European authorities will be unwilling or unable to implement a rescue in time.
- Policy Paralysis. Politically, there isn’t going to be any further fiscal stimulus. Conventional monetary policy is at its limit. Unconventional monetary policy will face widespread opposition from both the left and the right. We are thus vulnerable to any significant shocks that occur, whatever they may be.
Never forget the old boxing saying that it’s always the punch you didn’t see that knocks you out.