How Europe Should Tackle Its Three Main Problems

One cannot solve one problem without solving all three. Either they all get done or none truly get done. You can kick the can down the road by solving problems 1 and 2, but problem 3 will put you shortly back to square one.

Europe is now trying to address problems 1 and 2. They are talking about a "new treaty" that will require austerity of a real kind, although I understand that Germany has put in a clause that gives it some extra time to achieve its own balanced budget. And the ECB is dispensing euros through the back door to banks, in exchange for anything resembling collateral. Not directly of course, as that is prohibited, but the same thing is being accomplished, despite objections in some quarters, mostly German.

Staring Into the Abyss
It was late in September of 1998. I was flying from New York to Bermuda to speak at a hedge fund conference, and found myself upgraded at the last minute, back in the day when I did not fly that much, so I was feeling rather happy. As the door closed, a patrician-looking gentleman stepped in and came and sat next to me, immediately picking up a file and burrowing into it. I had a book and The Wall Street Journal, so I was content to read.

As soon as we took off, he asked for a scotch. He proceeded, over the next hour, to wage a very aggressive war on the diminishing cache of scotch bottles stored on board. (No, it was not Art Cashin. He doesn't fly.) It was an arduous campaign, but he was fully committed to winning.

He glanced over to my Journal and noted some headline about the crisis that had occurred the previous week. I had been following the extreme market volatility with interest, but this was in the first decade of the internet, so most of what you came by you still read in print or heard on the phone.

"They don't really know how close we came," he shuddered, his eyes showing the first signs of emotion -- and fear -- I had seen from him. That piqued my interest, and I engaged him, though without touching his precious hoard of scotch. I settled for a nice chardonnay.

It turned out he was the second-ranking executive at one of the three largest banks in the country. He had been at the table in the NY Fed boardroom when 14 banks were forced to put in $3.625 billion to keep Long Term Capital from collapsing, with only Bear Stearns declining (one of the reasons they had no friends 10 years later).

The NY Fed president had essentially called all the heads of the banks, told them to be in the room, not to send proxies, and to bring their checkbooks. There was subsequently a lot of criticism of the Fed, but they did what a central bank is supposed to do in times like that: They made the children play nice in the sandbox. They were the only entity that could force the various monster-ego players to even sit in the same room with each other.

"No one will ever really know," he said again. But of course, soon everyone did, as Roger Lowenstein wrote the must-read real-life thriller When Genius Failed.

"We walked to the edge of the abyss, and we looked over." He proceeded to regale me with the stories of the negotiations, as the immensity of what would happen if they allowed the collapse dawned on the group one by one. They all had exposure to LTCM but did not realize the extent of it until it was too late. Looking back, it might have looked something like the credit crisis of 2008 if they had not acted, except it would have happened much faster.

I can tell you that no one in that room wanted to write a $300 million check. It was not good for their careers. Interestingly, after two years the fund was liquidated and the banks got back their capital plus a small profit.

Now, the bankers and leaders of Europe are getting ready to walk to the edge of the Abyss. It will be a long way down, and look like the seventh level of Dante's Inferno.

Their first real look will come in the next few weeks, as Greece is negotiating aggressively with its lenders as to how much of a haircut they will receive and what sort of guarantees Greece will provide on the remaining debt (they are balking at putting the new bonds in a legal jurisdiction that will have some real bite if they default again, which they will).

They are also negotiating with Europe about how much additional real austerity they will have to endure in order to be allowed to take on more debt. If they walk away and there is an uncoordinated default, it will guarantee chaos. Bank collateral will collapse and credit default swaps will be triggered, including many sold by European banks that are already essentially insolvent.

The legal euphemism here is that if debtors "voluntarily" accept a 50% haircut, then no credit default swap protections will be triggered on those positions. But not all parties want to voluntarily take that loss (or an even greater one). If they are forced to do so, then the credit default swaps they bought come into effect.

Greece can legislatively force them to take the haircut, but CDS contracts are written in such a way that that action would be seen as a loss, triggering the CDS insurance. The governments involved want everyone to accept, so there is no crisis. The funds simply want as much money as they can get back, and many are playing a very hard-nosed game.

Can the holdouts be enticed with sweeteners that not all may get? Maybe different collateral? Or shorter terms, or …?

The sad thing is that a 50% cut of the private lenders only gets Greece back to what will soon be 120% debt-to-GDP, from the current 170% and rising. 120% (which I consider optimistic) is just another, lesser form of insolvency, as Italy now understands. And if Italy is under pressure at 120%, then it is almost a given that the market would see Greece as still insolvent.

An Unintended (and Very Negative) Consequence
There is at least one unintended consequence arising from the Greek settlement negotiations. Private investors thought they were buying a bond that was "pari passu," or equal with all other Greek sovereign debt. It now turns out they were buying junior, second-tier, subordinated debt. Something like a second mortgage on a home. You will take the first loss, so you then charge accordingly. But it now seems that the ECB, the IMF, and European public institutions are "more equal" than the private parties and will not have to share in the losses. The private lenders have found out they were taking subordinated risks while only getting senior-rate returns.

If the public lenders were involved in the haircuts, then maybe it would only have to be a 30% haircut, or if it was 50% it would be enough to maybe get Greece to the point where it might have a chance, and the remainder of the debt would be in better shape, rather than this just being the negotiations for the first haircut, with more to follow.

Every private lender in Europe now recognizes they are taking more risk when they invest in a sovereign debt instrument. This will have the effect of pushing rates up in the private market, like they have very recently climbed for Portugal (more on Portugal later).

Europe faces a set of choices. They can lend Greece more money on promises to turn things around, which can't happen because of (1) the very austerity being imposed and (2) the 10% of GDP trade imbalance with the rest of Europe. But if they don't lend the money and there is an uncontrolled default, they will get to inspect that Abyss more closely than they would like. It will mean hundreds of billions of euros in losses at their banks, which will have to be bailed out eventually by taxpayers.

Europe is worried about "contagion." If Greece gets a 50% reduction on its debt, will not Portugal point out that they deserve it more? There have been deep fiscal cuts by the free-market government of Pedro Passos Coelho in an attempt to reduce the deficits, but estimates are that, even with those cuts, the deficit will still be 6%, falling only to 4% in 2013. And that is if things go well.

The market is not acting as if it expects things to go well. Yields on Portugal's 10-year bonds climbed to 14.39% on Thursday. Credit default swaps measuring bond risk have reached 1,270 points, pricing a two-thirds chance of default over the next five years.

While Portugal's public debt of 113% of GDP is lower than Greece's, the private sector has much larger debts and the country's total debt load is higher, at 360% of GDP -- much of it external debt. Jürgen Michels, Europe economist at Citigroup, says:

"Without a sizeable haircut to its debt stock, Portugal will not be able to move into a viable fiscal path. We expect a haircut of 35pc at the end of 2012 or in 2013."

Ambrose Evans-Pritchard, writing in the London Telegraph (I really like his work), notes:

Portugal is a troubling case for EU officials, who insist that Greece is a “one-off” case rather than the first of a string of countries trapped in a deeper North-South structural rift. The official line is that Portugal will pull through because it has grasped the nettle of retrenchment and reform.

Europe's leaders have vowed that there will be no forced “haircuts” for holders of Portuguese bonds. If the country now spirals into a Grecian vortex as well they will have to repudiate that promise or accept that EU taxpayers will have to shoulder the burden of debt restructuring. While all eyes are on Greece, it is the slower drama in Portugal that will ultimately determine the fate of the eurozone.