How to Save Greece

billy d

Baruch MFE, Class '11
How to Save Greece

Debt doesn't have to spell disaster. A solution to Europe's crisis exists—and it's worked before

Greece is a chronic defaulter. Since winning independence from the Ottoman Empire in 1832, the nation has spent half its time in various stages of default or restructuring. At one point in the middle of the 19th century, Greece was in default—meaning out of compliance with debt obligations—for 53 straight years, according to This Time Is Different: Eight Centuries of Financial Folly by economists Carmen M. Reinhart and Kenneth S. Rogoff.
If Greece defaults again, this time really will be different. The finances of the world are linked more tightly. Derivatives obscure and sometimes concentrate risks. Greece is locked into a single currency with 16 other nations. It's possible that the global economy could get lucky, and a Greek default will be a minor event. But it's also possible that a default would cripple a chain of vulnerable economies, including Ireland, Portugal, and Belgium. The nightmare scenario: defaults by Spain and Italy, which might thrust all of Europe into a deep recession.
When big banks fall, as they did in 2008, nations rescue them. When big nations fall, there is no one strong enough to hold the safety net. "Failure to undertake decisive action could rapidly spread the tensions to the core of the euro area and result in large global spillovers," the International Monetary Fund, which is no stranger to sovereign debt crises, warned on June 20.
Can disaster be averted? The answer is yes, because a solution exists. It doesn't involve simply reprimanding the Greeks to cut their way back to good health, as the Eurocrats in Brussels have been pushing for. Nor does this plan force creditors to accept repayment stretched out by seven years, as Germany, until recently, has advocated. Best of all, the world has tried it before—and it worked.
The idea, which has floated around for months without getting much uptake from European decision-makers, is to scarf up Greece's unaffordable debt on the open market and exchange it for new, more affordable long-term bonds issued by a (presumably) reformed Greek government. A deal like this, modeled on the approach that helped Latin American nations emerge from debt crises in the early 1990s, would save Greece money on interest, while getting its debt into the hands of investors who want to hold it, instead of ones who can't unload it. (It's worth emphasizing that investors are not blameless—chasing after high returns, they ignored the warning signs that Greece was in over its head.)
A good time to try something like this would be, oh … yesterday. The debt crisis is doing visible damage even without a default. The Greek economy shrank 5.5 percent over the past year under the weight of austerity measures and punishingly high interest rates. Unemployment was 15.9 percent in March. Less visibly, though dangerously, European banks are getting nervous about their peers' creditworthiness. Instead of borrowing from one another, as usual, a growing number of banks—353 as of June 21—are getting loans from the European Central Bank itself through the so-called repo window. They're also asking the ECB for more cash than the ECB expected they would want. Those are early warnings that there's a "growing liquidity squeeze," says Lena Komileva, global head of G10 strategy for Brown Brothers Harriman in London.
Although some kind of compromise that averts default is in everyone's best interest, progress toward a deal has been slow because each player in the Greek drama has an incentive to play tough until the last minute. Greece's opposition New Democracy party, which is leading in opinion polls for the next election, opposes more concessions to creditors and withheld support from Prime Minister George Papandreou in the confidence vote that he survived on June 22. Under pressure from the German public, Berlin is demanding more budget cuts and asset sales by Greece, as well as shared sacrifice by private creditors. The European Central Bank says it will stop accepting Greek sovereign debt as loan collateral if there's any hint of default. And so on.

As in the U.S., where lawmakers are withholding approval of an increase in the federal debt ceiling to gain leverage in budget-cutting negotiations, the risk is that someone in the game of chicken will miscalculate and disaster will ensue. If Greece defaults, speculators will turn their attention to other vulnerable nations, driving their bond prices down and their borrowing costs up. Ireland and Portugal are already receiving official assistance to cover their debts, so they're temporarily insulated from speculative attack. The bigger problem would be if jittery investors drove up yields on Spanish and Italian bonds to the point where it became hard for those countries to roll over their debts. That's still a remote possibility, but not out of the question in investors' minds—Spanish and Italian 10-year bonds yield around 5.5 percent and 4.8 percent, respectively, vs. equivalent German bonds at 3 percent.
The trick, then, is to quell the fear before it turns to panic. Europe would do well to try something like "Brady bonds," created to stabilize Latin America two decades ago. Those bonds, named after former U.S. Treasury Secretary Nicholas Brady, were fixed-income securities that commercial bank lenders could receive as a replacement for loans they had made. Two former chief economists of the International Monetary Fund, Rogoff of Harvard University and Michael Mussa of the Peterson Institute for International Economics, say that some variation on the Brady bond plan could work in Europe. Says Rogoff: "The reason the Brady plan is appealing is there's some precedent. It gives people something to anchor their expectations around."
A Brady bond solution isn't perfect. Rating agencies, the ECB, and the credit default swap market would most likely deem a Brady debt exchange a default, since the new bonds wouldn't be worth as much as the face value of the bonds they replaced. Carl Weinberg, chief economist at High Frequency Economics in Valhalla, N.Y., proposes a variation on the Brady theme that might skirt default. He says an organization such as the European Financial Stability Facility should buy Greek bonds on the open market, swap them with the Greek government for new long-term Greek debt with lower interest rates, and sell the new bonds back to the public. Advantage: no coercion, so no default. The only question, a big one, is whether the market would buy the new Greek debt.
Greece's debts are so large that some of them almost certainly will never be repaid. If Greece must eventually default on portions of its debt, as investors expect it will, Europe's goal should be to make the process as orderly as possible to avoid chaos and contagion. Brady bonds help by giving investors something of clear, certain value, even if it's not 100 cents on the euro.
Whatever happens, it needs to happen soon. Above all, Greece must quickly balance its budget, painful as that may be. Greece's problem is too much debt, so extending it even more loans, even on favorable terms, can't be the solution. It's true that postponing a final reckoning through continued official aid will give European banks more time to build their capital cushions so they can withstand losses from a Greek default. But that has to be weighed against the pernicious effects of delay. Markets crave certainty. The longer Greece remains unresolved, the more investors will start to worry that the conflagration will jump the fire break and reach Portugal, Ireland, and beyond. Such fears can become a self-fulfilling prophecy.
Reprising something like the 1990s Brady bonds won't necessarily provide a way out for Europe. But it just might point the way forward.


Psychic in Training
The Brady plan to me was an organized way to restructure debt held by countries on the brink of default. Whether it is better than any other restructuring mechanism, I'm not sure. But from my vantage point, they all involve a large amount of debt forgiveness for Greece, and what bank wants to give Greece billions of $? Isn't that the point of making Greece sell things - so that banks would get more back?

I don't see it saving Greece. It's credit worthiness is still shot; its expenses are still well beyond its profits. That article seems to make the impression that this is an alternative to selling off property and cutting expenses, but it seems reality is that it is merely a restructuring plan (that no doubt will get priced into the interest rates that Greece will have to pay should it ever borrow money again). One that will still be infeasible going forward unless Greece sells off property and cuts expenses to levels which are sustainable...

The real question here is what is better, restructuring or default?
The real question here is what is better, restructuring or default?

It's like putting off a painful yet necessary visit to the dentist. Bondholders aren't willing to take a "haircut" (each time Merkel has diffidently broached the idea, she's been attacked). The debt is literally unpayable. The politicians are but kicking the can down the road.

On a side note, an article by a friend of mine.

And I recommend reading this:

The eurozone is based on three pillars: loopholes, fudges and lies. They made this crisis inevitable. The propensity to fudge now makes any real resolution all but impossible, even if it contains the problem.

The lies, loopholes and fudges gave rise to another trinity: no exit, no default, and no bailout—a logically inconsistent set.
If they ever want to emerge out of the debt cloud (restructured or not), Greece needs to change the culture of the entire Greek people in terms of financial responsibility, taxes and the like. It's a county where everyone's money is in cash under the mattress. Not saying it's the only country like that, but it's such an extreme case. Ingrained behavior for many many years, no one pays the government.

edit: Found a paper that discusses it in more detail: The Shadow Economy and Corruption in Greece - Stavros Katsios
If they ever want to emerge out of the debt cloud (restructured or not), Greece needs to change the culture of the entire Greek people in terms of financial responsibility, taxes and the like. It's a county where everyone's money is in cash under the mattress. Not saying it's the only country like that, but it's such an extreme case. Ingrained behavior for many many years, no one pays the government.

Greek tax avoidance 101.
Haha that's amazing. My Greek friends know all about this.

To this day their families take just under $10,000 (to avoid declaration) cash in bags each on separate flights back to Greece to build their houses and buy businesses. Black market foreign investment, haha.
Germany owes Greece a debt?

Germany's ducking of the war reparations issue makes its attitude to the current Greek debt crisis somewhat hypocritical

Think Greece's current economic malaise is the worst ever experienced in Europe? Think again. Germany, economic historian Albrecht Ritschl argues in a SPIEGEL ONLINE interview, has been the worst debtor nation of the past century. He warns the country should take a more chaste approach in the euro crisis or it could face renewed demands for World War II reparations.,1518,769703,00.html


Quant Headhunter
I have some time for a Brady bond style solution and having some experience of re-profiling of government debt and there is a clear issue about what exactly is a "default".

If Greece forces creditors to accept less cash or forces a different repayment schedule then that is a default in terms of perception, the triggers for default swaps and the effect on the stability of banks. We would be talking about issues that are worse than Lehmans.

A long accepted and frankly rather dull activity by most governments is a reverse auction.

Much government debt is auctioned typically with a fixed coupon, but the market sets the yield by bidding to buy the bonds and that varies the price.

A reverse auction is when a government offers to buy back an amount of debt and holders of the bonds state what they will freely accept for the bonds. A common reason for this is to improve liquditiy. Some bonds don't trade much, and it is better to hold debt that has a small bid offer spread than one that may take time and a bit more lost value to sell. Often bond holders want to move their maturity into the future because they want a low risk long term investment, and so this is something they actively want.

So imagine a 3rd party who offers to buy Greek state debt at whatever holders are willing to sell it for, on a very large scale offering longer maturity bonds. It will say in effect for E100 notional with 3% coupon maturity 10 years how much Greek paper maturing in one year will you give me ?
A stepwise argument is that given the choice between a 10 year bond due on the German or British Government (or even both working together under joint and several liability) and a one year Greek bond, would you take 99c cents for a Euro of nominal ?
The real drop is of course >1 cent, and not only is this a cheap solution, it could actually make serious money.

Choosing the optimal maturity and coupon for this activity is exquisitely difficult but processes already exist and work today for similar reprofiling.

Of course the 3rd party needs to have utterly impeccable credit for this to work, but remember there is a demand from various areas like pension funds for exactly this sort of instrument.

This is not a default at all by any criterion, bond holders get a fraction more than they expected and we don't have a plague of bank deaths.

The problem is that Greece might feel it is being let off the hook and not carry out the necessary reforms and may feel that it will get a softer ride from fellow EU governments than from the financial markets. Most people would rather they owed money to their parents than their bank.
Where did you get this conclusion from?

I think the Greeks are more concerned with their personal survival at the moment (cause due to the austerity measures there are families who don't have money even for the essentials). It's nice to talk theory when you haven't been there...
How is so?

You know what I see??? And this is my personal own view...

There have been a number of austerity measures imposed to the Greek people(taxes, lay offs, etc) directed by Merkel and the IMF in order to reduce the debt. I won't talk about the money owed to Greece by Germany, the fact that we are not allowed to take advantage of our own natural resources (oil, natural gas, metals, etc).

The Greek people is struggling to cope with everyday expenses and despite all the effort, when Greece is to agree for the next installment, the very nice (and by the way non-monitored by anyone) rating agencies, downgrade Greece so the debt can increase and we are just pushed and kicked on the floor instead of having a helping hand. I am not saying that we did everything perfect cause I know we did exactly the opposite. BUT, when becoming member of the EU means that the EU will protect you in times of need, don't freaking take advantage of the situation to create an even bigger debt pretending that you are helping by lending us with sky rocket interest rates to save us. Let us default, if that's what will happen in the end and don't impose all this misery to the Greek people.
It seems ridiculous to me... for Greece to borrow money in order to repay the ever growing interest payments because of the continuous downgrades... Cause from the money borrowed, only a fraction is actually used for domestic needs, the rest goes back to the lenders.
It seems non-Greeks are worried more about Greece's survival than Greeks themselves. Anyone sees anything ironic with this picture?

Depends on what "survive" means. The Greek people will survive, as will the land on which they live. There will continue to be a Greek government (though not necessarily the present one). The non-Greek bankers are concerned with the survival of the financial status quo, which is unsustainable. No amount of reforms and austerity are going to make the present debt payable. If memory serves, the government ran a deficit of about 10% of GDP last year; it needs a surplus of 14% to make a dent on the debt. No matter how much they cut, it can't be done. Furthermore the cuts themselves have an impact on economic activity, depressing it further and hence further decreasing tax revenues. As Michael Hudson is fond of repeating, debts that can't be paid won't be paid. The CDS spreads reflect the recognition that some form of default is inevitable. The Eurocrats are heming and hawing, fudging and procrastinating, as is their wont.


Quant Headhunter
I suspect the reason so many think that Greeks don't "care" about default is that so many of them think that the consequences will fall mostly on others.
Also some are looking at very bad personal outcomes, and may be entirely focused on that and you can see their point.

We also see the curse of state ownership here.
Greece has a horrifically bloated state sector which not only has a huge impact on the economy but raises nationalist issues so Greece is in the stupid position about seeing commercial assets as part of its national pride.
The Greek "big con," according to Charles Hugh Smith:

The banks and the Greek kleptocracy are like the wife and the mistress of a prominent conservative socialite who absolutely needs to preserve a facade of conventional propriety.The kleptocrats, like the mistress, know they can blow down the entire charade, and so when they demand some baubles (bailouts) from their "Sugar Daddy" European Central Bank, the bank whimpers and complains but forks over the cash, lest the whole shaky facade collapses in a heap, along with the ECB's dominance.

The wife, meanwhile, also gets her demand met.Now that the European banks have leveraged themselves up to pre-implosion Lehman Brothers levels of 30-to-1, they need a bailout, too, and so they tell the ECB, don't even think about saying "no" because massive bank insolvency would also shatter the Euroland's thin veneer of permanence.

The euro system is already broken, but the ECB and its Eurocrats are desperate to maintain the facade.The game is untenable, however, because the Greek kleptocrats and the European banks have all the leverage and the ECB is the bleating mark trying to satisfy the dualing demands of its wife and mistress.

"But you promised." Ah yes, Dearie, but I changed my mind.
The money the ECB, EU and IMF release (about 13bn euros) will play for the bond redemptions and coupon due in the middle of July (about 7bn euros). And there's a comparable payment to make in August. Then what? The austerity program and privatisations will buy a bit of time. After which? Greece has to default. The whole world knows it. The Eurocrats are a bunch of weak and dithering nincompoops. This bull has to be seized by the horns. The weakness of EU crisis management is being shown to the entire world. The EU is a paper tiger.