Opinion

James Saft

Euro debt and the high cost of justice

March 31, 2011

It looks just about possible that creditors are going to be paying something like their share of the euro zone debt disaster after all.

This could be a little patch of justice in an unfair world, but like most justice it promises long term benefits but short term pain, both for those dispensing and receiving it.

Firstly, people with money and a choice are going to – indeed already are – voting with their feet, choosing not to lend to the ailing governments on Europe’s periphery.

Secondly some of these creditors to Ireland, Greece and Portugal and their banks will very likely find that their share of the damage exceeds their capital, an inconvenient reality for both the banks involved and the sovereign hosts who will have to pick up the pieces.

The EU summit last week ended with a set of policies that told creditors directly that their heads will be on the block when the European Stability Mechanism (ESM), a bailout conduit, kicks in.

All European government bonds issued from July 2013 will include a provision that makes buyers vulnerable to forced extensions of the bonds, reductions in interest rates and ultimately write downs of principle in the event of a crisis.

On top of that, once the ESM takes effect, garden variety lenders like banks and pension funds will be subordinated, meaning the government bailout fund gets its money back first.

Accessing the fund may require a debt restructuring, a polite term for a partial default.

While this may be just and is definitely politically expedient for the politicians trying to sell the bailout back in Berlin and Paris, it is also the equivalent of ringing a great big fire alarm in a crowded theater – everyone is going to head for the exits.

And they duly have. Ratings agency Standard & Poor’s has downgraded Portugal and Greece, citing the new rules this week. There is every reason to expect that Ireland will not be far behind.

Credit spreads have widened in a self-reinforcing spiral that makes accessing emergency help more likely, which in itself is cause for yet more selling of government bonds.

Don’t get me wrong. People who have lent money in a cynical attempt to cash in on the moral hazard trade deserve their losses, as do earlier lenders who merely failed to do their due diligence.

That said, I can’t help but feel this is going to spin out of the orbit of burden sharing and into something a bit more chaotic. For me, as for many German taxpayers, this is looking like a “be careful what you wish for” moment.

IRISH BANK CREDITORS FACE SHEARS

Shortly after this column is published, Ireland will release the results of its new stress tests on its cratering banking sector. At the same time, if news reports are correct, an indefinite term bailout vehicle for them with ECB and EU support will also be announced.

The stress tests will likely show that Irish banks need an additional 30 billion euros or so of capital, taking Irish state investment to 75 billion or so, a whopping 45 percent of annual gross national product.

This is a staggering amount and given that the policies of austerity will only erode the value of the assets Irish banks have lent against further, there is no guarantee that this is where it ends.

Ireland’s new government appears to be taking a harder line about forcing lenders to Irish banks to take a portion of the losses. Subordinated creditors are sure to have their loans restructured and senior creditors may well face losses too.

To be clear, it is right that the banks that fed the Irish banking beast with easy loans take losses as a means of easing the hardships that are falling on the Irish people.  Ireland’s banking system, like Iceland’s and arguably Britain’s, was way out of proportion to the size of its economy.

This may well be simply a negotiating ploy by the Irish government, as a substantial write down of Irish bank debts will spread losses, and more importantly fear, widely across Europe’s banking system.

A rescheduling by Ireland, Greece or Portugal will be highly disruptive for global markets and you can bet that the ECB and EU are under tremendous pressure to make sure it does not happen.

There is, though, a sense that there is not political will or capacity to bring about a solution that keeps Greece, Ireland and Portugal all on board but can also be sold to the German electorate.

It has been a long first three months of the year. Egypt, Japan and Libya have distracted attention, while the long-running and procedural nature of the euro zone’s problems make them a pleasure to ignore.

Things could, in the next week, move rapidly and perhaps upend widespread expectations of an ECB hike on April 7.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. Email: jamessaft@jamessaft.com)

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