Tavakoli Structured Finance, Inc.

The Financial Report

By Janet Tavakoli

Euro Endgame

The European Central Bank (ECB) is facing a dilemma similar to that faced by major U.S. banks in the 1980’s with defaulted loans to Latin America. The PIIGS (Portugal, Ireland, Italy, Greece and Spain) collectively may require debt write-downs that exceed banks’ capital and reserves, and the ECB’s tantrums won’t change that fact.

Bullying Greece Is No Solution

The immediate crisis is in Greece, but it is not alone. It is futile to blame deadbeat borrower countries, and given the flaws in the European Union, it isn’t entirely their fault. The Euro is a super Deutsche Mark with a French accent. There was no Renaissance of manufacturing and productive jobs in the outer reaches of the Eurozone.

When you’re overleveraged, your entire future depends on cash flow, and the cash flow isn’t there for countries like Greece. The ECB is threatening to cut Greece off from bank liquidity— triggering Greek bank failures—if there is any restructuring of Greek debt. But the cash flow isn’t there to service and repay the debt, and even selling off assets won’t change the long-term situation for Greece.

The ECB alone bought €75 billion in government bonds, and €45 billion or around 60% of them are Greek debt. Despite JPMorgan’s estimate of around €81 billion in capital and reserves for other European banks to sustain a 50% haircut in various government bonds, it likely isn’t enough, and government bonds aren’t the only challenges the banks face.

The ECB’s problem and the problem for many Eurozone banks is that they do not want to mark their bonds to market. They don’t want to know what the debt is really worth, and it’s not worth anything near what they’re telling themselves it is worth. Threatening Greece so that they can cover-up the problem is only a temporary fix, and it isn’t fooling anyone.

Deep and Meaningful Discounts for Restructured Debt

Given that no one wants to face the magnitude of the problem, it is difficult to say how bad this can get, but history gives us an example of what needs to be done. In the late 1980’s if U.S. banks had marked their Latin American debt to market, the losses would have wiped out the capital of Bank of America and Manufacturer’s Hanover (now JPMorgan Chase). Citibank was close to being wiped out. Other banks were also on the ropes: Irving Trust (now Bank of New York Mellon), First Chicago (now part of JPMorgan Chase), and Continental (later seized by the FDIC due to other bad loans).

By the end of 1987, Latin American debt ranged from around 15 cents on the dollar for Bolivian debt to around 35 cents on the dollar for Argentina’s debt. There was precedent for these market values. Market value estimates at the time recognized a valid appraisal method based on the fact that the U.S. had forgiven a large chunk of Mexico’s debt and restructured it.

After Latin American countries defaulted on debts, the subsequent granular restructuring negotiations resulted in various dollar-denominated Brady Bonds, named for then U.S. Treasury Secretary Nicholas Brady. Each country negotiated its own terms. In the earlier Mexican debt restructuring for example, half of the $20 billion debt was forgiven, and the principal of the other half of the debt was secured with a zero coupon UST bond then trading at around $2 billion of the $10 billion face value (the other half of the original debt). Mexico then had to meet the interest payments to service the $10 billion bond.

Greece is a sovereign country. The ECB is acting as if it can dictate terms to Greece, but as U.S. banks found out, when someone owes you a lot of money and they cannot pay it back, you are in as much trouble—and sometimes in more trouble—than they are.

Restructure Debt and/or End the Euro

The crisis the Eurozone now faces is that citizens of countries with the most fiscally irresponsible governments and banks may be of a mind to vote out their current governments and repudiate their debt. The ECB can threaten all it likes, but it is dealing with sovereign states.

Greece provides the most current example of the problem. It will have to impose fiscal restraint. The austerity measures forced on Greece from the Eurozone will be more onerous than those Greece will have to impose on itself, if it takes back control of its own currency and devalues it.

Greece is coming under pressure to sell crown jewels like Thessaloniki Water and Sewage and Piraeus Port Authority. Greek citizens may view that as robbery, since it will only provide enough to make interest payments on debt for a short period to help the ECB cover-up Greece’s solvency problem. This benefits the Eurozone banks that are in denial, but it doesn’t help Greece.

The End Game

Either Greek debt will be meaningfully restructured, or Greece will eventually divorce itself from the Euro, implement its own austerity programs, force a renegotiation of its debt, and devalue its own currency. If the ECB keeps storming out of meetings and isn’t willing to engage in meaningful negotiations, then it’s in Greece’s best interest to exit the Euro. Other countries in the Eurozone may come to that same conclusion.

See also:

Structured Finance: Sovereign Debt, Banks and Gold” – October 8, 2013

Greece and the Troika: Next Moves” – July 6, 2015

Read finance articles by Janet Tavakoli

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