Greece's PSI: dead on arrival

In the beginning there was Wholesale Denial. Then the Denial began to subside under the weight of circumstances. It did so slowly, agonisingly so, with the result that, in the process, Greece lost any capacity it might have had to rebound. It also caused the crisis to spread like a bushfire throughout the eurozone, turning liquidity problems into unyielding insolvencies first in Ireland, then in Portugal. Still, to this day, Denial is in the air. But it cannot remain intact without the whole eurosystem crashing and burning. The Greek PSI may be the harbinger of denial’s end. If not, it is hard to see what will stop the juggernaut of the crisis from destroying the few chances the euro has of survival.

Taking things from the top, Wholesale Denial began life two years ago when imploding Greece was issued a triple ‘Nein’: No bailout, no interest rate relief, no haircut [1]. A few months later, with a second credit crunch looming, one of these Neins was revoked. The calendar read May 2010 when a massive bailout was agreed. But, still, no interest rate relief to mention, and, of course, no haircuts. A few short months later, when it became abundantly clear that the disease had spread to the Emerald Isle, and was on its way to the Iberian peninsula, Germany decided that another of the three Neins ought to be revoked: there would be haircuts, but not until the creation of the permanent ESM in 2013. It took another eight months or so (early summer of 2011) before the Greek haircut was given a snazzy new acronym. PSI they called it (making it sound as if it was the bright idea of the private sector).

The idea was not without appeal: Why should the taxpayers of the surplus countries fork out untold zillions to shore up silly bankers, who knew quite well why they were receiving interest rate premia by lending to basketcases like Greece, without having the bankers themselves take a haircut too? How else would banks be given an incentive to think twice before lending to profligate states? Such talk sounded good in the Federal Parliament, in Berlin, but also in Athens, in Paris; wherever the politicians used these ‘lines’ to feign ‘toughness’ in front of an audience aching for the bankers’ blood.

Alas, in the era of, what I call, Bankruptocracy [2], even a haircut imposed upon bankers can be a blessing in disguise for the most sinister operators of the runaway banking sector. After the Greek PSI was announced in July 2011, shadow banking (hedge funds, special vehicles et al) lived its finest hour. They bought  Greek government bonds en masse, at basement prices, with a view to swapping them for fresh bonds of much greater value. Why? Because PSI Mk1 specified no face value loss but a drop of expected net present value (estimated at around 20%) due to a swap with new bonds of much longer maturity. So, hedge funds bought old Greek government bonds (GGBs) for 30% to 35% of their face value in order to exchange them with bonds whose value was estimated at 80% of the old ones’ net present value. A nice little earner. This was one of the reasons why PSI Mk 1 bombed out, leading to PSI Mk2 in October 2011. (The other reason was, of course, the fact that this pitiful diminution in Greece’s debt burden was neither here nor there given the viciousness of the Greek recession.)

Back to the drawing board, our European leaders came up with a deeper haircut in October 2011. They called it PSI Mk2 and even had the foolish Greek PM fall on his sword, to be replaced by a hitherto loyal ECB functionary, so as to ensure that PSI Mk 2 would become Greece’s new light on the hill; a beacon of the last glimmer of hope for a desperate nation. PSI Mk 2 envisaged an impressive sounding 50% reduction in the GGBs’ face value which, in present value terms, would result in a haircut no less than 60% (since the interest rates charged on the new bonds, that would be swapped with the old ones, could not exceed the interest rates charged by the ECB and the EU for the original bailout funds). In other words, holders of GGBs would be haircut in two ways: a 50% reduction in face value and an interest rate less than 5% which would cut further into the present value of the old GGBs.

Alas, there is never a dearth of silver linings for the shadowy universe of our modern financial sector. Even when facing such a substantial haircut, many financiers will find something to smile about. In the case of PSI Mk 2, their smiles can be traced to two things: First, many of them bought GGBs for something around 30%. If PSI Mk2 implies an overall (present value) haircut of less than 70%, they are home and dry. Secondly, hedge fund managers have had more playful thoughts: Given the EU’s zeal to keep the semblance of a voluntary haircut (a “private sector initiative”) alive, what is there to stop them from pursuing a legal battle against any compulsory expropriation of even a cent of the GGBs they hold? Already a major hedge fund has opted out of the negotiations with the Greek government over the terms of PSI Mk2, clearly preparing for a legal challenge or, more precisely, for extracting a nice little out of court settlement once the all-singing-all-dancing PSI Mk2 ‘concordat’ is announced by the Greek government and the EU.

In short, and so as not to labour the point, PSI Mk2 is dead in the water. The shenanigans of the shadow banking sector (which, lest we forget, includes not only the hedge funds but also, remarkably, the ‘proper’ banks’ shady Special Vehicles), plus the predictable deterioration of the Greek economy, have put paid to it. The negotiations may go on for a little while longer; the announcement of a brilliant agreement may be made, but, in truth, the idea that the Greek haircut will put Greece’s debt-to-GDP ratio back on a course towards 120% has sunk without trace. And if you need hard evidence for this, the European Summit of 9 December provided it even before 2011 was seen off: officially, Europe’s great and good announced the end of PSI as a policy of the new ESM; Europe’s future central, permanent bailout fund. It had all been a mistake, they seemed to confess.

And now what?

This year’s first significant statement came from Athanasios Orphanides, head of the Central Bank of Cyprus and his country’s  representative on the ECB’s Council. In a letter to the Financial Times, published on 5 January 2012, Mr Orphanides wrote: “Government debt markets are about trust”, blaming the crisis’s inexorable progress within the eurozone on “…[a] collective failure of euro-zone decision-makers.” So far, so excellent. As for the PSI, Orphanides repeated that which many have said before him: It signalled to investors, especially non-Europeans, that “euro-zone sovereign debt should no longer be considered a safe asset with the implicit promise that it would be repaid in full.” Like I have been writing ad nauseum since PSI Mk1 was announced, back in July 2011, Orphanides agrees that the Greek PSI, rather than being the bankers’ scourge, has proven a bonanza for shadow bankers and mainstream banks’ Special Vehicles. [He mentions the example of funds that purchased GGBs 35 cents or 40 cents on the euro who now insist on an agreement that allows them to profit from the swap.]

Now, some will say, with considerable justification, that the Head of Cyprus’ Central Bank is saying all this because Cypriot banks are sinking in a mire of their own making, having bought oodles of GGBs. Still, the fact that Mr Orphanides has an ulterior motive in calling for an end to Greece’s PSI is not the reason why his argument is lacking. The reason is that he is making precisely the same mistake as that Mrs Merkel, Mr Sarkozy and, indeed, the Greek government have been making for almost two years now: They keep thinking of the Greek public debt crisis in isolation to (a) the deep malaise of Northern Europe’s banks and (b) the public debt difficulties of most eurozone states. The fact is that the Greek crisis cannot and will not be dealt with unless the ‘solution’ is part of a systemic redesign that deals with (a) and (b) as well as containing a program for stemming the tide of recession that is currently engulfing our continent.

As evidence of Mr Orphanides’s narrow focus, which detracts from his case against Greece’s PSI, I offer the alternative that he is proposing: Greece should be issued, in lieu of the failed PSI, thirty year loans at 3% interest rates. Similar suggestions come from different quarters (see here for an article by George Zestos) canvassing the idea that, instead of the PSI, the ECB ought to guarantee GGBs (with the Greek government paying the ECB a small premium in return for these guarantees). The problem with such proposals is that they fail to incorporate their solutions to the Greek problem within a broader plan for Europe. Mr Orhpanides cannot possibly believe (and I do not think he does believe) that 3% thirty-year loans can be extended to Greece but not to Ireland, Portugal, Italy, Spain, Belgium even. And he cannot believe that the banks will be left with ECB loans but not be forced to recapitalise big time. But where will the trillions involved come from? He does not answer the question, leaving it to us to imply that he is in favour of eurobonds. But then the question becomes: What sort of eurobonds?

The continuing appeal of the Modest Proposal

So, we have returned to the question of eurobonds. But we neither need nor want eurobonds jointly and severally issued and backed by member-states (for reasons that Mrs Merkel can explain better than anyone; namely that such bonds will sell at interest rates that are too high for Germany and not low enough for the periphery). And since we cannot have a Federal Treasury do this on Europe’s behalf (as opposed to member-states), it is imperative that it is the ECB that issues and backs such bonds so as to convert the Maastricht compliant part of the eurozone’s aggregate public debt into Union/Eurozone debt; a common pool of debt that is, however, to be serviced pro-rata by member-states at interest rates reflecting not their individual credit ratings but those of the ECB that organises this debt conversion on the Union’s behalf. (For more, see our Modest Proposal.)

Interestingly, George Zestos’s recent proposal (mentioned above) points in the Modest Proposal’s direction. Zestos’s idea that the ECB should guarantee new issues of GGBs is, in fact, more radical than our proposal for ECB bonds issued on behalf of each member-state and to be serviced in the long run by the member-state. While Zestos is asking of the ECB effectively to take onto its books the new issues of Greek, Italian and Spanish bonds, the Modest Proposal, much more…modestly, suggests that the ECB issues debt on behalf of these member-states but then charges them for their servicing on the basis of some super-seniority baring loan agreement. In fact, the two ideas are close in spirit, except that the Modest Proposal (i) gives more guarantees to the ECB that it will not have to print money to service member-states’ debts and (ii) gives international investors more grounds for confidence (since they would be much happier buying bonds issued by the ECB than bonds issued by Greece or Italy under a complicated insurance scheme backed by the ECB).

To recap, the Greek PSI was always an error in search of a rationale. It gave shadow banking a great new opportunity to profiteer at the expense of Greece and of Europe and escalated the latter’s crisis rather than helping tame it. The question is: What is the alternative? After two years of carefully studying all alternatives, I still believe that our Modest Proposal is the natural candidate. More recently, I had the dubious honour of talking to a hyper-smart Goldman Sachs apparatchik. He more or less agreed with the Modest Proposal’s basic thrust, albeit in a manner not at odds with the usual cynicism associated with his firm. This is how he put it: “Well, in the end your proposal will be adopted by default. Once the ECB has accumulated so many rubbish bonds, they will have to start borrowing to service them. Once they make it official, they will see the merits in charging the member-states for the cost of servicing what will effectively be ECB-bonds.” As they say, the Devil has all the best tunes.

[1] A fourth Nein was not even verbalised: A Nein to an exit from the Eurozone.

[2] The new regime that emerged from the ashes of 2008 in which the greatest power to extract rents from the rest of the social economy was granted to the banks with the largest black holes in their assets’ books. See my Global Minotaur for more.

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Image top: Kerelrobert.