Hannibal meets the hobbits

In 216 BC, the Carthaginian General Hannibal won a crushing victory over the Roman armies at Cannae.  For reasons that remain unclear, Hannibal hesitated and decided not to march towards Rome, prompting Maharbal, his famed cavalry chief, to tell him that he knew how to win, but not how to capitalize on victory.

In 1863, President Lincoln removed General Ambrose Burnside from command after his loss at the battle of Fredricksburg, and characterized his action as having snatched defeat from the jaws of victory.

Coming into being in 2009, the Tea Party crystallized popular rejection of Washington insiders, of politics as usual and of reckless taxing and spending.  Although it represents a minority of American voters and Congressmen, the Tea Party has gained strong political influence as it can call on 80 or so votes, thereby denying the Republican party of its majority in the Lower Chamber.

The Tea Party could justly take credit for sensitizing Americans to the need to rein in spending, for spurring the Republican Party to present a deficit and debt reduction plan and for trying to block Democrats from ever expanding the reach of government.  However, their insistence that there be no increase in the debt limit or that any legislation include provisions that the Democrats or the President couldn’t accept risks snatching defeat from the jaws of victory.

I believe that the Republicans could have successfully pushed for a package that would have been heavily geared towards spending cuts; such a package would have been credible and therefore more difficult for Democrats to reject outright.   Instead, Washington continues to show a sorry spectacle and sows doubt in our ability to govern ourselves. 

It is the very nature of democracy that victories are the result of negotiations, with one side rarely achieving 80% of his goals.  As Senator McCain observed, only in Middle Earth can the hobbits totally vanquish Mordor.  And as strange as Washington appears at times, it is not Middle Earth yet.

So the spectacle goes on.  We may yet stumble further as we did with the first vote on TARP.  Luckily (?) for the US, the eurozone is not looking too good, and there are not enough yens or Swiss francs to go around.

Looking further down the road, this debacle will have legs and will impact the presidential election of 2012.  Candidates viewed as close to the Tea Party ethos, such as Ron Paul, Michelle Bachmann or even Tim Pawlenty could suffer if voters decide that their planks are unrealistically rigid.  Mssrs Huntsman and Romney have studiously stayed away from the debt limit debate.  That was probably wise, but once the storm passes, they will need to show that, if elected, they would handle the budget and debt debate better than the President did.  Voters may yet decide that they want the next president to combine strong convictions with a successful track record as a reformer and governor.  This might open the way to Governor Perry from Texas.  Finally, the current crisis reinforces the image of a Congress far more polarized than the general population.  Either one of the traditional parties will move to the center or a new Independent Party is bound to arise.

Crunch time for Greece

Today, Prime Minister George Papandreou sent a letter to Jean-Claude Juncker, President of the Eurogroup.  The letter is interesting for several reasons: it tries to force the eurozone governments into concerted action, it stresses that “Crunch time” has arrived, and finally it seems to invite bold and drastic action so long as the results are worthwhile.

More precisely, PM Papandreou seeks a sustainable debt level (read a lower debt level), the means to restart economic growth and access to the markets (liquidity).  Sensing that contagion to Italy and Spain would doom the eurozone and the EU, he demands an end to the “cacophony of voices and views”, reminds his peers that they face equally dire straits should their banks need to take big hits, and finally suggests that Greece will not make further sacrifices for the good of other nations unless other nations decisively step up to the plate.

What next?  The PM may be bluffing, but then he must have Plan B too.  I may be wrong, but I think that he wants a substantial debt reduction, and if this reduction is big enough, he doesn’t care whether private creditors are participating or not, or whether the debt restructuring constitutes an event of default or not.  As he sees it, that is the problem of the rest of the eurozone.  What is interesting in the PM’s letter is that he seems to lament more the “meager results” of the (French banks) plan than the fact it may trigger a selective default.
  

Some commentators have written that Argentina might be a model for Greece, i.e. a unilateral default.  I doubt it, as the 2002 default and subsequent 75% “haircut” proved very costly to Argentina.  I do think however that the 2009 prepackaged bankruptcyof General Motors could, and probably should, be.

For one, I don’t see the ECB and the creditors accepting a significant debt reduction voluntarily.  For another, the current handwringing reminds me of the months that preceded the GM bankruptcy and the dire warnings that the company could never recover from it.  Then as now, markets wanted two things: (1) avoiding chaos and (2) being presented with a realistic plan that would enable them to recover a reasonable share of their claims.  That is why they responded positively to the GM plan, even if it contained objectionable features.

So the pressure is on the eurozone to help Greece devise a pre-packaged default and restructuring.  PM Papandreou is calling on finance specialists to come up with a plan that “will work” and that politicians will then have to implement.  The trade-off proposed by Papandreou is pain for gain.

A restructuring would make the lower debt load sustainable, and would be a necessary condition for an economic restart.  But it would not be sufficient.  Having reduced debt by 20% to 25% via an exchange of old obligations for new ones sporting longer maturities and lower interest rates, Greece will need to do much more to improve productivity and encourage investments.

As I have written in this blog, I think that Greece will need to privatize at least €100 billions worth of state assets, bringing its ratio of public debt to GDP down to 70% to 80%.  It will also need to enact far-reaching reforms, many of which will be unpopular and difficult to implement.  In other words, privatization and reforms will take TIME and a mechanism will have to be devised to provide the liquidity that Greece needs by reassuring those that will supply it.  One possibility could be the creation of a privatization trust fund where the assets to be sold would be held for the benefit of the European supranational institutions that would provide liquidity to Greece.

The Chilean privatization program in the 1980s is, in my view, the best example to follow, and this for two basic reasons: it reestablished confidence and (2) it secured popular and political support; by selling financially healthy companies, the government could devise programs to empower many Chileans to share in the privatization promises.  As was the case in Chile, it will take time for Greece to clean up the finances of big companies and to negotiate, vote and implement new and improved labor, financing and economic frameworks.
 
Selling healthy companies makes it possible to empower citizens of modest means to buy into privatizations; if free markets and capitalism are so good, they should be tangibly so to millions of people.  In Chile, a significant share of key privatizations was ear-marked for mass participation (capitalismo popular); because the firms being sold were financially healthy, they could guarantee set minimum dividends for five years or so; these annual dividends were greater than the annual interest payments charged by banks on loans made to people for the express purpose of participating in specific privatizations.  The combination of financing, positive carry and stock appreciation proved very successful and should prove equally so in Greece.

We seem to be approaching the beginning of the end game in Greece.  The stakes have been raised high and restructuring is increasingly viewed as inevitable by all parties.  Rather than avoiding the inevitable, the eurozone needs to agree on a prepackaged exit where the immediate pain will be accepted in order to permit a recovery.  Euro governments and agencies also need to learn FAST that the only way to stop a crisis is to overtake it and apply overwhelming force. Sadly, what Mexico learned and did in the 1990s  has yet to register in European capitals.  It is a pity, a very expensive one.

Greece: Let's try again

The latest iteration of the Greek saga offers little relief, except perhaps time.  It would however limit the participating banks’ losses to a maximum of 50%. 

 French banks have proposed a plan which apparently will be approved by German banks.   While its details have not been fully revealed, it would cover the maturities of Greek public debt held by banks and falling between 2011 and 2014 or around €60 billion. 

Under this plan, the most likely alternative would be for banks receiving €100 in repayments to keep €30.  The remaining €70 would be rolled into a 30 year Greek bond.  Greece would need to come up with €20 to buy AAA-rated zero-coupon bonds to be used as collateralize ensuring that, a maturity, the principal of the new 30 year Greek bonds will be repaid in full.

Since the participating banks keep €30 upfront, and since the present value of the collateral for the new bonds is €20, they insure that they will recover no less than 50%.

For the Greeks, the deal is less appealing.  They need to finance the 30% repayment, i.e. some €18 billion, and they need to buy the AAA zero-coupon bonds, i.e. another €12 billion.  In other words, Greece gets no reduction in debt.  Indeed, should its economic recovery materialize, the interest on its new bonds will go up.

The EU will likely have to come up with most of the 30 billion that Greece needs, getting it ever more committed to a successful rescue and more exposed to losses should a messy default become unavoidable.

What this plan does is buy time, time to set up the conditions for a more competitive Greek economy.  These would include less constraining labor laws, well thought out privatizations, pension reform, to name some key ones.  But does the plan incenticize the parties and is the burden sharing appropriate?

Some of the proponents of the plan have likened it to the Latin American Brady Plan.  Yes, the Brady bonds that were issued benefitted from rolling coupons guarantees and/or collateralized principal.  But unlike the Greek plan, they imposed ‘haircuts on the creditors.  Here, European taxpayers are picking up the tab.

Another area of concern is how “voluntary” the exchange of maturing bonds for new 30 year bonds will be viewed by rating agencies and the market.  Newspapers have reported informal contacts between European officials and rating agencies, whereby the former were appearing to warn the latter against ruling the exchange as a default.

I think it is fair to say that, if creditors were offered the chance to be repaid in full, they would jump at it.  If rating agencies stand firm, this plan will not work.  If they don’t, the European CDS market will likely be destroyed.  Would it be worth it?

Greece needs a debt reduction of at least 50% accompanied by a credible plan to improve its public finances and facilitate economic growth over time.  To that end, finding time is necessary, but it is not sufficient.

It is possible that the EU will reveal such a plan, but so far it has not and the latest effort is increasing, not decreasing the burden of the debt.