sexta-feira, dezembro 02, 2011

No relief in sight for Eurozone borrowers - liquidity vs. solvency

Debt workout 101- part 4 

No relief in sight for Eurozone borrowers

Under the appalling front page image of a flaming Euro, The Economist of 26-November-2011 notes, with apparent surprise, that the Eurozone crisis has “crept from the periphery to the core” countries.  But isn’t that the first rule of bad credit? 
 “If you (the periphery/borrower)  owe 100 and can’t pay, you have a problem. If you owe  1000 and really can’t pay, the core/creditor has a problem."
And a creditor and exporter can be no better than its borrowers/clients.  We certainly hope that no one besides the journalists are surprised by this turn of events, and certainly not the decision makers in Berlin, Paris and London. 

Internal Eurozone trade imbalances in forced rebalancing
To say that the Eurozone is “showing symptons of an internal balance-of-payments crisis” is perhaps the understatement of the year. This basic creditor/borrower and exporter/importer divide is the reason we have a “two-speed Europe”, which may have come to the end of their divergence.  From here on out, trade imbalances will have to be reduced, one way or another.  

As in any rebalancing effort, borrowers need material help from creditors to recover and workout their existing debt, in the form of much more time to pay  and lower interest rates, sometimes with a clawback clause to recapture potential upsides.  Troubled borrowers also need new money loans to relaunch their export effort.  Borroweres may or may not need debt forgiveness, the terrible haircuts.  Strangely, in the Eurozone debt crisis, there has been no debt standstill, no extension of tenors, no  reduction of interest rates on existing debt, perhaps because these would be considered “credit default events” under the Credit Default Swaps. 
Instead, Eurozone creditors, presumably incluing the local savers, were invited to voluntarily forgive 50% of the sovereign debt of Greece, a non-starter if we’ve ever seen one.

Thus far, the so-called “bailouts” have mostly channelled funds through the sovereign borrowers back to the International creditors, doing little to help the troubled borrowers, except staving off formal default and protecting the CDS issuers

Without  the “orderly default option” of extending tenors and working out the debt hand-in-hand with the troubled borrowers, and in the context of severe funding shortage, Eurozone investors have been shedding assets at increasingly deep discounts. To be fair, it is always difficult to workout negotiable bond obligations, since bond investors are far more intractable than bank creditors.

As Eurozone portofolio losses have become generalized in this contexto of a “presumed disorderly default”, this has exposed the “moral hazard” implicit in many of the earlier investment decisions, which were based on the expectation that creditor countries would pay on behalf o the borrower countries.  The end of this illusion will do more permanente dammage to traditional intra-Eurozone capital flows than any forced refinancing ever would, so we are looking to a future of forced reductions of intra-Eurozone trade imbalances, smaller deficits and smaller surpluses.  

Banks in the front lines
Because of the losses resulting from these fire sales or through the mechanism of mark-to-market, the intermediating banks  have have to be recapitalized by their national authorities in order to absorb the mounting losses. The same appies to the intermediating banks from outsider of the Eurozone, including UK and US banks.  Findng new capital in the existing market is not possible, so Governments have to step up, as did the US Government with the two TARP programs.  Whether the control of existing shareholders is diluted is, ultimately, a foregone conclusion, since the alternative would be much worse.  

In the Eurozone, bank creditor recapitalization is more complitcated by the fact that there is no one single prudential regulator, and banks are subject to “home rule” by their national central banks.  Even the recently created EFSF would provide new capital only for the banks of the the countries under troika programs.  Banks based in other countries, including the UK, would have to be recapitalized from national sources, which is only fair. 

This issue of who will absorb bank losses masquerades as the  liquidity versus solvency debate.  If it were seen merely as a question of liquidity and funding, then it could be resolved by the ECB, the monetary authority of the Eurozone.  If it a question of bank solvency and asset quality, then it should be resolved by the national central banks, under home rule prudential regulation.  

The quick answer is that when Portuguese banks have to sell US or Brazilan assets because of lack of funding, it is a question of liquidity.  When German, French or British banks find themselves overexposed to troubled periphery borrowers and have to take losses on impaired assets, that's a question of solvency. 

By definition under the concept of the sovereign rating ceiling, local depositors and creditors cannot regard their own sovereign debt as impaired, so the local sovereign exposure  should be treated as a problem of liquidity  rather than a problem of solvency. 

Mariana Abrantes de Sousa 
PPP Lusofonia

See also Banks, central banks and moral hazard
Orderly default
Eurozone balance of payments crisis
Lessons from earlier balance of payment crises
Distribution of bank exposure to Eurozone borrowers ´
One-armed midgets cannot rebalance Eurozone
What are CDS good for anyway?