by DOM J. RODRIGUEZ*
Q. What kind of dangerous precedent would this set for its remaining “weaker” members?
Q. Who would be next? Ireland, Portugal, Spain? Or does this “vulnerability” extend even beyond these countries?
Q. Will the independent agendas of its stronger members (Germany, France) ultimately act against the very thesis that the EU was built upon - and - will the relationships between member nations start to take on an “every man for himself” mentality?
Q. What does this say about the “glue” that binds the EU together and about the very underpinnings that support the European “Union”?
These questions, while hypothetical now, may become reality in the foreseeable future given the direction and velocity in which events are unfolding. Simply stated, that direction is one of deep uncertainty - which the markets do not like.
THE EU THESIS
If Greece and the other “crisis countries” continue to pull financial and political capital from the EU, what is the likelihood that the Euro-zone would remain intact?
Does the thesis for the continued existence of the EU crumble?
Where is the political will to keep the European “union” together while the markets conclude that the fate of the EU is in question as one - and possibly multiple - defaults may take place among its weaker members and the European people watch in disbelief contemplating the crisis management skills of its leaders?
Would the collective political and popular support be summoned to prevent the much written about global contagion?
Isn’t it possible and probable that at some point – just as the EU and IMF concludes that default is inevitable (thus coming around to the market’s foregone conclusion) – that the world will give up on Europe in its current form?
HISTORICAL PERSPECTIVE
Historically, the countries of Europe have been at war with each other over either territorial expansion or ideological hegemony. In order to become economically viable in today’s global economy, this led to putting historical differences aside and ultimately the unification of Europe.
The theory was that Europe (excluding Great Britain which chose to maintain its sovereignty rather than throw its weight behind the rest of Europe) would combine its economies so that together they would be a dominant player on the world stage. Has that really happened? Did the EU’s unity of purpose make it stronger or are there cracks in the foundation?
Today’s leading headlines are about finding the “right” solution to the sovereign debt crisis of the weaker countries in Europe - and Europe’s on-going defensive posturing when any criticisms are made speaks volumes.
As an example, Europe’s leadership this week attacked the rating agencies in the U.S. (Moody’s) because they downgraded the credit ratings of Portugal saying the downgrade was “unjustified” and “biased”. Europe was even said to be “considering legal redress” with regard to Moody’s ratings action.
Will threatening legal action so the fire alarms can be quieted down really work? Europe does have a history of railing against speculators - remember George Soros? Rather than assailing the critics, perhaps Europe’s leaders should pay attention to what the markets are saying – which, as we all know, listen to the rating agencies.
In contrast, let’s take the U.S. perspective. During the peak of the financial crisis, the rating agencies were similarly attacked as having taken their “eye off the ball”. Congressional hearings were held to examine the integrity of the ratings agencies’ business model. They held a legitimate debate about whether there was truly “independence” in the model where clients pay for independent ratings. Ultimately, Congress and the people (read: media) backed down. The solution: the rating agencies have to do a better job at keeping their “eye on the ball”.
Now who’s complaining? Those who don’t want to acknowledge that the “Emperor has no clothes”. However, one cannot have it both ways: complain when the rating agencies are asleep and complain when they are awake.
So, should Europe police itself?
IS DEFAULT THE RIGHT SOLUTION?
As some European leaders are now openly suggesting, default is an increasingly acceptable solution. As of today, the French “rollover” plan or the revived German “bond swap” plan would be viewed as a “selective default” by the rating agencies, but Europe’s leaders insist that they know better.
So the questions remain: will the markets ignore a “default” and will Europe apply its own definitions or accept those of the rating agencies?
Did the markets ignore the downgrade of Portugal? Or instead did the stock markets of Portugal, Italy and Spain sell off sharply this week in response to the downgrade?
IF A DEFAULT IS ACCEPTABLE, WHY NOT SELL THE BONDS AND TAKE THE LOSS?
To answer this question, let’s work backwards. Who has the most to lose?
Firstly, the sovereign bonds of the crisis countries - for the most part - are supposedly held by the big banks, including the banks of the countries in crisis. So if Greece defaults, for example, the biggest hits would be taken by the French, Greek and German banks.
But this week it was reported that some of those bonds (the ones that were meant to be included in the “voluntary” rollover plan) have been sold by the French banks.
So, wouldn’t the bonds that have been sold - or that could be sold - conceivably end up in the hands of “speculators” who are driving down the prices to begin with?
If the market is pricing in the high probability of a default - and significant losses to come to holders of the bonds - should holders of the bonds sell today?
In theory, speculators are making a bet that Europe will to come to the rescue, prices will rebound and they will make a profit. Alternatively, the market is telling us that the long term, rescue will fail and the bailout costs will exceed the sum of the losses to be taken by private investors today.
The longer the period of uncertainty remains, the more the market discounts a successful outcome to the rescue efforts.
Europe can, in effect, take advantage of the market’s sell off, clear the old debt at current market prices and replace it with new debt that the market considers sustainable over the long term.
If the “pain” is shared between the government and the private sector, this ultimately reduces the burden to the European taxpayers.
Question: if the Greek taxpayer is not willing to pay their taxes because they don’t trust the government which got them into the trouble they are in today - and the French and German taxpayers don’t want to pay for the Greek taxpayer’s unwillingness to pay - when does the system self-correct? Or does the system collapse?
Doesn’t it sound like the German and the French taxpayers would prefer that each country take care of their own and break up the European Union?
This would require each country in Europe to inject fresh capital into its respective banking system due to the losses to be taken, but this ultimately should be viewed positively by the markets as the banks’ balance sheets will be cleaned up and become stronger.
Given that the open talk by Europe’s leaders of a selective default is being viewed as negative by the markets, this would argue instead in favor of dealing directly with a public-private sector solution which could ultimately cost less to the European taxpayer.
But does this cut into the very “premise” of the EU if Europe’s leaders are not united in their approach?
AN ALTERNATIVE SOLUTION
Perhaps there is an alternative solution which the European leadership could consider: using their funding capacity to shut down the speculators (short sellers) and in the process give some “breathing room” to the weaker countries. This is a more viable alternative to a default and/or restructuring of any kind.
How would the alternative solution be implemented? What if all the European rescue facilities were used to repurchase sovereign bonds in the secondary market (at least those bonds maturing in the next few years) - and thereby lower the burden to the European taxpayer as debt is extinguished at prices that are clearly well below par.
This is similar to when companies announce stock repurchase plans in a bid to boost their stock price - as a “shareholder” approved vote of confidence that their stock is trading below the real intrinsic value.
As of 7th of July, the coalition of private investors who were to participate in the next installment of the Greek bailout fell apart, in spite of the EU’s best effort to form and hold this coalition. This is a signal that the EU rescue resources should be used to “clear” the market of existing debt, not to fund new debt. This will enable the proper pricing of troubled sovereign debt at levels where it can raise new capital.
By swapping out the speculators from the secondary market to issuing the new debt Greece needs, the EU can empower Greece and others to plan for its own future based on new market-priced notes, not short-term bailout packages.
So here’s an interesting question: what would the rating agencies have to say about debt that is extinguished and can no longer be rated? …Absolutely nothing.
CONCLUSION
So, if Europe truly believes in solidarity, it is worth considering the use of its full rescue powers to eliminate the risk of moral hazard and force the private sector (especially speculators) to absorb the cost today of restructuring the debt of the crisis countries and put in place a long term, sustainable debt solution.
The very fate of the European Union is in the hands of its leadership which should listen to the markets, act to find a shared public-private solution that reduces the burden to the European taxpayer, and stop “kicking the can down the road”.
* Partner and Director of Sales at Nova Capital Partners, LLC
By: N. Peter Kramer
