Tuesday, 21 February 2012

Europe: Return to normality, or a shocking new precedent?

Unless you’ve managed to avoid the news entirely for the last couple of days, you’ll have seen a lot of talk about Greece and the European economy as a whole. So far, that’s all that’s happened – talk. But what’s been said is relatively important, and reading between the lines throws up some interesting content.

So how will things turn out if the just-agreed plans are carried out? Will it be a return to normality, or are there major changes afoot? The answer, rather ambiguously, is both.

Firstly, a brief summary of what was agreed by European Finance Ministers over the last 24 hours:

1. Greece will be granted loans of approximately €130billion ($170billion)
2. Approximately €107billion ($140billion) of Greece’s debt will be written off
3. It will “have to” reduce its debt from the current 160% of GDP to 120.5% over the next eight years
4. Private holders (individual & corporate investors) of Greek debt will lose 53.5% of their investment, plus not receive very much interest until it is “repaid"
5. “Public” holders (predominantly the European Central Bank, and various national Central Banks) will not face any immediate losses on their respective investments, but will not receive any interest
6. Greece will amend its constitution to prioritise debt repayments over any other government expenditure

There’s so much to cover in the above points, for now I’ll gloss over the similarities of the last point in this agreement to the Treaty of Versailles (Google it if you’re not sure what I’m on about). For now, I’ll focus on the major changes – or “shocking new precedent”, as I like to call it – which would occur as a result of points four and five.

Up until today, every sort of loan, be it a loan to an individual, a company, or a government, has been assessed and valued based on the perceived credit-worthiness of the borrower. The actions or inactions of the borrower would be the sole determining factor of whether that loan gets repaid or not – regardless of whether the lender was themselves an individual, company, or government. Risk assessment, whilst rarely perfect, was at least consistent – but all that may be about to change.

Today, the Finance Ministers of European Union nations decided that the risk taken should depend on how powerful you are. If you’re a lowly individual, or company, then you should have thought harder about lending money to an entity which clearly couldn’t afford to repay it. But if you’re an all-powerful government institution, clearly you can’t be expected to lose out as a result of “somebody else’s” poor judgement.

Now I need to point out that there is still a “sacrifice” being made by the Central Banks – the money that they’ve already lent, and are about to lend, is effectively interest free – which in real terms, due to both inflation and “opportunity cost”, is a loss. But it’s nothing like the losses faced by private investors, who get a double whammy – an immediate loss in the “face-value” of their investment, plus a diminished return over the next few years. So not only will they receive less income than they were promised, they’ll also get back less of their capital when it’s due for repayment.

So how will this affect the future of government borrowing? Well, for starters you would have to assume that private sector lenders would be less willing to lend to many governments, in the knowledge that their contract is seemingly worth less than an identical contract signed by a Central Bank. This in turn will mean that to accept the increased risk, they will want an increased potential return. This will then either increase the cost of most government borrowing, or drastically reduce the potential pool of investors (leaving only Central Banks as potential lenders).

The paradox is that as public institutions, the ultimate risk lies with the citizens of the Country to which the Central Bank in question is part of. This rather bizarre situation will be in full view over the next couple of months, if this plan goes ahead – approximately 66% of privately owned Greek debt is owed to Greek Banks. This means that when they take a loss of 53.5% on all Greek government debt, they will need extra capitalisation, which assuming that no individuals or companies are stupid enough to provide, will have to come from the Greek state. Which means that Greece will need more money… and at the moment it can’t even find the money to provide adequate education or healthcare to its citizens. So a large part of this agreement consists of Greece both lending to itself, and not paying debts to itself – confused yet? Probably.

Now this brings me to the other statement – a return to normality. This is actually a two-fold observation, which I’ll deal with one at a time.

You’ll have no doubt heard about Hedge Funds being blamed for all sorts of things in the last few years, ranging from their complete disregard for morality in their search for profit, to their havoc-wreaking in the capital markets as a result of their short-sightedness. (Whether this is true or not is a debate for another day, although I hasten to add that most people who have made these claims are often trying to deflect criticism of their own decisions).

Hedge Funds are basically investment companies that have no parameters – other than those set by law. Whereas most investment funds have a specific remit to invest in certain asset types, or certain geographical areas, or fit within a certain risk category, Hedge Funds can do whatever they like. If they want to convert all their assets to cash, it’s done. Invest everything into shares in one particular company? Done. Throw the whole lot on number 32 at the local casino? That’s fine too.

The reason they are often very successful, is because of two things: Firstly, they attract a lot of money because of both their performance, and the fact that the guys who run them often have most of their own wealth (usually running into $billions) invested themselves – and more money means more opportunities. Secondly, due to the unrestrictive nature of the funds, they can change their direction like a speed boat rather than like an Italian cruise liner.

But overall, Hedge Funds have been having a tough time lately. They generally excel in times of volatility, but this is usually because the people who run them are very astute and can see when the capital markets have got it wrong. When in times of uncertainty, it’s much harder to make accurate predictions – because often not only does the situation change rapidly, but so do the rules – like today for example.

But Hedge Funds are particularly clever. According to reports, many of them have been hurriedly buying up Greek government debt. Is this clever? Actually, yes – on two counts.

Due to the uncertainty, Greek debt has been trading at levels far below par for some time, often as low as 35cents per Euro, or 35% of the face value. Those Hedge Funds which have bought at these prices will be seeing a very nice 33% profit on their balance sheets if the above-mentioned deal goes ahead, as they’ll be getting back 46.5cents per Euro. But their ingenuity doesn’t stop there.

Any self-respecting Hedge Fund wouldn’t be buying long term debt – that’s too boring. They’ll be buying up the short term stuff – part of the €14.4billion ($18.8billion) which falls due for repayment on 20th March 2012.

As is the nature with most things political, the emphasis is often put on short term gains rather than long term improvement. So it is reasonable to expect that even if the crisis isn’t solved by then, enough will be done to prevent a full default. This leaves the Hedge Funds (and other holders of this short term debt) in a much better position than holders of longer term debt.

In addition, the deal just agreed is described as “voluntary” – and whilst ordinary banks, pension funds etc may be in a weak position to argue with the powers-that-be, the same cannot be said of Hedge Funds. They could (and almost certainly will) politely decline the offer of receiving less than the full face value of their investment (which they bought at a 65% discount) and demand the full amount back. And would the Greek government, and the European Union, have the bottle to play a game of brinkmanship with the Hedge Funds, or would they simply pay out (quietly) the full face value on a few of the bonds? Most industry insiders would hunch for the latter – after all, what’s a few billion dollars when compared to hundreds of billions?

Most incredulously of all, there is talk of certain Hedge Funds suing the Greek Government at the European Court of Human Rights – on the basis that it is not allowable to force private investors to “voluntarily” accept a reduction in the amount owed to them. So it is almost certain that the “Troika” (consisting of the EC: European Commission, the IMF: International Monetary Fund, and the ECB: European Central Bank) would not risk a potentially damaging verdict on such a small percentage of the total liabilities.

Of course, this leaves many Hedge Funds in a position of almost certain profit, at the expense of others (and, it could be argued, rationality) – this looks very much like normality to me.

But the second, biggest indicator of a return to “normality” is the completely absurd way that the rules and accounting standards are being bent in a vain attempt to pacify public opinion. It’s worth reminding ourselves that the main reason that Greece is in this mess in the first place, is because it basically lied about its financial position.

As an example, around the time of Greece joining the Euro, its (government owned) national railway had, at any one time, more employees than passengers – and was making a loss of approximately €1billion ($1.3billion) per year. Stefanos Manos, a former Greek government minister, publicly said that it would be cheaper to send everyone by taxi. If this €1billion loss appeared on the balance sheet for the Greek government, it wouldn’t have been allowed to join the Euro. The solution? Every year, the state railway would issue €1billion of new shares, which the government would buy – which showed up as an investment, not an expense – and Greece could happily join the Euro club.

And the “creative accounting” was endemic – the Greek government, with the help of Goldman Sachs (the Investment Bank), merrily used the “Repo105” accounting rule (Google this one, it’s amazing) to “prove” that Greece was a solid economy with nothing to worry about. Except, of course, that it wasn’t solid, and there was plenty to worry about.

This is now common knowledge, and, with the benefit of hindsight, readily referred to as one of the main reasons why things went wrong. So the solution of the “Troika” is… to basically do the same thing again.

THIS is what I mean by the statement “return to normality”. It clearly wouldn’t be acceptable for the major European governments to admit that there’s risk involved in lending to THEM, so they couldn’t possibly take losses on THEIR investments – just change the rules instead.

It clearly wouldn’t be politically acceptable to admit that the European currency, in its current form, had failed – so just word things differently.

And it clearly wouldn’t be acceptable to allow a relatively minor Country like Greece change the way that a relatively major Country approaches economic policy. That would be a fallacy – surely it’s better to maintain the status quo, and find a new way to measure the problem…

So what is the outcome of all of this, and what can we learn from it? Well, firstly, that some things never change – both human nature, and the politics of power. Similar to the position that Germany was left in after the Treaty of Versailles, today’s agreement leaves Greece and its citizens in a position where they are not pacified or conciliated, nor permanently weakened. The likelihood of a backlash is huge, and the best case scenario is that a further crisis has been pushed back, not prevented.

In terms of what we can learn from this, it’s relatively simple: If you lie to yourself about your financial position, it might look good for a while, and you might convince yourself and others that there’s nothing to worry about, but eventually the truth will out – and the consequences could be extremely painful. So if you’re pretending that you have enough health insurance cover, or life insurance, or retirement provisions, when actually you don’t – please take the time to double check, and take expert advice where you can.

If you’d like to review your financial position with myself or one of my team, please get in touch. And if you’ve got any comments or questions in relation to the blog, send an email or leave a comment below!

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