The Greek Bailout Points to Eventual End to the Crisis
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The news that Greece has reached agreement on a $146 billion bailout package to avert sovereign default is the latest development in the financial crisis that began in earnest in the summer of 2007. The panic that began with the insolvency of highly leveraged investment funds has now spread to national governments. Each flare-up in the ongoing crisis has been triggered by a creditor revolt that was only extinguished when a more creditworthy parent assumed or guaranteed the debtors’ liabilities. This strategy cannot be repeated ad infinitum. A final resolution to the financial crisis will only come when borrowers are required again to stand on their own two feet and unsustainable burdens restructured rather than transferred. The conditions imposed on Greece suggest that this final resolution may at last be in sight.
The initial crisis was triggered by the insolvency of highly-leveraged, off-balance sheet vehicles sponsored by banks. Creditors refused to roll-over the short-term loans made to structured investment vehicles (SIVs), asset-backed commercial paper (ABCP) conduits, and other types of special purpose entities (SPEs) that financed holdings of highly structured mortgage securities in the money markets. The banks that implicitly or explicitly guaranteed the debts of these structures had to take them on balance sheet. The “liquidity crisis” of 2007 was “solved” when the alphabet soup of structured finance investment vehicles were bailed out by their parent banks.
Assuming such huge amounts of structured mortgage securities, of course, led to concerns about the solvency of these parent banks. At first, these concerns were attenuated by the issuance of preferred stock to raise capital, much of it to sovereign wealth funds eager to own pieces of supposedly profitable U.S. banks. It soon became clear that the scale of the losses were much greater than the capital injections. Bear Stearns’ creditors were the first to balk at rolling over their loans. Bear spent more than $3 billion in the summer of 2007 to bail out the investment funds it sponsored and had tens of billions of dollars of additional exposure to structured mortgage assets. The panic was only ended when the Federal Reserve agreed to accept $30 billion in Bear’s most questionable mortgage securities to facilitate a merger with JP Morgan that would bail out Bear’s creditors.
After a few months of relative quiet, the panic consumed the government-sponsored enterprises (GSEs) whose modest capital buffers were but a small fraction of the embedded losses on their nearly $1 trillion of combined Alt-A and subprime mortgage exposure. Creditors refused to lend to these insolvent behemoths unless the Treasury formally stood behind their liabilities. Then Lehman Brothers’ creditors panicked at the investment bank’s prospective capital hole and pulled their funding. The 91% losses experienced by senior unsecured creditors in the ensuing bankruptcy spooked creditors to every financial institution with exposure to questionable assets. Through TARP, the Federal Deposit Insurance Corporation (FDIC) debt guarantees, Treasury’s money market mutual fund guarantee program, and the Federal Reserve’s expanded liquidity facilities, this panic required the government to commit nearly $13 trillion in credit support so that creditors would again be willing to extend loans to these institutions.
The European governments were forced to rescue their banks in a similar fashion. In the case of Ireland, the size of the bailout was much larger than its GDP. By 2010, the bad assets alone held by these banks were revealed to be half of the size of Ireland’s economy. The government supplemented the bailouts with a dramatic austerity package which caused the focus of creditors to turn to the Eurozone’s other heavily indebted nations. Greece was the first to be “run” by its creditors, requiring €110 billion of credit support, roughly €36 billion from the International Monetary Fund (IMF) and €30 billion from the German government. The same “run on the bank” dynamics are now evident in Portugal.
However, the Greek bailout points to a final resolution to the crisis because of the terms imposed on the Greeks to gain access to the support. The Greek government was forced to commit to budget cuts in excess of 10% of its GDP. The public employee unions in Greece are protesting the “savage” cuts and vow to do whatever is necessary to torpedo the deal. While it is easy to scoff at the myopia of the Greek unions who should be relieved their European partners are willing to come to their rescue, it is worth considering that U.S. banks were hardly asked to accept any pain in exchange for their rescue. U.S. banks received capital injections and FDIC debt guarantees in exchange for some minor dilution to shareholders through warrants and executive pay restrictions that could be ignored as soon as the TARP capital injections were repaid.
Before concluding that the Greeks are insane to complain about the terms of the rescue, imagine if bailed out U.S. financial firms were forced to accept similarly draconian terms as the price of their bailout? For example, what if Goldman Sachs and Morgan Stanley executives were forced to relinquish control of the company and have their shareholders’ equity zeroed out when they agreed to be rescued by the Federal Reserve? With the wholesale funding markets closed and clients’ redemptions soaring, both investment banks needed the “access to permanent liquidity and funding” provided by Bank Holding Company status in order to survive. While it was right for the government to provide this support at the time, it came with virtually no costs imposed on the management or shareholders who benefitted from the short-term market-based funding strategy that left both firms vulnerable to a liquidity crisis. What would have happened had the government driven a tougher bargain?
Moreover, what cuts to state and local employees’ pay and benefits were demanded in exchange for the more than $280 billion bailout provided by the Obama Administration’s stimulus package? The explicit aim of these stimulus funds were to “save jobs” and avoid pay reductions in state government that could impair recovery. The Greeks are simply angling for a similar bargain.
Greece is in the situation it is only because it was able to borrow for just 0.2% more than Germany (over 10 years) as recently as 2007. Should investors who extended credit on such irresponsible terms really be saved from such stupendous misjudgment? The same question could have been asked at each flare-up in the crisis, starting from the SIVs and ABCP conduits able to borrow at nearly a risk-free rate prior to the summer of 2007 despite incalculably high leverage, thanks to the implied guarantee from their parent bank.
As the size of a bailout increases relative to the political and economic capacity of the “parent” to finance them, the “strings” attached to the bailout increase. It is now clear that the politics of the Greek bailout largely consisted of forcing Greece to accept tax increases and budget cuts of sufficient magnitude to attenuate the anger of German voters. Whether the Greek unions succeed in quashing the deal, eventually the strings attached to the aid will impose costs on an interest group with sufficient clout to make the interests of creditors seem less compelling. At some point, taxpayers in the “parent” will demand concessions that the bailed out entity will not abide. At this point, the bailouts will finally end.