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RE: [Fwd: Can the Euro Zone Cope with a National Bankruptcy?]

Released on 2001-03-13 18:00 GMT

Email-ID 1760720
Date 2010-02-23 01:33:01
That was great. Thanks so much for sending it. Brilliant idea for them,
too. Refinancing the debt by issuing more. But it will be interesting
w/Greece further indebted and not yet proven, what they will have to pay
to roll the debt (since this is new debt, and the maturing debt still has
to be repaid. Presumably it will have to be repaid with a new issue of
its own.)

How did Der Spiegel get that letter? It is so interesting that they know
exactly how much each bank had of Greek debt. It would really be
interesting to know more. I wonder if they had more details in there.
Also, I can't believe HRE got that far out on the risk curve at the same
time it was being recapped by the state. Some things I just will never
understand about German banks.

Interesting thing on that last statement about inflation. Nothing would
be better for Germany than a continuously devaluing currency due to
inflation. And for non-stop debt issuance. It will help their exports.

On the CDS, they do a good job discussing the difference between the old
days where you had to borrow bonds to short the currency and now where you
can buy CDS on the gov't bonds. Of course in those days, with floating
currency, it gets cheaper (in your currency) to borrow the bonds as they
go down, but also there is more leverage allowed in general these days,
instrument allowed or not.

One big difference w/CDS on countries vs. places like Bear is that, in
theory, no matter how wide the spreads on the CDS get on a country's
bonds, the country still refinances at the spread on their bond, not on
their CDS which is often wider. Also, Greece is a very long way from
defaulting. For it to actually not be able to pay, it would have to be
requiring much higher interest rates. In the meantime, they could still
stop payment on public sector employees, etc. They might not want to, but
they could. In the case of a place like Bear Stearns, they really did get
totally shut out of the capital markets. Hedge funds would buy CDS, then
short stock, which made the CDS price go up, which made the stock price go
down...the lower the stock price went, the less likely it was to be able
to issue new equity in a quantity that would be needed. To make it worse,
those hedge funds were pulling their prime brokerage accounts, fueling
fear and sapping liquidity. That is a death spiral caused by CDS. To me,
the Euro countries are CDS somewhat exaggerating the actual risks of
default in the bonds. They are not actually (yet, anyway) creating a
bigger risk of default in the bond. To a certain degree, people writing
about it causes some panic which makes it harder for Greece to refinance,
but serious bond buyers (most of whom are much bigger than CDS
speculators) understand that game.

I am going to start reading Der Spiegel.

Take care,


Lisa Hintz
Capital Markets Research Group
Moody's Analytics

Nothing in this email may be reproduced without explicit, written

From: Marko Papic []
Sent: Monday, February 22, 2010 2:38 PM
To: Hintz, Lisa
Subject: [Fwd: Can the Euro Zone Cope with a National Bankruptcy?]

I love Der Spiegel... This article is the reason why... long and thorough.

Hope everything is going good and that Mauldin fiasco is over.



-------- Original Message --------

Subject: Can the Euro Zone Cope with a National Bankruptcy?
Date: Mon, 22 Feb 2010 13:26:40 -0600
From: Marko Papic
Reply-To: Econ List
To: Econ List

Really long Der Spiegel piece... but it lays out some of the points that
Rob just explained in his discussion.


Can the Euro Zone Cope with a National Bankruptcy?

As speculators attack the euro, Europe is facing a growing threat of
national bankruptcies. The consequences would be dramatic for the whole of
the continent, especially German banks, which are highly exposed to risky
debt. EU politicians are willing to pay almost any price to help the
beleaguered countries. By SPIEGEL staff.

On Wall Street, they call Bill Lipschutz the "Sultan of Currencies." He
once turned the legendary investment bank Salomon Brothers into the
world's largest foreign currency trading operation. Today Lipschutz runs
his own hedge fund, which specializes in currencies.

"I still approach the market the same way. I still approach it as a 24/7
market," says Lipschutz. He trades almost constantly, even at home in his
apartment in New York's trendy NoHo district, where there are monitors
everywhere. Every night, Lipschutz gets up at two or three in the morning
to see what is happening on the European markets.

Europe is indeed currently the hottest topic on the global financial
markets. The value of the battered euro has been falling since the Greek
government confessed to the actual scope of its debt -- and since it
became clear that things are not looking significantly better in the other
PIIGS countries (the acronym refers to Portugal, Ireland, Italy, Greece
and Spain).

There has never been this much uncertainty. No one knows whether the
Greeks will manage to solve their problems, whether and how other
countries will come to their aid, whether the crisis can be confined to
Greece or whether it will spread like wildfire among the PIIGS -- and end
up tearing apart the European currency union.

All of this translates into excellent opportunities for foreign currency
traders and speculators. They can either bet on a decline of the euro or a
bailout for the Greeks in the form of a rescue effort by other euro zone
countries. In the first case, the price of Greek government bonds will hit
rock bottom, and in the second case it will rise.

These are the kinds of conditions that make it possible to make a lot of
money quickly -- but with devastating consequences, because speculators
amplify trends and increase risks. If they bet on a Greek bankruptcy, it
will become even more difficult, and expensive, to attract fresh capital.
This could lead to a national bankruptcy or the feared conflagration -- or
even the collapse of the euro.

Problem Cases

The financial industry is back to its old tricks, playing with the
greatest possible amount of risk. In the past, it speculated with the
debts of American homeowners and, as a result, triggered the biggest
crisis in the world economy since the Great Depression of the 1920s. Now
it is gambling with the debts of entire countries.

After the failure of investment bank Lehman Brothers, it was governments
that saved the financial markets from collapse. Now the governments are
being attacked -- with the cheap money their central banks pumped into the
market to keep the financial sector afloat.

A new Lehman, triggered by speculation in government bonds, would be
disproportionately more dangerous, because it would affect the entire
world economy. And who would rescue the economy then?

It is no coincidence, however, that the speculators have not zeroed in on
the dollar, the British pound or the yen. Although the United States,
Britain and Japan are also groaning under the burden of their debt, the
euro is much more vulnerable, for both historic and political reasons.

The weak southern countries, members of the so-called Club Med, have
always been seen as problem cases. They have lived beyond their means and
neglected the need to be competitive, they have built up -- partly in full
view, partly cleverly hidden -- enormous mountains of debt, and they have
avoided hard-hitting reforms. These conditions existed before they became
members of the euro zone, and they did not improve afterwards.

The other euro countries looked the other way. Initially, before the
establishment of monetary union, they looked away because they didn't want
to jeopardize their political goal of a European common currency. Later,
it was because they themselves were benefiting from the euro. The German
export economy, in particular, was able to expand continuously, unhampered
by troublesome revaluation and appreciation that would have made its
exports more expensive.

Vindicating the Critics

The euro has been a success story until now. During the recent financial
crisis, the common currency proved to be a blessing at first, particularly
for the smaller countries. But as debt levels increased, the problems,
previously suppressed, became more and more evident, including the
debt-based economy in the Club Med and the imbalances in terms of

Even before the common currency was introduced in 1999, Nobel economics
laureate Milton Friedman was warning that the euro would not survive its
first economic crisis. He predicted that the euro zone could break apart
after just 10 years.

Ever since the Greeks were forced to admit that their national debt was
much higher than originally claimed, the critics of a common European
currency have felt vindicated. They had always warned that the northern
countries would eventually have to vouch for the debts of the south, that
the differences in economic development within the euro zone were too
great and that a common currency could not function without a common
economic policy.

At the time, politicians ignored the concerns of many economists. Now they
realize that this may have been a mistake. The European agreements that
define the legal framework of the currency union do not include any
provisions to account for the kind of crisis the euro is currently
experiencing. For that reason, there are no instruments available to
combat such a crisis.

The Speculators' Sharpest Weapon

The speculators' campaign against Greece began in early December. The
rating agencies had downgraded the country and the press, particularly in
English-speaking countries, was reporting more and more on the Greeks'
doctored statistics and high level of government debt. The information
wasn't entirely new, but it had its effect, quickly driving up the price
of so-called credit default swaps (CDS).

Credit default swaps are the same financial instruments that caused so
much damage before the Lehman bankruptcy. They are considered partly
responsible for the financial crisis. For this reason, many people called
for strict regulation of credit default swaps after the Lehman bankruptcy.
But nothing happened, and the results are now becoming apparent.

A CDS contract is, in fact, a sort of insurance policy, which pays out
when borrowers, like Greece, go bankrupt. Credit default swaps were
invented so that lenders could hedge against such risks. In practice,
however, they have become the speculators' sharpest weapon when they go on
the offensive against companies or countries, because they make it
possible to achieve a maximum impact with a relatively tiny investment.
"Dealers can turn the market with only 50 million," says one investment

Because CDSs are traded completely independently of the underlying
securities, a gray market with a total nominal value of EUR26 trillion
($35 trillion) has developed outside the exchanges. The market has shrunk
since the beginning of the financial crisis, after it became too daunting
even for speculators. But now that money appears to be available in
abundance once again, credit default swaps on government debt are among
the hottest toys in the financial industry.

Too Expensive

The prototype of all currency speculators is George Soros, who kicked the
British pound out of the European monetary system in 1992 and became a
billionaire in the process. At that time, however, Soros had to take the
trouble to speculate with real currency.

"Buying real bonds is much too expensive," says a bond trader today,
explaining that this is something that only traditionalists still do. The
new speculators are intent on quickly getting in and out of
country-specific risk. Borrowing or even buying a bond, says the bond
trader, would be too cumbersome.

Because this is much more easily achieved with a CDS, there is a risk that
history will repeat itself. Even Soros warns that CDSs are "instruments of
destruction." In the first part of the financial crisis, in the years 2007
and 2008, a sharp increase in CDS prices was partly responsible for the
bankruptcy of US bank Bear Stearns. Speculators forced governments to bail
out British and German banks by unscrupulously driving up the costs of
credit insurance.

Now the hedge fund managers are betting on the insolvency of entire
countries. The CDS rate for Greek government bonds doubled within the
space of a few weeks. Speculators who get in at the right time can take
advantage of fears over Greece to turn profits of upwards of 100 percent.
For a time, it was costing investors EUR390,000 to hedge against the
default of a 10-year Greek treasury bond with a face value of EUR10
million. By comparison, the cost of a CDS for a similar German government
bond was only EUR40,000.

The speculative rise in CDSs has a real impact, in that it fans fear in
the markets. In early February, Greece had to offer a yield of 6.1 percent
in order to sell its five-year bond. This is twice as much as the current
yield on comparable German bonds.

Cunning Deals

Investment banks are among the biggest beneficiaries of uncertainty in the
markets. US investment bank Goldman Sachs, in particular, has its finger
in several pies at once: as an adviser to the beleaguered governments --
and on the side of the hedge funds that are speculating against the

Goldman Sachs was also involved when the Greeks tried to hide their debts
from Brussels. In 2002, the US bank helped them exchange a portion of
their dollar and yen debts, worth $10 billion, into euro debts. Goldman
even granted Greece a loan of EUR1 billion, which was never reported as
such to Brussels, and collected EUR200 million for its efforts.

Politicians are now beginning to frown upon these cunning deals. "It will
be a disgrace if it turns out to be true that banks, which already took us
to the brink of disaster, were also involved in the falsification of
statistics in Greece," German Chancellor Angela Merkel said in a speech
last Wednesday in the north-eastern German state of Mecklenburg-Western

Nevertheless, even the new Greek government, which is breaking with many
of the traditions of its predecessors, cannot manage without the US
investment bank. Goldman Sachs and Deutsche Bank were among the six banks
that placed Greek government bonds worth EUR8 billion in early February.
Perhaps the Greeks were trying to remain on good terms with the two
powerful banks. Both were among the most active traders in CDSs, which are
often traded on behalf of hedge funds.

Fallen from Favor

Of course, there are also the more traditional speculative transactions.
In the week before last, speculators bet a record $10 billion on a falling
euro on the Chicago Mercantile Exchange alone.

"The pressure on the euro isn't going away," predicts Sophia Drossos, a
native of Greece who runs the currency strategy division at US investment
bank Morgan Stanley. "The downside risks to the euro right now are the
largest that they have ever been since the single currency was launced."
It has fallen out of favor, she says, and that sort of thing doesn't
change that quickly.

Not even a bailout of Greece would drive away the speculators, says Marc
Chandler, chief currency strategist at the New York private bank Brown
Brothers Harriman. If that happened, "the market might go after other
countries that have similar DNA," he said. "And by DNA here I mean
financial DNA: large deficits, current account deficits. And so, if Greece
is bailed out by Europe in some fashion, it could be: let's go after
Spain. Or: Let's see how deep the pockets are really going to be."

It is precisely this concern -- namely, that they will have to come to the
aid of one heavily indebted country after another, until they end up with
a deficit of their own that's become too big to handle -- hat has Europe's
politicians so worried. But do they even have a choice?

German Finance Minister Wolfgang Scha:uble, a member of the center-right
Christian Democratic Union (CDU), and his senior staff aren't just worried
about the euro. They are also concerned that the German banking sector
could be thrown out of balance once again if Greece defaults on its debt.

Like Lehman All Over Again

The senior Finance Ministry officials were alarmed by a letter from Jochen
Sanio, the president of Germany's Federal Financial Supervisory Authority,
known as BaFin. In the letter, which was addressed to Jo:rg Asmussen, a
senior Finance Ministry official, Sanio urgently warned that the
consequences of a Greek default could resemble the effects of the Lehman

German banks could probably cope with a Greek default, but if it led to
the financial collapse of other countries, like Italy, Spain or Portugal,
the consequences for the banking sector could be catastrophic, Sanio
warns. If this happened, the financial market crisis would only get worse.

In his letter, the BaFin president calculates what could happen to
individual banks if securities from these countries lost 30, 50 or even 70
percent of their value. The results are horrifying. According to Sanio's
scenario, banks that were already hard hit by the effects of the Lehman
bankruptcy would be the most vulnerable, particularly German mortgage
lender Hypo Real Estate (HRE), which has since been nationalized.

According to BaFin, HRE, which had to be propped up in late 2008 with
government loan guarantees worth about EUR100 billion, holds by far the
largest amount of Greek debt out of all German banks, with a total volume
of EUR9.1 billion.

What makes the situation so contentious is the fact that HRE increased its
inventory of the troubled securities by almost 50 percent between March
and September 2009 -- which was precisely the period in which it was being
bailed out with government funds.

Downward Spiral

But other problem banks would also be affected by a Greek default.
According to BaFin calculations, partially nationalized Commerzbank
carries EUR4.6 billion in exposure to Greek debt. Germany's ailing
state-owned banks are also heavily exposed, with LBBW and BayernLB having
an exposure of EUR2.7 billion and EUR1.5 billion respectively.

On the whole, German lenders hold about EUR32 billion in Greek securities,
as well as another EUR10 billion in insurance holdings.

The situation would spin completely out of control if, in addition to
Greece, countries like Portugal, Italy, Ireland and Spain got into
difficulties. German banks have acquired debt from these countries with a
total volume of EUR522.4 billion. This is about 20 percent of the total
amount owed to German banks by foreign countries, according to a BaFin
internal memo. German banks are apparently the "principal creditors in
Spain and Ireland, and the second-most important creditor in Italy."

In their report, the BaFin experts even draw parallels to one of the
biggest national defaults in recent years. "As in the case of Argentina,
the countries named could face the beginning of a downward spiral," they
write. As revenues decline in these countries, they are forced to impose
drastic savings measures, which then hamper economic development.

"The main risk for the German financial sector lies in the collective
difficulties of the PIIGS countries," the BaFin memo reads. "Greece could
possibly be the trigger for this."

Betting on a Greek Insolvency

The German financial regulators also assign a significant portion of the
blame for the current situation to speculators. "Among hedge funds, in
particular, there are those that are betting on a Greek insolvency and a
collapse of the euro zone."

If a number of countries do in fact default, the BaFin experts believe
that the euro zone will have arrived at the limit of its effectiveness.
The EU countries, together with international central banks, could perhaps
fend off attacks on Greece, but, as the BaFin document warns, "in the
event of speculation and financing problems in all of the PIIGS countries,
serious problems could arise, along with substantial market disruptions."

Partly as a result of the pressure caused by the Sanio letter, Scha:uble
and Asmussen decided to clear the way for assistance to Greece. There are
essentially three options, although two have already been discarded. The
first option -- a joint bond issued by all the euro zone members -- was
considered unrealistic right from the start. Assistance from the
International Monetary Fund (IMF), which has helped countries out of
financial crises in all regions of the world, is no longer an option.
Scha:uble, for one, would consider it an embarrassment if Europeans were
unable to help themselves.

This leaves the third option, bilateral assistance, which Scha:uble has
discussed with his French counterpart, Christine Lagarde. The French are
particularly insistent that action be taken quickly, a point President
Nicolas Sarkozy has repeatedly made with Chancellor Angela Merkel.

Rescue Package

Early last week, the German-French duo brought the remaining finance
ministers in the euro group on board. Officially, all are still cloaked in
silence and behaving as if bailouts will not be necessary. Nevertheless,
the package of measures is beginning to take shape.

The German Finance Ministry expects support for Greece to amount to
between EUR20 billion and EUR25 billion. All the members of the euro group
are expected to participate, including those, like Spain and Portugal, who
also might find themselves needing help soon. The individual countries'
contributions will be determined on the basis of their respective shares
of the capital of the European Central Bank (ECB). Under this scheme,
Germany would be responsible for about 20 percent, or EUR4 billion - EUR5

The assistance is to consist partly of loans and partly of loan
guarantees. KfW, the German state-owned development bank, will process the
German share. Scha:uble's experts want to tie the measures to strict
requirements. For example, one credit tranche would only be transferred
once the Greek government demonstrated that it had begun reforms of its
pension system. The procedure is copied from the IMF. But is it legally

For years, the validity of Article 125 of the "Treaty on the Functioning
of the European Union," one of the EU's core treaties, was considered
irrefutable in Germany's political debates. The regulation bars the euro
countries from helping each other get out of debt.

This passage is also partly responsible for having convinced a skeptical
German population to accept the introduction of the euro. Article 125
"tolerates no compromises," says Otmar Issing, the former chief economist
at the European Central Bank.

New Provisions

Hence the legal experts in the German Finance Ministry had to go to great
lengths in order to justify the planned bilateral assistance. After an
initial review, they concluded that the measures were inadmissible.
Scha:uble was irate and ordered his staff to continue their review until
all objections had been swept aside.

Now, the official version is that the participating countries will not
assume any of Greece's debt, which would be forbidden under the treaty.
Instead, they will add new debt to the existing debt, something that the
rules do not prohibit.

Scha:uble's officials know all too well that the interventions will
nevertheless strain the framework of the agreement and the equilibrium of
the currency union. For that reason, they intend to introduce new
future-oriented provisions once the current measures have been taken.

They believe that the Stability and Growth Pact, the sole purpose of which
is to coordinate the debt policies of member states, is no longer
adequate, and that the euro countries will have to coordinate their
economic policies with each other more effectively in the future. They
also say that it will be necessary to develop a regulated procedure for
national insolvencies within the framework of the euro group.

European Inflation Union

The Finance Ministry officials are also thinking about creating a new
institution, modeled after the IMF, to handle future bailout efforts. This
European fund would provide financing to countries in difficulty.

It is still unclear how the new rescue fund will be financed. There are
two conceivable options: Each member state's contribution could be based
on either its share of ECB capital or the level of its deficit.

The second solution would be fairer: the worse a country's financial
policy, the higher its contribution. In other words, the biggest sinners
would be required to pay the highest indulgence.

Such an institution doesn't exist yet, which means that European
politicians will have to make do with what they have. The financial
strength of the donor countries could soon be depleted. This could force
ECB President Jean-Claude Trichet to buy up the debt of the countries
facing bankruptcy -- which is tantamount to printing money. Although this
is prohibited under the Maastricht statutes, the EU finance ministers
already demonstrated that the treaty could be amended if necessary when,
in 2005, they stealthily relaxed the 3 percent criterion for government

Such a bailout would come at a high price: It would turn the European
monetary union into an inflation union.


Translated from the German by Christopher Sultan

Marko Papic


Geopol Analyst - Eurasia

700 Lavaca Street, Suite 900

Austin, TX 78701 - U.S.A

TEL: + 1-512-744-4094

FAX: + 1-512-744-4334


Marko Papic


Geopol Analyst - Eurasia

700 Lavaca Street, Suite 900

Austin, TX 78701 - U.S.A

TEL: + 1-512-744-4094

FAX: + 1-512-744-4334


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