Greeks are Angry

Greeks are angry over the costs of reform. See this article in the Guardian.

A growing chorus of voices is urging the Greek government to restructure its debt as fears grow that a €110bn bailout has failed to rescue the country from the financial abyss and is forcing ordinary people into an era of futile austerity.

"It's better to have a restructuring now … since the situation is going nowhere," said Vasso Papandreou, whose views might be easier to discount were she not head of the Greek parliament's economic affairs committee.

Given the scale of protests to minor adjustments it is hard to see how Greece can make the big adjustments necessary to adjust their fiscal situation:

Tomorrow, in a clear sop to the thousands who have signed up to the "can't pay, won't pay" movement, the ruling socialists will announce reductions of up to 50% in road toll fees. As the nation struggles to rein in a debt of €340bn, the logic of appeasing protesters – an estimated 8,000 Greeks a day were refusing to pay tolls – has outweighed antagonising them further. "Our hope is that this will calm things down," the deputy transport minister Spyros Vougias said.

Last week, a man shot a bus inspector hired to crack down on fare dodgers after protesters stormed a police station, snatched hundreds of confiscated number plates and set light to thousands of fines. Days later thugs attacked Antonis Loverdos, the health minister, as he visited a hospital in Athens. In Patras, James Watson, the 83-year-old Nobel Prize-winning geneticist was also attacked as he prepared to give a speech at the city's university.

It is hard to see how Greece can adjust without haircuts from bondholders. Some trade between haircuts and real reforms might make it palatable. But that opens up a complex political economy problem for Europe, since there are other economies, notably Portugal and Ireland with similar, though right now more manageable, problems.

Greek Tragedy

I loved Cornelius Ryan's book, "A Bridge Too Far," and the movie too. Today, Paul Krugman likens the Maastricht treaty creating the euro as "A Money Too Far." An apt analogy. The resources (rather institutions) necessary to make a currency union effective were unavailable to those behind the treaty, just as Montgomery's plan to take Arnhem Bridge was too ambitious given the reality on the ground in Holland. And in both cases, naysayers were ignored.

The extent of Krugman's pessimism is evident:

Many observers now expect the Greek tragedy to end in default; I’m increasingly convinced that they’re too optimistic, that default will be accompanied or followed by departure from the euro.

Hard to see how this ends in a non-tragic way.

Greek Tragedy Spreading

Peter Boone and Simon Johnson reflect on the implications of the Greek bailout for Portugal and the EU. Key highligh:

The bailout of Greece, while still not fully consummated, has brought an eerie calm in European financial markets. It is, for sure, a massive bailout by historical standards. With the planned addition of IMF money, the Greeks will receive 18% of their GDP in one year at preferential interest rates. This equals 4,000 euros per person, and will be spent in roughly 11 months.

Despite this eye-popping sum, the bailout does nothing to resolve the many problems that persist. Indeed, it probably makes the euro zone a much more dangerous place for the next few years.

The key problem now is how to control fiscal profligacy. There seems to be no restraint, especially if the EU will bailout anyone who gets in trouble. As Boone and Johnson note:

Pity the serious Portuguese politician who argues that fiscal probity calls for early belt tightening. The EU, the ECB, and the Greeks have all proven that the euro zone nations have no threshold for pain, and EU money will be there for anyone who wants it. The Portuguese politicians can do nothing but wait for the situation to get worse, and then demand their bailout package too. No doubt Greece will be back next year for more. And, the nations that “foolishly” already started their austerity, such as Ireland and Italy, must surely be wondering whether they too should take the less austere path.

The question is how long with Germany be willing to live with this system.

More Naked CDS

According to Rajiv Sethi the prohibition of naked credit default swaps can be supported on the grounds of Diamond and Dybvig's financial instability model:

"In this case, expectations of default can become self-fulfilling even when solvency would not be a concern if expectations were less pessimistic. What does this have to do with naked credit default swaps? As John Geanakoplos notes in his paper on The Leverage Cycle, such contracts allow pessimists to leverage (much more so than they could if they were to short bonds instead). The resulting increase in the cost of borrowing, which will rise in tandem with higher CDS spreads, can make the difference between solvency and insolvency. And recognition of this process can tempt those who are not otherwise pessimistic to bet on default, as long as they are confident that enough of their peers will also do so. This clearly creates an incentive for coordinated manipulation."

I don't understand this argument for (at least) two reasons. First, unlike bank runs there is no sequential service constraint with sovereign bonds. If people try to exit the price falls, which prevents runs. Bank runs happen because of the advantage to rush to the head of the line.

Second, and more important, Sethi seems to forget that with naked CDS the purchaser is out money, the seller is receiving income. It is negative carry for the buyer. Thus there is a bias already against shorting in this fashion. The naked CDS holders are putting their money where their mouth is. Hard to see why they would do this based on some expectation that others will also do it, thus raising the cost of their play. Most traders would want to keep quiet to buy the insurance at a lower cost, and hope that others do not follow.

See The Money Demand for more interesting critiques of the Sethy argument.

Naked CDS and Greece

Sam Jones has a nice column on the benefit of naked CDS and the Greek crisis. It is a critique of the argument of Munchau that:

A naked CDS purchase means that you take out insurance on bonds without actually owning them. It is a purely speculative gamble. There is not one social or economic benefit. Even hardened speculators agree on this point. Especially because naked CDSs constitute a large part of all CDS transactions, the case for banning them is about as a strong as that for banning bank robberies.

Jones shows how hedge funds that were naked CDS are now likely to be buyers of Greek bonds. His argument is twofold:

Firstly, any naked CDS buying – as slated by Mr Münchau – occurred, by hedge funds at least, well before the current crisis. Hedge funds have not been the most significant buyers of CDS in recent weeks. (Banks, stuffed to the gills with sovereign debt thanks to the ECB, have)

Ergo, there is no speculative, opportunistic “attack” underway to try and push Greece further into catastrophe (as Mr Münchau notes, Greece seems content to do this all on its own anyway).

Secondly, and more importantly, however, hedge funds, completing their clever trade, have been buyers of Greek government debt, or else insurers of other holders as CDS writers.

In a market where one of Greece’s principal market makers -– Deutsche Bank –- says it will not buy Greek bonds, and where European politicians are having to force their own national banks to do so in order to try and avert the threat of a Greek bond auction failing, the boon from hedge funds looking to hoover-up Greek debt is undeniable.

And the only reason they are in the market to buy is because of naked CDS positions they laid on many months -– and in some cases years -– ago.

What I don't understand is why his argument is not even stronger and simpler. Hedge funds buy naked CDS when prices are low speculating that a crisis may occur. When the crisis occurs and spreads rise, the hedge funds sell the swaps to those in dire need -- those who are lenders to Greece.

Indeed, isn't this just like any argument for short selling -- that it is providing more market information about what might happen? Suppose that enough hedge funds bought CDS on Greek debt years ago and that spreads rose significantly then. Lending to Greece would have been reduced and the extent of Greece's debt woes today would be smaller. Wouldn't more naked CDS have been better?

Right On

Felix Salmon had a nice post today about politicians and their nonsense regarding Greece and credit default swaps. Carolyn Maloney, Chair of Joint Economic Committee, is quoted in the FT:

Ms Maloney compared the use of credit default swaps in the Greek situation to the “activities that brought down American International Group”, referring to the US insurer that collapsed and was bailed out in September 2008. “These reports, if true, are a shocking echo of the financial crisis that faced the US in 2008 – whose reverberations are still being felt today, in the worst recession in decades.”

This is nonsense, as Salmon notes. AIG sold CDS and then could not cover claims, Greece is not selling any CDS, it is the subject of insurance. People are buying insurance against their default. The comparison is daft.

Salmon also points to the German financial watchdog which apparently is worried that German bailout funds will go to speculators, even though the speculators seem to be betting on a Greek default. It is crazy.

But as Salmon notes:

it’s all a big Kabuki, wherein anybody bashing banks in general, and Goldman Sachs in particular, gets automatic political brownie points. And there are no points at all, it seems, for basic financial literacy.