Sovereign risk

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See also collateral and IMF.


Contents

Sovereign deleveraging and debt loads

McKinsey has released a very detailed report which focuses on the "final frontier" of the global credit bubble: the migration of private sector leverage over to the sovereign balance sheet, and the viability and sustainability of this process. This is not a new topic on Zero Hedge, and as Greece just experienced today, unless a country is well equipped with the dynamic duo of a reserve currency and a printing press, surging sovereign debt usually ends with just one outcome...

The McKinsey consultants have performed an in-depth empirical study tracing the history of (de)leveraging in both the developing and developed world, at both the corporate, financial institution and consumer levels, and the corresponding offset at the sovereigns. Amusingly, analysts read the "improvement" in the credit picture at various private sectors, while completely ignoring the vertical spike in new sovereign debt issuance. If you were wondering why everyone is on pins and needles every time there is a new UST auction, now you know: in the zero sum game of credit transfer, any improvement in the former is purely as a result of the largess of the later. A funding crisis in Greece, which at this point seems a certainty will likely start off the long-awaited European domino action which will begin at the FX level, and slowly migrate to default risk for all European countries. Once that happens, risk will promptly migrate away from Eurozone, and travel west over the Atlantic. In that regard, we still consider US CDS as very cheap, despite their doubling from the first time we suggested investors take a look.

Back to McKinsey - lot of pretty charts, which we suggest readers peruse at their leisure, coupled with insightful commentary.

Here is what happens to global leverage when you leave deranged money printers with aspirations for zero % cost of debt in charge of the whole show: (see chart above).


Eurozone creates stabilisation fund

European Union finance ministers moved toward agreement on an unprecedented loan package worth at least $645 billion to prevent Greece’s fiscal woes from triggering a broader sovereign-debt crisis and shattering confidence in the euro.

Jolted into action by last week’s slide in the currency to a 14-month low and soaring bond yields in Portugal and Spain, the 16 euro governments sketched out plans to make 440 billion euros ($570 billion) available, with 60 billion euros more from the EU’s budget, according to three officials at the talks in Brussels. An additional, unspecified sum may come from the International Monetary Fund, the officials said.

“We are going to defend the euro,” Spanish Economy Minister Elena Salgado told reporters as she arrived to chair the meeting yesterday. “We think we have a duty for more stability for our currency. We will do whatever is necessary.”

Europe’s failure to contain Greece’s fiscal crisis triggered a 4.1 percent drop in the euro last week, the biggest weekly decline since the aftermath of Lehman Brothers Holdings Inc.’s collapse. It prompted the U.S. and Asia to urge broader steps to prevent a debt crisis from pitching the world back into a recession.

New fund would make €70 billion available to zone's 16 member states to deal with 'most serious crisis' in the euro's history.

Leaders of the 16 eurozone countries have tonight agreed to set up a stabilisation fund to defend member countries against “speculative” attacks by the financial markets.

The fund, the draft details of which will be presented to EU finance ministers for approval on Sunday, is expected to have €70 billion available for use to help any member of the eurozone that is struggling to finance its debts because of high interest rates demanded by the financial markets.

Speaking in the early hours of Saturday morning after a six-hour meeting, Nicolas Sarkozy, France's president, said that that eurozone was facing “undoubtedly the most serious crisis it has experienced since its creation”.

He blamed the hike in yields on eurozone sovereign debt on the actions of financial “speculators” that he said would be fought “mercilessly” by the EU institutions and national governments.

“From now on the speculators are onto a losing bet,” he said.

Herman Van Rompuy, the president of the European Council, said that eurozone members were facing “exceptional circumstances”.

He said that eurozone leaders and all EU institutions including the European Central Bank had agreed to use the “full range of measures available” to ensure the stability of the eurozone.

Eurozone leaders also agreed other rapid steps to defend the euro from speculative attacks and to restore long-term investors' confidence in the euro and the state of its members' finances, amid fears that the debt problems that caused Greece to seek assistance from other eurozone members and from the International Monetary Fund (IMF) are evident in other countries.

Eurozone leaders decided to expand efforts to contain after the markets drove the yields demanded on Portuguese and Spanish government debts up to record levels.

“Now the attack is against the whole eurozone and not simply Greece,” Sarkozy said.

“We will not let the eurozone be destabilised...we will not let it be destroyed by the greed of a few people,” he added.

“If we do not stabilise the situation the whole world will be affected,” Sarkozy said.

Merkel’s coalition calls for EU ‘orderly’ defaults

"German Chancellor Angela Merkel’s coalition stepped up calls for allowing the “orderly” default of euro-region member states burdened with debt to avoid a repeat of the Greek fiscal crisis.

Floor leaders of the three coalition parties agreed in Berlin today to put a resolution to parliament alongside the bill on Greek aid calling for the European Union to revise rules for the euro to put pressure on countries that run deficits.

Merkel, who faces elections in Germany’s most populous state on May 9, is seeking to shift focus from the Greek bailout to drawing lessons from the euro’s biggest crisis. An “orderly insolvency” process would ensure that creditors participate in any future rescue, she said on ARD television yesterday.

“We want to move from crisis management to crisis prevention,” Birgit Homburger, the parliamentary head of Merkel’s Free Democratic coalition partner, told reporters after the coalition leaders’ meeting. “We have to do everything we can to ensure we never get into such a situation again.”

Merkel is seeking to have both houses of parliament approve Germany’s share of the 110 billion-euro ($143 billion) Greek bailout on May 7, the same day she heads to Brussels for a meeting of government leaders of the 16 euro nations to assess “lessons to be learned” from the crisis..."

Germany bans shorting Euro debt and 10 bank stocks

Traders are predicting chaos on the world's second-largest government bond market after the German authorities on Tuesday announced a ban on all naked short-selling in European public debt, as well as shares in the country's 10 largest financial institutions.

The unprecedented step saw the euro sink to a four-year low after Germany said that from midnight shorting of credit default swaps of any European government would be banned. The prohibition is an attempt to counter speculators that Berlin believes are trying to destabilise the region's sovereign bond market. Traders greeted the move by BaFin, the German regulator, with a mixture of anger and astonishment. One bond trader said he expected Wednesday's trading session to be one of the most volatile in living memory: "It will be complete chaos, I really don't know what the Germans think they are doing."

ECB official warns of potential sovereign debt crisis

"The global economy may be on the verge of a “sovereign debt crisis” following a severe financial crisis, a key member of the European Central Bank’s Executive Board warned Thursday.

“We may already have entered into the next phase of the crisis: a sovereign debt crisis,” Juergen Stark said at a Transatlantic Dialogue event in Washington.

The German economist also said risks to the global inflation outlook “seem to be tilted to the upside” given the prospects of a “multi-speed recovery” of the world economy.

“There is no doubt that the crisis will leave us a heritage of severe macroeconomic imbalances,” Stark said. “Dealing with them will represent one of the most daunting challenges for policymakers in modern history.”

Euro-zone government debt is projected to reach around 88% of gross domestic product in 2011. Debt-to-GDP ratios are forecast to reach highs of 100% and 200% in the U.S. and Japan respectively.

“In the euro area, adverse fiscal developments are a cause of particular concern in several countries, generally those that did not exploit more buoyant economic times to firmly consolidate their public finances,” Stark said, according to the text of his speech.

Greece’s deficit for 2009 stood at almost 13% of GDP–well above the deficit ceiling of 3% of GDP set by the EU’s Stability and Growth Pact.

“With an annual structural deficit reduction of only 0.5% of GDP, it will take the euro area 20 years or more to return to the pre-crisis debt-to-GDP level,” he said.

The ECB said consolidation must start in 2011, at the latest, and will have to “exceed substantially” the annual adjustment of 0.5% of GDP set as a minimum requirement by the Stability and Growth Pact.

“Outside the euro area, bringing the public debt ratio back to safer regions appears even harder for the United Kingdom, the United States and Japan,” Stark cautioned.

He even pointed out problems in specific U.S. states. “In the United States, too, some states [e.g. Arizona and California] have adopted a less prudent approach to the management of their public finances than others,” he said.

Stark wouldn’t rule out a potential negative impact from large fiscal imbalances on inflation.

“We also need to monitor very closely the possible adverse impact from fiscal developments on the inflation outlook.” Fast economic growth in some regions of the world could drive up prices for commodities and other goods globally, he cautioned.

“We need to monitor price developments in the more dynamic regions of the world very closely,” he said. “All in all, risks to the inflation outlook seem to be tilted to the upside.”

IMF: Sovereign default the greatest threat

Sovereign default is the most pressing risk facing the global economy, according to the IMF's flagship Global Financial Stability Report, released on Tuesday.

Since the Fund's interim report last October, sovereign credit risk has soared even as the threat of inflation, deflation and loss of economic activity have receded. "With markets less willing or able to support leverage, sovereign credit risk premiums have more recently widened across mature economies with fiscal vulnerabilities," the Fund said. Greece's woes had impacted credit default swap spreads in neighbouring countries with debt problems of their own, such as Italy and Spain. Beyond the eurozone, debt to GDP ratios in the G7 countries were approaching 60-year highs of more than 110%. Longer-term solvency worries had in some cases created short-term funding constraints, which were being spread by cross-border banks, the report said.

These vulnerabilities could only be mitigated through credible plans for fiscal cutbacks. "Consolidation plans should be made transparent, and contingency measures should be in place if the degradation of public finances is greater than expected," the report said. Better fiscal frameworks and growth-boosting structural reforms would also help in this respect," it said.

Banking problems persist

The global banking system was also still at risk, with some segments of country's banking sectors remaining poorly capitalised, and facing significant downside risks.

Echoing recent warnings from presidents of several regional Federal Reserve banks, the report pointed to brewing problems in the US commercial real estate sector. "Some 12 [regional banks] have commercial real estate exposures in excess of four times tangible common equity," the report said. It further highlighted that a significant amount of mortgage credit risk had been transferred to the US Treasury because of its takeover of Fannie Mae and Freddie Mac, the two government-sponsored enterprises.

Banks elsewhere also faced the threat of further deterioration. In Germany, the eight Landesbanken, the regional banking institutions, faced a high loan writedown rate. Along with other German banks, the Landesbanken still held a high amount of structured products, which were linked to writedowns in 2008, the report said. In central and eastern Europe, banking systems were vulnerable if economic growth failed to pick up sufficiently.

Meanwhile, the decline of risk in emerging markets meant that Asia, with the exception of Japan, and Latin America once again looked attractive. "Capital is flowing, attracted by strong growth prospects, appreciating currencies, and rising asset prices and pushed by low interest rates in major advanced economies as risk appetite continues to recover," the IMF said. The Fund last week reversed its long-held objection to capital controls, noting that they may have a role in aiding small and vulnerable economies in these circumstances.

Bank rescue packages moved risks to sovereign balance sheets

"... BIS points out in a new report that the bank rescue packages have transferred significant risks onto government balance sheets, which is reflected in the corresponding widening of sovereign credit default swaps:

The scope and magnitude of the bank rescue packages also meant that significant risks had been transferred onto government balance sheets. This was particularly apparent in the market for CDS referencing sovereigns involved either in large individual bank rescues or in broad-based support packages for the financial sector, including the United States. While such CDS were thinly traded prior to the announced rescue packages, spreads widened suddenly on increased demand for credit protection, while corresponding financial sector spreads tightened.

Fears of 'Lehman-style' tsunami

Julian Callow from Barclays Capital said the EU may to need to invoke emergency treaty powers under Article 122 to halt the contagion, issuing an EU guarantee for Greek debt. “If not contained, this could result in a `Lehman-style’ tsunami spreading across much of the EU.”

Credit default swaps (CDS) measuring bankruptcy risk on Portuguese debt surged 28 basis points on Thursday to a record 222 on reports that Jose Socrates was about to resign as prime minister after failing to secure enough votes in parliament to carry out austerity measures.

Parliament minister Jorge Lacao said the political dispute has raised fears that the country is no longer governable. “What is at stake is the credibility of the Portuguese state,” he said.

Portugal has been in political crisis since the Maoist-Trotskyist Bloco won 10pc of the vote last year. This is rapidly turning into a market crisis as well as investors digest a revised budget deficit of 9.3pc of GDP for 2009, much higher than thought. A €500m debt auction failed on Wednesday. The yield spread on 10-year Portuguese bonds has risen to 155 basis points over German bunds.

Daniel Gross from the Centre for European Policy Studies said Portgual and Greece need to cut consumption by 10pc to clean house, but such draconian measures risk street protests. “This is what is making the markets so nervous,” he said. In Spain, default insurance surged 16 basis points after Nobel economist Paul Krugman said that “the biggest trouble spot isn’t Greece, it’s Spain”. He blamed EMU’s one-size-fits-all monetary system, which has left the country with no defence against an adverse shock. The Madrid’s IBEX index fell 6pc.

Finance minister Elena Salgado said Professor Krugman did not “understand” the eurozone, but reserved her full wrath for the EU economics commissioner, Joaquin Almunia, who helped trigger the panic flight from Iberian debt by blurting out that Spain and Portugal were in much the same mess as Greece.

Mrs Salgado called the comparison simplistic and imprudent. “In Spain we have time for measures to overcome the crisis,” she said. It is precisely this assumption that is now in doubt. The budget deficit exploded to 11.4pc last year, yet the economy is still contracting.

Jacques Cailloux, Europe economist at RBS, said markets want the EU to spell out exactly how it is going to shore up Club Med states. “They are working on a different time-horizon from the EU. They don’t think words are enough: they want action now. They are basically testing the solidarity of monetary union. That is why contagion risk is growing,” he said. “In my view they underestimate the political cohesion of the EMU Project. What the Commission did this week in calling for surveillance of Greece has never been done before,” he said.

Mr Callow of Barclays said EU leaders will come to the rescue in the end, but Germany has yet to blink in this game of “brinkmanship”. The core issue is that EMU’s credit bubble has left southern Europe with huge foreign liabilities: Spain at 91pc of GDP (€950bn); Portugal 108pc (€177bn). This compares with 87pc for Greece (€208bn). By this gauge, Iberian imbalances are worse than those of Greece, and the sums are far greater. The danger is that foreign creditors will cut off funding, setting off an internal EMU version of the Asian financial crisis in 1998.

Jean-Claude Trichet, head of the European Central Bank, gave no hint yesterday that Frankfurt will bend to help these countries, either through loans or a more subtle form of bail-out through looser monetary policy or lax rules on collateral. The ultra-hawkish ECB has instead let the M3 money supply contract over recent months.

Mr Trichet said euro members drew down their benefits in advance -- "ex ante" -- when they joined EMU and enjoyed "very easy financing" for their current account deficits. They cannot expect "ex post" help if they get into trouble later. These are the rules of the club.

Harvard’s Rogoff sees sovereign defaults, austerity

"Ballooning debt is likely to force several countries to default and the U.S. to cut spending, according to Harvard University Professor Kenneth Rogoff, who in 2008 predicted the failure of big American banks.

Following banking crises, “we usually see a bunch of sovereign defaults, say in a few years,” Rogoff, a former chief economist at the International Monetary Fund, said at a forum in Tokyo yesterday. “I predict we will again.”

The U.S. is likely to tighten monetary policy before cutting government spending, sending “shockwaves” through financial markets, Rogoff said in an interview after the speech. Fiscal policy won’t be curbed until soaring bond yields trigger “very painful” tax increases and spending cuts, he said.

Global scrutiny of sovereign debt has risen after budget shortfalls of countries including Greece swelled in the wake of the worst global financial meltdown since the 1930s. The U.S. is facing an unprecedented $1.6 trillion budget deficit in the year ending Sept. 30, the government has forecast.

“Most countries have reached a point where it would be much wiser to phase out fiscal stimulus,” said Rogoff, who co- wrote a history of financial crises published in 2009. It would be better “to keep monetary policy soft and start gradually tightening fiscal policy even if it meant some inflation.”..."

Sovereigns encouraged to post collateral for CDS trades

Governments can cut funding costs by posting collateral on derivatives trades with commercial banks, according to the Association for Financial Markets in Europe.

Collateral arrangements are negotiated independently in unregulated derivatives markets, and most governments require their trading partners to make guarantees without reciprocating. The International Monetary Fund said in an April report that policy makers should “advocate more consistent and uniform collateral practices” for derivatives trades.

Governments posting collateral to back their trades would also help bring down the cost of credit-default swaps that banks use to hedge their counterparty risk, the IMF said in its Global Financial Stability Report. The Markit iTraxx SovX Index of default swaps on 15 European governments has more than doubled this year to 150 basis points, according to data provider CMA.

“With uniform collateralization requirements, sovereigns would be able to finance themselves at more competitive levels,” said Sander Schol, a director in London at AFME, an industry group representing banks. “In a time of shrinking balance sheets, the fact that a government is not paying collateral is an increasing cost to the banks.”

Corrigan says sovereigns hiding debt "for decades"

"...Concern about Greece’s ability to finance its deficit and debt roiled financial markets since the government revealed the country had a budget shortfall of 12.7 percent last year, more than four times the limit allowed for those countries using the euro. Eurostat, the EU accounting watchdog ordered Greece last week to provide information on its swaps as it probes whether the country used derivatives to hide its true deficit.

‘Nothing Terribly New’

Greece, whose burgeoning budget deficit caused it to fail the criteria for joining the single European currency in 1999, joined the euro in 2001. Member nations must keep deficits at less than 3 percent of gross domestic product and trim national debt to less than 60 percent of GDP under the pact.

“Governments on a fairly generalized basis do go to some lengths to try to ‘manage’ their budgetary deficit positions and manage their public debt positions,” [Gerald] Corrigan said. “There is nothing terribly new about this, unfortunately. Certainly, those practices have been around for decades, if not centuries. We have to keep that perspective.”

Banks to defend sovereign default swaps

The banking industry is arguing at a meeting with European Union regulators that trading in sovereign credit-default swaps isn’t large enough to affect Greek bond prices.

Swaps account for “only a small percentage of government bond trading volumes,” so it isn’t likely speculation in the contracts is “dictating price levels in the larger government bond market,” the International Swaps & Derivatives Association, an industry group, said in a statement today. The group said the Brussels meeting offered a chance to address “misconceptions” about credit swaps.

Banks and regulators across Europe have been summoned by the European Commission to an informal meeting to discuss regulation of the market for sovereign credit-default swaps in the wake of the Greek debt crisis. European leaders have said the products fuel speculation that can distort market perceptions, making it harder for countries to borrow.

The commission should ban naked swaps speculation, where investors insure bonds they don’t own, because “it is a demonstrably dangerous market,” Richard Portes, founder of the Centre for Economic Policy Research, said in a telephone interview today. “If I were the commission, I’d ask the banks to say what social function the trade in naked CDS has.”

The roundtable is a “technical meeting,” and the discussions will be taken into account for the commission’s planned derivatives proposals later this year, Chantal Hughes, a commission spokeswoman, told reporters today.

Face Value for Debt

Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a country or company default on its debt payments.

“The absence of competition between banks also means that the possibilities of effective cartel behavior in the CDS market have increased,” Portes said.

ISDA defended sovereign swaps, saying in its statement they “can be used to hedge financial, industrial and real estate investments in countries.” The products allow investors to buy and sell default protection “without having access to government bond markets,” the group said.

German Chancellor Angela Merkel’s government is considering ways to tighten rules in the sovereign default swaps market. French Finance Minister Christine Lagarde said Feb. 17 “we should examine the suitability” of credit-default swaps.

The cost of such contracts on Greece rose to a record 428 basis points last month, according to CMA DataVision in London. That meant it cost $428,000 a year to insure $10 million of debt for five years.

Efforts to limit sovereign swaps contracts were criticized by Citigroup Inc. analysts in a note March 2. The analysts said governments should address investor concerns about budget deficits, rather than ban derivatives that hedge against risks.

“We would do better to spend our time addressing the defects the mirror shows than blaming the mirror,” Citigroup analysts, led by Michael Hampden-Turner in London, wrote in a note to investors. “After all, banning mirrors does nothing at all to make the world a prettier place.”

Greece agrees to €110 billion bailout package

Today, Greece reached agreement with the International Monetary Fund (IMF), the European Commission (EC), and the European Central Bank (ECB) on "a focused program to stabilize its economy, become more competitive, and restore market confidence." The centerpiece of the program is a €110 billion ($145 billion) financing package, "unanimously agreed" to by Euro area ministers today in Brussels. Euro area members have pledged a total of €80 billion ($105 billion) in bilateral loans, centrally pooled by the European Commission under the conditions set out in their April 11 statement, with the first disbursement of bailout money available before several Greek government obligations fall due May 19. In addition, the IMF has agreed to provide an additional €30 billion ($40 billion) in support under a three-year Stand-By Arrangement, IMF’s "standard lending instrument."

As part of the financial package, the Greek government has also agreed to a variety of "new budget-reduction measures," and additional austerity measures, including new taxes and reductions in public sector salaries and pensions.

EC President Juan-Manual Barroso and the ECB both "welcomed" the Greek support program, noting that such financial assistance "will be decisive to help Greece bring its economy back on track and preserve the stability of the Euro area."


Greece may take legal steps against U.S. banks for crisis

Greece is considering taking legal action against U.S. investment banks that might have contributed to the country’s debt crisis, Prime Minister George Papandreou said.

“I wouldn’t rule out that this may be a recourse,” Papandreou said, in response to questions about the role of U.S. banks in the crisis, in an interview on CNN’s “Fareed Zakaria GPS.” The program, scheduled for broadcast today, was taped on May 13. Neither Papandreou nor Zakaria mentioned any banks by name.

U.S. stocks fell and the euro slumped on concern that Europe wouldn’t be able to contain the debt crisis stemming from Greece. The Standard & Poor’s 500 Index declined 1.9 percent May 14, while the euro fell below $1.24 for the first time since November 2008.

Papandreou said the decision on whether to go after U.S. banks will be made after a Greek parliamentary investigation into the cause of the crisis.

“Greece will look into the past and see how things went,” Papandreou said. “There are similar investigations going on in other countries and in the United States. This is where I think, yes, the financial sector, I hear the words fraud and lack of transparency. So yes, yes, there is great responsibility here.”

Greek bailout creates large tensions

"...This bail-out will be unpopular in Germany. Although there are those who say that the Greek rescue is not technically a bail-out because it comes as a loan, you'll find plenty of economists who say this is just playing with words. For, in effect, Greek borrowing will be subsidised.

So there could be challenges in the German courts to the legality of the Greek bail-out. Chancellor Merkel has made concessions but she wants the bail-out plan to be "convincing". There are regional elections in Germany in early May and the bail-out will be an issue.

In a revealing article in the New York Times, John Kornblum, a former US ambassador to Germany, says that "Europe in the institutional sense has become increasingly unpopular" in Germany.

"German courts have begun to define German European issues in the context of the German constitution rather than on the basis of EU law," he writes. He goes on to say that "the growing gap between Germany's aspirations and the perceived needs of other members of the EU is beginning to burden both sides. Most Europeans are simply not ready to live up to German standards".

Perhaps the most significant legacy of this crisis is the emergence of a Germany that asserts its own national interest above being "good Europeans"; the role it has played in the past.

The biggest challenge, however, is to the EU and the single currency. Some insist that the euro is fundamentally a strong currency. Many disagree, insisting that the single currency has been exposed as flawed. They focus on the difficulty of having monetary and not fiscal union. The differences between, say, the German economy that runs large surpluses and other economies that are crippled with debt are immense. Can all inhabit the same currency zone? The question remains unanswered.

There will be fall-out. Already the EU is discussing stricter enforcement measures; those countries that break the rules and run up huge deficits could well face severe sanctions in the future.

How to address the difference in competitiveness between countries in the eurozone is a much harder question. To persuade Germans to spend more or save less is a non-starter. Germany has sacrificed much to achieve its status as a major exporter and manufacturer.

There will be pressure to set up a mechanism to deal with similar crises in the future. That might necessitate treaty changes and that would open up another round of painful negotiations just after the Lisbon Treaty has been ratified. There are no easy options but the fundamental weaknesses in the euro will have to be addressed one way or another."

Euro govts pledge $61B Greece backstop

European governments offered debt- plagued Greece a rescue package worth as much as 45 billion euros ($61 billion) at below-market interest rates in a bid to stem its fiscal crisis and restore confidence in the euro.

Forced into action by a surge in Greek borrowing costs to an 11-year high, euro-region finance ministers said yesterday they would offer as much as 30 billion euros in three-year loans in 2010 at around 5 percent. That’s less than the current three- year Greek bond yield of 6.98 percent. Another 15 billion euros would come from the International Monetary Fund.

“This is a huge amount,” said Stephen Jen, managing director at BlueGold Capital Management LLP in London and a former IMF economist. “This is more than a bazooka. They have gone nuclear on the issue of Greece. In the short run the market is short Greek assets so we’ll get a rally in those.”

With the euro facing the stiffest test since its debut in 1999, the 16-nation bloc maneuvered around rules barring the bailout of debt-stricken countries, aiming to prevent Greece’s financial plight from spreading and to mute concerns about the currency’s viability. Germany also abandoned an earlier demand that Greece pay market rates.

The euro has dropped 5.7 percent against the dollar this year as the discord within Europe over the response to the Greek crisis sapped faith in Europe’s economic management. The single currency rose in Asian trading to $1.3634 from $1.35 on April 9.

Bond investors’ response will determine whether Greece needs to tap the aid, a Greek Finance Ministry official said in Athens yesterday. Finance Minister George Papaconstantinou said the government plans to go ahead with debt sales, including a dollar-denominated bond, without taking up the offer for aid.

Greece facing increasing solvency issues

by German Chancellor Angela Merkel and the Managing Director of the International Monetary Fund (IMF), Dominique Strauss-Kahn, on April 28, 2010 in Berlin] IMF, April 28, 2010


"...The message from the market could not be clearer: artfully worded communiqués from Brussels will no longer suffice. To avoid bankruptcy, analysts said, Greece needs a bailout from Europe, and fast.

“This is no longer about liquidity; it’s a solvency issue,” said Stephen Jen, a former economist at the International Monetary Fund who is now a strategist at BlueGold Capital Management in London.

But with European officials consumed with a debate over whether loans to Greece should be offered at rates consistent with a typical I.M.F. bailout or punitive ones closer to current market levels, the risk is that while Brussels fiddles, Greece is burning.

At a press conference on Thursday, Jean-Claude Trichet, the president of the European Central Bank, sought to break the fever in the markets by saying that the aid program proposed by the International Monetary Fund and the European Union was a “very, very serious commitment.”

The statement helped bring yields on 10-year Greek government bonds down from their peak for the day, to 7.35 percent, but it was not enough to turn around the mood of pessimism that contributed to a further fall in Greek and other European stocks.

“Time is running out,” said a senior official in the Greek government who spoke on condition of anonymity because of the delicacy of the issue. “The market is testing Europe’s resolve.”


BRUSSELS (Reuters) - European leaders have reached a deal to provide aid to Greece, EU president Herman Van Rompuy said on Thursday, in an unprecedented move to stave off a broader crisis in the 16-nation bloc that shares the euro.

"There is an agreement on the Greek situation. We will communicate now the agreement to the other leaders," van Rompuy told reporters gathered at an EU leaders' summit.

The agreement was forged in talks between Van Rompuy, European Commission President Jose Manuel Barroso, French President Nicolas Sarkozy, German Chancellor Angela Merkel, European Central Bank President Jean-Claude Trichet and Greek Prime Minister George Papandreou.

Polish Prime Minister Donald Tusk told reporters earlier that the aid, which would amount to the first bailout of a euro zone members since the currency was created 11 years ago, was likely to come in the form of loans.

"It could be voluntary loans from member states. That seems to be the best option," Tusk said.

A Spanish source told Reuters that details of the aid would be worked out at the latest by Tuesday, when EU finance ministers are due to hold a meeting.

"The general idea is to have broad European assistance with a tighter focus of assistance by euro zone countries," the source said, requesting anonymity. The European Commission would have a supervisory role over the aid deal.

European leaders are keen to prevent Greece's woes from spreading to other highly-indebted euro-zone members like Portugal or Spain, plunging the currency area into a bigger crisis that could reverberate around the globe.

Europe lays plans for how to bail out Greece

France, Germany and other European countries have begun discussing privately how they can come to the aid of fellow euro-zone member Greece, as doubts intensify over the country’s ability to get its budget under control.

Despite public attempts to discourage such expectations, discussions are under way, although the shape or scale of a possible bailout package has yet to be determined, according to officials in several capitals, all speaking on condition of anonymity.

“Greece failing is not an option and lots of people think that we will have to intervene at some stage,” said a euro-zone finance official, who was not permitted to speak publicly because of the sensitivity of the matter. “It doesn’t have to happen, and we hope it won’t, but it would be better than seeing a default.”

As a condition of any aid package, the Greek government led by Prime Minister George Papandreou, a Socialist, would be asked to provide a more detailed program to bring the country’s deficit of 12.7 percent of gross domestic product under control. European Union rules call for a maximum of 3 percent of G.D.P. Officials insist that any bailout must not put into doubt the credibility of the euro itself.

Greece’s budget crisis poses a big new test for the common currency and has even led to speculation that the country might be forced out of the euro zone, a suggestion that has been dismissed in Athens and other capitals.

The latest moves reflect a continuing skepticism among euro-zone members over the practicality of the plans put forward so far by the Greek government. It wants to reduce the deficit to 3 percent of G.D.P. by 2012, an objective described as unrealistic by one European diplomat, speaking on condition of anonymity. These plans are to be assessed by the European Commission early next month. A commission spokeswoman, Amelia Torres, declined Thursday to comment.

Greece’s deficit is four times the E.U.’s limit, while the country’s debt amounts to 113 percent of G.D.P. But officials insist that, because Greece is not one of the euro-zone’s larger economies, the problems created by its dire public finances can be absorbed.

Europe to create fiscal coordination body

THE European Commission will seek fundamental reform of the management of economic policy in the eurozone, including the co-ordination of fiscal policy, as it draws up details of a future European Monetary Fund.

The proposed EMF, which was given further support overnight by Angela Merkel, will go beyond the creation of a pot of money that would bail out errant members of the eurozone, such as Greece, a Commission spokesman said.

The talks in Brussels over the launch of such a fund will form part of a wider package of reforms that would enable Brussels to co-ordinate economic and fiscal policy among eurozone states.

The Commission will deliver a proposal "over the next two to three months," the spokesman said. The Commision wants what it calls preventive as well as corrective measures to pre-empt the disastrous accumulation of public debt by a eurozone member state, as well as to build an institution that might co-ordinate remedial action, such as a bailout.

The notion of an EMF that might have a similar role in the eurozone to the International Monetary Fund on the world stage in dealing with potential sovereign default was floated by Wolfgang Schauble, the German Finance Minister, over the weekend.

It has now gained the support of the German Chancellor.

However, the Commission is looking at even wider issues. Its spokesman confirmed that the EMF proposal was at a preliminary stage and added: "What we want to discuss is how to enforce the co-ordination of economies, how to co-ordinate the fiscal side."

Does the UK pose "Greek like" risk?

How far is Britain from Greece? That's the question lurking behind British headlines in recent days. And the answer isn't 1,400 miles. We're talking finance here, not geography.

Watching the scenes in Athens, people understandably want to know whether there's any chance of the same happening here.

You'll be relieved to hear the answer: however bad things might be here, we really are a long way from being Greece.

Here's what we have in common with Greece: our budget deficit is more than 12% of GDP; our national savings rate is too low; and we've both recently won the chance to host the Olympics.

You may laugh, but for Greece, the cost of hosting the Olympics played a non-negligible part in putting it where it is today. Hopefully it won't play a big role in our financial future.

The low rate of national savings tells you that Britain - like Greece, and Portugal, and Spain, and Ireland - has a current-account deficit. We're a net borrower from the rest of the world, which means, at the margin, we're dependent on the rest of the world to fund a good portion of our government debt.

But if I tell you the magnitudes involved, I promise you'll feel better. Last year, Greece ran a current account deficit of more than 11% of GDP - the highest in the entire OECD. Portugal's was not much better: nearly 10%. Spain's was 5.3% of GDP. Compared to that lot, the UK's roughly 2.5% of GDP current-account gap looks rather small beer. And Ireland's was similar.

What's important about these figures is that the Club Med countries - I'm trying to avoid the word "Piigs" - went into this crisis with even deeper macroeconomic imbalances than we did. That ought to make our path out easier as well.

But of course, there's still our whopping budget deficit. That's not so different from Greece. It's also why we have been somewhat affected by the squalls on the Continent in the past few weeks: the spread on UK sovereign default swaps has been rising for all the "high-borrower" countries recently, even those which, like the UK, have relatively low stocks of debt.

Senate raises US debt limit to record $14.3T

Senate Democrats passed a $1.9 trillion increase in the federal debt limit Thursday, seeking to push off another politically painful debt vote until after the midterm elections.

All 60 Democrats and no Republicans voted for the debt limit increase. The measure, which the House has yet to vote on, would put the debt ceiling at roughly $14.3 trillion.

Sen. Paul Kirk (D-Mass.) voted for the debt increase. Sen.-elect Scott Brown (R-Mass.), his replacement, has not been seated.

Democrats said the move is necessary because the debt is approaching its current ceiling of $12.4 trillion. If the debt breaches the limit, the government would lose its borrowing authority and risk default.

"We have gone to the restaurant, we have eaten the meal; now the only question is whether we pay the check," said Sen. Max Baucus (D-Mont.) in urging his colleagues to increase the limit.


"Serious fin management problems at the US DOD"

For the third consecutive year, GAO rendered an unqualified opinion on the Statement of Social Insurance (SOSI). Given the importance of social insurance programs like Medicare and Social Security to the federal government’s long-term fiscal outlook, the SOSI is critical to understanding the federal government’s financial condition and fiscal sustainability. Three major impediments continued to prevent GAO from rendering an opinion on the federal government's consolidated financial statements other than the SOSI:

  1. serious financial management problems at the Department of Defense,
  2. federal entities’ inability to adequately account for and reconcile intragovernmental activity and balances, and
  3. an ineffective process for preparing the consolidated financial statements.

In addition to the material weaknesses underlying these major impediments, GAO noted material weaknesses involving improper payments estimated to be at least $98 billion for fiscal year 2009, information security, and tax collection activities.

The recession and the federal government’s unprecedented actions intended to stabilize the financial markets and to promote economic recovery have significantly affected the federal government’s financial condition. The resulting substantial investments and increases in liabilities, net operating cost, the unified budget deficit, and debt held by the public are reported in the U.S. government’s consolidated financial statements for fiscal year 2009.

The ultimate cost of these actions and their impact on the federal government’s financial condition will not be known for some time in part because the valuation of these assets and liabilities is based on assumptions and estimates that are inherently uncertain. Looking ahead, the federal government will need to determine the most expeditious manner in which to bring closure to its financial stabilization initiatives while optimizing its investment returns.

In addition, problems in the nation’s financial sector have exposed serious weaknesses in the current U.S. financial regulatory system. If those weaknesses are not adequately addressed, we could see similar or even worse crises in the future. Consequently, meaningful financial regulatory reform is of utmost concern.

The federal government faces a long-term fiscal challenge resulting from large and growing structural deficits that are driven on the spending side primarily by rising health care costs and known demographic trends. GAO prepares long-term fiscal simulations that include projections of revenue and expenditures for all federal programs. As a result, these simulations present a comprehensive analysis of the sustainability of the federal government’s long-term fiscal outlook.

Many of the pressures highlighted in GAO’s simulations, including health care cost growth and the aging population, have already begun to affect the federal budget—in some cases sooner than previously estimated—and the pressures only grow in the coming decade. For example, Social Security cash surpluses have previously served to reduce the unified budget deficit; however, the Congressional Budget Office recently estimated that due to current economic conditions the program will run small temporary cash deficits for the next 4 years and then, similar to the Trustees’ estimates, run persistent cash deficits beginning in 2016. The fluctuation and eventual disappearance of the Social Security cash surplus will put additional pressure on the rest of the federal budget.

As shown in the figure, absent a change in policy, federal debt held by the public as a share of gross domestic product (GDP) could exceed the historical high reached in the aftermath of World War II by 2020—10 years sooner than GAO’s simulation showed just 2 years ago.

Although the economy is still fragile, there is wide agreement on the need to begin to change the long-term fiscal path as soon as possible without slowing the recovery because the magnitude of the changes required grows with time. Consequently, the administration and Congress will need to apply the same level of intensity to the nation’s long-term fiscal challenge as they have to the recent economic and financial market issues.

Congress recently enacted a return to statutory PAYGO and, in February, the President established a commission to identify policies to change the fiscal path and stabilize the debt-to-GDP ratio. In addition, comprehensive long-term fiscal projections will be required in the federal government’s financial statements beginning in fiscal year 2010, under a new accounting standard.

Russia approached China to sell off GSE debt

This is how the cold war will look like in the post-Lehman era (when all the debt risk is held on the public balance sheet): one country urging another to sell a third's bonds. According to Hank Paulson's soon to be released memoir, Russia had urged China to sell its GSE holdings in August 2008 "in a bid to force a bailout of the largest U.S. mortgage-finance companies." China refused... That time. Of course, what has transpired since is that China, through the Fed custodial account, has rotated a vast majority of its GSE holdings into Treasuries, in essence doing just what Pimco's Bill Gross has been doing since the beginning of 2009: offloading hundreds of billions of Fannie and Freddie bonds straight to the Federal Reserve. Alas, the Fed is 93% done with MBS QE... What happens when residual selling of bonds finally hits the public market, and the bottom falls out?

Bloomberg reports:

The Russians made a “top-level approach” to the Chinese “that together they might sell big chunks of their GSE holdings to force the U.S. to use its emergency authorities to prop up these companies,” Paulson said, referring to the acronym for government sponsored entities. The Chinese declined, he said.

Paulson learned of the “disruptive scheme” while attending the Beijing Summer Olympics, according to his new memoir, “On The Brink.”

“The report was deeply troubling -- heavy selling could create a sudden loss of confidence in the GSEs and shake the capital markets,” Paulson wrote. “I waited till I was back home and in a secure environment to inform the president.”

Sovereign ratings, collateral, haircuts and the ECB

"...The global financial crisis that intensified after the collapse of Lehman Brothers in September 2008 changed all that. Spreads widened as financial markets fretted about the possibility of governments defaulting. As finance ministries struggled to present credible plans for reducing public sector deficits, ratings agencies gained enormous influence.

If the ECB sticks to plans to revert to an A-minus minimum requirement at the end of this year, and Moody’s follows others in issuing a further downgrade, Greek assets could become ineligible for use. That is because Moody’s is the only agency still giving Greece the required single A rating.

”We have never advocated regulatory use of independent credit ratings by any authority, as it risks encouraging excessive dependency on ratings, often for purposes they are not intended for,” says a Standard & Poor’s spokesman. “If authorities are to continue using ratings, they should use other measures or benchmarks as well.”

But as Ewald Nowotny, Austria’s central bank governor, noted in exasperation this month: “The fate of Greece and, if you are going to be more dramatic, the fate of Europe, depends on the judgement of one rating agency. That is an unacceptable situation.”

The option of the ECB issuing its own ratings appears unrealistic – not least because its judgements would bring it into conflict with governments that were downgraded publicly.

An alternative put forward last week by Axel Weber, Germany’s Bundesbank president and possible future head of the ECB, would be a “sliding scale” system for treating government bonds.

”You could take higher haircuts for lower ratings, we could have a more continuous collateral framework. I think that’s something that needs to be discussed,” Mr Weber suggested.

Discussions are at an early stage. A sliding scale approach need not necessarily distinguish between all countries, but could penalise obvious fiscal sinners; after all, the ECB has said it will impose a “haircut add-on” if a government’s bonds fall to the current BBB- lower limit.

The risk would be that such a move forced up Greek bond yields, exacerbating Athens’ deficit problems, as banks and investors might demand a higher premium to buy bonds that require bigger haircuts to exchange as collateral.

Another drawback of a “sliding scale” would be the risk of the ECB’s decisions becoming politicised if governments felt they were being treated unfairly or the solidarity that binds the eurozone were threatened.

“It would suggest eurozone government bonds are not equal,” said Gary Jenkins, head of fixed income research at Evolution. “This could lead to resentment among those countries that have to pay more in haircuts for their bonds.”

It would also have negative consequences for banks in the stronger countries. French and German banks, for example, hold more Greek bonds than those of other eurozone members.

But those following the discussions suggest the rules could be made clear in advance – allowing the ECB to act impartially while improving the functioning of the eurozone..."

US could lose AAA rating in next five years

"The triple A rating of the US is at risk, S&P has warned, unless the country adopts a credible medium-term plan to rein in fiscal spending.

In a report published yesterday, the ratings agency said that there were risks that "external creditors could reduce their US dollar holdings, especially if they conclude that eurozone members are adopting stronger macroeconomic policies".

This could undermine the dollar's status as the global reserve currency, it said, an outcome which would "weigh on the triple A rating on the US."

"In our opinion, fiscal outturns, inflation figures, trade volumes, foreign exchange volatility and the current account will be the leading indicators if the dollar's role were to diminish," S&P said.

But the ratings agency said that the US could lose its reserve currency status and still hold on to its triple A rating. It added that the loss of a currency reserve status has historically been a gradual process, taking place over decades in the case of UK, for example..."


UK could lose AAA rating in next four years

The majority of respondents to a Risk.net poll believe the UK will lose its triple-A credit rating at some point in the next four years. Of those, 30% think the UK will be downgraded this year; 20% believe its rating will be cut in 2011, while a further 8% say it will lose its triple-A status in 2012 or 2013. 40% of respondents believe the sovereign's rating is not at risk of downgrade. Advertisement

All three internationally recognised credit rating agencies – Fitch, Moody’s and Standard & Poor’s – confirmed the UK’s triple-A ratings at the end of 2009, even though the country's fiscal deficit is estimated to reach £178 billion (12.6% of GDP) at the end of the 2009/10 fiscal year in March.

Concern over the country’s finances is reflected in its credit default swap price. On December 21, the cost of five-year credit protection on the UK sovereign hit 87.495 basis points. It was trading at 75.22bp on January 26, but to put that into context, its perceived risk of default based on CDS prices is currently higher than 17 European banks.

“It is not trading like a triple-A rated credit,” says David Byrne, head of the fixed income portfolio at Swiss asset manager Swisscanto. “The market has already priced in a downgrade.”

One of the key justifications used by rating agencies to confirm the UK’s triple-A status was the expectation the government will tighten fiscal and monetary policy sharply after the next general election, regardless of which party wins.

However, investors are not convinced the UK can easily do an about-turn on policy with the economic recovery still fragile.

According to figures released by the Office for National Statistics on January 26, UK GDP rose 0.1% in the fourth quarter, well below estimates.

Failing to lower the deficit could have implications on investor appetite for UK government bonds. In an exclusive interview with Credit, Pimco’s chief investment officer Bill Gross said the UK was “stretching the limits” with its quantitative easing programme. As a result, the Newport Beach, California-based investment firm is likely to shift its allocations to sovereigns with smaller deficits, such as Germany.

“The prize of investor funds ultimately goes to the most conservative and fiscal countries,” Gross said.

Stiglitz on "common economic support"

"GREECE has been condemned by European officialdom for its huge deficits. No government or state can expect from us any special treatment, was the warning from Jean-Claude Trichet, president of the European Central Bank. But Trichet failed to note that there had long been a double standard - in effect two Maastricht treaties - one for the large and powerful countries, another for the rest. When France broke the European Union edict not to let debt exceed 3 per cent of gross domestic product, there were strong words, but little else.

Of course, Trichet may claim there is a difference between what Greece and the many other countries that have broken the limits have done. There is a difference of size. But there is also a difference in culpability and consequences. Greece's large deficit has implications for the future of the citizens of Greece, but not for the stability of the euro - unlike a similarly large deficit in one of the larger countries.

A large part of Greece's deficit is the result of the global recession. Its impact was felt acutely by many countries who were not responsible for causing it. However, the crisis did reveal the deep-rooted structural problems of the Greek economy, which had deteriorated further during the past six years under the previous government. Unfortunately, European leaders have compounded Greece's problems. Their statements have sent the interest rates it has to pay soaring, making it all the more difficult for Greece to tame its deficits.

They should have welcomed the efforts of Greece's new government. At least it has come clean about the dishonest accounting of its predecessors. Like America's banks, it could have tried to keep up with a system of dishonest accounting, hoping that it would not be caught out. But Greece's new Prime Minister, George Papandreou, has always stood for honest and transparent government. Europe should be coming to the assistance of this kind of leader, not making his life more difficult.

Greece is among the poorest of the European family. Part of the basis of the success of the European project is a sense of social solidarity, which entails coming to the assistance of those less fortunate.

When the euro was created, many economists worried about the lack of stability-solidarity funds. If Europe had developed a better solidarity and stabilisation framework, then the deficits in the periphery of Europe might have been smaller and they would have been more able to manage them.

Economic downturns often affect those in the periphery much worse - they are the victims of their neighbours' failures. It is common wisdom that when the US sneezes, Mexico catches a cold. But this aphorism has mutated: Mexico now catches pneumonia.

The success of America's single market partly lies in a sense of social cohesion and a large federal budget to support it: when one part of the country has difficulties, federal spending can be diverted to help.

While Europe may not yet have a budgetary framework that can fully deal with weaknesses in one part or the other of the EU, it should at least adopt the principle of do no harm. For the ECB to announce that it will not accept Greek bonds as collateral would be counterproductive. For the ECB to delegate judgments about the credit worthiness of Greek bonds to the ratings agencies would be more than just irresponsible; it would be reprehensible. Delegation of effective regulatory responsibility to the ratings agencies is partly what got the world into the present mess; and the ratings agencies' judgments have proven to be deeply flawed.

With Europe's economy still weak, an excessively rapid tightening of its budget deficit would risk throwing Greece into a deep recession. Europe should reframe the targets it sets for Greece to what the deficit would have been had the country been able to achieve full employment.

The EU could and should show support for the honesty and integrity of Greece's Government and its efforts to bring the budget under control, to increase transparency of the entire budgetary framework and to reduce corruption. The EU can go further: institutions like the European Investment Bank should undertake counter-cyclical investments in the country to offset the deflationary impacts of the budget cuts. The provision of such support might lower interest rates and make it easier for the country to reach budgetary balance. The EU, the euro, and the premise of European solidarity are being tested again. The measure of Europe will not be in the harshness of its actions, but in the spirit of solidarity that it shows in assisting its neighbour.

America too has unprecedented deficits. Like Barack Obama, Papandreou inherited an economic situation that was not of his making. Both of their predecessors had made mistakes of colossal proportions. Both of their predecessors had engaged in dishonest bookkeeping - but George Bush's pale in comparison with that of Papandreou's predecessor.

For the sake of European solidarity and democracy, Europe should support Papandreou's efforts in every way it can, not turn its back on the people of Greece who must be convinced that supporting the Government's austerity measures is in everyone's best interest.

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