Banks to pay for their mistake
Given the circumstances, the decision by European Union leaders last week to halve Greece?s marketable debt of 206 billion euros was a major step toward improving the dynamics of the country?s public debt but a major step backward for Greek banks and social security funds. However, the latter would not have paid such a high price if they had followed the lesson learnt by college students in Finance 101. Simply, do not put all your eggs in one basket.
It took just a few months for Greece?s budget deficit target and growth projections to take a turn for the worse, raising the country?s financing needs from 2011 through the second quarter of 2014.
Last July, the country?s estimated cumulative financing needs for the primary budget deficit and interest payments were put at 38 billion euros while the economy was supposed to grow by 0.6 percent in 2012 after shrinking by 3.9 percent in 2011. Since then, the budget deficit for this year and next has been revised upward and the economy is projected to return to growth in 2013 instead of 2012.
The implied fiscal slippage created additional cash needs of an estimated 7-10 billion euros over the same period. This combined with changes in long-term interest rates and the market?s perception that European Financial Stability Facility (EFSF) bonds were riskier than their AAA status implied to increase further the funds needed to keep Greece going through the second quarter of 2014.
Moreover, the target of raising 5 billion euros from privatizations through the end of 2011 was obviously unrealistic and had to be revised lower.
The implications for the sustainability of Greek public debt were dire and a larger restructuring had to take place to improve its dynamics and help avoid multiple debt sovereign restructurings for other EU countries down the road.
The decision of the eurozone summit to ask bondholders to accept cuts in the nominal value of their Greek government bonds to 103 billion euros from 206 billion before providing guarantees of 30 billion euros to private bondholders is a major step in the right direction, assuming the vast majority of private bondholders accept.
However, it still requires a major effort by Greece to turn its primary budget deficit of 10 billion euros in 2010 into a primary surplus of more than 8 billion euros for a long period of time to drive the public debt-to-GDP gradually lower to more sustainable levels. German Chancellor Angela Merkel has made reference to the 120 percent level by 2020.
Readers are reminded that Greece has not produced a general government primary budget surplus since 2002, when it stood at 0.7 percent of GDP. It recorded an average primary surplus of 3.9 percent of GDP over the 1995-2000 period under Prime Minister Costas Simitis. The primary balance does not take into account interest expenses on the public debt.
But the restructuring of the public debt, which puts Greece in the infamous list of countries which defaulted on their obligations, has adverse implications for local banks and social security funds.
Greek banks are supposed to hold government bonds with a nominal value of 45 billion euros and treasury bills worth a few billion euros more. It is clear that the 50 percent haircut on their bond holdings deals a major blow to their equity capital and they will have to replenish it by next June, probably leading to their full or partial nationalization.
This is not a pleasant development for their shareholders, who have already lost a great deal on the Athens bourse as evidenced by the depressed share prices, but it is something they should have predicted long time ago.
It is true that the public sector is responsible for leading Greece to bankruptcy and consequently the banks. However, no one told listed banks to hold the vast majority of their debt holdings in Greek government bonds and this is exactly the price they are going to pay for it.
As a matter of fact, following Greece?s entry into the eurozone and the absence of foreign exchange risk, local banks should have prudently diversified their debt holdings into the government bonds of other eurozone countries, using each country?s GDP as a weight in the 10-trillion-euro economy.
Even if there was a bias toward home bonds because they offered a yield pickup, this should not have exceeded Greece?s relative weight in the eurozone economy by far.
If banks had adopted this policy, namely portfolio diversification taught in course Finance 101 in US universities, they would have escaped the debt crisis with much smaller losses and would not have endangered the holdings of their investors. But they did not. They put the interests of others before the interests of their shareholders, who will now pay the price.
Some may argue they did so because they wanted to help the country refinance its needs during the crisis. However, Greek banks had a good deal of government bonds in their portfolios even before the crisis. So it is normal for anybody to think they were doing so because they thought it was the right thing to do to make money at a time when many foreign investors and banks were snapping up Greek bonds like hot cakes.
Greek pension funds also made the same mistake by entrusting the money of their stakeholders in Greek government bonds. In this case, however, pension funds were ?managing? bonds worth about 8 billion euros on their own with the rest, some 16 billion euros, entrusted with the Greek central bank.
Regardless of whether they are right in claiming they had not asked the Bank of Greece to put their money in government bonds, the lack of portfolio diversification is striking as well and they face losses of some 12 billion euros due to the haircut.
All in all, the cost of the sizable restructuring of Greek public debt to local banks and social security funds would have been much smaller and bearable if the latter had respected the principle of portfolio diversification in their fixed income investments. So, although they have every right to blame the bankrupt public sector for their misfortune, they also have to blame themselves for ignoring portfolio diversification in their bond investment decisions.
