Ways of Treading Water I: Eupdate Portugal

Every so often, I want to blog about something other than the EU debt/banking/ fiscal/political crisis, but the continuing loopiness leaves me little choice but to launch a series:  Welcome to Eupdate.

Two things have happened in the Eurozone since my last pre-Eupdate update:  Portugal has asked for and negotiated a rescue package, and Greek restructuring rumors have gotten out of control.  Both nicely fit into the dominant theme of treading water, but present interesting variations on the theme.  I elaborate on Portugal below; I address Greece in a separate post.

Portugal asked for help when its banks staged a buyer's strike at a government debt auction on April 6.  The timing was awkward, since the government in power has no capacity to make policy commitments pending an election it is likely to lose on June 5.  The day the news broke, headlines blamed greedy banks.  I poked around to see what they had been doing for the past year or so--turns out they were busy loading up on government debt, so much so that the banking system's holdings of said debt doubled since the start of the crisis.  Treading Water 1.

But wait--why the leveling-off in 2010?  A little amateur trawling of the Portuguese central bank website reveals that the leveling-off coincides roughly with the European Central Bank's securities market program.  Treading Water 2.  Sure enough, the day after-the day after, the banks blamed the ECB for refusing to take Portuguese government debt off their hands.

Euroworried, Eurohappy, Euroflummoxed

Europe has fixed its debt and bank problems --  again.  Last week's EU summit produced a term sheet charting the path to a permanent, treaty-based crisis resolution regime, the European Stability Mechanism (term sheet embedded here starting p. 21).  You may recall it all started with revelations about Greece's government debt crisis in late 2009, and proceeded to reverberate around the Euro-periphery, with banking and government debt troubles bubbling up in Ireland, Portugal, Spain ... Italy ... Belgium ...   About a year ago, after much dithering, a one-off program for Greece, and a couple of false starts, Europe came up with an arrangement to finance countries in trouble, effective 2010-2013.  Soon thereafter, the European Financial Stabilization Mechanism and the European Financial Stability Facility deployed in Ireland, in conjunction with the IMF.   This is a fine overview.  Last week's deal establishes a standing successor to this model.   The term sheet is a fascinating study in EU governance (note the respective roles of the member states, the Commission, and the European Central Bank) and potentially an important step on the path to a fiscal union.  I will limit my comments to the legal and legal-sounding tidbits.

Macroprudentially Yours: A Literature Review

"Macroprudential" (policy, outlook, regulation, zeitgeist ... whatever ...) has been so in  of late, it threatens to beat out its cousin "Systemic" for the Random Overuse Award of the Century.  Worse, it is even trite to say that no one knows what Macroprudential is, or how to do things Macroprudentially:  macroprudentialists are totally hip to this line and have their talking points lined up ...  but in the end, you are still left wondering, if a little more sheepishly.  Nonetheless, I am convinced that the quest for macroprudential meaning is essential to design and implement viable financial reform.  There seems to be no better language to talk about interconnectedness, transmission, contagion, spillovers, and all the other scary crisis business at once.  This is why I was thrilled to stumble on this literature review from the ever-helpful folks at BIS.

Program Reminder: AALS Section on Financial Institutions and Consumer Financial Services

The section program at the Annual Meeting of the Association of American Law Schools in San Francisco on January 7 is a veritable Credit Slips reunion show.  The theme is post-crisis regulation of finance.  The Call for Papers panel at 4 pm features papers by William Birdthistle, Jim Hawkins, Adam Levitin, Alan White and Sarah Woo.  The 7 am breakfast is a policy roundtable representing a range of interdisciplinary perspectives, including Cristie Ford, Bill Kovacic, Brett McDonnell and Annelise Riles, with Heidi Schooner moderating.  Both meetings are at the Parc 55 hotel in Union Square.  Registration informaiton is here; program details are here.

Collective Action Clauses: Das Opium des Volkes

My Soviet roots manifest most acutely around New Year’s (a big holiday in the motherland), which must account for the urge to quote Marx apropos the European financial crisis.  Europe is the lead story of the 2010 Crisis Yearbook.  It holds the promise of radical legal innovation in financial crisis management:  it may yet become the birthplace of the first-ever sovereign bankruptcy regime, and the first-ever initiative to standardize sovereign bond contracts issued under the domestic laws of different states.  But for now, Europe is mired in CACology. 

Basel III and Cushy Capital

The Annual Meetings of the IMF and the World Bank this past weekend were mostly notable for the depth and breadth of political discord underlying the veneer of recent technocratic accomplishment in financial regulation.  So many things can go truly wrong in the next few months, from currency wars to institutional governance, that I was only glad to look on the bright side as I listened to Mario Draghi of the Bank of Italy, chair of the Financial Stability Board, give a thoughtful speech at the Peterson Institute on Friday (I expect they will post a video shortly).  Among the regulatory accomplishmens, he reasonably highlighted the recently agreed revision to the Basel Capital Accords, or Basel III.  For a description, I prefer the speeches here and here to the official press release.  The widely recognized achievement is tightening the consensus definition of bank capital, and building up (over a looooong time) additional cushions to absorb liquidity shocks. 

Measures of TARP

The curtain drew on TARP to a flood of assessments, from Treasury's up to TARP COP's down, with the commentariat all along the spectrum in between, converging around about the "necessary-evil-begets-moral-hazard" meme.  But this New York Times graphic and the surrounding talk of taxpayer repayment left me wondering.  To be sure, it is always better to make money than to lose money.  And I suppose if a government program were an abject policy failure but made a killing for the Treasury, it would not feel quite as bad as a failure that cost an arm and a leg.  The Clinton Administration's package for Mexico in 1995 is often described as a success in key part because it was repaid in a year, and made a profit for the Treasury -- so much so that Paul O'Neil, George W. Bush's first Treasury Secretary, famously endorsed his Democratic predecessors' controversial bailout.  All this makes sense if the fiscal rescue works like the central bank's lender of last resort function, meant to overcome illiquidity with safe short-term loans at penalty rates.  As Steve Davidoff points out, TARP's overriding goal was rapid stabilization, in which case the big difference between TARP's containment strategy and the preceding Fed facilities is some mix of extreme fear and political exhaustion.  I suspect that this view of  what makes TARP successful lends itself to certain methods-- big loans to banks over little subsidies to households, which would take a long time to wind their way back to the Treasury.  Should "bailouts" make more of an effort to distribute and stimulate, even if it means more risk of near-term loss?  I wonder.  Would any political body ever do it?  I doubt it.  Bye, TARP.

Time Flies

To keep this debt thing in perspective ... Germany is about to pay the last of the debt it took on to finance World War I reparations.  This debt is mostly interest payments to private bondholders.  The reparations came out of the Treaty of Versailles in 1919, but Germany had no money, so it issued bonds in the private capital markets in the 1920s to fund its payments to the Allies.  The bonds defaulted in the 1930s (first crash, then Hitler, then it got really messy), but resumed principal payments under a 1953 agreement.  Interest payments were deferred until reunification, and resumed once the Berlin Wall fell, with the last one due this weekend.  Der Spiegel story here.  How poignant yet deeply screwed up all around. 

Sovereign Bankruptcy Nostalgia, August Edition

Preventing a Greek default in August might just be the one thing that rates higher on the EU policy agenda than preventing a Greek default--or so I am told by a source familiar with the policy significance of August in Europe.  Yet August is a popular month for sovereign debt crises (Mexico, Russia, Argentina), which makes it an excellent time to contemplate institutional changes that might make the inevitable sovereign defaults less painful for the debtor, the creditors, and the bystanders.  Earlier this week, the FT obliged with a wistful retrospective on the odd combination of gunboat diplomacy (c. 1820-1956) and the International Monetary Fund's technocratic attempt at a sovereign bankruptcy regime (2001-2003).  Recent German proposals for European sovereign bankruptcy piggyback on the IMF effort, but are even more firmly rooted in the conviction that just the right rule could bind policy makers facing financial cataclysm to act prudently and predictably.  I find such rule nostalgia puzzling in the wake of the disgraced no-bailout clause in the EU treaties--the ultimate in bright-line commitments--and its relations the world over.  However, the revived conversation is valuable.

Call for Papers Extended to Invite Reactions to Dodd-Frank

I am honored to join Credit Slips, and grateful to Bob for the warm welcome. As process is always a sensible place to start, this first "occasional" post is to invite submissions for the January Association of American Law Schools (AALS) conference in San Francisco. The Financial Institutions and Consumer Financial Services Section committee has voted to extend the deadline from August 1 to September 20 to be sure we capture the love, hate, and analysis pouring forth after last week's signing of Dodd-Frank. Of course the full call for papers (here) is much broader than Dodd-Frank--we want it all!  So please spread the word.

Debt and the People, Part II: The Hot ... and Concluding Disquietudes

This last post is about old news that I have been avoiding.  Even so, it would be malpractice to omit Ecuador from even this partial snapshot of the sovereign debt landscape circa 2010.  So on with its latest debt default, and all that it has dredged up. 

In a nutshell, Ecuador announced in late 2008 that it would stop servicing two of its foreign bonds; six moths later, it bought most of them back for cash at about 35 cents on the dollar, effecting substantial debt relief.  Three things about the episode bear emphasis.  First, Ecuador specifically refused to claim that its debt was unsustainable by IMF metrics conventionally used as a threshold for sovereign debt relief in the absence of a formal bankruptcy regime.  Second, on the eve of the default, a Presidentially-appointed audit commission deemed the debts irregular and illegitimate.  However, not all the debts condemned by the commission were then formally renounced by the government.  Third, instead of walking away from the debt, Ecuador ended up reverting to market mechanisms to buy it back at a discount.

De-Detour: CDS Nudity on the Exotic Fringe

A recent FT Editorial implicates a topic I -- basis risk in emerging markets (EM) credit derivatives.  The problem is this:  If you want to buy protection against default by a big U.S. firm--say, GM--you buy a CDS contract on a GM bond.  But even in the leading emerging markets, it is often difficult to buy protection on major corporate credits, especially if you want to hedge against default on local-currency or other non-dollar/euro/yen obligations.  This is because local financial markets are relatively thin.  Your choice then is to buy a liquid standardized instrument, such as a CDS on foreign-currency sovereign debt, or to negotiate an expensive bespoke contract with a party willing to take the precise local risk off your hands.  If you opt for the liquid standardized sovereign CDS, you get partial protection.  This means that if your borrower defaults but the government is still servicing its dollar-denominated foreign bond, you cannot collect.  Herein the basis risk.  Note that even if you were able to arrange bespoke protection, you could be taking on more counterparty risk, since the only people willing to insure illiquid local instruments might be local institutions more exposed to measures such as capital controls ... or risk-hungry fringe elements that might flake out on you.

How is any of this relevant to the current debate on regulating "naked" CDS, or credit protection not matched by exposure to the underlying credit (aka fire insurance on your neighbor's house)?  It goes to the difficulty of defining the subject.  A CDS that might appear naked at first blush could in fact be partially clothed; and instead of encouraging better hedging, we might end up eliminating what partial protection is available in less liquid markets (damage insurance on your block?).  Not to say that EM basis risk should even remotely drive the discussion, but the example does expose the challenge of figuring out not just the legal terms of the regulated instruments, but the often less-than-intuitive ways in which they are used.

Debt and the People, Part I: The Cold

In earlier posts, I considered two trends:  first, the eroding boundary between chronically defaulting sovereign and risk-free government debt; and second, the comfy symbiosis among feckless rules, fudged government accounts and basic financial engineering.  I also considered the politics of erosion and symbiosis.  In this post and the next, I move to a third trend, perhaps the most overtly political of the lot: the resurgence of popular input in national debt matters.  The latest exhibit in this trend is Iceland, whose money troubles gave Michael Lewis the opening to set Beverly Hillbillies in Lake Wobegon.  The immediate predicate for this post is last weekend's referendum, where over 93% of the voters rejected a plan for Iceland’s government to guarantee payments to the United Kingdom and the Netherlands, compensating them for compensating their nationals who lost money in Icelandic internet bank accounts.  Curious referendum factoids include that (a) the deal voted on had long been superseded, and (b) “yes” votes came in third after empty ballots.  But the back-story is serious, complicated and revealing.

Do Not Miss

William White has a rocking op-ed in the FT arguing that debt overhang, notably in the U.S. household sector, makes fiscal and monetary policy ineffective.  White is one of the early pre-pre-pre-crisis proponents of macroprudential regulation, and always worth tuning in for.  Amen and testify.  (I am biased, as have been sympathetic to across-the board debt reduction in crisis.)

Gary Gensler uses the Greek controversy (and AIG) to argue the CFTC regulation brief, notably clearing houses.  He is a smart and complicated guy, and his argument is more nuanced than the demonization din.  He says that Greece might not have done the "Euroliar loan" swaps had the proposed reforms been in effect, because it would have had to post collateral, which would have made the transactions either useless or prohibitively expensive.  I leave the unpacking to the experts, but I suspect that it depends on some key factors in both the law and the swaps.  Nevertheless, a more productive framing for the conversation.

It's All Greek to Me FAQ, Part II: Euroliar Loans

While they hold some allure for the pointy-headed company I normally keep, the old fixing-floating-IMF-bailout handwringing detailed in my last post is nothing to the titillation of the Goldman-CDS angle on the Greek drama.  FAQ series continues with a focus on lying.

Who lied, to whom, about what?

It's All Greek to Me FAQ, Part I: Power of Commitment

This follows on Stephen's post earlier in an effort to help sort through the Greece-Goldman-Germany love triangle and the deafening din surrounding its implosion.  This post sets out the background for the Greek crisis, mulls law as a macro commitment device, and the relative merits of EU and IMF bailouts.  The next one goes into more depth on Goldman and derivatives.

Why is everyone talking about Greece?

It’s the Olympics! (Did You See the Inflatable Beavers?)  And because Greece needs to come up with Euro 20 billion (about $27 billion) by April-May to roll over maturing debt.  Greece is having trouble borrowing the money because its debt stock is pushing levels that help poor developing countries qualify for official debt relief, with little prospect of going down.  As a result, Greece may have to pay a 4% premium over Germany, if it can borrow at all.

So what?  What happens if Greece defaults?

De-Detour: FCIC Economists' Forum

I spent most of Friday at the Financial Crisis Inquiry Commission forum, which we are hosting at the American University Washington College of Law.  I am going back on Saturday morning.  The forum is open to the public, the papers are posted, and the proceedings are webcast live.  At a minimum, this is a pretty high-end conference, featuring some of the top names in the crisology business:  Brunnermeier, Geanakoplos, Gorton, Gourinchas, Jaffee, Kashyap, Kroszner, Lusardi and Mayer.  The presentations are quite accessible, reflecting the FCIC’s public inquiry mission. If it is any indication, a goodly number of my students came, stayed awhile, and seemed to leave happy.  Even where the underlying material is not new, I have found the exchanges among the panelists and the commissioners well worth tuning in for. A rare mix of economics and civics.

Why Sovereign Is the New Black

I am grateful to Adam and the Credit Slips team for indulging this detour.  After years on the exotic fringe of the legal academy sustained by the entrepreneurial spirit of Mitu Gulati, sovereign debt has blown right past the sleepy mainstream into the screaming headines.  Before launching into the substance of today’s crises and controversies, it is worth pausing to ask why.

First, the new celebrity sovereign debt is qualitatively different from the old fringy sort.  Old sovereign debt was about poor and middle income countries.  It surged with petrodollar lending in the 1970s, imploded in 1982, and re-surged in the mid-1990s, when it became Emerging Markets (EM) sovereign debt.  Much theory and jurisprudence ensued, which keyed off the problem of sovereign default:  the debt was apparently unenforceable despite restrictive immunity, yet this did not seem to dissuade lenders from lending and borrowers from paying most of the time.  Law scholars used sovereign debt as a natural experiment in theories about corporate contracts and bankruptcy.  The theory and practice of this “sovereign debt” were worlds apart from “government debt.” The former had an aggregate outstanding stock of a few hundred billion dollars spread among a few dozen countries (J.P. Morgan's EMBI, give or take) and was all about currency mismatch, default and recovery values.  The latter was in the way trillions, risk-free and “information-insensitive.”  You could buy default protection on the former; it made no sense to write protection on the latter.

The latest crisis in the Euro area has helped collapse the distinction between little “them” and big “us”; now everyone is groping along a discomfiting continuum muttering about market confidence.  Emerging Markets analysts are manning mainstream desks, I read about Greece in EM dailies, erstwhile über-skeptic and real-law person Kim Krawiec blogs about it at Faculty Lounge, and the whole thing feels totally self-justified without being useful to corporate theory.

Financial Summitry

The G-20 Summit to Save the World and Reinvent Finance produced a surprisingly meaty declaration and action plan.  At least one specific mention of bankruptcy: 

* National and regional authorities should review resolution regimes and bankruptcy laws in light of recent experience to ensure that they permit an orderly wind-down of large complex cross-border financial institutions. *

In general, the most interesting parts deal with regulatory reform.   

Contracts in Crisis: Variations in Z and S

Luigi Zingales of Chicago GSB put out a mortgage modification proposal about a month ago that got a bit of attention, but deserves more even if it has no political prayer.  It is one of a genre -- advocating across-the-board contract change in response to a macro shock -- that has at least two other prominent exponents, Randall Kroszner and Joseph Stiglitz.  I am noodling this literature for a U. Conn. symposium paper.

Zingales proposes legislation to allow homeowners to reduce the loan principal in line with the drop in home prices in their zip code from the time of purchase (as measured by Case-Shiller).  Creditors would get an equity kicker TBD.

T.A.R.P. R.I.P.: Illiquency Watch

TARP's third incarnation as a consumer lending catalyst goes straight to my pet crisis peeve.  I am endlessly flummoxed at the authorities' insistence on throwing liquidity at a solvency problem -- with TARP I, AIG, and now, the consumers.

I have ranted elsewhere about the perils of drawing a sharp line between illiquidity and insolvency in a financial and macroeconomic crisis.  While the bankruptcy world has moved beyond the distinction in important ways, it still dominates the crisis policy response.

International Financial Architecture: Dumb Chills and Opportunities

I am grateful to Adam, Bob and Credit Slips for scheduling this guest stint on the eve of what is billed as the Grand Global Rethink of All Things Finance. This Saturday, November 15, the leaders of the Group of Twenty rich and developing economies will meet in Washington to talk about crisis and reform. Regrettably, the organizers’ absurd pretensions to the legacy of Bretton Woods have diverted public attention away from the substance of what is surely an important international effort at coordinating economic, financial and regulatory policy.

Why should legal academics and debtor-creditor folk care?