What I Think is Going on With Greece

I want to offer a perspective on the Greek financial mess.

I am not confused about the Greek desire to get out from under their debt load - past governments have built up intolerable levels of debt which is costs a huge portion of Greek GDP to pay off.

At one time in my life I would have been confused by folks, often on the Left, who argue that the answer to Greek debt problems is ... deficit spending.  This might have seen inexplicable to me earlier in life as a wondered how the same behavior of fiscal irresponsibility that led them into debt would get them out.  But I have learned that there is no limit to the optimism Keynesians hold for the effects of government spending.  The last trillion of debt may have not done anything measurable but the next trillion is always going to be the one that turns us around.  Sort of like Cubs fans.

No, what confuses me today is the fact that other institutions and countries are still willing to buy Greek debt and even entertain some sort of debt swap where they end up with even more Greek debt.  I have heard it said by many experts that it is unrealistic to expect that lenders will get even a fraction of their principle back from these loans.  So why loan more?

The key for me in understanding this is the book "Engineering the Financial Crisis".  In that book, the authors presented the theory that the Basel capital accords, which set capital requirements for banks, had a lot to do with the last financial crisis.  Specifically, the rules allowed bank investments in two types of securities to be counted at 100% towards their capital levels.  Any other type of investment was severely discounted, so there were enormous incentives in the regulations to focus bank investments on these two types of securities.  What were they?  Sovereign debt and mortgages (and mortgage-backed securities).

In the authors' view, which I find persuasive, a lot of the last financial crisis was caused by these rules creating a huge artificial demand by banks for mortgage securities.  This created a sort of monoculture that was susceptible to small contagions spreading rapidly.  As this demand for mortgage backed securities inevitably drove down their returns, it also created a demand for higher-yielding, riskier mortgage investments that might still "count" as mortgage securities under the capital requirements.

Anyway, for the Greek crisis, we need to look at the other piece of these capital requirements that give 100% capital credit:  sovereign debt.  Now, I may have this wrong, but for Euro denominated credit, it all counts as 100% whether its German or Greek, which is a bit like saying a mortgage to Bill Gates and a mortgage to Clark Griswold's country cousins count the same, but those are the rules.

So here is the problem as I understand it:  Greek debt, because of its risk, paid higher returns than other sovereign debt but still counted the same against capital requirements.   So European banks loaded up on it.  Now that the debt is clearly bad, I am sure they would love to get paid for it.  But what they want even more is to continue to get credit for it on their balance sheets against capital requirements.  So what the banks need more than getting paid is for the debt to still exist and to (nominally) be current so that they can still count it on their balance sheets.  Otherwise, if the debt gets written off, that means banks need to run out and raise hundreds of billions in new capital to replace it.

Yes, I know this seems insane.  If everyone knows that the debt is virtually worthless, isn't it a sham to keep taking expensive steps (like issuing even more new debt) just to make sure the debt still appears on the books at 100%?  Yes, of course it is.  This is a problem with just about every system ever tried on bank capital requirements.  Such requirements make sense (even to this libertarian) in a world of deposit insurance and too big to fail, but they can and do create expensive unintended consequences.


  1. KPP:

    Ah, perfect timing! I've been teaching my kids economics and we just covered how government meddling in the financial systems has unintended and unexpected consequences. It's a complex system and each additional level of complexity can set the entire system up for a fall.

    This is a great example of how a little tinkering to meet government goals encourages behavior that is, on the face of it, insane. The banks get the blame, but they are, in many cases, just playing by the rules. I'm sure they had a say in how many of the rules were set up to benefit them, but we're a long way from the days when it was simple and straightforward.

    Doing this class with the kids has forced me to fill in some gaps in my economics understanding and it's been quite an eye-opener for them as well.

  2. Nehemiah:

    This makes perfect sense to me. Thanks for posting.

  3. ErikTheRed:

    Not to mention the fact that historically, whenever a country defaults there is often a long line of people ready and willing to lend it money five minutes later. Not necessarily because they expect a straightforward ROI, but because they have the leaders over a barrel and can directly purchase influence at a steeply discounted rate. Think Vladimir Putin and Ukraine, for example.

  4. LoneSnark:

    Surely there was, and especially now is, a better way. Perhaps the FDIC should do its job and actually research the institutions it is insuring? It is insane for the FDIC to allow banks to use Greek debt as 100% towards their capital requirements. I think the FDIC should hire a bunch of bureaucrats to study each and every possible asset and label it as AAA for 100% all the way down. Lending to Germany might be good...if the bonds are denominated in dollars.

    Solvency insurance kinda existed prior to the FDIC. I guarantee it didn't operate anything like the current FDIC/Federal Reserve rules. Yes, banks are going to influence the ratings and get things horribly wrong. But we need a system that doesn't sit there while bonds which just a little while ago took a haircut (partial default) continue to be counted the same as US Treasuries. If we are going to have the government run this stuff, then at least there should be someone somewhere that can be drug before congress and yelled at to stop something obviously stupid. As it is, however, I suspect strongly that to fix any one stupid investment strategy would take an act of congress.

  5. mlhouse:

    Do European banks need to mark to market these assets?

  6. August Hurtel:

    America is broke too. We are just lucky with that whole reserve currency thing. They want to keep the debt rolling because when the debt stops people have to face a re-evaluation and probably more war.

  7. Change Happens:

    Musical chairs is a fun game until the eight people let are fighters ng over the past chair.

    Then the crapola hits the air circulation machinery, really, really bad haircuts happen and a lot of people go from something to poverty overnight.

    Tick tock, tick tock. The can gets bigger and harder the further down the road it gets kicked.

  8. Matthew Slyfield:

    "Yes, I know this seems insane."

    I disagree. It's perfectly rational from the banks perspective. Because they have to replace the capital requirement, the cost to the bank of writing off the debt is much higher than just the value of the debt.

    The insanity it that the banking regulators couldn't see this coming.

  9. Titan 28:

    I understand what you say here, but you almost make it sound deterministic. A law gets passed, probably with the help of stooges on bank payrolls, at least at some remove, so banks get to pretend they have a full vault instead of an empty one, and voila, with the wonders of fractional reserve banking, they can all go leverage their banks to the hilt. Bankers win, ok. Financially. Long term? Their institutions have a self-inflicted cancer. Sooner or later, it will all come crashing down, and rightly so. Why I bring up determinism. These are not stupid people; they are avaricious, greedy people. They know what they are doing. They exercise free will. They don't have to do anything. They choose to ride the pony.
    The other side of all this is that as a working stiff, in effect, who pays taxes through the eyeballs, and can't rely on sweet interest from some financial flim-flam, I get very discouraged. Why should anyone work? We seem to have constructed a world where the worst among us get to the top. Maybe the Occupy folks are right at some level. Blow the whole damn thing up.
    Keynes. I'm not sure Keynes would have supported infinite deficit spending. These people, the banks and the fools in finance and government may see themselves as Keynesian. I suspect they are kidding themselves. I think Keynes was largely wrong (how's that multiplier working today?). But he wasn't stupid.

  10. Scott:

    Exactly. I've always wondered were regulators draw their "talent" from, and why they don't simply budget for a staff capable of forecasting rather predictable consequences. I figure they don't want to "see" anything coming, because its so much easier to simply throw people in jail after the crisis occurs.

  11. Scott:

    Yes, I believe so, because the market for these sovereign-backed securities is relatively active, as opposed to thinly traded synthetics, exotics etc., it would be extremely difficult for a financial institution to report the value of greek debt at artificially high to meet capital requirements

  12. Matthew Slyfield:

    What "talent"? The regulators are all "Civil Service" drones who can't be fired even for gross incompetence. The only requirement is a pulse and even that can be waved in certain circumstances.

  13. marque2:

    You can still google the article about the Los Angeles coherent worker who died at her desk and it wasn't discovered for several days. I believe coworkers thought she was sleeping.

  14. marque2:

    It is intetesting that sometimes after a personal bankruptcy, a person's credit rating can go up! This is because there is no longer any debt(not much anyway) and so debt to loan and income to loan ratios look great.

  15. Username99:

    The great majority of Greek debt is held by governments or their central banks now, the private bondholders took a haircut in 2012 and have been less than enthusiastic about buying Greek debt ever since. There are a number of reasons why Greece keeps getting propped up, the main one is the fear that letting Greece default would scare investors off off Italian, Spanish and Portuguese bonds, which would create huge problems.

  16. Canvasback:

    What jail? Kareem Serageldin is the only name I could find of someone who went to jail over the 2007-8 financial meltdown.

  17. CT_Yankee:

    Not really a air comparison. The Cubs actually made it work, perhaps only once, and some time ago, but somehow they achieved thier goals for a brief shining moment in time. Spending your nation out of debt? With a success rate of never once, in all recorded history, ever working for any nation, this is like betting against the tide comming in.

  18. markm:

    The trouble with FDIC, etc., is that they are underwritten by governments. The underwriters are bureaucrats who will never be responsible for losses. But if they were to set of standard of actually looking into a country's finances and discounting it's debt accordingly, their _own_ paychecks might be the victims of the next financial crisis, when their own government is unable to borrow to meet the payroll.

    As for mortgages, under certain circumstances they _are_ very nearly gold. If the borrower paid 20% down, the market wasn't in a huge bubble, the chances of the market value declining by 20% the first year are very slim. If in addition the borrower has a good credit rating and a stable income at a sufficient multiple of the payments, it's very likely that he'll keep making payments until the principal has been paid down below any possible market drop.

    But those rules made it difficult for "disadvantaged" people to get mortgages, including minorities who were formerly disadvantaged by their skin color, but who are now still disadvantaged by a cultural disdain for education, disdain for thinking ahead, and less rejection of criminal behavior. (Note that Asians were formerly just as badly disadvantaged as blacks; they have not become whiter, but now through hard work, education, and avoiding crime, they are so successful as to no longer count towards "diversity" quotas.) And so it became politically untenable for the bureaucrats at FDIC, the FHA, and Fannie and Freddie Mac to require such things for un-discounted mortgages. And the banks not only could count a whole mortgage portfolio at face value, but they could classify the mortgages according to risk, bundle up the riskiest slice, and sell that off - and the goobermint would still classify that as no-risk.

    Now, I think it is true that it wasn't mortgages on cheap homes sold with nothing down to people on the edge of poverty that sunk the housing markets and the mortgage investors. There just wasn't enough money in that slice of the market to bring the whole system down. But if the banks were required to make those obviously bad loans, they would compensate by earning more on less risky loans - like a nothing-down loan on a very expensive house, to someone with an imperfect credit record and a relatively high-paying job that was just barely enough to keep up the payments. If the borrower lost his job the day after signing the loan, the bank would be out the cost of foreclosure and of re-selling it, but the chances were very good that he'd keep on making the payments, (not always on time, but still you have to actually make the payment to get the tax deduction so they would not be too long delayed), and the principal would slowly drop until there was a decent buffer between the loan face value and the house resale value. Most likely, eventually he'd be promoted so his financial situation wasn't precarious, and then the bank would have a low-risk loan at high-risk interest rates - unless things went disastrously wrong, one of these loans would compensate for several bad loans in the slums.

    But every bank was issuing such loans, and far too many people were buying more house than they could afford on the theory that it was an investment as well as a tax deduction. That drove the price of houses up - and eventually when too many of those high-flyers were laid off at once, it would turn out that the $500,000 houses were really $200,000 houses in a bubble.

    But the banks who issued these mortgages were OK. They had adapted to ridiculous regulations by selling the risks, as the regulations allowed them to do, to quasi-government agencies, investment banks, etc., that needed the mortgage-based securities to meet their capital reserve requirements. Of course the reason these pieces of paper did that was that the government rated them as riskless without looking into the actual circumstances of each loan. When the bubble collapsed, taxpayers bailed out the banks, most of the bankers kept their jobs, and the bureaucrats who'd initiated the whole mess not only kept their jobs, but got to do some empire-building as the agencies expanded to enforce more regulations.

    As for the political pressure for banks to make loans to unqualified borrowers, it's still on!

  19. TruthisaPeskyThing:

    Your analysis is generally good. There is just one impression with which I would quibble. Yes, pressured by government regulations, banks made loans they should not have. (The Clinton administration initiated a dozen cabinet level moves to pressure banks into making these loans.) The FED's easy money policy and a belief -- back up by government declarations -- that real estate would not go down in value enabled these loans to be made. Moves in the early 2000s to rein in excesses of these policies were thwarted by charges of racism and bigotry -- remember, it was racist to believe that the real estate prices might not continue to rise. Yes, the government moved in with bail-out money that was "forced" upon banks whether banks wanted the funds or not. Here is my quibble: tax money was not used to bail out the banks. Banks were in a liquidity crisis -- not a real solvency crisis -- due to government mismanagement of the credit markets. The funds for "bail-outs" essentially came from China who charged less than 1% for the money. This money was used to buy preferred stock that banks were forced to sell to the government. This preferred stock paid a guarantee 6% dividend rate. With this spread of 5% plus fines and fees for retiring this preferred stock, the banks ended up giving the government a profit of about $70 billion. I hesitate to say that taxpayers bailed out the banks because tax money was not spent on the move.

  20. Lawrence Karch:

    Greece will just have to go back to drachma and the rest of the EU will just have to write off Greek debt. It was folly to think that Greeks could become like Germans.

  21. epobirs:

    Keynesians sound exactly like gambling addicts who insist they have a 'system' that just needs a little more refinement.

  22. TeleprompterOTUS:

    I think Greece determines whether it defaults or not and they are in the drivers seat right now. I agree that any way this goes it becomes a template for the other PIGS and France. If a white knight appears to buy all current greek debt - say the US fed and/or the EU central bank - and bail out the banks, it will have implicitly green lighted the purchase of the other PIGS debt. Ditto a write-down of the debt. This is the real concern and it will be interesting to see what type of derivative or other machination the banks will develop to lay this one off.

  23. Q46:

    Your analysis is correct. The entire problem with the euro is that the eurozone has a single monetary policy within a single market which has 26 different fiscal policies and business cycles and economies. This problem was known from the start which is why entrants to the euro were required to meet and adhere to 'strict' convergence criteria (among which budget deficit < 3% of GDP, National debt < 60% two stipulations insisted upon by Germany and France). Thus, supposedly, the euro Countries would all come together with harmonious economies.

    The problem was the majority of those lined up to join did not (and the ones now in trouble) but creative accounting fudged things otherwise the eurozone would have consisted of about four Countries.

    Then within six months both Germany and France failed to adhere to the 'strict' convergence criteria and have never met them since. Supposedly, errant States would face financial penalties for failing to stock to the criteria. After much deliberation, it was decided that fining Fran and Germany would only make things worse and was not in the best interest of the project... France and Germany run the EU, so no surprises there, but you can be sure if Greece had back then, or Ireland, failed the criteria they fining them would have been in the interest of the project.

    But once it is clear the rules can be broken without sanction, it then becomes impossible to impose discipline on others. Others took note.

    The notion was that the less disciplined euro zone members would 'learn' fiscal probity from Germany... like sending a nun into a whore house with the expectation the whores will become nuns.

    The point being missed, Cyote, is the euro is a political not an economic project, if it had been the latter it would never have been attempted because all the pitfalls and what we now observe were predicted, but swept aside because the political implications of a single currency, the advance of the European Project which requires increasing political integration to form a single superstate... the United States of Europe... were primary.

    In fact it was calculated and openly spoken about until mid-last year, that the euro crisis was a good thing, because it would force fiscal integration without which a single currency at no time in no place in history has been able to survive.

    That ship has sailed however as the European people have gone very cold about further political integration and want their Countries back.

    Where will it all read. Take a look at history. We are already cueing a second Crimean War and the EU is part-mobilising via NATO to 'defend' its putative eastern border with Russia.

    Summary: it is a political situation not an economic one, so you cannot rationalise it by applying the logic and reasoning of economics.

  24. Me too:

    But as long as you can kick the can into the next election cycle who cares. Not my problem.

  25. Harry:

    I am not sure the following will be of any help, Coyote, and it does not answer your broader question, but it is an aspect I think many may have overlooked back in 2008.

    Though not a banker, but rather as an investment advisor running a business, I have calculated my company's net capital for regulatory purposes. Any securities I had to put up for net capital requirements were first valued to market and then were given a standard haircut that reflected the quick liquidation value of those securities. If you put up bonds that were traded on the NYSE (those days are gone), you subtracted a few points per bond. Then you calculated net capital, which still had to be a proscribed excess, so your liabilities would be paid, period, should yor company approach insolvency. No, I do not understand how Bernie Madoff did it.

    So in early 2008, I think Chris Cox, head of the SEC, ruled that banks had to mark securities in banks' trading account to market. Banks in the old days were able to mark their home loans at par, which was entirely reasonable for Fred and Mabel's 30-year mortgage where there was a single house to foreclose on, but by 2008 every bank had off-loaded their loans to AIG, Merrill Lynch, Citi, etc,, who sliced and diced everything into mysterious tranches, ultimately with Fannie Mae and Freddie Mac providing the ultimate collateral. Then mark-to-market came along, and the investment banking community started crossing their fingers.

    It should have been a signal that Baa3 corporate bonds yielded less than Aa1 Lehman Brothers Senior Notes due 2020, or Goldman senior notes.

    This concept of securitizing mortgages was nothing new. Indeed, Federal Home Loan Bank survived the Depression, and were long nearly as safe as Treasurys and yielded significantly more to the most gun-shy of investors. GMAC's, a riskier situation, paid off I know in June of 2008, and I think they even paid off in GM's "bankruptcy", probably because the GM pension fund hold a large pile, to the chagrin of GM bondholders, who got screwed. That is a related story about 2008.

    So how does one mark to market more sophisticated securitized mortgages? You compare with similar securities rated similarly. It is easy, until bad news arrives. Then everybody runs for the door when the first trader, margined to the hilt, jumps off the Brooklyn Bridge.

    The problem is, when you hold a security that is part of ten thousand times 100 mortgages, how can you possibly liquidate them, without having to pay lawyers and judges, clerks and consultants. It is the same story as Bleak House, regardless of the soundness of the mortgages or the legitimacy of the inheritance.

  26. Matthew Slyfield:

    Except that they Keynesians think that their system is already perfect.

  27. Joe:

    As always - I believe Paul Krugman -

    His esteemed , nobel prize in economics, conclusion is that Greece's problem with their debt is that the have not borrowed enough. If the lenders would just lend them more money that Greece cant pay back, then everything will be okay
    See krugmans NYT editorial Monday Feb 16, 2015

  28. Don:

    If the bank loans you $100,000 and you can't repay it, you have a problem. If the bank loans you $100,000,000 and you can't repay it, the bank has a problem.

    Add Greek-lettered Monopoly money... Problem solved!

    I love Keynesianism!

  29. Mercury:

    That appears to be the case re: bank capital requirements. Of course the banks are generally too big to fail so that distorts normal incentives and decision making too.
    Non-bank buyers (at least the last time around) were essentially gaming the politics of the default process and the knock-on effects of associated events/non-events. Also, some Greek debt was issued under foreign (non-Greek) law juristictions and were therefore different animals.
    The easiest answer to the Greek debt problem is not more deficit spending but default or debasement - but the Greeks can't print their own money as long as they are in the Euro.

  30. bigmaq1980:

    Not just "unintended consequences", but "perverse incentives" too are described here.

  31. paul:

    I think another thing "going on" is that if Greece defaults, then lots of countries like Spain and Italy and probably even France are also bankrupt since they own so much of the Greek debt. So Greece can't be allowed to default (or leave the Eurozone that comes to the same thing).