U.S. and EU Debt Crises Compared

Subtitle:  If Soros Could Bust BOE, Greece Can Bust ECB

by Guest Author Andrew Butter

The recent events in Greece are reminiscent of when Soros busted the Bank of England. That crisis was caused by an artificial peg of the pound to the euro which restricted the ability of U.K. to print money to inflate away their debts. The current crisis is caused by the inability Greece (and Ireland, and Portugal, and Spain, and perhaps Italy), to print and inflate away their sovereign debt, since it is denominated in euros.

Now the ECB is exposed to Greek (and other) paper, which, if it were valued properly would mean that right now at least according to its mandate, it is probably already insolvent. Although no one will ever know, since no one is inclined to do valuations of assets held by banks strictly in accordance with International Valuation Standards; particularly the ones that are too big to fail; and ECB is one of those.

Many forget that IVS pointed out in 2003 that the valuations (of assets by TBTF banks) were fundamentally flawed and bound to be misleading; much better to use the Voodoo Valuation Standards promulgated by FASB, IASB, and BIS (Basel III), but that’s another story.

That of course is not really a big deal (in the short-run), and these days there are plenty of banks which would be insolvent if their assets were valued properly but for the wonderful get-out of Fractional Reserve Banking as in … “Rolling Loan Carries No Loss.”

Martin Wolf has a rather depressing but as usual, spot-on, analysis of the ramifications of rolling-over debts denominated in Euros, in the FT.

The Dilemma of Democracy:

Apart from having at its heart the seductive drug of Election Candy, which is the Achilles Heel of all democracies; since the majority will always vote that someone else should pay for them to live beyond their means; the European crisis is fundamentally different from the crisis that hit America.

In America, the majority (at least the 70% who owned (a part of at least) their own homes), voted for higher house prices; and that’s what their elected representatives delivered, to the best of their abilities. For a while everything was wonderful, the newly rich rushed out to unlock-capital on their (partially owned) houses, and went on a spending spree, which boosted the economy, which boosted house prices, in a delicious feedback loop. So that by 2005 Alan Greenspan could declare that everything was splendid, prior to handing over the unexploded bomb to his faithful underling, who proceeded to pump it full of more explosives and then detonate it.

In Europe the candy was benefits plied on benefits piled on entitlements, and that released money into the economy, so everyone went on a spending spree, and that boosted the economy, which made affording all those benefits and entitlements, affordable (more tax revenues), in another delicious feedback loop.

What’s similar is the candy, what’s different is how the candy was financed.

It all comes down to the collateral. In America the collateral for the really suspect assets was people’s homes, and that was made possible by the wonders of securitization. Many people say that the Fed caused the bubble and thus the bust, that’s not correct.

Apart from standing idly by and pontificating about froth, they didn’t cause anything: the money to pay for the bubble which didn’t (won’t) get paid back after the bust, was generated by securitization. Between 2000 and 2008 thanks to the selfless toil of legions of God’s Workers, $21 trillion of new debt was created in the private sector in USA (that’s when Fannie & Freddie were considered private sector).

That’s a chart I put up first in August 2009, I haven’t updated it (although I couldn’t help noticing that my projection of just under $2 trillion added to the National debt in 2009 was spot-on); my point is simply that while the private sector created the $21 trillion of debt (much of it securitized); during that time the National Debt only went up by a measly $3.5 trillion, which according to Joseph Stiglitz is hardly enough to even pay for a decent sized war these days!!

The difference from Europe is what you get if the deadbeats don’t pay the money back (with interest). In America it was (and is) based on real things, from the future revenues of municipal sewage treatment plants in Tennessee, to fixer-uppers in suburban Detroit.

The point is that debt was non-recourse, i.e. if you sold that nice little fixer upper in Detroit that you had lent $200,000 against, for $10,000 you can’t do anything against the person who borrowed the money to get back the $190,000 deficit (except trash his credit score).

In Europe it was different, very, very different.

The first line of defense was that in case of default, it would be up to the taxpayers of the future to pay the money back (with interest). The problem with that of course, is that (a) taxpayers of the future quite often feel a bit miffed about having to pay for the extravagance of their parents and (b) that gets even more complicated when the taxpayers who’s pockets you want to put your hand in live in another country from the bank that lent their government the money.

The Germans recently came up with a clever idea whereby they could take a charge on some assets owned by the Greek Government and sell them so that their banks could get back the money they had lent (with interest). Sadly that idea didn’t sell very well to the population of Greece who suggested rather rudely, that if the Germans wanted to try on the tactics employed by the Third Reich, they had better darn well try invading again.

So much for the happy family of the European Union (and so much for Greece’s revenues from German tourists), that’s the problem with collateral, you need to think-through the logistics of collecting it, and when the bailiff gets confronted by an irate homeowner holding a loaded shotgun, well that can cause complications.

Where the EU and the euro really went wrong was that the defense against the potential complications of German banks having to raise an army to invade Greece in order to get some collateral they owned, was that the EU had rules.

That ought to have worked, particularly since the system was devised by the French; who although they swear they are anarchists at heart, love rules; and by the Germans who always follow rules. Except for one thing, Greeks, Italians, Spaniards and Irish – don’t follow rules, and predictably they cheated, they cooked their books and they lied about their GDP and about just about everything else.

Perhaps that might provide a nice case-study example of when you do a valuation of collateral that is being put up as surety for a loan, you need to think hard about (a) what is it going to be worth (i.e. what is the minimum price I can reasonably expect to exceed), not today, but on the day that you get the keys in the jingle-mail? And (b), are there any potential complications in collecting the proceeds of the sale?

That’s not a new concept, the Merchant of Venice faced exactly the same problem many years ago; the problem that German and French banks and their bailiff in the form of the ECB, face today, is how to cut out their pound of flesh, without spilling any blood.

Editor’s Note: This originally appeared at Seeking Alpha on June 3.

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Andrew Butter started off in construction in UAE and Saudi Arabia; after the invasion of Kuwait opened Dryland Consultants in partnership with an economist doing primary and secondary research and building econometric models, clients included Bechtel, Unilever, BP, Honda, Emirates Airlines, and Dubai Government.
Split up with partner in 1995 and re-started the firm as ABMC mainly doing strategy, business plans, and valuations of businesses and commercial real estate, initially as a subcontractor for Cushman & Wakefield and later for Moore Stephens.  Set up a capability to manage real estate development in Dubai and Abu Dhabi in 2000, typically advised / directed from bare-land to tendering the main construction contract.
Put the unit on ice in 2007 in anticipation of the popping of the Dubai bubble,defensive investment strategies relating to the credit crunch; spent most of 2008 trying to figure out how bubbles work, writing a book called BubbleOmics.  Andrew has an MA Cambridge University (Natural Science), and Diploma (Fine Art) Leeds Art College.
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