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Trading Lessons

Structured Finance: Sovereign Debt, Banks, and Gold

Stock-Markets / Credit Crisis 2013 Oct 18, 2013 - 08:50 AM GMT

By: Janet_Tavakoli

Stock-Markets

The U.S never really minded if a Latin American oil minister took a kickback here or a bribe there to grease the wheels for a foreign oil company or an importer of hard liquor. Latin American taxpayers wouldn’t notice. The money was really just an upfront golden parachute. No U.S. executive ever went to jail just because he voted himself a huge separation bonus as a corporate raider took over a company. Shareholders didn’t complain. The only difference between an executive and a Latin American honcho was the executive got his money after he lost power. But the U.S. minded a lot after Alan Garcia won Peru’s presidential election in 1985. Garcia announced to the world that Peru couldn’t pay back its debt. Garcia was going to mess with U.S. banks, and that was definitely not okay.


Peru’s $14 billion in foreign debt was equivalent to Peru’s entire annual national income. Peru hadn’t made principal payments on its commercial debt in more than a year and was $475 million in arrears on interest payments, 36% of which was owed to U.S. banks. All the foreign bankers that had lent money to Peru knew it couldn’t pay them back. But Peru’s new leader committed the cardinal sin of saying it out loud. Garcia said Peru was honest and would repay, but Peru’s expected $3.1 billion in exports wouldn’t cover principal and interest payments of $3.7 billion due in 1985.

U.S. Banks Balk at Write-Downs

Six months into Garcia’s presidency, U.S. bank regulators decided not to declare Peru’s debts as impaired, since Garcia hadn’t yet clarified his new policies. In other words, they stalled. If the loans were “value impaired,” U.S. banks would have to build up reserves and report lower earnings.

Garcia advocated a Peru-first strategy. Lowered debt payments meant he’d have more money to invest towards economic growth for Peru. But in the process tiny Peru would draw attention to the Latin American debt problem and jeopardize bonuses for U.S. banking executives. Who did this Garcia guy think he was anyway?

In March 1986, the week after Peru’s central bank announced it withdrew all of Peru’s deposits of gold and silver from European and U.S. banks, Garcia kicked out the International Monetary Fund (IMF) and declared:

“All successful revolutions require a foreign enemy. The [IMF] is my enemy.”

Garcia proposed to pay only 10 percent of Peru’s export earnings each year to service Peru’s foreign debt. At that rate, Peru wouldn’t ever pay back all of its interest much less its principal.

U.S. banks had to reserve 15% against their exposure to Peru. It was chump change, but it drove U.S. banks nuts. Tiny Peru wasn’t close to being the U.S.’s largest Latin American debtor, and it wasn’t even the worst. But Alan Garcia had decided to restructure Peru’s debt without so much as genuflecting at the Fed’s doorstep. Moreover, Garcia repatriated his gold, and the U.S. had kicked the gold standard to the curb more than a decade earlier. The U.S. dollar was the world’s reserve currency, and king of the petrodollar. Peru was revealing chinks in its armor. They had to teach this guy a lesson.

The Global Gang: Banks, the IMF and the World Bank

The IMF warned Peru that if it didn’t accept IMF-style austerity and debt, it would cut off assistance, and the World Bank would cut Peru off, too. Moreover 200 creditor banks would take action. Then they cut all credit to Peru, even short-term credit needed to finance foreign trade.

A year later, Peru was in economic chaos. Peru relented. It still didn’t have the means to pay all of the interest owed on foreign debt. But now, just like the other Latin American debtors, Peru shut up about it.

Peru got its national credit card back overnight. The economic problems didn’t go away, and by the 1990’s it was in hyperinflation, but the most important objective had been accomplished. Americans weren’t reading about Peru anymore.

Alan Get Your Gang (Next Time)

Alan Garcia wasn’t wrong; he just had a lousy strategy, and he was too early. No single Latin American country could defy U.S. banks and win, much less a tiny country like Peru. Garcia didn’t have enough clout; he didn’t owe the U.S. enough money. The U.S. banks and their allies at the IMF and World Bank ganged up on him. He needed a gang of his own. If he had negotiated a joint strategy with Mexico, Brazil, and Venezuela, their combined debt would have given them real clout.

By the late 1980’s U.S. banks could no longer pretend that loans to Latin America weren’t seriously “value impaired,” a regulatory term that in this case meant banks better find money they don’t have fast to add to reserves. But that would mean revealing banks’ problems, unseating CEOs, and cutting bonuses.

Most of Citibank’s equity would have been wiped out. Losses at Bank of America and Manufacturers Hanover (now part of JPMorgan Chase) would have wiped out all of their equity and then some.

Tavakoli’s Law of Sovereign Bailouts

Structured finance in the form of Brady Bonds, named for U.S. Treasury Secretary Nicolas Brady, mitigated what otherwise would have been a horrific write-down for U.S. banks. For example, Mexico owed $20 billion. Half was forgiven. A zero coupon U.S. Treasury bond trading at around $2 billion secured a bond’s $10 billion face value, and Mexico agreed to service the interest payments.

None of this required banks to get any smarter or better disciplined. Ongoing taxpayer subsidies and fantasy accounting keep the U.S. banking system alive. Remember Tavakoli’s Law of Sovereign Bailouts:

“Never call bad debt bad debt—at least not in public. “Restructure” bad loans to good loans by lending bad debtors more money. Then bad debtors can pay interest on bad loans, and banks won’t have to admit loans are impaired and increase reserves. [When substantial haircuts are involved, the party/s with the most clout will determine the size of the haircut and they will decide when that occurs.] This type of restructuring is a bailout that protects the egos, status, and bonuses of banking executives and their cronies. Done properly you will transfer wealth from lower classes to the upper classes, preferably executives in the global banking industry.”

If you’re a sovereign debtor, you may want to do something more prudent for your country, and you might be some sort of crazy idealist who thinks the truth actually matters. But remember. If you break Tavakoli’s Law of Sovereign Bailouts, banks and their water-carriers at the IMF and World Bank will cut all your credit lines. They’ll cut you until you stop screaming and shut up. All bailouts will be done on their schedule and in their own way to minimize the impact on banks in countries with the most clout.

The Eurozone: Inherently Unstable

If you have a common fiat currency union with a central authority setting policy based on economic conditions in a diverse geographic area, you must have a political and fiscal union. If you don’t, you won’t have a fiscal policy and ability to make transfer payments to rebalance the effects of the monetary policy. The European Union is a monetary union without the political policy and fiscal union, and it is inherently unsustainable.

That’s an elegant way of saying that small countries like Greece will always get the short end of the stick in this kind of system.

The five countries with the largest economies by gross domestic product (GDP) in the European Union (EU) are Germany (€2.666 trillion), France (€2.032 trillion), the UK (€1.927), Italy (€1.566), and Spain (€1.029). Greece is one of the smaller countries with a GDP of only €194 billion. Unlike the UK which uses British pounds as currency, Greece doesn’t have an independent sovereign currency. Greece is part of the Eurozone, and its former currency, the drachma, was replaced with the Euro.

The Eurozone’s so-called troika is comprised of the IMF, the European Commission, and the European Central Bank. The troika has already arranged two bailouts for Greece totaling €246 billion.

Greece has been trying to clean up its economy and reform its pension and tax collection structure, but it doesn’t have the industry, energy independence, alternative income sources, or assets to pay-off its debt.

The IMF’s False Narrative on Greece

The IMF, Greece’s “friend,” was embarrassed in June when the Wall Street Journal’s Martina Stevis reported that a “strictly confidential” internal IMF document revealed the IMF lied when it said it thought Greece’s debt levels were “sustainable,” meaning the debt could be completely repaid in a timely manner. The document revealed Greece failed three out of four of the IMF’s assistance criteria. [Note: The IMF released the report, "Ex Post Evaluation of Exceptional Access under the 2010 Stand-By Arrangement," to the public in June 2013, after the WSJ reported on its contents. You can scroll down to read the document online for free.]

The IMF forecast a 5.5 percent decline in Greek economic output for 2009 to 2012. But Greece lost 17 percent in real gross domestic output. The forecast also called for only 15 percent unemployment in 2012; actual unemployment was 25 percent. The IMF fabricated a rosier forecast to build consensus to pressure Greece into compliance with the bailouts.

The IMF’s document also revealed that Greece didn’t benefit from the bailout. The wider Eurozone benefited. Banks and investors didn’t have to recognize losses on Greek debt that couldn’t be repaid. If banks marked down all Eurozone debt to realistic levels, many of the banks would fail.

Greece Needs a Gang

Unlike Peru, Greece isn’t squawking about not paying back this bad debt or restructuring the debt on Greece’s terms. Instead, Greece has begun talks with the troika for a third multibillion-euro bailout. What choice does it have? It can’t defy the troika alone. It can cede from the Eurozone and use its own currency, but if it does, it will face the “Peru punishment.”

Thinking in the Eurozone is very far from a balanced solution. Spain and Portugal have engaged in reforms, too, but debt levels have risen for both countries. Alone, Greece doesn’t have bargaining power. But if it worked out a joint strategy with Italy, Spain, and Portugal, it would have a chance. That might include leaving the Eurozone and going through the pain of rebuilding its economy on its own with better terms than the troika will offer.

Since the Eurozone doesn’t have a Central Bank that can issue Eurobonds, a Euro Brady Bond solution isn’t feasible. Even if commingled Eurobonds were possible, Germany balked at the idea that it could inherit 27% of the debt (based on an initial proposal).

German Chancellor Angela Merkel said nein on the grounds that Germany didn’t accumulate the debt. That’s true. Germany was merely a country that glossed over Greece’s ineligibility to enter the Eurozone in the first place. Greece’s economy was too weak, and Greece engaged in derivatives transactions that were essentially a disguised loan. In February 2010, the National Bank of Greece removed the prospectus for Titlos PLC, the financial engineering vehicle arranged for it by Goldman Sachs International, from its web site.

Germany was eager to give Greece a credit card to buy German goods and services. Now Germany is happy to help with “refinancing” at a reasonable interest rate via guarantees. Germany wants aid on its terms, not Greece’s.

Germany’s banking system has its own problems. Deutsche Bank is wildly overleveraged and undercapitalized. The bank persuades doubters at the door.

The U.S. Fed has provided hidden bailouts to European banks. One small example is the tens of billions of dollars of transfer payments from U.S. taxpayers to Societe General and Calyon as part of the bailout of AIG. The Fed’s lending to the global banking system through front and back doors has distorted the value of U.S. dollar. Foreign central banks engage in money printing to keep in step. As a result, we’ve inflated distorted asset bubbles on a scale never before seen in the history of the world. This is the reason many investors have diversified part of their portfolio into gold, a form of money still used in the global banking system.

Endnote: In the next and final segment of this series, I’ll discuss the United States. See also:

Structured Finance: Price Manipulation Includes Silver and Gold (Part One)

Who Says Gold Is Money? (Part Two)

Washington Must Ban U.S. Credit Derivatives as Traders Demand Gold (Part One) – March 6, 2010 and Part Two - March 12, 2010

P.S. It’s unlikely–but not impossible–that anyone in Washington would ever allow the U.S. to experience a technical default just so banking cronies could trigger a technical default on over-the counter (OTC) sovereign credit default swaps referencing the United States. These contracts usually settle in euros, but you can write the terms so that they settle in gold. CDS contracts can have custom language for defaults and restructurings that trigger (or obviate) contract payments. Counterparties of JPMorgan Chase in credit default swaps on Argentine debt found that out the hard way, albeit those contracts didn’t settle in gold.

By Janet Tavakoli

web site: www.tavakolistructuredfinance.com

Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based firm that provides consulting to financial institutions and institutional investors. Ms. Tavakoli has more than 20 years of experience in senior investment banking positions, trading, structuring and marketing structured financial products. She is a former adjunct associate professor of derivatives at the University of Chicago's Graduate School of Business. Author of: Credit Derivatives & Synthetic Structures (1998, 2001), Collateralized Debt Obligations & Structured Finance (2003), Structured Finance & Collateralized Debt Obligations (John Wiley & Sons, September 2008). Tavakoli’s book on the causes of the global financial meltdown and how to fix it is: Dear Mr. Buffett: What an Investor Learns 1,269 Miles from Wall Street (Wiley, 2009).

© 2013 Copyright Janet Tavakoli- All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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