The Failure of Risk Management: A Preliminary Look at the Cost of a Greek Bailout

Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

European politicians, when creating the euro, failed to consider the risks of their actions.  Policymakers looked at developments in Greece as a temporary liquidity squeeze rather than a solvency crisis.  Paolo Manasse wrote on this issue in a voxeu communiqué called “Greece, The Unbearable Heaviness of Debt”.   He noted analysts have been arguing that Greece will default on part of its debt – leaving its creditors to take a “haircut”.  Manesse argues the prospect is becoming more likely.

 

S&P further downgraded the junk rating of Greek debt reflecting the larger than projected budget deficit and the unsustainable growth rate of government debt.  They estimate a 50% haircut may be required to restore solvency.  There are expectations of a euro 50-60 billion loan from the EU/IMF, which at best may provide temporary relief.  Currently, the only other alternative to debt restructuring, is to leave the euro which seems extremely unlikely.  The rising interest rate on Greek debt combined with new debt issuance/borrowing indicates that the stock of debt is growing much faster than GDP, which is not sustainable.

 

Currently, there are three potential tools to make Greece’s debt sustainable: lowering the interest rate on outstanding debt, turning the primary deficit into a surplus, or writing down the existing debt stock.  A reduction in the market rate may provide a cushion for Greece.  Any move to a primary budget surplus would most likely cause social unrest.  The most likely scenario would be restructuring plus new money at a concessionary rate.  Eurozone bank exposure to sovereign Greek debt is estimated around $100 billion according to the BIS.  Any write-down of Greek debt along with the need to recapitalize the banks will be an expensive lesson on risk management.

The Euro will affect us all

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

  

Recent talk had been of Germany, France and other relatively strong Eurozone countries withdrawing from the Euro.  This talk has now turned to the possibility of weak countries like Greece, Portugal and others withdrawing from the Euro.  If that happened, their new domestic currencies would surely immediately depreciate massively.  However, they would still have unsustainable debt levels denominated in Euros.  At the same time, the Euro would quite possibly strengthen thus exacerbating the problem.  This would necessitate an immediate requirement to restructure and debt holders would need to take significant write-downs on the debt.  Actually, the underlying economies do not support existing levels of debt and current actions are really only delaying the inevitable.  Sooner or later, recognition of loss of underlying value must happen. 

 

Many of these debt holders are banks in Germany, France, etc.  German taxpayers, and hence the German government, are very strongly opposed to bailing out the weak Euro countries.  However, eventually they may effectively have to do so to some extent if their banks need bailing out.  Weak countries exiting the Euro would precipitate immediate action.  However, markets are pushing for early action in any event with bond yields for weak countries going through the roof.

 

All this has the potential to cause great volatility in foreign exchange rates and that volatility will likely go way beyond the Euro.  That will affect any business transacting in foreign currencies.  It will affect other businesses with significant indirect foreign sourced inputs, e.g. through their suppliers sourcing foreign components, and all consumers. 

 

Any business not assessing their FX exposures and formulating risk management strategies to deal with such exposures is taking a big gamble.  It may be that, for any individual business, the risk is within tolerable limits.  However, wouldn’t you feel more comfortable if you came to such conclusion from a proper assessment rather than just having a gut feel that this must be the case.  Guts can be very sensitive to a little bad food input.

“I cann’t do it Captain (of industry). We got no power."

by Michael Arbow, MBA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

With these words Chief Engineer Montgomery Scott (Scotty) of television’s starship Enterprise would warn Captain Kirk of the ship’s limits and capabilities.  These very same words are being said again but this time in China where the providers of electric power are warning China’s industries to expect massive rolling black outs and power restrictions this summer.  With subsidies in coal (where industrial users pay 1/10^th the price of oil) and oil, Chinese industry burns through the stuff with near hopeless abandon.  The subsidies may end, eventually, but in the interim expect the demands for energy making stuff – like coal, oil, uranium and equipment like windmills, solar cells, generators to increase.  Assuming you don’t work in the oil industry or at General Electric; sadly what is China’s problem is our problem.  Commodities will continue to rise as will the currencies of those who produce the goods and this will be over a number of years.  In the short term look for another spike in energy prices this summer.

 

While this may sound like a broken record, I fear and sense that many industries and governments are not fully preparing for the shocks and have not put in place risk reduction measures.  Some of these will be long term (energy efficient buildings and infrastructure like public transit) and some will be short term (hedging strategies).  The past is past and we are entering a new dynamic environment – has your risk perspectives and handling changed to better suit this new world?

 

For Jeff Rubin’s thoughts on this subject, click on the link:

 

http://tinyurl.com/4348gtm

 

Risk Management in Large, Complex Organizations – Lessons from the Eurozone

By Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Guillermo de la Dehasa wrote an interesting paper for Voxeu called “Eurozone Design and Management Failures” (May 2011).  The paper provides an interesting perspective on the role of risk management in a large, complex organization.  The risk management failures include: taking into account and ignoring known risks, monitoring and managing risk, and using the appropriate risk metrics.

 

Europe’s sovereign-debt crisis is a defining moment for the Eurozone in that it exposed the weakness of the monetary union’s design, governance and management.  Academics pointed out three basic initial design flaws overlooked by policy makers in their haste to create the euro:  the lack of price and wage flexibility, a monetary policy where one size fits all and the lack of monitoring of individual countries’ fiscal policy.

 

The Eurozone sovereign-debt crisis uncovered more serious flaws:  the Eurozone policymakers (IMF was) were not equipped to deal with a solvency crisis; the European Financial Stability Fund (EFSF) only provided a short-term liquidity facility.  A liquidity facility may delay the day of reckoning and raise the cost and lastly there was no provision in various Eurozone agreements for resolving a solvency crisis.  The present system, at best, contributes to the creation of a debt overhang increasing the cost of crisis resolution.

 

The three current bailouts were triggered by policymaker management failure to address the solvency issue.  The failure to incorporate risk analysis into Eurozone policymaker culture and strategic thinking could prove extremely costly for investors and painful for Eurozone citizens. 

Old McHedgeFund now has some farms

by Michael Arbow, MBA

Partner, RSD Solutions.com

www.RSDsolutions.com

info@RSDsolutions.com

 

Occasionally this blog talks about the rising cost (real and nominal) of the soft commodities (food) and has also pointed out that farmland is becoming an alternative asset in the investment portfolios of billionaires; well it looks like hedge funds are now moving down on the farm.  It is estimated that US farm land will be increasing at a rate of between 5-10% per year in the foreseeable future.  Add onto this the return of the food grown and farmland is looking pretty attractive.  Of course the road will be rough (volatile) but the trend is entrenched as long as the wealth in China and India and numerous other emerging markets increases.

 

Where does that leave the food processors; the candy makers, the bio-fuel creators and the brewers? Well for them, the future will be filled with uncertain prices and shifts in consumer tastes towards alternatives.  Budgeting and price forecasting will become more uncertain as will consumer tastes as demand destruction begins to control the markets.  This world is no longer on the horizon, it is here and the hedge funds know it and are making plans to profit from it.  Meanwhile for commodity users: are they ready, has the risk team and the Board updated themselves with viable alternatives to reduce the worry and volatility, are hedging strategies been re-visited?  According to the attached article, time is running out.

 

For more on this story follow the link to The New York Observer article:

http://tinyurl.com/4yvgend

The Underpricing of Risk – What Can We Learn?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Jeffrey Frankel, in a recent Vox communiqué called “The ECB’s Three Mistakes in the Greek Crisis and How to Get Sovereign Debt Right in the Future”, reviews the failure of the European Central Bank (ECB) and policymakers to fully integrate Greece into the Euro and fulfill the necessary conditions for membership. .

 

The first mistake, by the ECB and the European Commission, was to allow Greece to join the Euro in 2000 when it failed to meet the economic criteria established by the Maastricht Treaty, particularly the 3% ceiling on the budget deficit expressed as a share of GDP.  The second failure by European authorities, was to monitor budget deficits and debt levels that exceeded limits established by the Stability and Growth Pact, resulting in Greek borrowing costs similar to that of Germany.  As a result, international investors grossly underestimated potential risks.   The third mistake was not to send Greece to the IMF earlier.  European policymakers looked at the events in Greece as a temporary liquidity crisis rather than outright insolvency.  The result is a higher cost for a bailout.

 

There are two major lessons learned by policymakers from the Greek experience.  The first is that when specific criteria are established, such as the Maastricht fiscal criteria and the No Bailout Clause (1991) and the Stability and Growth Pact (1997), someone has to take responsibility for monitoring and enforcing them. The second lesson is that European authorities are not equipped to impose policy conditionality in rescue loan packages; this is the IMF’s job. International politics is less likely to prevent the IMF from enforcing painful fiscal retrenchment and other difficult conditions. Europe is no different in this respect than Latin America or Asia.

 

The failure to price risk correctly is now resulting in European policymakers discussing the possibility of a “soft restructuring” of Greek debt.  The term soft restructuring is used as a euphemism for extending the maturity of outstanding debt.  European authorities are looking for further spending cuts and increased privatization by Greece.  However, the failure to do the large-scale debt restructuring, increasingly demanded by investors, will increase the ultimate costs.