Monday, June 13, 2011

Greece makes the case for disclosure under the FDR Framework

The NY Times ran an article that looked at a number of potential scenarios for what could happen if Greece defaulted on its debt.  What made the article interesting is that in the absence of disclosure under the FDR Framework, nobody knows what any financial institution or governmental entities true exposure is.

Hence, it made sense to look at scenarios ranging from

  • no impact as everyone has already written down the debt to 
  • a Lehman Brothers type financial crisis where, because no-one knows who is solvent or insolvent, the financial system freezes.
Under the FDR Framework, where market participants have access to all the useful, relevant current asset and liability-level data in an appropriate, timely manner, it is straightforward to figure out what the impact should be.
Bond traders and officials at the European Central Bank have been unified in their warnings that a restructuring of Greece’s debt would set off an investor panic similar to the one that followed the bankruptcy of Lehman Brothers
Others, however, have argued that Greece’s debt of 330 billion euros, or $473 billion, while too large for the country to bear, is small enough to allow banks and other institutions to take a loss without bringing the world financial system to its knees. 
With disclosure, there would be an answer to the question of could banks and other institutions take a loss without bringing the down the world financial system.
But the comparisons between Greece and Lehman grew more frequent last week as global markets reeled, spurred in part by the view that Germany’s insistence that private investors participate in a second rescue package for Athens would overcome the objections of the European Central Bank. 
“It is a valid concern,” said David Riley, head of sovereign ratings at Fitch. “The Rubicon would be crossed — we would have a sovereign default event and that can be quite a shock, not just for the peripheral countries but for Spain and beyond.” 
The thinking goes like this: though banks and other investors have done much to pare their Greek holdings in the last year, if they are forced to take a loss, and the ratings agencies declare Greece in default, investors would start selling in a panic. And they would not sell just the bonds of countries struggling with debt — Portugal, Ireland, Spain and Italy. In a hasty retreat into cash, traders would unload more liquid assets as well, everything from high-grade corporate bonds to American and emerging market equities — as occurred in 2008 after Lehman failed. 
One of the benefits of disclosure is that it directly addresses the issue of investor panic.  Investors have a tendency not to panic when they have the facts.  Investors have a tendency to panic, think bank runs, when they do not have access to the facts and instead are basing their investment decisions on fear.

With disclosure, the probability of this contagion scenario drops significantly.
To be sure, much has to be wrong for the European debt crisis to approximate what happened after Lehman failed in 2008. Not only did banks, hedge funds and insurance companies immediately seize up, but the effect on the broader global economy was also striking as trade flows nearly ground to a halt. 
Analysts point out that the global financial system has survived sovereign defaults in the past, including Russia’s in 1998 and Argentina’s in 2001. 
Also, since the prospect of a Greek default has been foreshadowed for so long, financial institutions have had sufficient opportunity to reduce their holdings of Greek debt. But in doing that, the private sector has passed much of the exposure to Greece and other troubled economies in Europe to public sector entities like the European Central Bank and the International Monetary Fund. That means that if a restructuring comes, the taxpayer — more than the private investor — will pay. 
One of the cardinal rules of central bank lending is to lend against good collateral.  It was clear to the ECB that Greece had problems.  It is possible that the ECB and the IMF have adequate collateral so that they will not suffer a loss if a default occurs.  Without disclosure, we do not know.
Lending weight to the fears of another Lehman crisis, regulators are warning that in such a situation, even super-safe money market funds may not provide the risk-free refuge they proclaim to offer. 
According to a recent report by Fitch, as of February, 44.3 percent of prime money market funds in the United States were invested in the short-term debt of European banks. Some of those institutions, like Deutsche Bank and Barclays, do not have dangerous Greek exposure. But some of those funds also hold shares of French banks like Société Générale, Crédit Agricole and BNP Paribas, which do have significant Greek bond holdings — about 8.5 billion euros, or, in the case of BNP and Société Générale, about 10 percent of their Tier 1 capital. 
This month, the president of the Federal Reserve Bank of Boston, Eric S. Rosengren, warned that the large share of European banks in American money market fund portfolios posed a Lehman-like risk if, in the wake of a default in Europe, panicky investors took their money out all at once. 
“Money market mutual funds have the potential to be impacted should there be unexpected international financial problems emanating from Europe,” he said in a speech at Stanford
These comments show that despite their monopoly on current asset and liability-level data for financial institutions, the global regulatory community does not know what the impact might be.  This directly contributes to the instability of the financial system.
The idea that European banks, not those in the United States, would take a hit if Greece defaulted, has sustained a view that such a crisis might be containable. But according to a recent analysis by The Street Light financial blog, this misses the point. It will be American banks and insurance companies that will have to make the lion’s share of default insurance payments to European institutions if Greece fails. 
Citing recent data from the Bank for International Settlements, the blog points out that in the event of a Greek default, direct creditors would be on the hook for 70 percent of the losses, with credit default insurance picking up the rest. Thus, if one includes credit default exposure, American exposure to Greece increases from $7.3 billion to $41.4 billion. 
Again, a pinch of salt: such numbers in no way approach the wild bet that the American International Group made on the United States housing market, a wager that led to the company’s collapse. But they are a reminder that, as was the case with Lehman Brothers, the links that directly or indirectly bind investors to Greece extend far beyond Europe. 
The concern over the inter-connectedness of the financial system further demonstrates the need for disclosure.  It is only with disclosure of the current asset and liability-level data that market participants are able to adjust the price and risk of their exposure to a specific financial institution based on its risk profile which includes its direct and indirect exposure to Greece.  Market participants make this adjustment knowing that they might lose 100% of their exposure. 

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