Monday, January 23, 2012

Euro Sovereign Bond Investors Get a Raw Deal

IMF Managing Director Christine Lagarde, speaking in Berlin, said, "It (stepping up to a bigger bailout fund) is about avoiding a 1930s moment, in which inaction, insularity, and rigid ideology combine to cause a collapse in global demand."

These profound insights are said by the Wall Street Journal to constitute a "dire" warning.  We've been talking "dire" since last summer.  I must say that before watching the behavior of sovereign bond investors, I had always thought of bond investors as being more the "green eye shade" types than manic-depressive equity investors.  Now, I'm not sure at all. 

European sovereign bond investors, particularly Greek bond investors, include many European banks.  They are apparently willing to accept interest rates on new Greek bonds of 3% max, with a fifty percent haircut on the principal value of their old bonds, plus some unspecified higher rates in future years if the Greek economy does better than a baseline number.  The IMF and the ECB have drawn a Maginot Line at 3%.

My question is the following: why on earth would any rational investor take a 20-30 year risk for 3% from a country that will not realistically ever be able to repay? The investors must not have any realistic mechanism for pursuing a default, but it's probably more rational to bite the bullet now, take the write downs, file perfunctory lawsuits, and wait and see what the ECB would do. The banks would be short regulatory capital, but it's hard to see the IMF, ECB and other alphabet soup regulators pushing the banks over the edge; that would be bad for everybody.  Someone has to lend Greece money, but surely a 3% rate is irrational.  Who's going to win this game of chicken?

The longstanding low interest rate environment which central banks have institutionalized globally has completely distorted capital prices, forcing investors to take more and more risk in search of returns.  For example, stories abound about hedge funds that leveraged their Japanese sovereign bond purchases at three-to-one yielding them an annual return of 12.5% per year; the lenders who gave the money to the hedge funds didn't earn very much for taking this risk. 

C. Fred Bergsten, formerly of the Brooking Institution and late of the Peterson Institute for International Economics ("PIIE")  predicts that European leaders will dither until the last minute, pull a rabbit out of the hat, end the euro/Greek/European periphery crisis and Europe will emerge from the crisis "much stronger."  I've followed his work since I was a graduate student, and he has thirty years of professional and emotional investment in the euro currency experiment.  If the bondholders are irrational and give in, nothing fundamental will have changed: the weak players in Europe will still be weak, will be further eroded by ongoing recession and debilitated by internal political crises. 

When MD Lagarde talks about rigid ideology and a collapse in global demand, that is very disingenuous.  The growth in demand was driven by artificially low rates and the ability of EU periphery countries to borrow with impunity while running fiscal deficits in violation of their treaties.  Now, the absurd suggestion is put forward that Germany should run fiscal deficits in order to purchase goods and services from Spain, Ireland and Greece.  Not agreeing to do so would be "rigid ideology," according to the IMF. 

PIIE authors Boone and Johnson take a more normal economic approach to the crisis, suggesting that it has to deepen unless ongoing fiscal issues and bank insolvencies are addressed.

If the bondholders are irrational enough to go along with this charade, then I might just go and rip up all my teaching materials about the Capital Asset Pricing Model and Efficient Market Theory.  This stage is not filled with economic actors, for sure.

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