The intensifying crisis in Greece presents both immediate implications for U.S. financial institutions as well as longer-term points of reflection for policymakers and analysts. Although many commentators seek to use the situation in Greece to warn about the risks inherent in deficits and a bloated public sector, it also teaches that governments cannot impose financial stability in situations where that very stability depends on the suppression of basic economics. Just as significantly, both the European regulatory response and Greek political dynamics demonstrate the dangers of attempting to suppress basic political pressures.
By now, nearly everyone is aware of the fact that Greece has too much debt relative to its income. The debt will need to be renegotiated in some way to reach manageable levels. The problem is not simply the size of the debt load, but also that the Greek economy is uncompetitive. The country’s current account deficit stands at about 10% of GDP and shows no signs of falling. (The current account is the amount borrowed from aboard, as it equals the trade deficit plus unilateral transfers and net factor income like dividends).
Greek banks are likely to become insolvent if the government debt were to receive large haircuts in a sovereign resolution. A more immediate concern is that the Greek banks would become illiquid even if the haircuts were modest because defaulted government debt could no longer be used as collateral for short-term loans from the European Central Bank (ECB). The seeming inevitability of a debt restructuring has driven 5-year borrowing rates in excess of 20%. Current credit spreads imply a cumulative default probability of 97%!
The International Monetary Fund (IMF) is likely to provide Greece with an additional €12 billion to avoid default. But the additional debt is conditional on more austerity. At this point, further budget cuts are a tough sell, not only because so much of the Greek workforce is employed by government that lack good job opportunities elsewhere, but also because it’s becoming easy to draw the link between reduced payments for hospitals and increased payouts for bondholders. When a country is closing hospitals to ensure creditors get paid 100 cents on the dollar, turbulence in the domestic political situation is inevitable.
The ECB argues that allowing Greece to default would invite catastrophe. The euro requires that the currency liabilities of all member country central banks be treated as equivalents. But this requires an equivalence of these banks’ assets, which are the bonds of their respective countries’ governments. A default in Greece would suggest to all market participants that Spanish and Portuguese banks are not part of a euro system, but rather national banks with access to national liquidity facilities that are provided by national central banks that are themselves at risk of facing insolvency. This news would almost certainly lead to a run on the banking systems of other peripheral countries. The only solution is a unified euro Treasury, but this faces political opposition from Germany and other countries that would fund it. For those voters funding the bailout, the politics of austerity demand even greater cuts than currently contemplated.
The U.S. would likely feel immediate financial repercussions from the Greek default in two ways. First, as explained previously, data from the Bank for International Settlements (BIS) suggest that U.S. banks may have large residual exposure to Greece through credit derivatives. Secondly, the U.S. money market mutual fund (MMMF) industry basically provides the dollar funding for European banks today. Both exposures could be significant and pose an enormous risk to the continued functioning of the U.S. financial system.
According to BIS, European banks hold about $8 trillion in dollar-denominated assets. To avoid currency risk, they have to either finance these holdings through dollar liabilities or through currency swap arrangements. The cheapest way to finance these positions is through issuing commercial paper to U.S.-based money market funds. MMMFs are eager to provide this low cost funding because the interest rates European banks pay are actually higher than the rates paid by U.S.-based commercial paper issuers (called the “Yankee premium”). While this seems like a match made in heaven as both sides get better deals than available from other market participants, the effect is to import European financial fragility to the U.S.
As was clear in the aftermath of the Reserve Fund’s default following the Lehman bankruptcy, the government has no choice but to come to the rescue when credit losses cause one or more MMMFs to “break the buck.” If a MMMF suffers losses from a European bank that causes the NAV to fall below $1, taxpayers would almost certainly be asked to fund another bailout.
Boston Fed President Eric Rosengren recognizes this risk and urged Congress and the Administration to address it in a recent speech:
I do think it would be particularly prudent to address this issue now, as money market mutual funds have the potential to be impacted should there be unexpected international financial problems emanating from Europe. Consider that many (but not all) MMMF’s have sizeable exposures to European banks, by virtue of holding the banks’ short-term debt. This means some MMMFs are potentially sensitive to a disruption in the European banking system, should one arise from the fiscal and sovereign-debt problems we are seeing in some European countries.
The risk European banks present to MMMFs is not a new phenomenon. The BIS has recognized European bank borrowing from these funds as a source of systemic instability because the loans tend to be overnight, while these banks’ dollar assets are longer term. Yet, Congress and the Administration have yet to address the full extent of the systemic risk in this area in part because of the resistance from the money market fund industry. (For the latest actions in this area, see the SEC’s 2010 rule, the PWG White Paper that reviews MMMF reform proposals, and the SEC led MMMF roundtable with other U.S. regulators.)
The industry’s argument seems to be that investors and businesses like money market funds, so why spoil a good thing? But the “good thing” is the stable, $1 net asset value of these funds, which is something that is obviously being underwritten by taxpayers. Allowing NAV to reflect the value of underlying assets would make MMMFs less attractive than bank deposits. If NAV were allowed to fluctuate, it would be the equivalent of depositing $5,000 in a checking account only to discover $4,850 is there the following week. Depositors are likely to either choose to use checking accounts where the value is guaranteed to remain at par ($5,000 in this case), or to move to short-term bond funds that offer higher interest rates to compensate for the variation.
The stability in MMMFs is similar to the “stability” in Greek’s public finances. In both cases, government policy attempts to suppress the basic economic forces at work. In the case of Greece, the disconnect is between the size of the government’s debts and its capacity to pay them. With MMMFs, the mismatch concerns the “risk free” character of the liabilities and the riskiness of the short-term loans they extend. Creating the appearance that MMMFs are safe actually makes the situation much worse by creating a moral hazard where creditors are relieved of any due diligence obligation as they can assume NAV will remain at $1 without fail.
A goal of the Dodd-Frank Act generally, and Volcker Rule specifically, was to separate banking functions that benefit from deposit insurance from other activities not deserving of government support. The protection afforded to MMMFs doesn’t make sense in a world where taxpayers are seeking ways to dial-back their commitments to the financial sector. Credit analysis for overnight or weekly loans is much poorer than on-balance sheet banking lending, which is precisely why so many structured investment vehicles (SIVs) funded their collateralized debt obligations (CDOs) using money markets. The fact that banks enjoy deposit insurance is simply not a good reason to extend liquidity guarantees to non-banks. Let’s hope Congress and the Administration can act swiftly enough to avoid another crisis.