First Dose of Moral Hazard Delivered

Includes: ERO, EU
by: Shishir Nigam

With an aid package finally being confirmed for Greece, the first dose of moral hazard has been confirmed and the Greek government can look forward to some breathing room now that they don’t have to rely entirely on the market to roll-over the short-term debt that’s coming due. It is still looking to continue with its roadshow in the US in an attempt to get investors for its US$ bond issue, however several Greek officials have already downplayed how much they are hoping to raise.

Initial estimates indicated that the Greek government hoped to raise up to $10 billion but now that PIMCO has expressed their disinterest, many other investors are likely to follow their lead and sit out this auction. In response, the Greek officials indicated that they’ll probably only be able to raise $1-4 billion from the issue, or they might even scrap the entire issue all together. If the issuers themselves have so little confidence in their own bonds, it’s hard to expect the markets to do any better.

The loan package proposed by the EU will only be given to Greece once it “asks for it”, which is really more a question of when, and not if. Greek officials probably felt comfortable coming out in the open with their expectations of the US$ bond issue only because they knew they have a fall-back option in the form of the aid package. The package includes $40 billion in loans that are slated for the first year, with the possibility of more loans in the years after that.

The loans will be issued at slightly below market rates but will not be very highly subsidised because the EU itself needs to avoid breaking its own rule which states that none of the member countries can be “bailed out” in times of stress. Of course, Greece is indeed being bailed out but only because the definition of “bailout” is malleable enough to allow the passage of this loan package.

The intention of the “no bailout” rule was definitely in line with the notion of free markets and the risk-takers having to bear the consequences of their actions. But clearly when you’re IN the heat of the situation, no one wants to be responsible for the consequences of a failed state that results from a fiscal collapse – thoughts of moral hazard and setting a precedent for future bailouts become a secondary concern.

We saw the consequence of inviting such moral hazard almost immediately after the loan package was announced, as a Greek official said that Greece will likely need loans amounting closer to $80 billion to help it ride out the storm. No one should be surprised. The first bailout is hardly ever the last – what did we see with AIG? Or GM? Or Fannie Mae (FNM) and Freddie Mac (FRE)? All of them have had repeated bailouts as the need for money grows exponentially once someone is willing to open up the tap.

With the Greek government providing lofty assurances of deficit reduction and debt controls to the EU and IMF, while its own citizens are completely against the notion of any reform that will reduce their welfare, it's quite likely Greece is set for a rough and slow climb out of the hole it has dug for itself. And I have little doubt that this first package is only the beginning. Aside from Greece, you also have Portugal and Spain next in line – why should they be denied of handouts if the money is being doled out to other EU members. All they’ll need to do is duplicate – make strong, even if empty, assurances of future improvements in their fiscal situation, guarantees of debt reduction, and of course, claims of strong economic growth just beneath the surface.

Disclosure: Long market