Why Bondholders Should Share the Burden of a Greek Bailout

Includes: FXE
by: BubbleBustInvesting

By Sebastian Buttet and Panos Mourdoukoutas

Judging from the violent protests in Athens today, Greek citizens are angry. And they aren’t alone. Irish, Portuguese, Spanish, and German citizens are angry, too. They certainly have every right to be angry, as they are called upon to shoulder the entire burden of a bailout that breeds more problems than solutions. Bondholders should have to pay too, as they miscalculated credit risk by lending money to the Greek government at the same rate as they did to French and German governments.

The EU's ongoing policy that bails out member nations with heavy debt burdens is a dangerous game that threatens the economic and political cohesion of the euro zone and EU itself. It prolongs and generalizes the debt crisis; it injects an unhealthy dose of moral hazard into financial markets by transferring risks from bondholders to taxpayers; it pits one European member against another as neither bailout recipients or bailout providers are satisfied, for different reasons though.

When the newly-elected Papandreou faced a mounting debt problem a year ago, he had three options: Rush to the markets to refinance the Greek debt, while the window was still open; negotiate a deal with bondholders that would make debt repayment manageable; and/or ask for a European/IMF bailout, an option he successfully pursued. Greece received $145 billion in bailout funds at a high interest rate of 5.5 %.

When Ireland faced with a similar debt problem a year later, Prime Minister Brian Cowen reluctantly followed the same road. Ireland received $100 billion in bailout funds at an even higher interest rate of 5.8% per year.

At first glance, the European Union's plan was a fair and safe plan. Greek and Irish citizens seemed to be fortunate enough to have fellow members and the world community help them out with their financial hardships. And the EU and the world community seemed to be fortunate enough to avoid the prospect of a financial contagion that could shake up anew confidence in the world financial system.

Taking a closer look, the EU's plan is unfair and dangerous for more than one reason. First, bailouts merely kick the proverbial can down the road and do not address any fiscal or solvency problems faced by EU governments. It forces countries with already too high debt-to-GDP ratios to pile up even more debt, when too much debt was the root of their current financial woes. In addition, the nominal interest rate on the new (bailout) debt is higher than GDP growth rates projected by the IMF for Ireland in the near future, thereby increasing its debt burden even further. As such, bailouts prolong the crisis and make it harder for bailout recipients to return to markets.

Second, bailout policies create economic environments fraught with moral hazard that encourages investors (e.g., French and German banks) to take on more risk than they would otherwise do, thus undermining the proper functioning of financial markets and the banking system at large. Perhaps because they assumed that taxpayers would ultimately shoulder the bailout costs, investors who purchased the debt of different European countries since the inception of the euro failed to recognize that different countries pose different degrees of default risks, and to demand the corresponding premium for riskier countries.

All of this changed quickly when European leaders unveiled the permanent bailout mechanism making clear that starting in 2013 the private sector will assume a large share of the future bailout costs. After the announcement, investors sold their holding of Portuguese and Spanish debt en masse, sending the cost of funding debt in these countries higher, and fueling rather than preventing a contagion.

Third, bailouts proved to be politically unpopular among citizens in both receiving and providing countries. Greek and Irish taxpayers are more cognizant than their current leadership thinks they are. They know that a big chunk of the bailout funds will end up leaving the country and, in essence, bail out German and French banks. Why should they swallow the austerity pill of the plan?

And German and French taxpayers aren't oblivious to economic incentives either. They understand that the Greek and the Irish bailout is in essence a bailout of their own banks, but that's not how their leadership presents it, and that's where the danger is. Greeks are upset with German banks, and Germans are upset with Greeks. The EU is no longer a happy family.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.