Subprime Sovereign Debt


It’s, I think, unlikely that we are going to witness the collapse of the European Union, though the revelations that it wasn’t only Greece which was cooking its government books has ominous implications for just about all of the countries in the EU.

An article in the WSJ this evening reveals that the Greeks were not the only creative bookkeepers in the Union:

Concerns that Greece and other struggling European nations may not be able to repay their debts are focusing investor attention on another big worry: Economies across the Continent may have used complex financial transactions—sometimes in secret—to hide the true size of their debts and deficits.

Investors long turned a blind eye to European governments’ aggressive bookkeeping, aimed at meeting the euro zone’s budget ceilings. In reports to the Eurostat statistics authority, Portugal classified its subsidies to the Lisbon subway as equity. Greece insisted that large portions of its military spending were “confidential” and thus excluded from deficit calculations.

Now, suggestions that Greece’s budget could be further constrained in the coming years by interest payments on years-old bank transactions has refocused attention on long-forgotten financial deals undertaken by Athens and other euro-zone capitals to bring down budget deficits. Many of these deals involved currency swaps. In such transactions, countries might borrow in a currency not their own, for example, and use a derivative to offset the risk of currency fluctuations. But these instruments can also be used to artificially massage cash flows and liabilities, to meet debt and deficit thresholds.

Remember how all of this started? A few subprime mortgage lenders started having trouble offloading their mortgages, Bernanke assured us that this was a manageable problem confined to a small part of the trillion dollar market for mortgages and, well you know how all that worked out. Now we have a problem in Euroland that has had everyone clicking their tongues about those conniving Greeks and voila, all of a sudden there may be more skeletons in the closet than anyone would admit to.

Even mighty Germany and self-righteous France played the game:

Are there other hidden derivative deals out there? Euro-zone governments are under no obligation to disclose the precise nature of the agreements they enter into, making it nearly impossible for investors to discern the potential risks associated with them. Eurostat permitted the use of such transactions to adjust debt figures until 2008.

Countries in the euro single currency have a rich history of exotic maneuvers to make their debt and deficit numbers look rosy. Euro-zone rules require governments to keep their debt to levels equivalent to 60% of their gross domestic products and their annual budget deficits to no more than 3% of GDP.

To try to meet these targets, governments have sold state assets, bundled expected future payments into securities to hawk and even, in the case of Germany, tried to reappraise gold reserves for a fast fix. Such moves were criticized at the time, but European leaders deemed them acceptable as they sought to begin the long-planned currency union.

France arranged a deal with the soon-to-be privatized France Telecom in 1997 under which France Telecom paid the government a lump sum of more than €5 billion. In return, France agreed to assume pension liabilities for France Telecom workers. The quick cash injection helped bring down France’s deficit and permit it to join the euro.

A 1996 Italian currency swap, arranged by J.P. Morgan, allowed Italy to receive large payments upfront. That helped keep its deficit in line. The downside was greater payments later.

If you thought that figuring out what Citibank and AIG were up to was a daunting task, you ain’t seen nothing yet. This is the sort of cat that won’t be let out of the bag. Assuming investors start to ask hard questions and probe European governments’ financial transactions, or more precisely try to probe those finances, a rather impenetrable veil of silence is likely to descend. If you see the EU back away from calling Greece to account for it’s shenanigans assume that the other governments have suddenly realized the extent of the glass in their own houses.

I’m not inclined to be a bank basher nor one that has seen a vast conspiracy between governments and the banksters. Given the development of this story, I wonder if I might change my stripes a bit. If the subterfuges have been widespread, then the banks have held a trump card of enormous consequences. Not only did they abet those governments’ maneuvers designed to evade their own self-made rules but by dint of their participation and knowledge were in a fine position to influence regulation.

One wonders just how far and wide this sort of financial subterfuge has spread. If supposedly developed nations were resorting to these ruses what have the weaker credits been up to? It makes one recall the great comment by Tanta that “We’re all subprime now.”

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