A Bedtime Story To Haunt Your Sleep

Imagine if you will a friend–perhaps imaginary, perhaps not–who spends money as if it grew on trees. He buys things constantly, upgrading to the latest and greatest, always drives a new car. None of this is a problem if he’s independently wealthy but let’s say he’s not. Let’s say he makes $40,000 a year but has outstanding debt $66,400. At first, this isn’t a problem. Nik makes the minimum payments, creditors are happy and Nik goes on his merry way. One month though, Nik misses a payment. Suddenly, one of the credit cards he has jumps from 9.9% to 18.9%. Not a deal breaker for his lifestyle but a sign that maybe things aren’t going too well. Then something bad happens. Nik loses his job. Lucky for him, he finds another one but it only pays him $35,000 a year and in the meantime, he’s missed a payment on another credit card, jumping that rate up to 18.9% too.

Suddenly, Nik is in a bit of a spot. He’s making less money, still has the same debt but has to pay more on that debt just to service it because his overall interest rate has gone up. In the real world, Nik has a few options. He can try to get a better job and make more money. He can drastically cut back on his spending, lowering his quality of life and make larger payments towards the debt. He can try to approach his creditors and negotiate his debt down, either by lowering the interest rate or the amount or both. Or he can default, declare bankruptcy and try to get a fresh start. What he chooses depends on his particular situation but as his friend, you are in impartial observer for the most part.

However, let’s change the story a little. Let’s say that late in the game, Nik decided to go to the local loan shark, Heinrich. He wants to borrow some money from Heinrich to keep the lifestyle going. Heinrich, normally the lender of last resort, takes one look at Nik’s balance sheet and says, “yeah, not so much. There’s no way you’re going to be able to pay me back so I’m not loaning you any money.” Nik tells you this sob story over coffee one day and you get a brilliant idea to make some money off Nik. You’ll go to Heinrich and tell him that you’ll sell him an insurance policy that essentially says, if Nik declares bankruptcy, you’ll pay Heinrich for Nik. You’re a model upstanding citizen with a large bank account so Heinrich agrees. He gives Nik the money and then every so often at agreed upon intervals, Heinrich gives you a small insurance payment. Everybody is happy.

Unless Nik declares bankruptcy. Then, you’re not so happy because you have to pay Heinrich back. Suddenly, you have some skin in the game. Now in normal circumstances, you’d probably never agree to sell Heinrich that insurance policy no matter how much money you had or how good a friend Nik was. It’s just not very smart. But what if you had a pretty good idea that the insurance policy was guaranteed, e.g. there was no way Nik would default? Nik would never default, Heinrich would keep paying you insurance and you were guaranteed never to have to pay off the policy. Well then, it’s free money! Yay for free money! Even if it wasn’t guaranteed that Nik wouldn’t default, you’d have a strong self-interest in making sure he didn’t. You might even act in ways that were contrary to Nik’s long term success just to keep him from defaulting, if you could. Man, you’re a shitty friend.

While this is a highly simplified little story, it’s somewhat analogous to what’s going on on the world’s economic stage right now, as best as we can tell. Imagine if you will that Nik is Greece, Heinrich is Germany and you are the hedge funds and money markets of America. Most countries look at Greece’s finances and say, “no way in hell are we loaning them any more money, they can’t pay back what they already owe.” But somewhere along the way, American hedge funds and money markets thought to themselves, “There’s no way that Greece is defaulting, the EU won’t allow it. It would cause huge catastrophe. On top of that, our own government has shown in the past that they will step in and backstop companies like AIG and Lehman Brothers if need be. We could sell insurance on Greek debt that would essentially be guaranteed not to be collected on and make a mint.”

This is the very definition of moral hazard. And while we have no explicit proof of the above scenario to my knowledge, we have some pretty good circumstantial evidence that it’s going on:

And the Europeans are very angry that a few weeks ago Tim Geithner, the bank lobbyist, came over and insisted that Europe not forgive Greece’s bank loans, not let Greece write down the loans, and indeed that it not even claim that Greece should do what Argentina is and write down the loans as a premise. Mr. Geithner explained to the Europeans that the largest insurers of the Greek debt are American money market funds and hedge funds. And he said American hedge funds and banks would lose money and actually would crash the U.S. economy, if Europe made a concession to Greece to bring debts down to the ability to pay. So, instead of a debt write-down or a haircut, the banks said, “OK, we will agree with what the Americans are insisting on, and we will ask for a voluntary write-down by the banks on the Greek debt they hold.” Obviously, European banks who are not part of the credit default swaps have disagreed with this. So the Americans are putting immense pressure on Europe, saying, “We will wreck your economy, if you don’t wreck Greece’s economy.”

Last week, when a deal for a supposed bailout for Greece was announced, the market celebrated. Monday, when the Greek Prime Minister said he was going to put it to a vote of the Greek people, the market tanked. Today, when the referendum was yanked back off the table, the market celebrated. Why do we think that is so? Because the market knows that bailouts for Greece are good for the market whether they are good for the Greek people or not. The Greek people are starting to see that bailouts when they come with the conditions of severe austerity programs are not actually good for them. It is fun for certain people to say this is what they deserved all along, that they should have lived within their means. But this continued insistence that the only people at fault in these situations are the debtors is ludicrous. In every agreement between a creditor and debtor, blame lies equally with both. Without one, you cannot have the other. The countries that continually loaned money to Greece well beyond the amount they could possibly pay are equally to blame for this crisis as are the Greeks. But the major players on the stage do not care one whit about the Greek people. They only want to keep making money. They knew–or thought they knew–that loaning money to an EU partner that that partner could not possibly repay would be guaranteed by someone. Moral hazard has created a situation where the financial elite and the oligarchy make decisions based on what they expect from some governmental entity in the future.

Satyajit Das has pointed out that the European debt crisis can end in one of three ways:

The European debt endgame remains the same: fiscal union (greater integration of finances where Germany and the stronger economies subsidise the weaker economies); debt monetisation (the ECB prints money); or sovereign defaults.

Of the three, the first is almost completely out the window. Even if the German populace would agree to it, they don’t have as much wiggle room as would be necessary to fix the debt problem of all the weaker EU countries. The European Central Bank (ECB) has a set policy against expanding its balance sheet which makes number 2 difficult as well. That leaves us with sovereign defaults which means all the bailouts in the world only kick the can slightly farther down the road until the market forces the politicians’ hands.

So what happens if we get a sovereign default or two? Well, contrary to the many people in America who think they are largely insulated from such an occurrence, if the above scenario is true and the hedge funds and money markets of America have engaged in selling insurance (credit default swaps) on Greek, Italian and other European debt, we have a situation where economic collapse could easily happen in America. If those CDS are cashed in, people may discover that they can’t pull any money out of their money market funds. That could cause a run on banks and we all know how that ends up.

We had a chance to handle instances of moral hazard back in 2008. Our politicians completely let us down at the time and only reinforced the idea for the banks and the oligarchy that the government will always backstop them. By doing so and refusing to significantly reform the financial system, they opened up a scenario where a small country in Europe could possibly bring down the financial system around the world. They kicked the can a little farther down the road but we’re all going to be paying for it for a very long time.