A Question of Collateral Damage

 | Oct 27, 2011 | 4:30 PM EDT
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While there is universal agreement that the European crisis has passed and the world can get back to other matters, there are two fundamental issues not yet being discussed: Where will the revenue to service the new debt come from, and what's the collateral? Of these two questions, the collateral issue is the most important.

The plan for recapitalizing the banks, writing off Greek sovereign debt and precluding the debt crisis from expanding beyond Greece is predicated on the assumption that holders of the existing debt will have no other choice than to agree to it. If they don't "voluntarily" accept the haircuts necessary and provide the additional capital required to backstop the sovereigns and the banks, Europe will suffer cascading defaults that will cause creditors even greater losses.

J. Paul Getty once observed, "If you owe the bank $100 that's your problem. If you owe the bank $100 million, that's the bank's problem." European sovereigns and their banks appear to be holding creditors hostage to this concept.

But something Ronald Reagan said reflects the creditors point of view: "To sit back hoping that someday, some way, someone will make things right is to go on feeding the crocodile, hoping he will eat you last -- but eat you he will."

These two points of view represent a divergence in the way creditors and debtors see this situation. Debtors need money, and creditors are aware that by providing it, they risk increasing the moral hazard, and their losses, in the long run.

There is only one way to solve such a dilemma: The capital infusion must be structured so that the creditors win if the deal works, and win even more if it fails. The way debtors assure creditors is by providing tangible collateral. This has not been addressed anywhere in the opaque agreements that have been floated by European authorities.

When Brazil, Mexico and other countries defaulted on their sovereign bonds in the 1980s and 1990s, they were required to put aside 100% of the capital necessary to collateralize the issuance of new bonds. 

I wrote about this exact issue in my first RealMoney column almost two years ago, "The Greece Issue Goes to the Roots of the EU." There has been no discussion by European leaders regarding what new collateral they will provide in return for the additional capital needed to bail out the sovereigns and their banks.

It has been implied that just by making the new debt senior to the existing debt, it's enough assurance to convince creditors that their new investments are safe. But that's not how these things work. The attitude is best reflected in something Richard Tarlton said more than 400 years ago: "For who deceives me once, God forgive him; if twice, God forgive him; but if thrice, God forgive him, but not me, because I could not beware." This is familiar to today's audience as, "Fool me once, shame on you; fool me twice, shame on me."

Creditors are not in the habit of throwing good money after bad. They will demand collateral. Debt holders need to watch for when European leaders disclose to their citizens and the world what this collateral will be. Right now, the subject is lost in the working out of the details. When Brady Bonds were structured in 1989 to provide resolution to the crisis of defaulting countries in Latin America, it was so above board that citizens were aware of it.

I am concerned that the subject is not being addressed in Europe right now and nobody is willing to inquire. German Chancellor Angela Merkel suggested that using the country's gold reserves as collateral may be required, which would surely mean that the rest of Europe's sovereign gold reserves would have to be pledged as collateral, too. 

If that happens, it could derail the bailout package.

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