With the world focusing on the Greek debt tragedy, an article in the NY times about one Mr Kazarian, who claims that Greek debt in reality is only one tenth (!) the official size, caught my attention.
Mr Kazarian, founder of Hedge fund Japonica partners, is one of the largest private owners of Greek government debt. He has bought the bonds in 2012 and has made a (paper) killing so far, as they have appreciated in value. He says he is still holding on to his bonds believing they are still good value and – untypical for a creditor – argues for a debt write-off. According to him, the official debt figure (175 percent of GDP, ahem) is a meaningless number since it does not reflect “fair value” and is diverting attention from Greece’s true problems and “unnecessarily suffocating” the country.
My immediate reaction was that this is another version the “we owe it to ourselves” argument made by Keynesians to justify ignoring budget constraints. (For those of you who are unfamiliar with this argument: just remember that it is always helpful to be on the side of government if your goal in life are fat consultancy contracts or a tenured position).
Then I was prompted to ask Mr Kazarian how can the official debt be meaningless and “unnecessarily suffocating” at the same time? I mean, if something really doesn’t matter how can you be bothered with it? Isn’t that illogical?
But, Mr Kazarian is not another Nobel-prize winner without real world decision-making experience. Watching the video I learned he has a quite long and successful track record as a distressed debt investor. As a general rule, I tend to take arguments made by investors who are more experienced than me seriously even if they appear ludicrous. Therefore I decided to delve deeper into the matter.
I am not sure I have captured all of the arguments, but I think the following points summarize his view:
- Due to concessions made Greece’s debt burden is sustainable and lower than it appears
- Concessions (lower coupon, long maturities…) mean that the debt is worth less than par
- Writing of the debt to fair value leads to more realistic figures (“better accounting”)
- “Better accounting” leads to more confidence and “better decision making” by politicians
In the following paragraphs I will elaborate on each of these points.
Point 1: Due to concessions Greece’s debt burden is sustainable and lower than it appears
During the Greek debt restructuring 2012 part of the debt was written off, part of it was refinanced. This was a political decision/process, not a market based outcome. Due the fact that the write-off was not high enough (in order not to jeopardize banks who had foolishly lent the money encouraged by government-serving regulation) its debt debt-levels remained elevated and Greece remained shut-off from capital markets access. European tax-cows were forced to refinance the debt via various institutions (“Troika”) which are now the main Greek creditors.
However, at the time of the restructuring periphery debt was yielding upwards of five percent and at these levels Greece’s regular interest payments would have been overwhelming even after the write-off, with the result that Greece’s problems would have been in the news every second day. Now, NOBODY of the bureaucrats involved in the decision could need that. Therefore concessions were made: mostly below average coupon rates and maturity extensions. (The Austrian Finance minister at the time even said this would be a good deal for taxpayers. I don’t think she lied, I honestly think she was/is clueless – there is a lot of negative selection going on in bureaucracies).
So, yes, concessions were granted, but does this mean the debt level is lower than it appears?
Readers will remember the exchange I had with David Einhorn about the true size of Greece’s interest/GDP ratio. There was a material discrepancy between his bottom-up estimate and the official EU commission budget forecast numbers I used. I still have not resolved where difference comes from. Anyway, I have changed my mind and now think that interest/GDP does not matter much.
What matters much more is interest/tax revenue – and here Greece scores poorly. Below you find the tax revenue/GDP ratios for selected European countries.
As you can see, Greece’s tax revenue ratio is much lower than in other countries, even Cyprus’s ratio (39%) is significantly higher. And the difference is material.
Since I could not agree with David Einhorn on the correct interest expense/GDP ratio I have used another source. This post on FT-Alphaville features an IMF projection of Greece’s interest payments of about EUR 10 billion annually, i.e. about 4.75 percent of GDP. This is slightly lower than Portugal’s burden (5%) and close to Italy’s (4.7%) or Ireland’s (the latter figures taken from my post). If we forget for a moment that these countries have debt problems of their own, one could indeed conclude Greece is not extraordinary and wonder what the fuss is all about.
Adjusted for the lower tax base, however, the picture changes dramatically,
Now Greece looks considerably worse than the rest. For instance, it has to set aside double the tax revenue for interest payments than Spain, another crisis country. And these figures do not yet take into account the recent tax strike of Greece’s citizens.
Of course, you could say that Greece could raise taxes and the problem will go away. This is exactly what the creditors want and we hear lot’s about how Greece needs to improve tax collection these days. Economic ignorance wherever you look! As if increasing taxes has ever solved any problem or led to economic growth (The causality runs exactly the other way: higher wealth allows the political class to extract a larger share before people revolt).
It is absolutely certain that this will not work. The reason being, of course, that higher taxes will stifle what (legal) economic activity is left in Greece. Just think about it: Greece would have to increase average taxes by 30 percent in order to reach Cyprus’s or Portugal’s tax level – impossible!
To sum up: No, Greece’s debt load doesn’t look sustainable WITHOUT new concessions. Even if you ignore the stock and just look at the flows it remains too high.
Ad 2.) The concessions (lower coupon, long maturities…) mean that the debt is worth less than par
This is obviously correct. Without concessions made the bureaucrats could not even pretend that Greece is solvent.
Ad. 3) Writing of the debt to fair value leads to more realistic figures (“better accounting”)
Now, I am not exactly sure what he means by that.
It is certainly true that a write-off would bring much-needed transparency. For instance, tax-payers in the rest of Europe would finally be confronted with holes in their governments’ budget. So far most of the “educated” citizens of Europe have believed their governments’ assurances that all is well. The politicians can get away with this because government accounting doesn’t know about provisions for expected losses and they will be acknowledged only when finally written-off. This is indeed a huge flaw in public accounting and Mr Katzarian is absolutely right to criticise that.
Or take the ECB. A write-off would finally make it clear that it has engaged in government financing, although explicitly forbidden by EU contracts. This certainly would mean the end of the fiscal union debate. As someone who is tired to see government economists and “quality” newspapers argue for that nonsense, I would highly welcome such a development – even if I am aware that it would lead to a big economic and political crisis. (I confess that am a fan of the German proverb: “Besser ein Ende mit Schrecken, als Schrecken ohne Ende!”)
And this is exactly the reason why a write-off will never happen, as long as extend and pretend works. The accounting of government is opaque for a purpose. It has never been otherwise. If you do not believe me, read this book, it will cure you of any illusions you might have.
But, I feel that Mr Kazarian labours under another misconception as regards debt accounting. Warning: this is a bit technical!
He claims that EU accounting is arcane and does not reflect reality, i.e. the “fair value” of Greece’s debt, with the consequence that the parties involved (Troika, IMF, the Greek government) discuss about the wrong figures. Using proper accounting (fair values, not nominal values) the parties would realize that the Greek problem is much smaller. Happy end!
First possibility: Mr Katzarian confuses debtor vs. creditor accounting.
If you are a creditor of someone who is likely to default, the “fair value” of the loan will be below its par value. Now, a conservative management would provision against a likely default and write down the loan to fair value. They would still keep the nominal value on their books, however, for that’s what was lent in the past, but they would book a provision against this claim until the problem is resolved in bankruptcy. For the reasons mentioned before, Greece’s lenders (Troika) are not interested in conservative accounting practices. Heck, this is why they try to avoid technical bankruptcy and continue to pour money into the hole.
As a debtor, however, you are NOT allowed to write down the loan. And this is not arcane, but good and honest accounting. For, when it comes to bankruptcy the creditors’ nominal value represents the legal claim against the debtor’s assets. They form the basis for negotiations and the ultimate court decision.
Now, I would be shocked, if Mr Katzarian did not know all this. I mean that’s the bread and butter of distressed debt investing and he has a 20+ year track record in that field.
Which brings me to the second possibility: he thinks that due to the fact that a lot of the refinanced debt has a negligible coupon, it should be booked like a zero bond.
How does that work?
If you issue a zero bond at, say 50 percent of par, with a maturity of 30 years, it is not the par value that appears on your balance sheet. That would be insane, as it implies the creditors have a pledge on your assets twice as high as the amount they lent you. Instead, the liability rises in line with the interest accrued over time. The more time passes, the higher the creditor’s pledge becomes. It is this sum, i.e. the sum of price paid + interest accrued, which constitutes the claim in bankruptcy.
So is Mr Katzarian right, after all?
Well, I am afraid he is not. First, the refinancing by the Troika was not a zero coupon bond transaction – they really refinanced the whole nominal amount, not some fraction of it. The fact that the “fair value” at the time was significantly below the price paid doesn’t affect the accounting. The correct way would have been to provision part of the exposure immediately on the creditors’ books, but the nominal amount should stay there nevertheless. For comparison, in a real zero coupon transaction there is no need to provision immediately, since only a fraction of par is paid in.
But even if we pretended, it was a zero coupon bond transaction, not much would change for Greece WITHOUT further concessions. Yes, debt/GDP would be lower, but the interest expense would remain the same, with the difference that instead of a coupon payment, the (higher) interest accrual on the zero would need to be budgeted for. I see no way around it: Greece’s debt load is simply unsustainable without significant further concessions.
Ad. 4) “Better accounting” leads to more confidence and “better decision making” by politicians
Politicians do not want to make good decisions. They want to stay in power, not maximize welfare, or what have you. Arcane accounting is a tool to achieve that (by misleading the public).
But let us pretend for a moment that “better accounting” is indeed achievable. How would it look like?
Clearly the debt would have to be written-off to sustainable levels, whatever that means. If we define the German level as sustainable (defined by interest/tax payments) one would have to cut Greece’s debt load by roughly 65 percent, ceteris paribus, and Greece would be AAA credit according to current rating agency logic.
But is this logic correct? If we talk about “true accounting” would not we also have to record the debts of off-balance sheet liabilities into account? For example, would not we have to account for demographic changes and associated welfare liabilities as well? After all, something similar happens in life insurance/pension accounting.
And Greece’s demographic “off-balance” liabilities are indeed huge, as this article in Handelsblatt argues (unfortunately only in German). The main points:
- Greece is expected to be the third oldest nation on earth by 2030 (average age 50 years)
- Greece ranks 55 in innovation (out of 142), behind Uruguay, Serbia and Mauritius (!)
- Greece’s Math-PISA Rankings show a worrying trend (2006: 28; 2009:39; 2012: 42)
- International patents (PCT) in 2012: Greece 628 vs. Germany’s 46620
- Last but not least: with 1.4 births per woman Greece’s population is shrinking
We can safely assume that nobody in Greece’s political class (and the rest of Europe) is interested in honest accounting…
I think that Mr Katzarian gravely misunderstands the situation. He seems to think that by working hard and persuading politicians he can work on a turnaround of the country. He strikes me as somebody completely unfamiliar with bureaucratic logic and political processes. I seriously hope that I am wrong and he succeeds, although I think the chances of this are close to nil. I congratulate him on his paper profit and advise him to sell as much as he can as quickly as possible.
That’s the “nice guy” version.
The “bad guy” version is that Mr Katzarian has realized that he cannot turn his paper profit into cash due to a lack of market depth. There are probably not many people willing to risk large sums of money on Greece staying afloat. In this case, his only chance to get out at close to current levels is a write off of Greece’s debt ratio, such that sustainability is achieved and market liquidity in the bonds increased. The plan is good, there is certainly enough dumb money out there willing to lend money to a serial defaulter (see Ecuador, Argentina, Ivory Coast…). However, this requires that his claim is treated pari-passu with public creditors such as the ECB and the IMF for write-off purposes. I know, I know, that’s what the bond prospectus says. But what’s a contract worth to Mrs Lagarde or Mr Draghi? Not much, I am afraid…