Thursday, July 14, 2011

Avoiding Default Protects Phony Asset Valuations

Aswath Damodaran provides an insightful explanation about the various forms default can take and the potential consequences of those actions. He believes that the current situation in Europe reflects implicit rather than explicit default. Damodaran suggests a major reason for lenders selecting implicit default may be the ability to NOT write-down asset values. Personally I believe this is the primary reason for the current efforts by lenders in Europe and also a point missed by many investors. Although Greek debt may be trading at significant discounts, banks are currently not required to show losses on their positions. Despite the widespread perception of losses on European periphery sovereign debt, those losses have largely not yet been realized on bank income statements or balance sheets. Since very few people know how much sovereign debt each bank is holding or the currently assigned values, the ultimate realized losses present a significant risk for banks going forward.

From Aswath Damodaran at Musings on Markets

Default and Bankruptcy: Black, white and shades of grey

The talk of default is all around us, as we watch Greece and Italy struggle with impending disaster and the fight over debt limits in the United States fills the airwaves. But what is default? What are the consequences? And given a choice, when is default the best option?

Let's start with the most basic question. What is default? Most people would view it as the failure to meet an obligated interest or principal payment. That may technically be true, but it does not capture the shades of grey that characterize default. In fact, the ratings agencies seem to have thrown the Greek situation into tumult by viewing the country as being in default, notwithstanding the legislative approval of the
The ratings agencies have a solid argument here, since default cannot be defined narrowly as failing to make an obligated debt payment. It has to be defined more broadly as lenders accepting a drop in value in their positions, in return for letting the borrower escape technical default; this could include loosening debt covenants or restructuring the debt to the borrower's advantage, without being compensated adequately for these changes. Thus,  if lenders let borrowers sell secured assets to raise cash, delay later payments, borrow more money on already secured assets, or lend them more money at below-market rates, they are accepting a reduction in value of their loans, in return for on-time payments. I will let you make the judgment on whether Greece is in default, but this story is telling:
In effect, French banks are re-lending money to Greece at the rates that they set when Greece was viewed as a much healthier borrower. That is the equivalent of lending at below market rates and no amount of dancing around the truth will change that basic fact.

Why would lenders go along with this charade? In other words, why would lenders choose implicit default over explicit default? One reason is psychological. Explicit default casts as much light on lenders as it does on borrowers, since it reflects on the lenders' failure to assess credit risk adequately at the time of the original borrowing. Classifying a loan as being in default makes it impossible to deny that failure, while implicit default allows them to delay that recognition. The other is financial. Once a loan is classified in default, the rules on what follows are also more clear cut. Lenders have to write down the values of their loans to reflect the fact that default has occurred. This will have negative consequences for lending banks, which will take a hit to their regulatory capital holdings, and it will also lead to immediate losses for other investors who hold non-traded Greek debt in their portfolios. With implicit default, the rules are hazier and lenders can use the discretion built into the rules to put the best possible spin on the consequences. But implicit default has its own costs for lenders. By putting off the day of reckoning, it allows them to continue with the practices that led to the problems in the first place. In fact, if the price of implicit default is that lenders have to bring in fresh funds to cover past mistakes, it will make the eventual blow-up much bigger. (The best analogy that I can think off is the experience of Japanese banks in the early 1990s. Rather than accept the fact that the real estate loans that they had made during the boom years of the eighties were in default, they chose the path of implicit default, thus letting the problems fester and grow for another decade)

What about borrowers? Is implicit default better than explicit default for them? While there may be more shame and immediate cost associated with the latter, it is sometimes better to default, accept failure and move on to making the fundamental changes that need to be made. With implicit default, both borrowers and lenders remain locked into a dance, where fundamental changes are delayed or deferred. It remains an open question whether Greece is better off with its austerity package (and implicit default) or whether it would have better served by defaulting on its debt (even though that may mean exiting the European Union and giving up on the Euro). I know that there are many economists and investors who view the latter as a doomsday option, noting that default by Greece would have led to default by Spain, Italy, Ireland an Portugal. Well, guess what? Greece managed to avoid explicit default but that did not stop Italy from moving into the danger zone this week. Greece's actions may have bought some time for the EU to fix its problem states, but unless the fundamentals change, it has not changed the underlying dynamics that created these problems in the first place.

Postscript: The very first comment brought up a point that I should have addressed in my post, i.e., whether Greece's actions constitute a credit event in the Credit Default Swap market. That is not an academic question. If it is classified as a credit event, the sellers of the CDS are liable to cover potential damages. If not, life goes on... For the moment, it does not look like it meets the credit event criteria, but this post does a much better job than I ever could discussing the issue:
It also raises an interesting problem with default. When different entities define default differently, there will be more game playing around default...

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