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Syriza and the Soul of a Bank Under Hyperinflation

The biggest concern is if the market views Grexit as an isolated case that poses little systemic risk and credit investors have a more sanguine view on bank debt in general. The effect would far outweigh the effect of capital requirement increases and strengthened bank balance sheets. Equity investors are in a far weaker position, and it is share prices that will, as always, bear the brunt of the global sell-off.

Since the effect of Grexit will have wide repurcussions, I would by all means read it as a welcome opportunity to enter some quality positions cheaply. There are the those that will want to take a punt on Greece. What follows is that story.

So Syriza looks like it is set to dominate the Greek polls. Syriza has exploited anti-German sentiment more than anything. Germans certainly haven’t acquitted themselves well in this mess, but in all honesty, I’m not sure I could have done much better as a creditor. Maybe it is just my constant head-shaking when I hear Jens Weidmann sniping at all constructive efforts as a default posture.

Their platform in rough outline is simple. The broad terms set with the Trioka—call these terms “austerity”—are going to be radically altered Greece favorable or Greece will exit the EU. Secondly, they are avowed socialists and will push a socialist agenda.

I’m not too worried about the latter. If Greece exits the EU, there will be no fat to support a real socialist agenda anyway. Fat is what socialism in all its forms needs to finance its misguided policies. There is no fat nor will there be in the foreseeable future. Syriza will need financing, and it will be hard to come by given that they have the profile of an intransigent and irresponsible debtor. They are going to get a taste of real austerity.

Austerity will chiefly mean that covenants will be far more stringent, debt will be secured by revenue streams. It will feel even more like the Greek national wealth is being stolen form the populace even as financing comes at a mere trickle. An even deeper austerity will be felt if the Greeks do make a complete and full exit from the EU and return to the drachma. This will feel like the national wealth is suddenly worth very little. Then Syriza will have no choice but to offer foreign capital in to buy up goods on the cheap. This is real austerity. The conditions that the EU placed on Greece will look like afternoon tea with friends. Syriza will be surrounded by Goodfellas.

If Greece does exit, it will eventually work itself out faster but with a double-dose of pain. It will provide an important lesson to the other challenged countries in the EU on how to behave. They will find that no country is readily equipped to deal with the challenges of going it alone and exiting the EUR. This isn’t Iceland. This is Latvia (see chapter 1 of my book). Government default or not, there is plenty of corporate debt and household debt that cannot be so summarily written off. And the financial system will be shut-out of the interbank market it has relied on for a decade. At least for a time the situation will feel like a sudden and lurching stop.

The question is not what will survive this inept bunch of populists (no offense meant). When it comes to the financial ecosystem, people and their businesses are as hardy as cockroaches. The real question is whether some investment in Greece can offer returns high enough to make such a crazy play worth your time because the standard song and dance about “assured payment of interest and principal” is never assured in any case and plain silly to talk about in this context. There should be no expectation of any liquidity inside a year at least.

The real vig is whether it is safe to expect key industries to be protected regardless of any socialist pretensions to the contrary. Or Syriza really is a dedicated socialist party—not just a populist gang of power grabbers—with an agenda to truly nationalize key industries. Take it or leave it.

There is one such sector already primed for either protection or nationalization, come Grexit or austerity. You guessed it, the big four banks NBG, Piraeus, Alpha, and Eurobank. They will be under immediate pressure, since there will be an epic bank run as everyone rational in Greece will remove their Euros in fear of getting them converted into pretty much worthless drachmas if left in deposit.

These widespread bank runs to rip bank funding to shreds, and with it, the financial system to shreds. This will be a short-term knock-on effect, as the bank payment system is a necessary part of modern life. In time, deposits will return. The important matter is whether there is sufficient capital available to shore up Greek banks in the interim. There are funds ready at hand to address financial difficulties: the Hellenic Financial Stability Fund. This is a “bad bank” scheme that has absorbed the bad debts of the big four Greek banks, has about €625 million in reserve firepower to deploy via a short-term lending facility. See below.

Hellenic stability fund.jpg

Source: Hellenic Financial Stability Fund 2014 report

It may not be enough. Even as bank runs lock up ank funding, you can expect the Greek economy to absolutely implode as it adjusts through wages and consumption. The AQR stress test results will be meaningless. There will no immediate way to assess the resulting NPL provisioning needs. The only capital available to cushion the fall will be common equity. Common is nothing but loss absorbing tier I capital, funds to use as needed by management whenever needed. It is also likely, based on past precedent, that sub debt will be bailed-in a la Cyprus. I’m not discounting that senior bonds and senior secured credit could be bailed in as well, given we are dealing with Syriza, who may well want to socialize everything. Someone in finance has to have their ear and be able to impart to them that violating senior debt will be an act that cripples their ability to secure finance for the foreseeable future. The effect would be like the sanctions that locked Russia out of the capital market, plus an additional set of sanctions that would lock them out of the money market as well. It can’t see this as a choice.

A Grexit will mean businesses will effectively operate on a cash basis. Leverage will be offered at a premium. As a result asset prices will collapse as they would be re-priced in, potentially, drachmas. Any Greek government adopting a return to the drachma, socialist or not, will attempt to monetize budget funding gaps and subsidize key businesses. This will not last long as a policy, because the resulting inflation will make external funding needs impossible to service. The effort will become counter-productive. Yet high-inflation, even hyperinflation, does not imply a Permian extinction of the Greek economy. And certainly not banks.

Deutsche bank did quite well during the German hyperinflation of the early twenties. It survived by moving out of cash, the money market, and government securities as quickly as it could. At a floating rate, loans could be money good even while term was extended or loans were called and real assets gained.

DB loans.jpg

Ladies and gentlemen, Deutsche Bank returns on assets improved initially under hyperinflation. So it looks like short-term floating rate lending fares OK until underlying businesses are disrupted by it. Normalization to lower inflation is where Deutsche bank returns on equity cratered. I’m missing 1923 data, so this story is admittedly incomplete.

DB ROA.jpg

It is true that no business will be immune to an exit from the EU and recovery will be slow for most sectors. There are less drab spots. Of course, the tourism industry would rebound, as Greece is a lovely country with appeal for both casual vacationers across Europe. But there is a deeper, richer appeal to millionaire oligarchs looking to store their wealth in cheap assets and in cash deposits outside of their oppressive satrap, and ECB or Fed oversight and restrictions.

The bigger concern is if the market views Grexit as an isolated case that poses little systemic risk and credit investors have a more sanguine view on bank debt in general. The effect would far outweigh the effect of capital requirement increases and strengthened bank balance sheets. Equity investors are in a far weaker position, and it is share prices that will bear the brunt of the global sell-off.

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