Second Quarter 2011

Not for redistribution. Not an offer to buy securities.

1. EXECUTIVE SUMMARY ....................................................................................................................................................4 2. INTRODUCTION ..................................................................................................................................................................5 3. PRESENT EUROPEAN SOVEREIGN DEBT CRISIS.......................................................................................................10 4. BUILDING BLOCKS OF THE EUROPEAN SOVEREIGN DEBT CRISIS .....................................................................18 EXCESSIVE PUBLIC AND PRIVATE DEBT ...................................................................................................................18 WEAK BANKING SYSTEMS AND EXCESSIVE LENDING GROWTH .......................................................................21 INABILITY TO CONTROL MONETARY POLICY .........................................................................................................24 DECREASED COMPETITIVENESS AFTER EURO ADOPTION ...................................................................................24 INCREASING DEPENDENCE ON GLOBAL CAPITAL MARKETS..............................................................................25 WEAK GDP GROWTH .......................................................................................................................................................26 FINANCING WITH SHORT-TERM DEBT .......................................................................................................................27 LARGE FISCAL DEFICITS AND EXPANDING GOVERNMENT..................................................................................28 RATING AGENCY DOWNGRADES.................................................................................................................................29 5. EUROPEAN SOVEREIGNS OF PRIMARY CONCERN ..................................................................................................30 GREECE ...............................................................................................................................................................................32 The Rescue of Greece ......................................................................................................................................................32 IRELAND .............................................................................................................................................................................36 The Rescue of Ireland’s Banks.........................................................................................................................................37 The Rescue of Ireland ......................................................................................................................................................38 PORTUGAL .........................................................................................................................................................................42 The Rescue of Portugal ....................................................................................................................................................43 SPAIN...................................................................................................................................................................................46 ITALY ..................................................................................................................................................................................53 BELGIUM ............................................................................................................................................................................57 6. GOVERNMENTAL ENTITIES AFFECTING SOVEREIGN DEBT MARKETS .............................................................59 EUROPEAN UNION ...........................................................................................................................................................59 EUROPEAN ECONOMIC AND MONETARY UNION (EMU)........................................................................................63 EUROPEAN CENTRAL BANK (ECB) ..............................................................................................................................64 EUROPEAN FINANCIAL STABILITY FACILITY (EFSF)..............................................................................................67 INTERNATIONAL MONETARY FUND (IMF) ................................................................................................................69 EUROPEAN STABILITY MECHANISM (ESM)...............................................................................................................72 7. HISTORICAL SOVEREIGN CRISES, RESTRUCTURINGS, AND LESSONS...............................................................74 MEXICO’S TEQUILA CRISIS OF 1994 AND 1995 ..........................................................................................................80 RUSSIAN DEFAULT OF 1998 ...........................................................................................................................................82 ARGENTINEAN DEFAULT OF 2001................................................................................................................................86 URUGUAY’S DEBT EXCHANGE OF 2003......................................................................................................................89 THE BRADY BOND PLAN ................................................................................................................................................92 8. CRISIS SOLUTIONS AND RISKS .....................................................................................................................................98 THE PREFERRED EUROPEAN SOLUTION: INCREMENTALISM..............................................................................98 RESTRUCTURING SOLUTIONS ....................................................................................................................................106 OTHER SOLUTIONS ........................................................................................................................................................107 9. INVESTMENT CONSIDERATIONS ...............................................................................................................................111 10. CONCLUSION.................................................................................................................................................................116 APPENDIX: CREDIT DERIVATIVES..................................................................................................................................119 GLOSSARY ............................................................................................................................................................................125 INDEX OF FIGURES AND TABLES....................................................................................................................................127 REFERENCE LIST .................................................................................................................................................................130 2

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This research paper will discuss the multi-faceted dynamics of the European sovereign and financial debt crisis, with a comprehensive discussion of the background, status, potential solutions, and the ramifications for banks, economies, citizens, and investors. We also will discuss the countries of concern, key government-related bodies, and lessons from historical sovereign crises and defaults. Fears of default and difficulties in sourcing affordable financing for countries resulted in rescue packages for Greece and Ireland in 2010, the pending rescue package for Portugal, and contagion threats for Spain, Italy, and Belgium. The rescues have addressed near-term liquidity but resolving the fundamental solvency issues of the sovereigns and banking systems will require substantial coordination of government policies, capital raising, and financial support to restore long-term market confidence and avoid debt restructurings. The foundational problems for each country are idiosyncratic in nature, with varying ties to years of over-leveraged and under-capitalized banking systems, real estate bubbles, excessive government debts and spending, and fundamental economic weakness. Additional contributors to the present crisis included limited control of exchange rates and monetary policy, as well as declining competitiveness on the global stage, further accentuated by the financial, real estate, and economic crises that began to emerge in 2007. The reactions to these crises included banking support and government-funded stimulus, resulting in the transfer of private debt to public debt. The present crisis has significantly increased financing costs and restructuring probabilities for Greece, Ireland, and Portugal; however, concerns have decreased regarding contagion from peripheral Europe seriously affecting the much larger economies of Spain and Italy, though they too face significant challenges. The solutions to the European crisis – with progressive efforts led by the governments of Germany and France – will likely require preserving the common currency, providing incremental liquidity to support the weaker countries and banking systems, and restructuring sovereign debt. Similar historical crises in emerging markets have been resolved by restructuring banking systems (now underway in Ireland and Spain) and sovereign debt, which cannot be ruled out within Europe given the scale and complexity of the challenges ahead. Sovereign debt restructurings could include negotiated and market-friendly approaches such as discounted bond repurchases, exchanges, and/or a Brady Bond Plan tailor-made for Europe. As the sovereign and banking issues are resolved, the volatile and uncertain economic environment will provide numerous alpha-generating opportunities for experienced and flexible investors. Credit Stress in Developed Europe

■ ■

Serious Concerning


The amount of sovereign debt outstanding has soared in recent years, with particularly alarming increases in much of the developed world. This research paper analyses the causes, effects, and potential outcomes of the increased leverage for European countries, with a focus on the peripheral countries with increasing probabilities of restructurings among sovereign debt and banking systems. Our analysis could have encompassed other developed markets such as the U.S. and Japan given their broadly recognized fiscal challenges and increasing leverage; however, these countries have much less default risk than certain European countries due to their diversified economies, low funding costs, and monetary policy flexibility. Not since 1948, when Germany defaulted on the Nazi-era debt, has a developed country defaulted on its sovereign debt. Meanwhile, during this period (the past 63 years), there have been 68 sovereign defaults among emerging market issuers. In the present sovereign and banking crisis, Greece faces the greatest challenges in terms of excessive leverage and required fiscal reform, and as a result, could be subject to the first debt restructuring in a developed market in multiple generations. Portugal faces similar challenges due mainly to long-term declines in competitiveness, while Ireland’s difficulties stem mostly from an over-leveraged banking sector tied to a collapsed real estate industry. Avoiding default and contagion threats from these three peripheral European countries will require near-term solutions coordinated by various European authorities to address liquidity, with longer-term solutions entailing fundamental fiscal reforms and restructurings of sovereign debt and banking systems. The multinational coordinated efforts to impede contagion from reaching larger economies and banking systems facing similar challenges are critical to preserving Europe’s Economic and Monetary Union (EMU) since Spain and Italy represent a larger combined economy than Germany. Deterioration within certain European economies following the recession and near collapse of the major U.S. and European banks in 2008 and 2009 has led to major concerns about European sovereign credits and their financial systems. The present sovereign and financial debt crisis is focused on liquidity, sustainability, and solvency issues confronting the European periphery, defined as Greece, Ireland, Portugal, Spain, and Italy. History has witnessed many similar sovereign debt crises, though concentrated in emerging rather than developed markets, with a wide range of causes and outcomes. Like other sovereign debt crises, the troubles facing peripheral Europe resulted from high sovereign and private debt loads, large government deficits, declining global competitiveness of labor and industry, lack of control over domestic exchange rates and monetary policy, price deflation of real estate and corporate securities, and liquidity and solvency issues within the banking system following weaker lending standards during prior strong economic environments. However, Europe’s situation is different from prior crises in terms of absolute scale, the intertwined nature of its governments and banking systems, the global implications for trade and competitiveness from upholding the common currency, the absence of banking and currency runs, the lack of currency devaluation options, and the complexities across political and social strata. These sovereign issues will take many years to resolve, requiring long-term political coordination and fiscal determination in order to avoid defaults as each respective peripheral European country struggles to make their economy more competitive while deleveraging their banking system and administering austerity programs. The economic and financing crisis affecting peripheral Europe has challenged the founding philosophy of the 27member European Union (EU): the desire for closer political integration and coordination. This noble goal was complicated by attempting to simultaneously allow for continued fiscal and legislative independence among countries with varied economic and social regimes while surrendering control over monetary policy and exchange rates. The lack of monetary controls affects the 17 countries in the EMU, which established the euro (€) as the common currency (fully rolled out in 2002) and empowered the European Central Bank (ECB) to coordinate monetary policy among members, with the explicit and singular mission of controlling inflation. This patchwork of governmental powers, along with the divergent economic and fiscal performance of sovereigns, has resulted in the slow and convoluted incremental responses to the deepening crisis. This crisis has produced major increases in bond yields and spreads for credit default swaps (CDS) for more questionable sovereigns and major banking institutions.

The five-year CDS spreads for Greece and Ireland increased from roughly 150 basis points (bps) in late 2009 to peak above 1,000 bps and 600 bps, respectively, during 2010. The liquidity vacuum that began to develop in May 2010 resulted in the €110 billion bailout for Greece (with stringent preconditions for fiscal reform), which has long suffered from weak economic and competitive standing, over-zealous fiscal spending and entitlement programs, and a weak tax collection system. Concurrent with the Greek rescue, European government leaders announced the formation of a €750 billion stability package to address future sovereign financing needs, with funding from the EU, European governments (through the €440 billion European Financial Stability Facility, or EFSF), and the International Monetary Fund (IMF). Although these rescue packages were supposed to silence all questions about the liquidity support for heavily indebted European sovereigns, this left unanswered the deeper issues of economic competiveness and health of financial systems, and ultimately the solvency of governments (Greece’s bond yields and CDS prices have recently risen to record levels). After the Greek rescue, credit markets recovered but the renewed focus on fundamentals brought Ireland to the forefront of concerns, though for very different reasons than Greece. Ireland had been one of the great economic successes in recent decades, but the Celtic Tiger over-indulged in the optimism of perpetual prosperity following the euro’s introduction and strong economic results, producing a real estate bubble and a related grossly oversized banking system. The largest Irish banks were soon crippled by enormous levels of troubled loans when property values inevitably turned, which prompted the Irish government to provide guarantees for depositors and investors to prevent banking runs. However, the enormous scale of banking losses overwhelmed the government and triggered the October 2010 sovereign rescue financing package, with the government forced to tap the European support programs created in May 2010. This €85 billion rescue package required the Irish government to accept numerous conditions involving the implementation of austerity measures and other structural reforms; these were deeply unpopular and inevitably contributed to subsequent political turnover. During Ireland’s elections in February 2011, with declarations from Gerry Adams (leader of Ireland’s Sinn Féin party) echoing the populist sentiment that citizens should not have to pay for “the sins of bankers”, the Fianna Fáil party’s multidecade rule of Parliament came to an end. In addition to changes among leaders, the government has also pushed forward a much needed restructuring of the banking system. They are winding down two of the largest domestic banks already taken over by the government (Anglo Irish Bank and Irish Nationwide Building Society) by transferring assets to the government’s bad bank, then divesting the depositor base and selected assets to two new “Pillar Banks” (Allied Irish Bank and Bank of Ireland), which also are largely government owned. Ireland’s recent stress tests for banks, which excluded Anglo Irish, showed they require €24 billion of additional capital on top of the €46 billion already provided. Ireland’s struggling economy and need for additional banking capital have prompted its leaders to soften their rhetoric regarding tax rates (suggesting their low corporate tax rates could be increased) and burden sharing among senior bondholders in troubled banks (though losses are assured for subordinated bondholders). The rescues of Ireland and Greece evolved from quite different situations, which also differed from the rationale for Portugal’s recent €78 billion financial assistance package. Portugal’s difficulties resulted from long-term economic and competitive weaknesses along with excessive government spending and leverage. Despite continued insistence by government officials that internally driven austerity measures would be sufficient to manage their finances, increasing bond yields made financing costs unsustainable. Given Portugal’s high borrowing costs, the government will need to finalize the rescue package before the €5 billion of bond maturities in June 2011. The lack of market confidence shown by the Portugal’s escalating bond yields was furthered by the government missing budget deficit targets for 2010 and admitting prior debt and deficit figures were understated (reminiscent of Greece’s earlier admissions). As highlighted in the following table, the high leverage, weak fiscal performance, high bond yields, and high implied default probabilities of Greece, Ireland, and Portugal have threatened other countries with contagion that authorities recognize must be countered.


Summary of Western European and Reference Credits
(in trillions of € ) Credit Rating 10 Year 10-Year CDS Implied Moody's / S&P Bond Yield Probab. of Default Rescued Countries Greece Ireland Portugal Contagion Concerns Spain Italy Belgium Reference Countries Germany France U.K. U.S. Australia Japan China Brazil
Source: IMF and Bloomberg

2010 GDP € 0.23 € 0.15 € 0.17 € 1.06 € 1.55 € 0.35 € 2.50 € 1.95 € 1.69 € 11.06 € 0.93 € 4.12 € 4.43 € 1.57

Public Debt € 0.33 € 0.15 € 0.14 € 0.64 € 1.84 € 0.34 € 2.00 € 1.64 € 1.31 € 10.13 € 0.21 € 9.08 € 0.78 € 1.04

% of GDP Public Public + Fiscal Debt Private Debt Deficit 142% 96% 92% 60% 119% 97% 80% 84% 77% 92% 22% 220% 18% 66% 330% 293% 379% 389% 268% 385% 287% 324% 453% 355% 237% 477% 163% 142% -9.6% -32.2% -8.6% -9.2% -4.6% -4.6% -3.3% -7.7% -10.4% -10.6% -4.6% -9.5% -2.6% -2.9%

B1 / BBBaa3 / BBB+ Baa1 / BBBAa2 / AA Aa2 / A+ Aa1 / AA+ Aaa / AAA Aaa / AAA Aaa / AAA Aaa / AAA Aaa / AAA Aa2 / AAAa3 / AABaa3 / BBB-

14.9% 10.3% 9.5% 5.5% 4.8% 4.3% 3.3% 3.6% 3.5% 3.4% 5.5% 1.2% 3.9% 12.8%

83% 59% 61% 34% 24% 23% 11% 16% 12% 16% 10% 15% 15% 19%

The troubles of Greece, Ireland, and Portugal have caused global investor concerns about the liquidity and solvency of other countries in the developed world, thus requiring imperative corrective and decisive actions by authorities to avert contagion beyond these peripheral European nations. Greece, Ireland, and Portugal are each relatively small and similar in scale, accounting for a combined 6.1% of gross domestic product (GDP) for the EMU and under 5% of the EU, but the threat of contagion spreading to the financing markets of larger countries is the critical concern. Spain represents the line in the sand for Europe, as its economy is 1.9x larger than the combination of Greece, Ireland, and Portugal. Spain’s problems are complex, with a real estate collapse, a poorly capitalized and uniquely structured banking system, high unemployment, and overall challenges in economic competitiveness. Any failure of Spain, while increasingly unlikely as market access has improved and certain banks have made progress in recapitalizing, could jeopardize the survivability of the entire EMU and fulfillment of the EU’s intentions for political and economic integration. Further, any required rescue of Spain would overwhelm the capacity of the headlined €750 billion financial stability package, which has actual capacity closer to €365 billion due to estimated utilization by Ireland and Portugal and constraints in creating AAA-rated liabilities. Since Italy is even largely than Spain, and considered the next most at risk, financial rescue resources announced to date could be quickly exhausted well before the unique difficulties facing Belgium come into play. The resolution of the European crisis will require the complex balance of calming markets, financial stabilization, and agreement among multiple governments to avoid default among sovereigns and their intimately connected major banks. Due to the inadequacy of the present financial aid packages and their temporary nature (expiring in June 2013), the markets have communicated that a much more significant financing and resolution package must be created and implemented in order to restore investor calm and restore reasonable costs for sovereign financing in order to minimize the chances and costs of sovereign debt restructurings. Given the choice to resolve the crisis by “economizing or agonizing”, borrowers will surely choose the former, at least as a first attempt, rather than deal with the potential political and economic agony of default. The European Stability Mechanism (ESM), the permanent financing facility under construction that is intended to replace the aforementioned €750 billion aid package upon expiration, will play a critical role in providing troubled countries the time to economize by implementing fiscal austerity and structural reforms, while also rebuilding investor confidence and delaying

potential restructurings. The ESM is intended to allow countries to work through economic weakness, which could help stabilize the EMU by maintaining the present membership and preserving the euro. The priority of preserving the EMU was exemplified by German Finance Minister Wolfgang Schaeuble stating “We are not just defending a member state but our common currency”, and EU Council President Herman Van Rompuy warning that debt contagion was a “survival crisis” that threatened the existence of the euro and the wider EU. Any breakup of the EMU would be unacceptable to Germany and the other strong economies within Europe as it would result in a deep economic recession, devastation for weaker euro countries like Greece, and certainly introduce default scenarios that would imperil Europe’s banking system and other investors. In addition to preserving the EMU and the status of the European financial system by adding liquidity facilities such as the ESM, other productive solutions to avoid default could involve allowing countries to directly or indirectly purchase bonds at discounts (e.g. with an expanded and extended EFSF), additional support from the ECB, reforms of fiscal and social policies, privatizing industries, selling assets, and/or issuing debt with ranking senior to existing debt. These are all preferential to countries dropping out of the EMU, which has a remote probability since it would likely lead to debt restructurings. Default concerns are justified over the long term for any country with excessive fiscal deficits and leverage, and weak economic growth and competitiveness. Greek Finance Minister George Papaconstantinou has hinted that sovereign reforms could be paired with debt restructuring: “The issue of burden sharing by the private sector is in principle absolutely right...because taxpayers cannot continue to pay the bill and bondholders also need to be responsible for their actions.” The likelihood of a Greek debt restructuring is the focus of present debates in the ongoing crisis, with vastly differing opinions ranging from “impossible” to “inevitable.” The numerous and relatively recent defaults of emerging markets illustrate the restructuring possibilities and dangers of countries foregoing control of their currencies and monetary policies, and hence potentially their economic competitiveness and stability. The defaults of Russia (1998), Argentina (2001), and Uruguay (2003), along with the 17 countries that restructured using Brady Bonds (1990-1997), highlight the variety of factors contributing to default as well as different restructuring solutions that could prove prescient in any future sovereign restructuring. The historical emerging market solutions have included a variety of restructuring alternatives including par reductions, coupon reductions, rescheduling maturities, currency devaluation, inflation, and economic, financial, and fiscal reform. While the economic and financing recovery of these emerging market countries post-default exemplify sovereign survivability, the present crises is less likely to produce broad-based defaults for reasons including the absolute scale of the problem, the resulting global economic implications (especially for Germany), the interlocking and inter-dependent borrowers and lenders between countries, the inability for banks to absorb losses on sovereign debt positions (which would entail even larger required rescues given their enormous holdings of troubled sovereign debt), and recognition of the danger of contagion spreading to larger economies and banking systems. The European authorities are keenly focused on exploring contained sovereign restructurings for certain peripheral European countries given their unsustainable debt structures and borrowing costs, but want to ensure that actions taken are “bank-friendly”. For example, Greek sovereign debt holders could be offered the option to avoid default by exchanging into 30-year bonds with lower coupons; this could allow European banks that hold Greek sovereign debt to avoid write-downs even though they would receiver lesser payments over time. Whatever the form and timing of eventual sovereign restructuring, there is no question that restructurings among Europe’s banking systems are occurring with greater haste (as seen in historical emerging market crises) given their dependence on market access and customer confidence. Ireland and Spain, the countries with the most significant banking industry troubles, have each taken significant steps to restructure banks through nationalizations, forcing mergers, segregating lower quality assets, divesting assets, and raising capital. Additional capital is needed by banks to restore solvency, as seen by Ireland’s recent banking stress tests. The upcoming announcement of the European banking stress tests in June 2011 by the European Banking Authority could substantiate market estimates that Spanish banks need €50 billion to €100 billion of new capital, in addition to revealing potential capital shortfalls for German Landesbanks and others. However, it remains to be seen if

these stress tests will presume losses on any sovereign debt, despite the increasing risk of sovereign restructurings. The resolutions to the European sovereign problems – which are most severe in Greece, Ireland, Portugal, and Spain – will require incrementally working through a combination of initiatives over time that will produce a challenging and rewarding environment for astute investors. Portfolio flexibility, shorting capabilities, hedging abilities, restructuring expertise and experience, and thorough knowledge of CDS will all be important attributes to produce attractive investment returns. Importantly, these uncertain times share commonality with historical crises, with potential opportunities across sovereign credit, CDS trading, bank capital structures, long positioning in assets and portfolios divested by banks, and potentially distressed sovereign and corporate bonds. By way of organization, this research document will review the present European sovereign debt crisis in Section 3, detail the historical building blocks of the crisis in Section 4, review the more concerning countries and the rescues to date in Section 5, discuss the critical governmental and supranational players in Section 6, provide examples and lessons of prior sovereign debt crises in Section 7, and review the potential near-term and longerterm solutions and outcomes in Section 8, before detailing the considerations and opportunities for investors in Section 9. This is followed by an Appendix reviewing CDS and a glossary of the numerous acronyms and terms used throughout the document.


Prior to the global credit crisis that began in 2007, all European countries could access sovereign debt markets at yields implying miniscule credit risk. However, one of the greatest lessons of the financial collapse in 2008 was that enormous companies and institutions are not immune from the laws of economics, especially when burdened with high leverage. The downside of excessive leverage, particularly when combined with weakening conditions and asset bubbles, was well encapsulated by Yale Professor Irving Fisher in 1933: “Over-investment and overspeculation are often important; but they would have far less serious results were they not conducted with borrowed money.” In the financial crisis, despite repeated reassurances from management teams throughout the highly leveraged financial industry that losses from sub-prime mortgages, other mortgages, trading exposures, and commercial bad debts would be contained and manageable, and that stock dividends would continue uninterrupted, investors suffered extraordinary wealth destruction as the banking and economic crisis deepened and management’s claims proved entirely false. This led to the failures, bailouts, and/or take-overs of some of the largest financial institutions in the U.S. and Europe: Lloyds Banking Group, Royal Bank of Scotland, Allied Irish Banks, Anglo Irish Bank, Fannie Mae, Freddie Mac, AIG, Washington Mutual, Wachovia, Bear Stearns, Lehman Brothers, and Merrill Lynch. This reawakening to credit risk among high investment-grade institutions left investors wary of other heavily indebted entities that claim all is well when facing major and unappreciated challenges, which perfectly describes many sovereign credits. This wariness led to new metrics for sovereign risk pricing, with virtually all sovereign bonds in Europe now including various degrees of idiosyncratic credit risk. The present European debt crisis has long been building for the certain countries, for reasons including the inability for each country to control its own currency exchange rates and monetary policy, a history of sizable government deficits and debt loads resulting from weak economies and dwindling competitiveness, expensive and underfunded government entitlement programs, difficult debt maturity schedules, dependency on capital markets, structural imbalances in their economies, and banking system fragility. These issues were exacerbated by the downdraft in real estate prices following the multi-year build-up of prices in the early 2000s, which contributed to a liquidity crisis for banks beginning in 2007. Numerous government initiatives to stem the banking liquidity crisis, with much of the burden assumed by sovereign entities through guarantees for depositors and investors, proved insufficient to match the scale of the severe economic recession during 2008 and 2009. The deflation of asset and securities prices during the recession, along with the burst real estate bubble, highlighted that banks had not only liquidity problems, but also solvency problems. The explicit and implicit governmental support for the banks – conjoined with justified concerns surrounding excessive leverage, fiscal discipline, major debt refinancing requirements, and a weak economic outlook – then contributed to heightened investor concerns surrounding sovereign credits and their worsening balance sheets. These challenges, among others, are summarized in the following table for European and other reference countries. Although the most challenged European countries are relatively small, larger markets such as the U.K., the U.S. and Japan share some of these troubling signs. However, the subjective graces of the market and other more justifiable differences in financing methods and economic outlook have kept these larger developed markets off the troubled list of credits, at least for now. However, any country is subject to default risk without conscientious and sustainable fiscal and monetary policies, particularly when ignoring Professor Fisher’s lesson above.


Sovereign Credit Deficiencies
Criteria Excessive total debt Excessive private debt Excessive public debt Maturity profile of sovereign debt Strong dependence on global capital markets Less currency flexibility (ability to devalue currency / reserve currency status) Less competitive economy Less ability to deliver on fiscal austerity Significant banking system concerns Rating agency downgrades
Source: Deutsche Bank, Marathon

U.S. Japan U.K.



Portugal Spain Italy Belgium




Rescued Rescued

Rescued Rescued

Pending Pending













Concerns about government balance sheets escalated during 2009 after Greece increased its budget deficit forecast for 2009 to 13.6% of GDP (the final figure was 15.4%); this resembled the negative revisions for banking expectations and dividends that preceded the banking financial crisis. This deficit was far beyond the 3% of GDP allowed for the 17 countries in the EMU (though most other members have also breached this requirement over time). Investor sentiment toward Greece soured again in early 2010, with bond yields spiking after the government was found to have repeatedly and intentionally misreported the country’s economics figures. Leading investment banks were associated with arranging transactions that assisted Greece in manipulating its reported debt levels, which masked the actual budget deficit and allowed the government to continue borrowing and spending freely. Investor concerns quickly spread from Greek sovereign debt to other countries in peripheral Europe, producing higher yields for bonds of Ireland and Portugal (see following charts), and also impacting funding costs for Spain, Italy, and Belgium. Apprehension grew about Greece and other European countries’ increasing debt levels and government deficits through 2010, as reflected by a series of sovereign debt downgrades by rating agencies (Standard & Poor’s and/or Moody’s lowered ratings on Greece, Portugal, and Spain in April 2010). With markets becoming more volatile in May 2010, the IMF and governments in the EMU attempted to contain the spreading crisis by granting Greece a €110 billion financial support facility (€80 billion from the EMU countries and €30 billion from the IMF). As discussed further in Section 5, this rescue provided €45 billion immediately but required the Greek government to implement a series of austerity measures including strict budgetary and structural reform. In conjunction with the Greek rescue, the IMF and European leaders also approved the €750 billion Financial Stability Package to ensure financial stability and address market uncertainty across Europe and prevent the crisis from spreading further. The €440 billion European Financial Stability Facility (EFSF) was the largest element of this package, with the remainder consisting of €60 billion from the European Commission’s European Financial Stability Mechanism (EFSM) and €250 billion from the IMF (or up to 50% of the combined contribution from the EU). As discussed further in Section 6, the EFSM is funded under the EU’s budget, and thus can provide immediate funding to any of the 27 EU members; in contrast, the EFSF supports only the 17 Euro-Zone members and requires significant approvals before funding.


Yield Curves for Greek and Irish Sovereign Debt – March 2011 versus March 2010
18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 3M 6M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 12Y 15Y 30Y
Ireland 3/31/10 Greece 3/31/11 Ireland 3/31/11 Portugal 3/31/10 Greece 3/31/10 Portugal 3/31/11

Source: Bloomberg

Yield Curves for European Sovereign Bonds













0% 1 2 3 5 7 Ye ars to Maturity 10 15 20 30

Source: Bloomberg

The IMF’s involvement in Greece’s recent rescue was a novelty in the sense that the IMF had never rescued a developed market, much less a member of the Euro-Zone. It had, however, been active in many historical problems in emerging markets and even other Western and Eastern European states in the recent past, such as providing loans to Hungary, Latvia, and Ukraine during 2008 and Romania in 2009. The IMF’s involvement with Greece was initially viewed with skepticism by many, including the U.S. and Euro-Zone members; the French

and Spanish governments viewed the Greek troubles as an internal Euro-Zone matter, with IMF involvement considered humiliating for the Euro-Zone. On the other hand, Germany actively lobbied to involve the IMF given their expertise in managing fiscal adjustment programs. From a practical standpoint, Germany’s position could be interpreted as either (i) signaling they are unwilling to be serve as the Euro-Zone’s lender of last resort, which is important in the light of significant internal political opposition in Germany, (ii) their dedication to protecting the euro and local banks to help the German economy, since German banks have the largest debt exposure to troubled European sovereigns and banks, and their export markets (roughly two-thirds of exports are within Europe) have benefitted tremendously from the cheap euro (a stand-alone German currency would be valued much higher, meaning their exports would suffer from higher prices), or (iii) strengthening its negotiating position to demand stricter Euro-Zone budget discipline, since the IMF is seen as tougher on enforcing austerity than the European Commission. The Greek rescue, the EFSF, and other rescue initiatives did not quell investor concerns about peripheral Europe, which also faced challenging ramifications from ongoing economic weakness and questionable solvency of major banks. Ireland was the next country in the market’s cross-hairs. This resulted from the country’s major recession and fiscal damage from pledging to support depositors and bondholders of over-levered domestic banks, despite the fact that their main banks were collectively much larger than the entire economy and far beyond the government’s ability to rescue (domestic assets of Ireland’s banks were 484% of GDP, and much larger including non-domestic assets). The bond market turned on Ireland after its major banks reported losses in October 2010 that exceeded even morose expectations. This prompted the Irish government to effectively take over its largest domestic banks, including Allied Irish Bank, Anglo Irish Bank, Bank of Ireland, and Irish Nationwide Building Society. However, the crisis continued to build. The overwhelming obligations from supporting banks outweighed the government’s claim that their fiscal budget was fully funded through most of 2011, which forced them to request a bailout package in November 2010. This €85 billion package consisted of €17.5 billion from internal reserves, €4.8 billion of bilateral loans, €22.5 billion from each the IMF and EFSM, and €17.7 billion from the EFSF. As with the Greek package, the relatively high interest rates for these rescue loans have only increased the country’s interest burden. As investors connected the dots between Greece and Ireland, contagion fears threatened to consume other countries, similar to the repercussions of Argentina’s debt crisis ten years earlier. This risk aversion among investors – often justified for countries running major budget deficits, subject to increasing debt loads, and pending maturities – can quickly increase interest costs and deepen a government’s fiscal deficit. Such circular problems can prompt a liquidity crisis, potentially leading to further concerns surrounding sovereign solvency. This was the fear as investors turned to Portugal as the next most concerning sovereign credit. The concerns regarding Portugal were not punctuated by a banking crisis (as in Ireland) or acute fiscal mismanagement and deception (as in Greece), but resulted mainly from its escalating debt burden paired with long-term weak economic growth and competitive positioning. Although the Portuguese government insisted it could handle the upcoming refinancing requirements and fiscal deficits without external aid packages by implementing austerity and stimulative measures internally, the market’s lack of faith produced unsustainably high refinancing costs. These costs increased sharply after the government missed the 2010 fiscal deficit targets and admitted some earlier economic statistics were incorrect, and Parliament rejected the austerity plan presented by the Prime Minister Jose Socrates. In the ensuing turmoil, the Prime Minister resigned (though still serving until a replacement is appointed), the President called for early elections (to be held on June 5, 2011), and the government officially requested financial assistance. Terms of the resulting €78 billion rescue financing package for Portugal remain to be determined, though stated goals from the likely capital providers include reducing the budget deficit as a percent of GDP from 9.1% in 2010 to 3% in 2013. Other terms of Portugal’s rescue will likely include harsher austerity measures than the rejected plans from the Prime Minister. Given the upcoming elections, securing the rescue package will be complicated by the potential unwillingness of lenders to accept pledges from outgoing politicians.

The main intention of the rescue financing packages to the smaller countries of Greece, Ireland, and Portugal (collectively 6.1% of Euro-Zone GDP) is to preserve liquidity and short-circuit the contagion fears from spreading to larger and more systemically important countries that could threaten the broader European economy. Any contagion fears affecting Spain, Italy, and/or Belgium – which account for 12%, 17%, and 4% of the EuroZone’s GDP, respectively – could substantially increase their refinancing costs and therefore jeopardize the future of the euro and impair the broader economies and banking systems within Europe. Also, any fundamental or investor-driven rescue needed by these larger economies could easily require hundreds of billions of euros, bringing into question if the €750 billion Financial Stability Package (intended to handle the scope of any foreseeable crisis) is sufficient to support such larger countries while also providing a sufficiently large cushion to appease markets. The scale of available rescue financing is especially concerning given that EFSF borrowings are intended to be rated AAA, meaning the practical limit of the EFSF’s size is governed by funding countries rated AAA (e.g. Italy and Spain account for over 30% of the EFSF funding, but are rated below AAA). This rating constraint resulted in the €440 billion EFSF having a more practical limit of €256 billion (with roughly €226 billion undrawn), and limits the total Financial Stability Package to €474 billion rather than the €750 billion headline. Further, availability under the plan decreases as countries need financing or participants are downgraded. The AAA rating constraints, in addition to estimated commitments for countries that have requested recues (which also effectively eliminates their commitment to the EFSF and the related 50% matching commitment from the IMF), have reduced availability on the Financial Stability Package to roughly €365 billion (see following table). That availability amounts to only 57% and 20% of the public debt balances for Spain and Italy, respectively. Government leaders increasingly recognize that the present financing programs are insufficient, yet they must restore confidence and stop contagion in its tracks. Any serious difficulties for such larger countries would apply great pressure on France and Germany to support the entire region. Summary of Commitments and Availability under Europe’s Financial Stability Package
(in billions of €) Funding Source Commitment EFSF 440.0 EFSM 60.0 IMF 250.0 Subtotal 750.0 Internal Bilateral Total Exclude Greece 12.3 6.2 18.5 Exclude Portugal 11.0 5.5 16.5 Exclude Rescue Ireland Ireland 7.0 17.7 22.5 3.5 22.5 10.6 62.7 17.5 4.8 85.0 Est. Rescue Portugal 30.0 20.0 25.0 75.0 0.0 3.0 78.0 Est. Undrawn Commitment 361.9 17.5 187.3 566.8 Est. Undrawn from AAA-rated Countries 225.9 17.5 121.7 365.1 57% 20%

% of Spain's Public Debt: % of Italy's Public Debt:

Investor concerns and contagion worries have produced increased sovereign bond yields and major divergences in yields among the higher and lower quality European sovereign credits (see following graph), in contrast to the historical tight clustering of yields. In recent months, the spreads of sovereign yields above the low-risk German government bonds (i.e. the bunds) have reached all-time highs for Greece, Ireland, and Portugal although spreads have remained more stable or slightly decreased for Spain, Italy, and Belgium. While this latter group of countries continues to experience elevated bond spreads and face longer-term issues, the decreased refinancing costs have improved near-term liquidity prospects.


10-Year Sovereign Bond Spreads to German Bonds (bps)
Greece Ireland Portugal Spain Italy Belgium

1,000 800


400 200

0 Apr-10 May-10
Source: Bloomberg




Sep-10 Oct-10 Nov-10 Dec-10


Feb-11 Mar-11

10-Year Sovereign Bond Yields
Greece Ireland Portugal Spain Italy Belgium Germany

13% 11% 9% 7% 5% 3% 1% Apr-10 May-10
Source: Bloomberg



Aug-10 Sep-10 Oct-10 Nov-10 Dec-10


Feb-11 Mar-11

Another indication of market confidence and default expectations is the pricing of credit derivatives such as credit default swaps (we discuss CDS in the Appendix); the pricing of such default protection mirrors the sovereign credit spreads versus Germany, which reflect concerns about a given country’s ability to service its debts. CDS pricing for European sovereigns (see following chart) has implied increasing probabilities of default for certain countries. The implied cumulative default probability on 10-year CDS is 83% for Greece, 59% for Ireland, 61% for Portugal, 34% for Spain, 24% for Italy, and 23% for Belgium; this compares to 10% for Australia, 11% for Germany, 12% for the U.K., 15% for both China and Japan, and 16% for the U.S. and France, which are among the world’s lowest. Elevated default concerns contributed to the 15% depreciation in European stocks (using the

Euro Stoxx 50) and the euro (versus the U.S. dollar) from December 2009 through June 2010, when concerns began to mount. However, equity markets across Europe have largely recovered as the shock of the crisis has waned, though bank equities and CDS levels continue to reflect grave concerns, especially with bank stress test results due in June 2011, the pending negotiations for the rescue of Portugal, political uncertainty, and the prospect of sovereign restructurings. CDS Curves for Selected European Sovereigns
Greece Ireland Portugal Spain Italy Belgium France Germany

2,000 1,800 1,600 CDS Spreads (bps) 1,400 1,200 1,000 800 600 400 200 0 6M
Source: Bloomberg








The recent market stabilization in equity prices throughout Europe and stabilized CDS prices for Spain, Italy, and Belgium have paralleled the ECB’s increasing salvation efforts. These efforts have expanded well beyond the ECB’s traditional means of fulfilling their price stability mandate. The ECB has been actively purchasing debt of sovereigns, debt of banks, providing more access to financing lines, and expanding acceptable collateral to improve bank liquidity. The ECB will have to play a more significant role than its standard to help stabilize the banking system, which is the largest holder of the troubled sovereign debt. The ECB will need the assistance of the more stable sovereign governments, the IMF, and a reassured investor base to contain the crisis. The nearterm risk to sovereigns primarily arises from the potential failure to refinance these debt maturities at reasonable rates. However, with the recent market stabilization, the ECB has curtailed earlier stimuli, decreased debt purchases in recent months, constricted eligibility criteria for collateralized ECB financing, and even raised interest rates in April 2011 (the first increase since June 2007) in response to increasing inflation. Beyond the near-term stabilization and potential triggers from refinancing requirements, the more fundamental risks concerning long-term solvency of sovereigns and certain major banks remain largely unanswered. The solvency questions arise from the legacy and outlook for rising sovereign debt loads, major fiscal deficits, depreciation of real estate, and high unemployment. Also, the limited sovereign ability to control monetary policy, inflation, or exchange rates impairs any single government’s ability to influence the weak competitive stance and troubling outlook for economic growth, especially with the recessionary and deflationary austerity measures being implemented. Given the breadth and depth of the crisis, near-term and longer-term solutions to successfully emerge from the current crisis will take substantial, coordinated efforts among political decision makers and possibly require consent and certainly some degree of cooperation from the global financial markets. Multiple pathways exist to lay the foundation for a potential recovery from the unprecedented peacetime deterioration among European developed nations. In the near term, European governments and supranational

entities will utilize all available stop-gap measures to delay any restructuring of sovereign debt given the default repercussions across financing markets, economies, banking systems, and potentially the currency regime. The extent of such efforts has been proven in the rescues of Greece, Ireland, and Portugal. The rescue programs have been funded by internal reserves and external financial support including the EFSF, ECB, IMF, and bilateral loans. The external support generally requires significant austerity measures and fiscal reforms. These external financing programs will have to be supplanted shortly by a more comprehensive and sizable rescue financing commitment due to (i) consumption from announced rescues, (ii) the inadequate scale of the current EFSF and other programs to finance or refinance all obligations of the rescued countries, much less support larger countries, (iii) their inherently temporary nature, with the Financial Stability Package expiring in June 2013, and (iv) the repercussions of contagion spreading from the smaller peripheral European countries to larger sovereigns such as Spain, Italy, and Belgium. The near-term solutions will also have to address the liquidity and health of the banking system, since further banking troubles could result in even more liabilities transferred from the private to public sector through nationalizations, bail-outs, and/or guarantees. The troubled sovereigns will also have to do their part to promote progress and solutions internally, which will involve a major overhaul of long-standing fiscal, social, and economic policies. These fiscal commitments will be difficult to maintain given the economic implications (austerity requires higher tax rates and/or collections paired with reduced spending) and political repercussions (austerity is unpopular and likely produces shifts in political willingness to stay the course if the politicians are to maintain their positions). Another supplemental, not to say replacement, element to a near-term solution could include debt buybacks for sovereigns and/or banks. For example, the ECB has reputedly acquired €50 billion of Greece’s long-term debt at average price near 70% of par; if this debt could be refinanced or exchanged for new debt at the ECB’s cost (with the 30% haircut forgiven), the Greek government would reduce debt by roughly 5% (€17 billion). However, all of these initiatives still fall short of resolving the long-term issues of fundamental solvency and projected fiscal deficits. The long-term solution to the credit crisis must involve means of reducing the unsustainable debt service requirements for suspect sovereigns and banks. In order to prevent default – the least desirable solution due to difficult economic, political, and reputational repercussions – fiscal and monetary policies must produce economic growth in excess of debt growth to regain investor confidence in each country’s debt servicing capabilities. This can be partly addressed internally by reducing fiscal deficits and reforming entitlements, and with external assistance if (albeit unlikely) the ECB promotes inflation. Other long-term solutions could also entail asset sales, privatizations, or new capital infusions (e.g. collateralized debt for sovereigns or junior capital for banks). Assuming no positive exogenous events correct the current account deficits of the over-leveraged sovereigns, and the existing solvent Euro-Zone countries do not substantially increase their support commitments to buttress the present incrementalist approach, there is a higher probability that some form of debt restructuring will eventually be required. The numerous restructurings of emerging markets have proven that reducing debt service obligations can be accomplished via IMF-assisted voluntary exchanges to reduce principal and/or reduce coupons (thereby reducing the net asset value of obligations), along with rescheduling maturities. However, such a sovereign default for any developed market could produce investor flight, heightened contagion fears, and necessitate a restructuring of the banking system as well. The removal of troubled countries from the EMU (even though voluntary withdrawal and involuntary expulsion are not permitted) would not provide a solution since the likely outcome would be massive losses on debt held by other EMU members, not to mention that a devalued currency would produce substantial economic confusion and contraction (this would also hurt trading partners by reducing exports to this country). The default repercussions could potentially be lessened by creating a new support mechanism reminiscent of the Brady Bond Plan which was used so effectively to restructure emerging market debts for 17 countries from 1990 to 1997. While these ultimate solutions are likely to be postponed by the political powers in place for as long as possible, any market attack or withdrawal of fundamental liquidity could force these actions to take place sooner rather than later.

The present European sovereign debt crisis is the result of many factors, including structural and cyclical features. The cyclical downturn among economies and real estate markets have impacted government finances through lower tax receipts, fiscal spending to stimulate the economy, and higher spending on unemployment. However, certain European countries also suffered from structural issues such as excessive private and public debt loads, unsound banking systems, negative consequences from delegating monetary policy to the ECB, weak economic growth and competitiveness, poor records of fiscal spending well before the recession, and dependence on capital markets for ongoing financing (especially when facing major debt maturities in the near term), as well as changes in investor sentiment and exposures following downgrades by rating agencies.

The difficulties for many European countries have been fueled by a decade of debt-fueled macroeconomic policies pursued by local policy makers and complacent central bankers. A long period of low interest rates and credit spreads, abundant liquidity, development of real estate bubbles, and globalization of banking fostered rapid and substantial credit growth. This was particularly evident among peripheral European countries, which saw a surge of debt-financed consumer demand and capital inflows following their adoption of the euro. The expansion of private debt in the 2000s coincided with increased public debt in several mature economies (notably excluding Germany and Switzerland). While the level of public and private debt by itself is not enough to predict a crisis – which requires a more granular analysis of other macroeconomic factors, budgetary analysis, investor sentiment, and interest costs – the amount of debt relative to a country’s economy can provide insights related to the debt burden, impacts on GDP growth, and quality of the sovereign credit. As shown below, the high levels of public debt as a percent of GDP (highest in Greece, Italy, and Belgium) should be added to private debt including household and corporate debt to understand the total leverage within a country, especially since certain private debt could be transferred to the government in a crisis (as shown with Ireland’s banking rescue by the government). Debt among households is highest in Portugal, the U.S., and Ireland; debt for financial institutions is highest in Spain and the U.S.; while non-financial companies have the highest relative debt loads in Belgium, Spain, and Portugal. These debt levels have long been creeping higher, particularly with the deterioration of lending standards in the 2000s that contributed to housing bubbles in several countries including Spain, Ireland, the U.K., and the U.S. Debt by Sector as Percent of 2010 GDP
Financial Businesses 450% 400% 350% 300% 250% 200% 139% 150% 100% 50% 0% Spain Belgium Portugal U.S. Greece France Ireland Germany Italy 105% 77% 157% 137% 389% 60% 97% 84% 54% 95% 142% 91% 60% 76% 58% 55% 97% 70% 83% 92% 92% 84% 52% 104% 85% 59% 53% 79% 61% 66% 39% 58% 52% 385% 379% 355% Non-Financial Businesses Households Government


324% 293% 96% 287% 80% 119% 268%

Source: Central Banks, IMF, Deutsche Bank


Although the mix of public and private obligations varies by country (see graph above), many have total debt levels considerably greater than GDP. Growth of public debt has accelerated since the start of the banking crises and economic downturn due to stimulative initiatives, banking rescues, and larger government budget deficits. This increased debt corresponds to the conclusion by Carmen Reinhart and Ken Rogoff that, after crises, “central government debt rises, on average, by about 86% within three years.” As presented below, public debt levels and growth as a percent of GDP stand out for Greece, Italy, Ireland, and Belgium. All of these exceed 90% of GDP, the level generally corresponding with lower future economic growth rates, according to Reinhart and Rogoff. To reduce this ratio, European countries need economic growth to exceed debt growth, which can be influenced through trade policies and budgetary measures such as fiscal austerity in spending and changing tax rates or tax collections. However, such fiscal changes often are politically hazardous and difficult to implement. This is doubly difficult if countries lack the most powerful sovereign weapon to lower relative debt levels: control over exchange rates and monetary policy. EMU members have transferred this power to the ECB (as discussed in subsequent pages). Also, any country unable to effectively manage their budget and debt maturities could discover investors unwilling to advance additional capital, with potentially catastrophic consequences. Public Debt as % of GDP – 2010 versus Average from 2000 to 2008
160% 142% 140% 120% 100% 80% 62% 60% 40% 20% 0% Greece Italy Belgium Ireland France Portugal Germany Spain
Source: IMF, ECB, European countries central banks

Average 2000-2008 119%



106% 96% 97% 96% 84% 92% 80% 58% 64% 60% 47% 32%

Debt levels for many European countries coming into the crisis were already elevated due to sizable budget deficits that accumulated over time, which were partly attributable to extensive and expensive social welfare systems. Crucially, the official debt figures, although already high, entirely exclude massive off-balance sheet obligations such as contingent liabilities and underfunded pensions. These obligations are especially onerous for countries with large populations of government employees (including civil service, administration, utilities, transportation, teaching, security, and defense). These types of issues certainly apply to Greece’s bloated civil employee base and the huge unfunded pensions in the U.K. (estimated at 78% of GDP) and unfunded pensions/other liabilities in France (330% of GDP), Germany (190% of GDP), and Italy (130% of GDP). Such liabilities can only remain hidden for a limited time, as mounting actuarial requirements to fund pension and healthcare obligations can overwhelm a country’s or company’s ability to pay. In addition to excessive public debt, the troubling growth of European private sector debt has built over many years. As shown in the preceding and follow charts, Spain, Belgium, Portugal, and Ireland have the most concerning levels of private debt and household debt. Growth of borrowings within the financial sector was another critical component of the increased private debt, as discussed in the following pages. High corporate

leverage can contribute to financial distress, reduced competitiveness, employee layoffs, damage to investors through restructurings or bankruptcies, and turmoil among suppliers and customers, among other negative consequences. Similarly, over-leveraged households not able to fulfill their debt obligations could impart significant damage to lenders, particularly lenders highly leveraged themselves. Household debt is mostly non-revolving debt such as mortgages, with a lesser share from revolving debt such as credit cards and home equity lines. Excessive household debt was strongly evident in European countries that experienced real estate booms, such as Spain and Ireland. Households increased their borrowing mainly through home mortgages, which fueled rising housing prices and encouraged more borrowing. In Spain, the leverage increased mostly among the poorer households with little savings, resulting in significant credit losses during the crisis. The resulting collapse in housing prices and economic activity led to surging defaults, high unemployment, inability among banks to recruit financing, and government bail-outs and take-overs of banks damaged by mortgage and other losses. Any banking system in such a weakened condition can impair overall economic activity by restricting credit, producing negative feedback loops of higher unemployment that strain household debt servicing capabilities. The unemployment rate is expected to remain high in certain European countries, with Spain seemingly stuck at a troublesome 20%. Consumer Debt and Unemployment for 2010
Consumer Debt % of GDP 110% 100% 90% Consumer Debt % of GDP 80% 70% 60% 50% 40% 30% 20% 10% 0% Portugal U.S. Ireland Spain Germany Belgium France Greece Italy Unemployment Rate 22% 20% 18% 16% Unemployment Rate 14% 12% 10% 8% 6% 4% 2% 0%

Source: Central Banks, IMF, Deutsche Bank

Historical data shows that deleveraging has followed almost every major financial crisis in the past half-century, contributing to painful GDP declines or slow growth for years. Reducing debt-to-GDP ratios requires debt growth to lag GDP growth. This can include (i) GDP growing due to higher inflation, and/or (ii) debt reductions from defaults, lower deficits (potentially aided by decreasing interest rates), lesser credit availability from banks, increased consumer or corporate savings or decreased spending, and/or companies pursuing asset sales or more equity financing. Historically, a significant increase in net exports often helped support GDP growth during deleveraging, particularly following currency devaluations, though peripheral Europe will find this solution a stretch given their limited competitiveness and the ECB’s control of monetary policy. The deleveraging required for sovereigns is mirrored by the requirements for the private sector across banks, corporates, and households. While media has thoroughly excoriated banks and bankers for their aggressive

practices before the crisis, the following chart highlights that many individuals across the globe also significantly increased leverage during the boom years. Household Debt to Disposable Income
200% 180% 160% 140% 120% 100% 80% 60% 40% 20% Belgium Finland 0% Italy France Spain Austria Germany Portugal Ireland U.K. Netherlands Denmark U.S. 1997 2007



Source: Federal Reserve Bank of San Francisco

The financial sector was an enormous contributor to the growth in private debt balances discussed above. The increased scale of borrowings in the financial sector was paired with increasing leverage (i.e. under-capitalization) and more dependence on short-term funding, all of which were troubling signs. The excessive leverage left little room for error, while the increased assets magnified the scale of the problem, as financial debt to GDP reached very high levels (see following chart). Further, as discussed later, the over-concentration of short-term funding and small deposit bases also made the banks susceptible to asset-liability mismatches. The increasing bank leverage was unfortunately applied during strong economic times. As shown on the following chart, the strong economic conditions were conjoined with property bubbles in many areas, with inflation-adjusted real estate prices increasing cumulatively from 1997 to 2007 by roughly 270% in Ireland, 250% in the U.K., and 210% in Spain. Such performance dwarfed the U.S., which is known to have experienced its own massive real estate bubble (with commensurately large losses for homeowners and invests), where cumulative real price increases over the same period closer to 150%. Much of the real estate price increases globally were driven by increasingly aggressive mortgage lending practices, in addition to changes in investor sentiment. The optimistic sentiment also contributed to significant over-building of real estate. The property bubble and aggressive lending produced over-sized banking systems with inadequate capital cushions. The banking credit losses due to weaker lending standards, the sliding economy, and real estate price erosion (with declines from record highs aided by excessive unsold inventory) quickly eroded major portions of bank capital cushions and pushed bank leverage towards unsustainable levels. This phenomenon was seen clearly in Ireland and Spain, which relied on considerable increases in property prices to support economic growth prior to the crisis.



Inflation Adjusted Real Estate Prices by Country
300 Ireland 250 U.K. Spain Italy U.S. Germany Japan

Index Level




50 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: Federal Reserve Bank of San Francisco

With expanded real estate lending, the assets of Ireland’s banks reached 736% of GDP (see following chart); their domestic assets roughly tripled from 160% of GDP in 2003 to 484% of GDP in 2010. The U.K. also has a high ratio of domestic banking assets to GDP at 465%, although unlike Ireland, U.K. bank assets are inflated due to its role as a global financial leader. Much of the lending growth within Ireland and the U.K. (as in Spain and the U.S.) came from lower quality borrowers such as homebuyers and real estate developers with over-valued collateral (as real estate prices spiked), resulting in immense bad debts as property depreciated and construction ceased. The Irish government attempted to rescue its banking sector by injecting €7 billion of equity into its two largest banks (Allied Irish Banks and Bank of Ireland), establishing a “bad bank” to handle the troubled assets, and providing guarantees to bank depositors and lenders. These actions transferred the banking sector’s risk to the Irish government, forcing the country’s rescue in late 2010 as banking losses and investor concerns overwhelmed even the government’s efforts (the ongoing restructurings within the Irish banking system are detailed in Section 5). Domestic Bank Assets to 2010 GDP
800% 736.22% 700% 600% 500% 400% 311% 300% 200% 100% 0% Ireland U.K. Spain Portugal Italy Greece Japan U.S. 244% 277% 178% 103% 484% 465% 449% Domestic Assets Total Assets

Sources: Deutsche Bank, Bank of England, Federal Reserve, Central Bank of Greece, Bank of Italy, Central Bank of Ireland, Bank of Portugal, Bank of Spain, IMF


Clearly, any over-sized banking system that lacks funding access, market confidence, capital and liquidity, can precipitate a sovereign crisis. As with Ireland, this factored into earlier sovereign defaults of Russia, Mexico, and Uruguay (discussed in Section 7). Spanish banks have withstood the economic downturn and heavy real estate exposure thus far, though investor concerns and market pressures continue to mount. Such large banking systems are now more interconnected to global financial markets and neighboring countries than in the past, potentially threatening fast and severe contagion and multiple extraordinary considerations in producing a solution to the crisis. For example, among foreign lenders, the banks and governments of Germany and France are the largest lenders within Greece, Spain, and Italy; those of Germany and the U.K. are the largest within Ireland; and those of Spain and Germany are the largest within Portugal (see cross-border financing relationships below). Further, since the European banking system is loaded with domestic sovereign debt and the governments effectively stand behind their major banks, a failure by either a government or major bank could imperil the other. European Borrowers and Lenders by Nationality
(billions of U.S. dollars as of September 2010)

Creditor Country Borrower* Greece Ireland Portugal Spain Italy Greece -$1 $0 $0 $1 Ireland Portugal $8 $11 -$22 $6 -$27 $26 $44 $4 Spain $1 $13 $85 -$33 Italy $5 $15 $5 $29 -Belgium Germany France $2 $40 $63 $55 $154 $45 $2 $40 $37 $20 $201 $183 $25 $177 $449 U.K. $15 $160 $25 $116 $65 U.S. $7 $60 $5 $52 $42

*Borrowers include public, bank, non-bank private, and unallocated; does not include derivatives contracts, credit commitments, or guarantees. Source: Bank for International Settlements Quarterly Review, March 2011

Given this risk of contagion, the ECB has assumed the position as a limitless provider of liquidity to assist the European economy and major banks, though they have yet to pursue significant monetary stimulus. In fact, total ECB lending (i.e. the size of its balance sheet) actually declined over the course of 2010. This is in marked contrast to the U.S. Federal Reserve, which has significantly increased its balance sheet over the same time. As of November 2010, the ECB had lent €400 billion (see following graph); Ireland accounted for over 22% of these borrowings, despite accounting for under 2% of the EMU’s economy, which prompted the ECB to discourage additional fundings and push European governments and the IMF to craft a rescue financing package. ECB Lending in 2010
€ 600 € 500 € 400 Billions of € € 300 € 200 € 100 €0




Source: Central Banks, Wall Street Journal, and Deutsche Bank










However, the ECB has also applied other pressures for banks to deleverage, including changing collateral requirements as of January 2011 to borrow from the ECB. These pressures, plus investor concerns about future losses to come (particularly from real estate exposure among Spanish banks), have produced funding problems for banks; this has produced surging issuance of covered bonds (i.e. collateralized bonds, usually backed by mortgages) to make up for limited demand for senior bonds, which effectively subordinates other bank lenders.

The ECB has also been a critical factor in the Euro-Zone with its exclusive authority over monetary policy. Normally, monetary policy is among a country’s most powerful tools for competing in international markets, by controlling interest rates, money supply, and influencing foreign exchange rates. By devaluing the domestic currency, a country’s services and goods become more affordable in the global markets, thus promoting labor competitiveness and more exports, which improve current account balances, stimulate economic growth, and improve government budget balances. On the other hand, an over-valued currency tends to decrease a country’s international competitiveness, prolonging and intensifying recessions and currency crises. Common ways to devalue a currency include (i) switching from a fixed or pegged exchange rate to a freely floating rate set by the foreign exchange markets, (ii) increasing money supply through a National Central Bank, and (iii) lowering interest rates to decrease demand for the currency. The downsides to currency devaluation can include higher inflation, copy-cat moves from competing countries, and if mismanaged, political instability. Countries in the EMU have no currency devaluation options to improve trade or budget balances, which leaves them with only painful fiscal adjustments, such as increasing tax rates or austerity spending programs.

The euro’s broad implementation in 2002 as the common currency for EMU members, though transferring control of monetary policy from countries to the ECB, was greeted warmly by the weaker peripheral European members due to opportunities to expand trade and reduce interest rates. This was aided by higher consumer and business confidence that boosted incomes and domestic demand, much of which was fueled by borrowings that coincided with an influx of foreign capital. The growing confidence and leverage boosted imports among weaker countries, producing weak trade deficits and current account deficits (see following chart) for Spain, Ireland, Greece, Italy, and Portugal (SIGIP for short). 2010 Current Account Balance and GDP Growth
8% 2010 Current Acct Balance as % of GDP 6% 4% 2% 0% -2% -4% -6% -8% -10% -12% Greece Portugal Spain Italy Ireland France Belgium Germany -1% -2% -3% -4% -5% Current Acct Balance as % of GDP 2010 GDP Growth 4% 3% 2% 2010 GDP Growth (%) 1% 0%

Source: IMF, ECB, National Central Banks


The strong demand increased prices for housing and financial goods not historically exposed to international competition, detracting investment from export industries. Between 1997 and 2007, an average of 4% of GDP within SIGIP shifted from industrial entities to financial services and real estate; this was twice as much as the shift among countries in Northern Europe (Austria, Belgium, France, Germany, and the Netherlands). The economic shifts increased demand for financial and construction personnel, with labor cost increases outpacing productivity growth, a dynamic further reinforced by rigid labor markets within SIGIP. SIGIP’s employee compensation grew at an annual average of 5.9% from 1997 to 2007 (compared to 3.2% for core Europe) while productivity increased only 1.3% annually. SIGIP’s unit labor costs grew 32% over the same period, while Northern Europe’s grew 12%. The decrease in SIGIP competitiveness was further felt with the rise of China’s low-cost labor force and increases in productivity within the U.S., Germany, and Japan. The loss of competitiveness varied across the SIGIP countries, as presented below. Change in Competitiveness Ranking from 2000 to 2010 (among roughly 130 countries)
20 10 0 -10 -20 -30 -40 -50 -60 Greece Ireland Portugal Italy Spain Belgium France Germany

Source: World Economic Forum

With the high debt loads, high fiscal deficits, weak GDP growth, and weaker banking systems, many European countries have become increasingly dependent on capital markets for financing. The increased optimism and consumer demand within weaker countries after joining the EMU contributed to debt accumulation, which was largely provided by external sources (especially via capital markets) as foreign investment increased. These factors greatly increased the exposure and reliance of several European countries to external funding, with foreign holders increasing from 33% of public debt in 1999 to 54% in 2009, according to the ECB. Excessive reliance on foreign lenders increases sovereign funding risk and can signify low domestic savings rates (i.e. banks are financed by external borrowings instead of deposits). Such strong dependence on sourcing foreign investors through capital markets increases a country’s susceptibility to investor sentiment, which can quickly change during crises to reverse capital flows. Such a change in foreign investor sentiment was critical in many historical sovereign debt crises for emerging markets. This was shown again in 2010 with the rapid escalation of bond yields and CDS spreads for Greece, Ireland, Portugal, and Belgium, as each have a hefty proportion of their public debt in foreign hands (see chart below). Spain and Italy are better positioned with a larger portion of their debt controlled internally. This single factor has permitted Japan to long support the world’s highest debt to GDP.


Share of Public Debt Held Abroad or Domestically
Held Abroad 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Greece Portugal France Belgium Ireland Germany Spain Italy
Source: IMF- Global Financial Stability Report April 2011; and BIS-IMF-OECD-World Bank Joint External Debt Hub.

Held Domestically

The inability to control monetary policy and the resulting decreased competitiveness, combined with private deleveraging and large government debt loads and fiscal deficits, have suffocated GDP growth for many European countries. GDP growth is also hampered by lacking well developed export industries as well as inflexible labor markets with high wages and low productivity in comparison to other economies. With a lack of monetary control and current account improvements (normally driven by an improving trade balance), economies generally shrink, credit profiles deteriorate, and budget improvements depend more on rigid fiscal policies. As shown below, real GDP of many European countries has declined in recent years and is expected to remain weak for some going forward, including declines during 2011 for Greece and Portugal. Real GDP Growth from 2007 to 2010
Country Belgium France Germany Greece Ireland Italy Portugal Spain 2007 2.8% 2.3% 2.8% 4.3% 5.6% 1.5% 2.4% 3.6% 2008 0.8% 0.1% 0.7% 1.0% -3.5% -1.3% 0.0% 0.9% 2009 -2.7% -2.5% -4.7% -2.0% -7.6% -5.2% -2.5% -3.7% 2010 2.0% 1.5% 3.5% -4.5% -1.0% 1.3% 1.4% -0.1%

Source: IMF, ECB, European countries central banks


National debts are rarely ever repaid, but rather just refinanced. This refinancing or roll-over risk remains low as long as sovereign fundamentals are reasonably strong and investor appetite is sufficient. However, countries using excessive short-term debt are highly exposed to changes in investor sentiment, which can be particularly volatile among foreign lenders for reasons including domestic concerns, currency changes, and global market conditions. Any inability to refinance maturing debt can quickly become a liquidity crisis and produce default risk. According to Deutsche Bank, EMU countries needed to refinance debt equating to 26% of GDP during 2010, and will continue to face major maturities in coming years (see chart below). The combined financing needs for just Italy, Spain, and Portugal exceed €500 billion in 2011, with €350 billion required in the remainder of 2011 (roughly €220 billion for Italy, €117 billion for Spain, and €16 billion for Portugal). Note that Greece and Ireland will meet refinancing needs through the rescue financing packages arranged in 2010; Portugal will likely need to finalize their announced rescue financing package to meet €5 billion of sovereign bonds maturing in June 2011. Any false starts on these refinancing requirements could spook investors away from the next financing request for other countries. This would increase borrowing costs, worsening the country’s budget deficit and potentially decrease capital available to private enterprise (i.e. investors could choose to lend to governments for higher rates than companies, thus crowding out private borrowers). Sovereign Debt Maturity Profile
€ 500 € 450 € 400 € 350 Billions of € € 300 € 250 € 200 € 150 € 100 € 50 €0 2011 Remainder
Source: Bloomberg













Like the sovereigns, the dependence of many banks on short-term funding has also exposed their asset-liability mismatches, and driven banks to increase their longer-term borrowings. Relying on short-term borrowings rather than deposits has increased susceptibility to market changes. The ratio of loans to deposits (an indicator of assetliability mismatches since deposits are redeemable at any time) are high for the banking systems of Greece (1.0x), Ireland (1.3x), Portugal (1.4x), and Spain’s regional savings banks (0.8x). When the credit markets collapsed in 2008, short-term debt financing evaporated, causing panic in the banking system and increasing the severity of the financial crisis. Also, the constrained abilities of certain banks to raise junior capital, given uncertainty surrounding asset values, have produced (i) surging issuance of covered bonds, with much of the capital sourced from the U.S., (ii) various exchanges of debt for more subordinated capital to increase reported Core Tier 1 Capital, and (iii) forced deleveraging through asset divestitures.

Much of the sovereign financing and refinancing requirements are due to a lack of fiscal budgeting austerity and the ever expanding scale of European governments. These problems increased for some countries after the adoption of the euro ushered in new optimism and economic vitality as trade and tax revenues increased while borrowing costs decreased. Many countries matched their higher incomes with even higher spending, as shown in the following table. Deficits have materially increased since the recession began as tax revenues decreased, spending increased due to unemployment and fiscal stimulus (at least before recently imposed austerity programs), and interest costs increased due to higher debt loads and the recent increases in borrowing rates. Growth of European Sovereign Revenues and Expenditures
CAGR 2000-2009 Government Government Revenues Expenditures 4.4% 10.3% 4.7% 7.8% 4.8% 7.8% 3.4% 5.0% 3.1% 4.5% 2.8% 4.1% 1.2% 2.3% 3.0% 4.1% Annual Deficiency -5.9% -3.1% -3.0% -1.7% -1.3% -1.3% -1.1% -1.0%

Ireland Greece Spain Portugal Belgium France Germany Italy
Source: IMF

The large primary deficits (i.e. excluding interest spending from the budget) partly result from inefficient government spending, generous social and entitlement programs, and government largess, as governments now account for a disturbingly large proportion of their economies (see chart below). Another element of fiscal deficits is the government’s inability to accurately gauge incomes and collect taxes. In Greece, widespread tax evasion is estimated at €15 billion per year. Further, unreported income is estimated at 25% of GDP in Greece, 22% in Italy, and 19% in Spain and Portugal. Government Expenditures as a Percent of 2010 GDP
70% 65% 60% 55% 50% 45% 40% 35% 30%
Belgium Slovenia Luxembourg Finland Portugal Netherlands Austria Cyprus Germany Ireland Spain Italy Greece France Malta

Source: IMF - World Economic Outlook Database, April 2011

Slovak Republic


Sovereign bond yields have proven sensitive to the credit rating actions by Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings. The downgrades of sovereign credit ratings in 2009 and 2010 (see following table) encouraged lenders to revisit their risk premiums for each country individually. Downgrades included Greece and Ireland in 2009, on Greece, Portugal, and Spain in April 2010. These downgrades also created forced bond sellers and decreased bond buyers as certain real money accounts are prohibited from purchasing lower-rated bonds. Credit rating agencies have been criticized for assigning ratings higher than deserved for certain sovereigns and not adjusting to changed conditions. For example, bonds of Greece, Ireland, and Portugal have been trading with yields far above many other sovereigns and corporate credits with similar or lower ratings. This same complaint was voiced during the housing collapse, as many asset-backed securities that proved worthless were originally assigned high credit ratings. Nevertheless, agency downgrades can still impact a country’s ability to raise financing or at least borrowing costs, potentially contributing to a sovereign crisis. The rating agencies have more actively downgraded troubled sovereigns in recent months (see table below), though remain thoroughly disconnected from market perceptions of default risk. For example, bond yields for Greece presently imply a high likelihood of sovereign restructuring, though the country still carries a rating of B1 from Moody’s and BB- from Standard & Poor’s. Rating Agency Actions Since December 2008
Date Dec-08 Jan-09 Mar-09 Apr-09 Jun-09 Oct-09 Dec-09 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Feb-11 Mar-11 Apr-11 Current Rating ↓ to ANeg Watch ↓ to Ba1 ↓ to A1 ↓ to Aa1 ↓ to Aa2 ↓ to AA↓ to Aa1 Neg Watch Neg Watch Neg Watch ↓ to A3 ↓ to Baa1 Baa1 ↓ to BBBBBB↓ to Baa3 Baa3 ↓ to BBB+ BBB+ ↓ to Baa1 ↓ to A↓ to B1 B1 ↓ to BBBB↓ to Aa2 Aa2 AA ↓ to A Neg Watch Neg Watch Neg Watch Neg Watch Portugal Moody's S&P Aa2 AANeg Watch ↓ to A+ Ireland Moody's S&P Aaa AAA Greece Moody's S&P A1 A Neg Watch ↓ to ASpain Moody's Aaa S&P AAA Neg Watch ↓ to AA+

↓ to AA+ Neg Watch ↓ to AA Neg Watch ↓ to A2 ↓ to A3 Neg Watch ↓ to BBB+ ↓ to BB+

↓ to AA

Note: Rating is for foreign currency long-term debt. Source: Bloomberg


The series of problems and concerns facing Europe, as described in the preceding section, have increased investor awareness of downside risks for highly leveraged sovereign and banking credits. Marathon classifies Europe into three regions: (i) peripheral Europe, represented in red on the map below, which includes countries whose weak economies, competitiveness, and/or banking systems have resulted in actual or pending rescues, and could face sovereign restructurings, (ii) the Yellow Zone, which are countries (in yellow below) struggling to stabilize financing markets while under various macroeconomic, banking, and political pressures, and (iii) core Europe, comprised of lesser concerning countries (in green below) such as the larger and more stable developed markets and smaller emerging markets that have little risk of troubling contagion. Countries in peripheral Europe and the Yellow Zone were greatly impacted by the economic and banking crisis that began in 2007, as well as increasing pressures from fiscal mismanagement and political turmoil. Europe now faces a defined battle line against the contagion vortex, having already seen smaller countries require rescue packages. A coordinated and definitive multi-national agreement is needed to defend Spain, Italy and Belgium since they (i) are far too large to be rectified under the hastily prepared prior financial stability plan, and (ii) represent roughly 32% of GDP for the entire EMU. If the contagion reaches these larger countries, the resulting tremors could be severe throughout the European banking system, the EMU, and the global economy. For this reason, policy makers and central bankers are vigilantly working on solutions to calm jittery markets which are reacting with significant volatility following each new policy action, data release, and political speech. European Sovereign Debt Issues
■ ■
Serious Concerning
Finland 2.0% Austria 3.1% Belgium 3.8% Netherlands 6.4% Spain 11.6%

2010 Euro-Zone GDP Contribution
Portugal 1.9% Greece 2.5% Slovak Republic Slovenia Ireland 0.7% 0.4% 1.7% Luxembourg Cyprus 0.5% 0.2% Malta 0.1% Germany 27.2%

Italy 16.9%

France 21.2%

Source: Marathon

Source: IMF

As shown in the following graphs, these six troubling countries have experienced significant declines in GDP and higher unemployment since the financial crisis, have high and increasing debt loads and maturities along with recent deterioration in fiscal budget deficits, and for the most part, have consistently had current account deficits (largely attributable to weak exports). Other factors contributing to the downturn included real estate depreciation and even deflation concerns. Crucially, these countries each face major challenges to deleverage in the future and even to meet the rising debt maturities (which require continued capital market access) given the weak outlook for growth, real estate, and banking systems along with their inherently weak competitiveness, excessive fiscal spending, and constrained monetary supply. However, markets have increasingly distinguished the credit fears and default probabilities of peripheral Europe from Spain, Italy, and Belgium.

Historical and Projected Economic Statistics for Selected Sovereigns
Greece Ireland Portugal Spain
16% 14% 12% 10% 8% 6% 4% 2% 0%
2007 2008 2009 2010 2011E 2012E



Public Debt to GDP
180% 160% 140% 120% 100% 80% 60% 40% 20% 0%

Sovereign Debt Maturities to GDP

Source: Bloomberg




Source: IMF, ECB, European countries central banks

Real GDP Growth
8% 6% 4% 2% 0% -2% -4% -6% -8% -10% 2007 2008 2009 2010 2011E 2012E

Unemployment Rate
25% 20% 15% 10% 5% 0% 2007 2008 2009 2010 2011E 2012E

Source: IMF, ECB, European countries central banks

Source: IMF, ECB, European countries central banks

Fiscal Surplus/(Deficit) to GDP
5% 0% -5% -10% -15% -20% -25% -30% -35% 2007 2008 2009 2010 2011E 2012E

Current Account to GDP
4% 2% 0% -2% -4% -6% -8% -10% -12% -14% -16% 2007 2008 2009 2010 2011E 2012E

Source: IMF, ECB, European countries central banks

Source: IMF, ECB, European countries central banks


GREECE – 83% Implied Probability of Default on 10-Year CDS
Greece ushered in the European sovereign debt crisis by revealing in early 2010 that its general government deficit for 2009 was 13.6% of GDP rather than the initially reported 6% (later finalized at 15.4%). Greece’s large primary deficits (i.e. fiscal deficits excluding interest costs) and excessive leverage problems have resulted from an unsustainable system of public sector employment and government entitlements. These problems led to the first crisis of confidence in the present crisis, resulted in the first rescue financing package, and threaten to produce the first sovereign default for a developed nation in 63 years. Greece’s financial problems have been exacerbated by information systems unable to accurately track incomes or taxes due, and a legal system not consistently enforcing tax collection policies. These are contributing factors to Greece having the lowest revenues-to-GDP in the EU at 32.6% (versus the EU average of 39.3%). Greece offset the difficulties in collecting taxes by borrowing, as they took full advantage of the lower borrowing costs made available to weaker countries by admission into the EMU. These borrowing advantages (interest costs dropped to only 40 bps over German levels) allowed the Greek government to construct a vast system of public employment. The average government worker receives significantly higher compensation than the average private employee, with additional entitlement programs including generous pension and retirement terms (55 years of age for men and 50 years for women within a lengthy list of “arduous” professions, and 61 years for other jobs, compared to 67 years in Germany). Prior to joining the EMU, Greece had nearly the worst inflation, borrowing costs, and GDP growth of any country in Western Europe. Their entrance into the EMU proved beneficial by lowering inflation to roughly 3% and spurring GDP growth (averaging 4.2% from 2000 to 2007). However, this GDP growth was accompanied by (i) strong reliance on foreign capital inflows, (ii) uncontrolled fiscal spending, with expenditures growing at an average rate of 7.8% from 2000 to 2009 while government revenues grew only 4.7% annually, producing fiscal deficits of 9.5% of GDP or more from 2008 to 2010, and (iii) ballooning debt levels, with public debt climbing from 98% of GDP in 1997 to 142% in 2010, and expectations to reach an unsustainable 160% in 2012. Importantly, Greece has few options to decrease its leverage given high borrowing costs and forecasts for large fiscal deficits, large current account deficits, and high unemployment. As one mildly positive note, Greece’s banking system had remained relatively conservative by some measures. Greek bankers avoided the U.S. structured sub-prime mortgage bonds purchased by other European groups, maintained lower leverage than its European counterparts, had a strong base of deposits, and kept compensation to reasonable levels. They did, however, lend €30 billion to the Greek government. The Rescue of Greece – The global financial crisis (concentrated in 2008 and 2009) had major impacts on Greece’s economy, and particularly its two largest non-governmental industries: tourism and shipping. Greece’s economy grew 4.3% in 2007, but only 1.0% in 2008, then contracted by 2.0% in 2009 and by 4.5% in 2010 with an additional expected decline of 3.0% in 2011. These recent and expected GDP declines were also influenced by the global liquidity crisis for banks, in addition to the government’s specific punishment by investors after admitting to intentionally and repeatedly misreporting the country’s economics figures, even constructing complex trades with leading investment banks to mask the true figures. The resulting crisis of confidence and the weaker economic standing pushed Greek 10-year government bond yields to 7.1% in January 2010, the highest since joining the EMU. These higher interest costs, especially with the government’s dependence on foreign investors, only intensified the crisis. Fears temporarily subsided in February 2010 when the European Commission endorsed Greece’s plan to cut its fiscal deficit to 3% of GDP by 2012, and Parliament approved an austerity bill in March 2010 to reduce spending by €4.8 billion.


In April 2010, Greece lost its investment-grade rating when Standard & Poor’s downgraded them to BB+ (and estimated 50% to 70% principal losses in the event of default), soon followed by downgrades from Fitch and Moody’s. Portugal and Spain were also downgraded near the same time amidst market worries about worsening economic performance, high deficits, threats of contagion, and potential sovereign defaults. Yields on Greek government two-year bonds spiked above 15% following the downgrade (also sending equity markets lower globally), with increasing questions about their ability to refinance €8.5 billion of bonds due in May 2010. These looming debt maturities forced the Greek government to plead for emergency loans to avoid imminent default. Facing clear evidence of Greece’s deep recession and liquidity problems, the ECB, IMF, and European Commission approved an unprecedented bailout package in May 2010. The IMF’s involvement was its first rescue of a developed nation, much less a Euro-Zone member (since followed by Ireland and Portugal). The ECB boosted liquidity for Greek and other banks in May 2010 by suspending credit rating requirements on sovereign debt pledged as collateral for borrowings from the ECB, which allowed Greek sovereign debt to remain eligible collateral to access ECB liquidity lines and prevented a fire sale of Greek debt. The complementary €110 billion financial support facility from the EMU (€80 billion) and IMF (€30 billion) was another attempt to limit contagion concerns affecting other Euro-Zone countries, particularly Ireland, Portugal, and Spain. In fact, Greek 10-year bond spreads over German government bonds declined from over 900 bps to under 500 bps shortly after the rescue plan was announced (but have returned to record levels presently). The rescue financing provided €45 billion immediately to address debt maturities (Greece faced €40 billion in 2011). This rescue facility expires in 2017 and bears an average interest rate of 5.2% (after amended to match terms on the subsequent Irish rescue package); this rate is considered rather high for a bailout loan and could be reduced over time. Of course, this rescue financing is smaller than Greece’s roughly €327 billion of public debt, but like all rescues, it focuses on near-term funding needs rather than full repayment of all public debt. This financial support program is estimated to cover the Greek government’s estimated €95 billion of borrowing requirements through 2012 (roughly €65 billion of debt maturities and €30 billion of deficit financing). In return for the rescue financing package, Greece had to agree to reduce spending to bring the fiscal deficit to 3% of GDP (the level required for, though seldom achieved by, EMU members). To achieve this ambitious target, the Greek government is required to implement a series of austerity measures including reforms to pensions, wages, taxes, and government largess: • • • • • • • • • • • • Limit bi-annual bonuses for public employees to €1,000, and abolish bonuses for those earning over €3,000 per month. Cut 8% from public sector allowances; cut wages 3% for DEKO (public sector utilities) employees. Limit the “13th and 14th month” pension installments (i.e. annual pension bonuses) to €800 per month; abolish these for pensioners receiving over €2,500 per month. Freeze pensions for three years, and reinstitute a special tax on high pensions. Equalize pension age qualifications for men and women. Scale future age requirements for pensions to life expectancy changes. Increase retirement age for public sector workers from 61 to 65. Plan changes to laws governing lay-offs and over-time pay. Increase the value-added tax (VAT) from 21% to 23%. Increase taxes 10% on luxury items, alcohol, cigarettes, and fuel. Address weaknesses in tax compliance; persecute large cases of tax non-compliance. Create a financial stability fund to provide some cushion for uncertainties.

• •

Institute an extraordinary tax on company profits. Reduce government-owned companies from 6,000 to 2,000.

These massive required adjustments represented more than the annual government spending on military defense, health care, and education combined. These cuts, although necessary, are likely to reduce tax revenues by weakening the economy and producing wage and price deflation. This could also push more activities into the already sizable untaxed shadow economy and encourage even more tax evasion, which will pose additional challenges for the government’s recovery. As Greece’s Finance Minister George Papaconstantinou said, the government had to make a “basic choice between collapse or salvation.” Implementation of these drastic measures has not been easy, with disruptive and violent protests, police clashes, and strikes resulting in deaths, dozens injured, and over 100 arrested. For example, the civil servant union (ADEDY) and the private sector union (GSEE), representing half of the Greek workforce, struck six times in 2010; the strike in May 2010 involved firebombing a bank that killed three people. This bitter medicine of austerity and external aid was required to prevent imminent default on debt obligations, enable its banks to preserve access to ECB financing, and provide time to implement the fiscal and social restructuring. The government has a limited time to repair its finances and economy, or be faced with a fundamental debt restructuring similar to emerging markets in recent decades. Greek officials continue to push for internal remedies to forestall a restructuring, including announcements to raise €50 billion of proceeds by 2015 (with €15 billion through 2013) by selling stakes in telecom companies, electric companies, casinos, train operators, and airports. Although a Greek default would only affect 2.5% of the Euro-Zone economy, losses from a default on roughly €330 billion (and growing) of debt could ripple through the financial world (especially within Germany and France, as the largest lenders). Also, spreading fears could endanger the euro and produce crises in additional countries with devastating consequences. While the contagion fears have decreased, Ireland and Portugal remain problematic, and Greece’s bond yields are at or near record highs (despite the large rally after the rescue package was announced). Greece’s elevated bond yields (over 18% on two-year bonds) clearly exhibit market consensus for a restructuring of sovereign debt in the near term. Even certain leaders within Germany and the IMF have shown new openness to the concept of a restructuring as the inevitable conclusion of growing debt balances, an uncompetitive labor system, entrenched unions, an inefficient system of tax reporting and controls, unaffordable pension and entitlement programs, high unemployment (expected to exceed 14% for years), recessionary and deflationary fiscal austerity measures, and social unrest which has the potential to create political instability. Greek CDS Levels and Bonds Spreads vs. Germany - Past 18 Months
20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 10/14/2009 11/14/2009 12/14/2009 10/14/2010 11/14/2010 12/14/2010 1/14/2010 2/14/2010 3/14/2010 4/14/2010 5/14/2010 6/14/2010 7/14/2010 8/14/2010 9/14/2010 1/14/2011 2/14/2011 3/14/2011 4/14/2011 Greece 5 year CDS 2 year bond spread 5 year bond spread 10 year bond spread

Source: Bloomberg


Country Snapshot – Hellenic Republic (Greece)
(Billions of €, unless otherwise noted) 2003 172 156 5.9% 97.3% -5.7% -6.6% 9.7% 3.1% 2004 185 162 4.4% 98.8% -7.4% -5.9% 10.5% 3.1% 2005 195 166 2.3% 100.3% -5.3% -7.4% 9.9% 3.5% 2006 211 175 5.2% 106.1% -6.1% -11.2% 8.9% 3.2% Macro Summary 2007 2008 227 237 182 184 4.3% 1.0% 105.1% 110.3% -6.7% -9.5% -14.4% -14.7% 8.3% 7.7% 3.9% 2.2% 2009 235 180 -2.0% 126.8% -15.4% -11.0% 9.4% 2.0% 2010 230 172 -4.5% 142.0% -9.6% -10.6% 12.5% 5.1% 2011E 227 167 -3.0% 153.8% -7.4% -7.9% 14.8% 2.4% 2012E 230 169 1.1% 159.4% -6.2% -6.3% 15.0% 0.5% 2013E 237 172 2.1% 158.9% -4.5% -5.0% 14.5% 0.7% 2014E 245 176 2.1% 156.2% -2.5% -4.0% 13.8% 1.0% Nominal GDP Real GDP Real GDP Growth Public Debt to GDP Surplus/(Deficit) to GDP Current Account to GDP Unemployment Rate Inflation Rate

Source: Eurostat, IMF, European Commission

National Bank of Greece Alpha Bank A.E. Efg Eurobank Ergasias Piraeus Bank S.A. Emporiki Bank Of Greece S.A.
Source: Bloomberg, Bank of Greece

Largest Banks Mkt. Cap. 12-Mo Share Price ∆ 5 -49% 2 -41% 2 -43% 1 -66% 1 -68%

Loans/Deposits 1.2x 1.3x 1.3x 1.3x 1.7x

Banking Sector Total Banking Sector Assets % of GDP Loans/Deposits
Source: Bank of Greece

637 277% 1.0x

Central Bank: Sov. Credit Rating (S&P/Moody's Fitch): Global Competitiveness Score: Share of Government Debt Held Abroad:
World Economic Forum

Other Bank of Greece, Τράπεζα της Ελλάδος BB-/B1/BB+ ; Outlook: neg./neg./neg. 3.99 (83rd ranking out of 139 countries) 61%

Sources: IMF, Global Stability Report April 2011 and Joint BIS-IMF-OECD-WB Statistics,

Tenor 2-Year 3-Year 5-Year 10-Year
Source: Bloomberg

Bond Yields Yield 12-Month ∆ (bps) 23.3% 1,547 22.7% 1,457 17.0% 885 14.9% 676

Tenor 5-Year 10-Year

CDS Spreads Spread 1,331 1,166

Creditor Country France Germany U.K. Portugal Ireland U.S. Netherlands Italy
Source: BIS

Cross Exposure Exposure % Debtor GDP 43 19% 28 12% 10 4% 7 3% 6 3% 5 2% 3 1% 3 1%

Monthly Maturity Profile for Sovereign and Largest Bank (with combined amounts as % of GDP) € 16 € 14 € 12 € 10 Billions €8 €6 €4 €2 €0 1.0% 2.3% 0.9% 1.0% 0.9% 0.3% 0.3% 0.5% 0.1% 0.4% 0.0% 1.0% 0.2% 0.0% 4.0% 3.1% 3.5% 3.7% 7.0% Hellenic Republic (Greece) Largest Banks Combo % of GDP 8% 7% 6% 5% 3.4% 4% 3% 2% 1% 0% Debt/GDP


Apr-11 May- Jun-11 Jul-11 Aug- Sep-11 Oct-11 Nov- Dec-11 Jan-12 Feb-12 Mar- Apr-12 May- Jun-12 Jul-12 Aug- Sep-12 Oct-12 Nov- Dec-12 11 11 11 12 12 12 12
Source: Bloomberg

€ 60 € 50 € 40 Billions 17.0% € 30 € 20 € 10 €0 2011 Remainder
Source: Bloomberg

Annual Maturity Profile for Sovereign and Largest Bank (with combined amounts as % of GDP) 33.1% 25.9% Hellenic Republic (Greece) Largest Banks Combo % of GDP

35% 30% 25% 20% 11.7% 15% 10% 5% 0% Debt/GDP











IRELAND – 59% Implied Probability of Default on 10-Year CDS
Ireland’s problems – unlike Greece’s over-sized public sector and entitlement spending, inefficient tax collection, and high government debt-to-GDP – mainly resulted from its severely outsized banking sector and its losses from the collapsed real estate bubble, along with the related major economic recession. Ireland’s banking assets reached 736% of the €154 billion GDP for 2010, or 484% when including only domestic assets (up from 160% in 2003). Losses in the banking system began to accelerate in 2008 with sliding property prices and weaker economic conditions, prompting the Irish government to invest capital into its major banks and temporarily guarantee Irish banking liabilities to prevent a run on their deposits and preserve their market access. However, the scale of the banking system relative to the government made it “too big to bail” and transitioned the crisis from bank liquidity to bank solvency, which then grew to concerns of sovereign liquidity before reaching the final stage of questionable sovereign solvency. Prior to the banking troubles, Ireland enjoyed a long period of economic prosperity as its economy shifted from agriculture to a focus on services, industry, and investment. From 1995 to 2007, the country’s real GDP growth averaged 7.2%, earning it the “Celtic Tiger” nickname. As with Greece, this growth was spurred by optimism, lower borrowing costs, strong corporate and personal spending, and foreign capital inflows after admission into the EMU. Much of this was justified by Ireland’s efficient, low-cost, and skilled English-speaking work force, low 12.5% corporate tax rates, attractive location for an export base, and strong gains in productivity. All this led to major increases in private debt loads for banks, companies, and households that contributed to booming consumer spending, construction, and investment. However, this economic boom teamed with weakening lending standards to build a frothy property market starting in the early 2000s, with increasing prices and speculative building. Irish housing prices increased 12.5% on average per year from 1997 to 2007 (see charts below), while financial sector assets multiplied by 9.0x. By 2007, roughly 20% of Ireland’s jobs were connected to the real estate industry through either construction (roughly 13%) or supporting roles like brokers and bankers. Prices soared as domestic and foreign speculation grew in residential and commercial property, aided by cheap financing from banks. Such aggressive lending practices (e.g. the majority of mortgages were floating rate, interest-only loans grew to 16% of borrowings in the third quarter of 2007, and several banks offered 100% financing) – helped Irish private debt more than double to roughly 190% of GDP from 2003 to 2010. Average Irish House Prices
€ 350 € 300 € 250 Thousands of € € 200 € 150 € 100 € 50

Annual Change in Irish House Prices
40% 30% 20% 10% 0% 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 -10% -20%

€0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010


Source: The Economic and Social Research Institute, TSB/ESRI Index

Source: The Economic and Social Research Institute, TSB/ESRI Index

The burst property bubble, financial crisis, and ensuing economic recession produced a wave of mortgage defaults throughout the country. Ireland’s real GDP, with its dependence on construction and real estate, contracted 3.5% in 2008 (the first European government to officially declare a recession), and another 7.6% in 2009 and -1.0% in 2010. With tumbling property prices (now down nearly 40% from the peak in 2006) and construction activity, Ireland’s unemployment rate increased from 4.6% in 2007 to 13.6% in 2010 while public debt-to-GDP soared

from 25.0% in 2007 96.1% in 2010 due to deficit spending and banking bailouts. As a result of major declines in government revenues and GDP, along with a generous state pension system built during more prosperous times, fiscal deficits reached 7.3% of GDP in 2008 (after running surpluses the five prior years). The deficit worsened to 14.4% of GDP in 2009 and 32.2% in 2010 (11.9% excluding the cost of bank bailouts) after six consecutive years of surpluses through 2007. The Rescue of Ireland’s Banks – Ireland’s extraordinary construction activity during the prosperous times produced a massive oversupply of projects, especially with demand and prices falling in the recession. The property depreciation and inability to sell properties exposed the banks to tremendous write-downs on loan portfolios. The resulting erosion of the banks’ equity capital spooked markets, which strained liquidity in the banking system by constricting market access. With $123 billion of cross-border liabilities as of December 2008, and much of them short-term, Irish banks were extremely vulnerable to such shocks in the global capital markets. In September 2008, the Irish government attempted to control the banks’ liquidity crisis by providing guarantees for bank deposits and lenders, backed by taxpayer funds. They declared “The Government has decided to put in place with immediate effect a guarantee arrangement to safeguard all deposits (retail, commercial, institutional and interbank), covered bonds, senior debt and dated subordinated debt (lower tier II), with the following banks: Allied Irish Banks, Bank of Ireland, Anglo Irish Bank, Irish Life and Permanent, Irish Nationwide Building Society, and the EBS Building Society.” Despite these guarantees for the country’s largest domestic banks, the banks’ equity prices continued to decline. In December 2008, hidden loan scandals emerged at Anglo Irish Bank, Ireland’s third largest bank, resulting in the resignation of the CEO and two other executives. These departures and the bank’s losses left the government few options to prevent a bank run except via full nationalization, which was completed in January 2009. With fears affecting other banks and the Irish equity index hitting 14-years lows in February 2009, the government put €3.5 billion of equity into the two largest banks: Allied Irish Bank and Bank of Ireland. That same month, rising unemployment and weakening economic conditions were producing social instability and increased protests, including over 100,000 people taking to the streets of Dublin. The government also tried to remove troubled assets from the banks by forming the National Asset Management Agency (NAMA) in April 2009. This “bad bank” would acquire property development loans from Irish banks in return for government bonds. Although NAMA’s goal was to improve availability of credit and support the Irish banking system, it seriously damaged the sovereign’s credit quality by effectively converting the banks’ private debt into the government’s public debt. The government’s efforts were not enough to prevent foreign capital from fleeing the Irish banks, which forced the banks to begin collateralized borrowing from the ECB. Ireland accounted for roughly 23% of the ECB’s total funding despite accounting for under 2% of the Euro-Zone’s GDP (see following chart). This put Ireland and the ECB on a collision course due to the ECB’s increasing unwillingness to increase its balance sheet exposure to Irish collateral of questionable value. Banking troubles continued to mount in March 2010, as the Irish government nationalized Irish Nationwide Building Society and EBS Building Society, infusing €2.6 billion and €875 million of capital, respectively. Also, more capital was required at Anglo Irish Bank due to increased losses; by May 2010, as Greece’s rescue was finalized, €22.3 billion had been injected or earmarked for Anglo Irish. These increased capital commitments and assumptions of ever growing liabilities added strain to the government’s deficit and financial flexibility. As a result, Standard & Poor’s downgraded Ireland from AA to AA- in August 2010; their research estimated that the costs to support the Irish banks could be as high as €50 billion. This helped push up borrowing rates for Ireland and its banks, with spreads hitting new highs in September 2010 as additional analysis suggested Irish Nationwide and Anglo Irish would need roughly another €3 billion and €7 billion of capital, respectively, and even more under a stress scenario.

European Periphery Share of 2010 GDP versus Share of ECB Funding (Nov. 2010)
25% Share of ECB Funding Share of EuroZone GDP





0% Ireland Greece Spain Portugal

Sources: Deutsche Bank, Central Bank of Ireland, Bank of Spain, Bank of Greece, Bank of Portugal, Wall Street Journal

By late October 2010, the cost of recapitalizing the Irish banks was clearly far greater than originally expected, meaning the government’s earlier pledge to support bank depositors and lenders was proving extremely costly. By this time, the government’s banking bailout totaled €80 billion of common equity, preferred equity, promissory notes, and asset purchases (compared to the IMF’s estimated banking losses of €35 billion in June 2009). In response to mounting costs, Standard & Poor’s further downgraded Ireland’s sovereign rating and warned of additional downgrades if negotiations with the IMF and EU failed to alleviate the funding crisis. The Rescue of Ireland – After Ireland became the largest user of ECB funding (see chart above), the ECB began to resist taking further Irish risk and requested that European governments support Ireland. Despite protests from Ireland’s Finance Minister that aid was not necessary (yet CDS levels rose to new highs), the government requested financial assistance on November 21, 2010. The EU, EMU, and IMF agreed to a financial rescue package of €85 billion. This package consisted of €12.5 billion from internal pension reserves, €5 billion of treasury reserves, €22.5 billion from each the IMF and EFSM, €17.7 billion from the EFSF (its first usage), and €4.8 billion of bilateral loans (€3.8 billion, €0.4 billion, and €0.6 billion from the U.K., Denmark, and Sweden, respectively). The interest rates are 5.7% for the EFSM loans, 6.05% for the EFSF loans, and 3.12% for IMF loans (increasing to nearly 4% after three years; requiring repayment over 10 years, beginning after 4.5 years). The new government following the February 2010 elections, which saw Fianna Fail lose their roughly 80-year rule of Parliament to a coalition of Fine Gael and Labour parties, will likely attempt to lower the interest rates on the rescue package, which include a penalty premium and therefore do not lower Ireland’s effective interest burden. The rescue package is intended to sufficiently recapitalize the banks (at least the ones intended to continue as going concerns), refinance debt maturities for the key banks, and cover the government’s financing needs from deficits and debt maturities through June 2013. The government expected to immediately recapitalize certain banks with €10 billion, preserve €25 billion for banking contingencies, and use €50 billion for budgetary financing needs. In exchange for receiving this capital and flexibility, the Irish government has agreed to numerous conditions (upon receipt or subsequently), many with the goal of improving the deficit-to-GDP to 3% by 2015:

• • • • • • • •

Cut €10 billion in public expenditure and raise €5 billion in taxes over four years; this includes €6 billion planned for 2011. Increase VAT increases to 23% by 2014 (increases in the 12.5% corporate tax rates could be needed to garner additional international support in the future). Cut social welfare €2.8 billion and health spending €1.4 billion by 2014. Cut minimum wage to €7.65 per hour. Cut pay 15% for new entrants to public service. Cut public service pensions by an average of 4%. Introduce property tax in 2012 and domestic water charges in 2014. Effectively nationalize Allied Irish Banks by injecting an additional €3.7 billion of capital; this followed the government’s earlier take-overs of Anglo Irish Bank, Irish Nationwide Building Society, and EBS Building Society. Set aside €35 billion to recapitalize the Irish banking system. Conduct a stress test for Irish banks by March 31, 2011 with a minimum required Core Tier 1 ratio to risk weighted assets of 10.5% for Allied Irish Banks, Bank of Ireland, EBS Building Society, and Irish Life & Permanent.

• •

The restructuring of Ireland’s banking system remains a work in progress and a sensitive political issue, particularly relating to potential burden sharing for bank bondholders. During the recent elections, certain politicians opined in favor of burden sharing among even the banks’ senior bondholders, which has been much opposed by other European governments and banking regulators since (i) large holders include the ECB and other banks throughout Europe with little ability to absorb more losses, and (ii) losses in this small market could scare investors from participating in the much larger senior bond market throughout Europe, leading to higher financing costs for the entire industry. The new government has recently toned down the rhetoric about losses for senior bondholders, though losses to subordinated bondholders have been realized, and will likely continue to unfold as recapitalizations continue. The government has made significant progress in recapitalizing and cleaning up certain troubled banking operations. For example, the government has announced plans to reconfigure the country’s banking system around two “pillar” banks: Allied Irish Banks and Bank of Ireland. They also announced plans to transfer billions of troubled assets into NAMA from Anglo Irish and Irish Nationwide in exchange for NAMA bonds (95% guaranteed by the government), then move the deposit base and the NAMA bonds from these troubled banks to the pillar banks. Another element of the ongoing recapitalization of the banking system was the stress tests completed in March 2011, which required banks to raise €24.0 billion (vs. the €35 billion set aside from the sovereign rescue package), including €18.7 billion of required capital and €5.3 billion as an additional buffer. To improve the credibility of the tests (since prior stress tests and loss estimates proved woefully inadequate), Ireland employed Blackrock Solutions to conduct an independent test with stressed macroeconomic forecasts. The stress tests were comprised of a capital stress called the Prudential Capital Assessment Review (PCAR) and a liquidity stress test called the Prudential Liquidity Assessment Review (PLAR). These tests were based on realistic default and loss rates on various asset classes as well as funding targets for the banks to reduce leverage in the system, reduce reliance on short-term ECB funding, and ensure compliance with Basel III liquidity and capital standards. Importantly, the conclusions of these stress tests confirmed that all senior bank bondholders would remain unimpaired. However, subordinated bondholders and preferred holders of the tested banks were slated for burden sharing, as exemplified by the Subordinated Liability Order (SLO) recently issued by the High Court of Ireland for Allied Irish Banks to unilaterally convert its subordinated debt into zero-coupon bonds and preferred equity

with maturities beginning in 2035. This unilateral power will provide the bank with strong negotiating leverage and provide strong motivation for holders of the affected instruments to consent to an expected tender or exchange offer. Similar exercises are expected for other Irish banks as part of their recapitalization efforts. Ireland clearly has a difficult road ahead, but has moved forward well on austerity measures and is on the right track with bank restructurings. Still, CDS spreads and bond yields clearly indicate the market remains skeptical about the final resolution. One thing seems sure: the economy, real estate, wages, and unemployment are likely to remain strained for quite some time. The IMF is forecasting 0.5% to 2.4% real GDP growth each year from 2011 to 2013, though with public debt-to-GDP increasing from 96.1% in 2010 to 125.8% in 2013 before stabilizing. However, unlike certain other European economies, Ireland’s future could benefit from achievable fiscal reforms and favorable competitiveness.


Country Snapshot – Republic of Ireland
(Billions of €, unless otherwise noted) 2003 140 151 4.4% 30.9% 0.4% 0.0% 4.7% 3.0% 2004 149 158 4.6% 29.4% 1.4% -0.6% 4.5% 2.4% 2005 162 168 6.0% 27.2% 1.6% -3.5% 4.4% 1.9% 2006 177 177 5.3% 24.8% 2.9% -3.6% 4.4% 3.0% Macro Summary 2007 2008 189 180 187 180 5.6% -3.5% 25.0% 44.4% 0.1% -7.3% -5.3% -5.7% 4.6% 6.3% 3.2% 1.3% 2009 160 166 -7.6% 65.5% -14.4% -3.0% 11.8% -2.6% 2010 154 165 -1.0% 96.1% -32.2% -0.7% 13.6% -0.2% 2011E 155 166 0.5% 114.1% -10.8% 0.2% 14.5% 0.7% 2012E 160 169 1.9% 121.5% -8.9% 0.6% 13.3% 1.0% 2013E 166 173 2.4% 125.8% -7.4% 0.2% 12.8% 1.4% 2014E 174 178 3.0% 125.0% -4.8% 0.2% 11.9% 1.5% Nominal GDP Real GDP Real GDP Growth Public Debt to GDP Surplus/(Deficit) to GDP Current Account to GDP Unemployment Rate Inflation Rate

Source: Eurostat, IMF, Department of Finance

Allied Irish Banks Plc Bank of Ireland
Source: Bloomberg, The Central Bank of Ireland

Largest Banks Mkt. Cap. 12-Mo Share Price ∆ 2.7 -86% 1 -79%

Loans/Deposits 1.8x 1.8x

Banking Sector Total Banking Sector Assets % of GDP Loans/Deposits
Source: The Central Bank of Ireland

745 484% 1.3x

Central Bank: Sov. Credit Rating (S&P/Moody's Fitch): Global Competitiveness Score: Share of Government Debt Held Abroad:
World Economic Forum

Other The Central Bank of Ireland BBB+/Baa3/BBB+ ; Outlook: stable/neg./neg. 4.74 (29th ranking out of 139 countries) 59%

Sources: IMF, Global Stability Report April 2011 and Joint BIS-IMF-OECD-WB Statistics,

Tenor 2-Year 3-Year 10-Year
Source: Bloomberg

Bond Yields Yield 12-Month ∆ (bps) 11.5% 969 11.9% 952 10.3% 572

Tenor 5-Year 10-Year

CDS Spreads Spread 623 494

Creditor Country U.K. Germany U.S. Belgium France Netherlands Japan Switzerland Italy
Source: BIS

Cross Exposure Exposure % Debtor GDP 110 71% 106 69% 41 27% 38 24% 31 20% 15 10% 14 9% 13 9% 10 7%

€8 €7 €6 €5 Billions €4 €3 €2 €1 €0 0.5% 0.1% 3.4% 4.5%

Monthly Maturity Profile for Sovereign and Largest Bank (with combined amounts as % of GDP) 5.2% Republic of Ireland Largest Banks Combo % of GDP

6% 5% 4% Debt/GDP



3% 1.4% 1.6% 0.5% 0.3% 2% 1.0% 1% 0.0%0.0% 0.0% 0.1% 0%


0.5% 0.0% 0.1%


Apr-11 May- Jun-11 Jul-11 Aug- Sep-11 Oct-11 Nov- Dec-11 Jan-12 Feb-12 Mar- Apr-12 May- Jun-12 Jul-12 Aug- Sep-12 Oct-12 Nov- Dec-12 11 11 11 12 12 12 12
Source: Bloomberg

€ 24 € 21 € 18 € 15 Billions € 12 €9 €6 €3 €0 2011 Remainder
Source: Bloomberg

Annual Maturity Profile for Sovereign and Largest Bank (with combined amounts as % of GDP) Republic of Ireland Largest Banks 14.6% 11.4% 10.7% 11.0% Combo % of GDP

21% 18% 15% Debt/GDP 12% 9%


6.7% 6% 1.4% 3% 0%








PORTUGAL – 61% Implied Probability of Default on 10-Year CDS
Portugal’s problems differ from Ireland’s property and banking collapse, driven instead by high overall debt and a stagnant economy, but with a troublingly bloated public sector like Greece. Portugal’s total public and private debt has reached 379% of GDP with few deleveraging prospects, given the economy’s sparse competitive advantages and limited growth opportunities. The recent spike in sovereign yields and CDS reflected the market views that Portugal’s financing was unsustainable, which forced the government to officially request external rescue funding on April 7, 2011. Terms of the resulting €78 billion rescue financing package remain to be negotiated, as CDS pricing suggests a likelihood of default similar to Ireland. Portugal’s economic predicament can be traced to the Carnation Revolution of 1974, when a military coup effectively began the transition from an authoritarian regime toward a democracy with leaders from socialist political parties. Between 1975 and 1977, Portugal transformed its social system and political economy through sweeping nationalizations and land expropriations; this included nationalizing virtually all banking, insurance, chemical, tobacco, cement, iron, steel, shipping, agriculture, and media companies. In addition, the government indirectly took control of numerous small and medium size businesses through equity stakes held by the seized banks. These seizures led to a significant drain of intangible resources as leading entrepreneurial, managerial, and technical expertise fled (mainly to Brazil). Following these take-overs, government-controlled commercial monopolies were created by merging seized companies, although the banking system was left deconsolidated. As a result, nearly 25% of employment and 50% of gross fixed capital was in the public sector. Following the revolution, there was a rapid and unchecked expansion of public expenditures, which resulted in fiscal difficulties and required rescue financing from the IMF in 1977-1978 and again in 1983-1985. The growth of government expenditures and social entitlements, coupled with weak economic growth, led to pubic debt-to-GDP quadrupling to 74% by 1988. In 1989, Portugal amended its constitution to allow for denationalization of the financial system and public enterprise. However, inefficiencies under governmental control left companies with bloated costs and substantial operating losses, forcing management to use debt to finance roughly 86% of capital expenditures during the nationalized period. This legacy remains, as shown by non-financial business debt-to-GDP of 137% (see following chart), which is behind only Spain among the concerning European countries. Portugal Private Debt to GDP


Household non-Financial Corp. Financial




60% 137%

100% 98% 50% 55% 0% 19% 2000
Sources: Bank of Portugal, IMF World Economic Outlook Data Base, April 2011



Due to government operating controls, inefficient investment, and limited educational incentives, Portugal has the lowest productivity and GDP per capita in Western Europe, and among the lowest in the entire EMU (see following chart). OECD data regarding education levels indicate that 28% of Portuguese adults have completed high school (vs. 30% in Turkey, 34% in Mexico, 51% in Spain, 61% in Greece, 85% in Germany, and 89% in the U.S.), thus limiting Portugal’s ability to transition into many skilled and knowledge-based industries or produce successful entrepreneurs. 2010 GDP per Capita (with % of the EMU average)
€ 95 282% € 80

€ 65 Thousands of €

€ 50 117% 111% 73% € 20 115% 119% 88% 71% 51% 56% 42% 122% Average 79% 61%

€ 35

106% 105%

Slovak Republic







€5 Austria






Sources: IMF World Economic Outlook Data Base, April 2011

Portugal’s weak industries and competiveness have produced low levels of GDP growth, relatively high unemployment rates and fiscal deficits, unsustainable debt loads, and a negative net investment position that has contributed to the dependency on external financing markets. Compounded real GDP growth was among the lowest in Europe at only 0.7% from 2002 to 2006; GDP per capita fell from 61% of the EMU average in 1999 to 56% in 2010 (shown above). Between 2003 and 2007, the unemployment rate averaged 7.4% (well above the EMU average); this has expanded to 11.0% in 2010 and is expected to rise further. Despite recent austerity measures including salary cuts for public employees and tax increases, the budget deficit for 2010 was 9.1% of GDP (missing the 7.3% target, though government officials said the excess was due to non-recurring reclassifications). Real GDP growth for 2010 was 1.4% after contracting 2.5% in 2009, but is expected to decline in 2011 and 2012, especially with austerity measures elevating risks for a second recession. The government’s increasing leverage have resulted from debt-fueled Keynesian economic policies, the effects of the recent recession, a legacy of inflexible labor markets, and decades of unproductive investment. These issues built into the unstable situation within Portuguese credit markets, notwithstanding their austerity programs, particularly after the recent rescues required by Greece and Ireland. The Rescue of Portugal – Portugal’s government has long been highly dependent on external capital markets to finance budget deficits and refinance maturing debt, as shown by the extended historical deterioration in its net




international investment position and large recurring current account deficits. The government requires roughly €9 billion in 2011 for the budget deficit and €16 billion for debt maturities remaining during 2011, including €5 billion in June (see the following Country Snapshot page). Such market dependency proved damaging as bond yields have spiked (five-year bond yields have topped 11%) due to concerns over financing availability, inaccurate economic data, economic and fiscal performance, and longer term growth possibilities. The lack of capital market receptivity had made Portugal a major recipient of aid through the ECB’s bond purchase program and finally forced the government to officially request a rescue financing package. This followed insufficient internal austerity efforts, including Parliament’s rejection of the spending cuts and tax increases proposed by Prime Minister Jose Socrates. This rejection contributed to the resignation of the Prime Minister and the announcement of general elections on June 5, 2011. Portugal has announced a €78 billion rescue financing package (expiring in three years), though terms remain to be negotiated among European governments, the ECB, the IMF, the incumbent Portuguese government, and Portugal’s main political opposition parties. The size of the rescue financing appears adequate to support the government’s needs during the rescue term, and provide the expected €5 billion to €10 billion to domestic banks. The goal will be to finalize the financial rescue and the required fiscal and economic austerity program prior to Portugal’s general election on June 5, 2011. However, these negotiations will be complicated by obtaining reliable commitments from outgoing politicians, or those with uncertain election prospects. The large bond maturity on June 15, 2011 provides another critical date to finalize terms of the rescue financing (or a subset of the financing) given that prevailing high sovereign financing costs make refinancing impractical, and all parties recognize that the inability to repay the maturing debt would trigger the default that all efforts are directed towards avoiding. Detailed terms of the rescue package – including the capital providers, austerity requirements, and uses of funds – will be unveiled over time. However, negotiations to date have produced goals to reduce the fiscal deficit as a percent of GDP from 9.1% in 2010 to 5.9% in 2011, 4.5% in 2012, and 3.0% in 2013. The last time the government deficit was 3% of GDP or less was 2003, though numerous other EMU members have also repeatedly failed to meet the stipulated 3% maximum. The austerity programs required by the rescue are not expected to include (i) reductions in the minimum wage or wages of public employees, (ii) layoffs of additional public workers or increased retirement ages, (iii) special tax increases on bonuses, or (iv) divesting the government’s ownership of the largest domestic bank (Caixa Geral de Depositos). Still, Portugal faces formidable and potentially adverse fiscal and economic reforms while achieving the targeted deficit reduction, especially with the economy expected to contract through 2012.


Country Snapshot – Portugal Republic
(Billions of €, unless otherwise noted) 2003 143 154 -0.9% 55.9% -3.0% -6.5% 6.4% 2.3% 2004 149 157 1.6% 57.6% -3.4% -8.4% 6.8% 2.6% 2005 154 158 0.8% 62.8% -5.9% -10.4% 7.7% 2.5% 2006 160 160 1.4% 63.9% -4.1% -10.7% 7.8% 2.5% Macro Summary 2007 2008 169 172 164 164 2.4% 0.0% 62.7% 65.3% -3.1% -3.5% -10.1% -12.6% 8.1% 7.7% 2.7% 0.8% 2009 168 160 -2.5% 76.1% -10.1% -10.9% 9.6% -0.1% 2010 173 162 1.4% 92.4% -9.1% -9.9% 11.0% 2.4% 2011E 173 160 -1.5% 90.6% -5.6% -8.7% 11.9% 1.4% 2012E 174 159 -0.5% 94.6% -5.5% -8.5% 12.4% 2.1% 2013E 179 161 0.9% 97.5% -5.7% -6.6% 11.9% 1.3% 2014E 184 162 1.0% 100.8% -5.8% -6.4% 11.3% 1.6% Nominal GDP Real GDP Real GDP Growth Public Debt to GDP Surplus/(Deficit) to GDP Current Account to GDP Unemployment Rate Inflation Rate
Source: Eurostat, IMF, Ministry of Finance

Banco Espirito Santo-Reg Banco Comercial Portugues-R Banco BPA SA Banif SGPS SA-Reg
Source: Bloomberg, Banco de Portugal

Largest Banks Mkt. Cap. 12-Mo Share Price ∆ 3 -26% 3 -28% 1 -35% 0 -35%

Loans/Deposits 1.7x 1.7x 1.4x 1.6x

Banking Sector Total Banking Sector Assets % of GDP Loans/Deposits
Source: Banco de Portugal

537 311% 1.4x

Central Bank: Sov. Credit Rating (S&P/Moody's Fitch): Global Competitiveness Score: Share of Government Debt Held Abroad:
World Economic Forum

Other Banco de Portugal BBB-/Baa1/BBB- ; Outlook: neg./neg./neg. 4.38 (46th ranking out of 139 countries) 57%

Cross Exposure Creditor Country Spain France Germany U.K. Netherlands Ireland Belgium Italy
Source: BIS

Sources: IMF, Global Stability Report April 2011 and Joint BIS-IMF-OECD-WB Statistics,

Tenor 2-Year 3-Year 5-Year 10-Year
Source: Bloomberg

Bond Yields Yield 12-Month ∆ (bps) 910 11.5% 831 11.2% 766 11.5% 474 9.5%

Tenor 5-Year 10-Year

CDS Spread Spread 636 576

Exposure % Debtor GDP 58 34% 26 15% 27 16% 17 10% 4 2% 4 2% 2 1% 3 2%

Monthly Maturity Profile for Sovereign and Largest Bank (with combined amounts as % of GDP) € 12 € 10 €8 Billions €6 €4 €2 0.2% €0 Apr-11 May- Jun-11 Jul-11 11
Source: Bloomberg


6% Portugal Republic Largest Banks Combo % of GDP 5% 4% Debt/GDP 3%

3.6% 2.5% 1.4% 0.7% 1.5%


1.9% 1.7% 1.2% 1.2% 0.9% 0.1% 0.2%

1.2% 0.5% 0.2% 0.2% 0.3%

2% 1.1% 1% 0%

Aug- Sep-11 Oct-11 Nov- Dec-11 Jan-12 Feb-12 Mar- Apr-12 May- Jun-12 Jul-12 11 11 12 12

Aug- Sep-12 Oct-12 Nov- Dec-12 12 12

Annual Maturity Profile for Sovereign and Largest Bank (with combined amounts as % of GDP) € 30 € 25 € 20 12.4% € 15 € 10 €5 €0 2011 Remainder
Source: Bloomberg

Portugal Republic 17.7% 13.4% 10.2% 9.4% 7.3% 6.6% Largest Banks Combo % of GDP

25% 20%


15% 10% 5% 0%









SPAIN – 34% Implied Probability of Default on 10-Year CDS
Spain is under the market’s microscope due to the size of its economy and the consequences of a Spanish failure on the global economy, including contagion spreading to the even larger Italy. Spain’s economy is at least four times larger than Greece, Ireland, or Portugal, and has twice the public debt and over five times the individual sovereign debt of these countries. As a result of its scale, Spain is the critical country in the unfolding European sovereign and banking crisis. To avoid failure, Spain must overcome an anemic economy, the highest unemployment rates in the developed world (approximately 20%), an inflexible labor force, high government entitlement spending, high private debt levels, a fragile banking system plagued by troubled property and development loans, and a difficult funding schedule. Encouragingly, Spain has begun to recognize the risks it faces and is taking steps to correct its structural imbalances via labor reform, fiscal austerity, and restructuring the banking system. Still, the elevated probability of default implied by CDS prices indicates Spain is under considerable stress, though markets have increasingly differentiated Spain from the troubled three peripheral European countries. The main causes of Spain’s current fiscal problems are the repercussions of the property bubble that burst in 2008 after building for ten years, which triggered major losses for banks and employment. The earlier boom in property prices was fueled by cheap loans from Spain’s commercial banks and regional savings banks (cajas), which drove private debt to dangerous levels, created a bubble in employment connected to construction and real estate, and excessive real estate prices as Spanish citizens and foreigners increased their speculative activities. With the real estate collapse (even with the government’s official data and banking practices obscuring the true pricing declines) and the general economic slowdown, Spain’s public debt has ballooned with expanding fiscal deficits, especially from covering the social benefits for the newly unemployed. Total debt (public and private) in Spain is 389% of GDP, which ranks behind only Japan’s 477% and U.K.’s 453%. Government debt is 60% of GDP, but expected to reach 67% in 2012. While these government debt numbers are low by comparison to other EMU members, private debt is very high at 139% of GDP for nonfinancial businesses, 105% for financial institutions, and 84% for household debt. Much of this debt accumulation related to the bubble in property prices and construction activity, as real prices rose roughly 210% between 1995 and 2007 and construction grew to employ 16% of the Spanish labor force. Housing starts vastly exceeded population growth (see following graph), with a cumulative one million units of excess construction persisting throughout the early 2000s, before new construction activity fell off a cliff in 2008 and 2009. In fact, the Spanish market accounted for two-thirds of home construction in all of Europe between 1999 and 2007, resulting in a banking system with loans to property developers (for land and construction) accounting for a massive 42% of GDP, and 1.6 million empty residences (seven years of demand). This bubble in real estate prices and construction was inflated largely by aggressive lending by Spanish banks, including cheap development loans and mortgages up to 50 years. This was particularly true for the cajas (or Caixa), which grew to account for roughly 50% of Spanish banking assets. Unlike commercial banks, cajas are not-for-profit entities created to benefit the poor and to develop local economies by taking deposits and making loans. Cajas have no common equity; rather, initial donations funded reserves. Their earnings are intended to cover credit losses, fund charities, and promote regional development. Since the cajas do not operate with a profit motive for shareholders, other considerations were made when extending loans such as social and political benefits and expanding the regional tax base.


Cumulative Excess Housing Starts versus Change in Population
1,600 1,400 1,200 1,000 Thousands 800 600 400 200 0 -200 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Spanish New Housing Starts Cumulative Excess Housing Starts Change in Population

Source: TINSA Database

The focus of the cajas on promoting local economies included encouraging real estate development and construction by often lending 100% of land costs, then 100% of construction costs, and then provided nearly 100% financing to homebuyers. This free option for developers and homebuyers encouraged massive speculation and contributed to ballooning private debts and the rapid growth in banking assets shown below. Such aggressive lending produced major increases in banking assets, which expanded across the industry from 268% of GDP in 2000 to 449% in 2010 (see following graph). The questionable lending practices also produced large bad debts, although write-downs have been limited for Spanish banks thus far. Further, the unclear ownership of cajas (with various charities, governments, and board members declaring control) has complicated the restructurings and capital raising required by the real estate losses. Spanish Banking Assets as a % of GDP
500% 400% 300% 200% 100% 0% 2000 Sept. 2010 268% 449%

Source: Bank of Spain, IMF

The amount of bank restructuring required is unclear given that banks and cajas are distorting reported property values to prevent marking down assets by such actions as canceling debt in exchange for taking ownership of property, followed by “appraising” property at the original loan value, then reselling the property to new buyers with 100% financing (also with low rates and long maturities). The lack of distressed portfolio sales by Spanish banks corroborates this view. As shown in the following table, even though 41% or €181 billion of Spanish

banking assets are classified as potential problems, they have written off only 1% (€5 billion); they have provisioned for 24% of the other €176 billion of potential problem loans. Breakdown of Potential Problem Loans in Spanish Banks
(billions of €) Doubtful Sub-standard Foreclosures and repossessions Write-offs Potential problem loans
Source: Banco de España

Amount € 48 € 58 € 70 €5 € 181

% of Investment 11% 13% 16% 1% 41%

Specific Provisions € 19 €8 € 17 €5 € 48

% Provisioned 39% 14% 24% 100% 27%

Officially, Spanish housing prices have fallen under 20% from the peak, but the actual drop is likely closer to 50%. As shown on the following graph, real estate prices in the other over-built economies such as Ireland and the U.S. have declined back near levels of 2003, which would require another 30% decline for Spain. This discrepancy is partly due to using appraisals (which are heavily reliant on offering prices) rather than actual sales prices. Real Estate Prices Among Over-Built Countries
200 Spain 180 160 140 120 100 80 Dec-05 Dec-10 Dec-02 Dec-03 Dec-04 Dec-06 Dec-07 Dec-08 Dec-09 Jun-03 Jun-04 Jun-06 Jun-07 Jun-08 Jun-05 Jun-09 Jun-10 U.S. Ireland

Source: TINSA Database for Spain, S&P/Case-Shiller U.S. Home Price Index, ESRI Ireland House Price Index

Spain’s high unemployment rate is also related to the troubled real estate market. Their labor market has a rigid and bifurcated structure. Among the employed, 70% are subject to inflexible work contracts (even though only 16% are unionized), while 30% are temporary workers without job training or job security beyond their rolling one-month agreements. The contract workers are on long, fixed contracts that also provide seniority bonuses, profit sharing, annual pay increases, and early retirement; these workers are expensive to fire, requiring 45 days of severance pay per year of service (versus 20 days of total severance for much of the rest of Europe). Spain’s extreme unemployment rate is heavily influenced by this labor structure since companies are reluctant to hire contract workers. Importantly, the contract workers are mostly older people, while temporary workers are mostly the younger; in fact, the unemployment rate is near 40% for workers under 25 years old, which has important social implications for the future. Spain’s high unemployment has contributed to higher government spending, which grew from roughly 39% of GDP during 2001 to 2006 to 45% in 2010 (see following chart).

Spanish Unemployment Rate and Government Expenditures
48% Total Government Expenditure as % of GDP Government Expenditure as % of GDP Unemployment rate 45% 20% Unemployment Rate 25%





38% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010


Source: IMF, World Economic Outlook Database, April 2011

In 2010, Spain instituted half-hearted labor reforms that eased restrictions on firing contracted workers but raised restrictions on firing temporary workers. This was matched by fiscal reforms during 2010 that included a series of austerity measures meant to reduce the fiscal deficit (roughly €95 billion in 2010) by 16% or €15 billion. The most important measures in this plan were the 5% wage reduction for civil servants and reductions in pension obligations. They have recently announced other changes to the labor market such as increasing the retirement age from 65 to 67 (phased in over time). However, while austerity measures can benefit fiscal deficits (which is highly necessary for Spain following the reversal from surpluses shown below), they are by nature contractionary. This is expected to contribute to the extension of Spain’s anemic change in real GDP (below 1% in 2011 and below 2% through 2014). Spanish Economy: Recent Performance and Forecasts
6% 4% 2% 0%
7 6 20 08 20 09 20 10 1 2 2 01
Current Account Balance as % of GDP Fiscal Account Balance as % of GDP GDP Change (%)

-2% -4% -6% -8% -10% -12%

Source: IMF, ECB, European countries central banks

20 13


2 00

2 00

2 00

2 01


Given these economic and banking challenges, Spain was downgraded by all three rating agencies in 2010, with an additional downgrade by Moody’s in March 2011. On April 28, 2010, Standard & Poor’s put it succinctly, “We now believe that the Spanish economy’s shift away from credit-fueled economic growth is likely to result in a more protracted period of sluggish activity than we previously assumed. We now project that real GDP growth will average 0.7% annually in 2011-2016, versus our previous expectations of above 1% annually over this period.” They also cited the burden on economic growth from the large private sector debt, inflexible labor market, and low export capacity. Certain of economic challenges facing peripheral Europe are shared by Spain, including a real estate bust, high unemployment, and an undercapitalized banking sector; however, Spain’s differences from peripheral Europe include a larger and more diversified economy, and better access to financing in the capital markets. As shown in the chart below, yields on Spain’s debt remain elevated, though with increasing divergence from countries already subjected to financial rescues. Nevertheless, Spain’s yields have increased (see following graph) along with concern levels following Portugal’s request for rescue financing, as well as higher German rates (the pricing benchmark for most other European sovereigns) following the ECB’s 25 basis point increase in interest rates during April 2011. Additional concerns regarding Spain include a difficult debt maturity schedule in 2011 and 2012 (see our Country Snapshot of Spain) which leaves them susceptible to capital market gyrations. Spain has to refinance €117 billion of debt maturities for the remainder of 2011, and €98 billion in 2012, with roughly another €50 billion in each year for deficit financing. Additionally, the five largest Spanish banks also face refinancing requirements averaging over €40 billion annually through 2014. Any refinancing failure among the banks could effectively transfer their debts to the government; even absent such as failure, Spain could need to provide €50 billion to €100 billion to recapitalize its banking system due to unrecognized real estate losses. This is particularly true for the cajas, which the government has ordered to raise capital by various means after a weak series of stress tests, though the logistics for such transactions remains uncertain given their lack of shareholders and political board members. These banking problems and the mountain of coming debt maturities are already contributing to higher credit spreads for Spain; continual spread increases could make external financial assistance increasingly likely. Yield on Spanish Government 4.8% Bond due January 2024





3.5% Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11

Source: Bloomberg


Repairing Spanish banks will be aided by the Fund for the Orderly Restructuring of the Banking Sector (FROB) created by Spain’s National Central Bank (Banco de España or BdE). This fund was initially capitalized with €9 billion of capital, and had the ability to use leverage of 10x the capital, giving it €99 billion of purchasing power. The fund’s purpose is to provide Core Tier 1 capital to banks and cajas to facilitate mergers of weaker banks and cajas into larger, better capitalized institutions. Capital injected by the FROB carries minimum coupons of 7.75% and must be redeemed by the banks within five years. Banks and cajas were initially reluctant to borrow from the FROB, though a new law virtually forced many institutions to take FROB capital. Royal Decree Law 2/2011 required Core Tier 1 capital ratios of 8% for entities with public shareholders and 10% for entities without public shareholders. This law also required banks and cajas to submit capital plans to the BdE by March 31, 2011; all 13 of the plans submitted have been approved by the BdE. However, these capital plans were not made public and apparently resulted in only €3.3 billion of FROB drawings, which appears inadequate given the quantity of troubled assets within the Spanish banking system (analyst estimates have been concentrated between €50 billion and €100 billion of required capital). Among other capital raising strategies for banks, several IPOs of merged cajas are scheduled for the summer of 2011, which will be closely watched as a gauge of market confidence. The volatility of Spain’s banks and the country at large are likely to provide numerous appealing investment opportunities going forward.


Country Snapshot – Kingdom of Spain
(Billions of €, unless otherwise noted) 2003 783 600 3.1% 48.7% -0.2% -3.5% 11.5% 2.7% 2004 841 620 3.3% 46.2% -0.3% -5.3% 11.0% 3.3% 2005 909 642 3.6% 43.0% 1.0% -7.4% 9.2% 3.7% 2006 984 668 4.0% 39.6% 2.0% -9.0% 8.5% 2.7% Macro Summary 2007 2008 1,054 1,088 692 698 3.6% 0.9% 36.1% 39.8% 1.9% -4.2% -10.0% -9.7% 8.3% 11.3% 4.3% 1.5% 2009 1,054 672 -3.7% 53.2% -11.1% -5.5% 18.0% 0.9% 2010 1,063 671 -0.1% 60.1% -9.2% -4.5% 20.1% 2.9% 2011E 1,085 676 0.8% 63.9% -6.2% -4.8% 19.4% 2.1% 2012E 1,119 687 1.6% 67.1% -5.6% -4.5% 18.2% 1.4% 2013E 1,157 699 1.8% 69.9% -5.0% -4.1% 17.1% 1.4% 2014E 1,199 713 1.9% 72.1% -4.7% -3.9% 16.3% 1.6% Nominal GDP Real GDP Real GDP Growth Public Debt to GDP Surplus/(Deficit) to GDP Current Account to GDP Unemployment Rate Inflation Rate
Source: Eurostat, IMF

Banco Santander S.A. Banco Bilbao Vizcaya Argenta Banco Popular Espanol Banco Esp Credito (Banesto) Banco de Sabadell Sa
Source: Bloomberg, Banco de España

Largest Banks Mkt. Cap. 12-Mo Share Price ∆ 70 -19% 38 -20% 6 -29% 4 -25% 4 -28%

Loans/Deposits 1.3x 1.5x 1.7x 1.8x 1.6x

Banking Sector Total Banking Sector Assets % of GDP Loans/Deposits
Source: Banco de Espana

4,769 449% 0.8x

Central Bank: Sov. Credit Rating (S&P/Moody's Fitch): Global Competitiveness Score: Share of Government Debt Held Abroad:
World Economic Forum

Other Banco de España AA/Aa2/AA+ ; Outlook: neg./neg./neg. 4.49 (42nd ranking out of 139 countries) 50%

Sources: IMF, Global Stability Report April 2011 and Joint BIS-IMF-OECD-WB Statistics,

Tenor 2-Year 3-Year 5-Year 10-Year
Source: Bloomberg

Bond Yields Yield 12-Month ∆ (bps) 3.5% 195 4.1% 200 4.7% 182 5.5% 164

Tenor 5-Year 10-Year

CDS Spread Spread 243 245

Creditor Country Germany France U.K. Netherlands U.S. Italy Ireland Portugal Japan
Source: BIS

Cross Exposure Exposure % Debtor GDP 138 13% 126 12% 80 8% 54 5% 35 3% 20 2% 19 2% 18 2% 16 2%

€ 30 € 25 € 20 Billions € 15

Monthly Maturity Profile for Sovereign and Largest Bank (with combined amounts as % of GDP) Kingdom of Spain Largest Banks Combo % of GDP 3.3% 2.7% 2.6% 2.6% 1.9% 2.5% 2.2%




2% 0.9% 0.9% 0.7% 1.1% 0.6% 1% 0.4% 0.1% 0%


€ 10 0.8% €5 €0




1.1% 0.7%


Apr-11 May- Jun-11 Jul-11 Aug- Sep-11 Oct-11 Nov- Dec-11 Jan-12 Feb-12 Mar- Apr-12 May- Jun-12 Jul-12 Aug- Sep-12 Oct-12 Nov- Dec-12 11 11 11 12 12 12 12
Source: Bloomberg

€ 125 € 100 € 75 € 50 € 25 €0 2011 Remainder
Source: Bloomberg

Annual Maturity Profile for Sovereign and Largest Bank (with combined amounts as % of GDP) Kingdom of Spain 15.3% 13.8% 11.7% 9.8% 7.0% 5.8% Largest Banks Combo % of GDP


15% Debt/GDP


10% 5.7% 5%

0% 2012 2013 2014 2015 2016 2017


ITALY – 24% Implied Probability of Default on 10-Year CDS
Italy is the largest economy presently of concern, accounting for 17% of GDP for the EMU (behind only Germany and France). Italy has long carried public debt-toGDP above 100% (now 119%) but it is Italy’s economic malaise that concerns the market. Italy has consistently under-performed the EMU average growth (see graph below). The 5% decline in real GDP in 2009 is expected to be followed by growth under 1.5% through 2014, leaving debt-to-GDP at the recently elevated levels. Similarly, the fiscal deficit (4.6% of GDP in 2010) is not projected to improve materially through 2014. GDP Growth for Italy and the EMU
6% Italy 4% 2% 0% 2001 -2% -4% -6% Source: IMF 2002 2003 2004 2005 2006 2007 2008 2009 2010 Average

Italy’s stagnant economy can largely be attributed to Southern Italy, which is less affluent and less industrialized than the North. The large economic gap between the North and South (as shown below, GDP per capita in the South is 55% that in Northern Italy), has resulted in large transfer payments to the South through investments. However, these investments have had little positive effect. This is believed partly attributable to the significant underground economy throughout the country (but especially the South), which the U.S. Central Intelligence Agency estimates accounts for 15% of GDP and therefore contribute to the government’s difficulties in tax collection. Regional Italy GDP per Capita
€ 35 € 30 € 25 Thousands of € € 20 € 15 € 10 €5 €0 North-Western North-Eastern Central Insular Southern € 17 € 17 € 31 € 31 € 29

Source: Eurostat


Further, the economy suffers from limited competitiveness, ranking near the bottom among EMU members (see following graph). The Italian economy is made up of mostly small and medium-sized businesses which have high labor costs; it has few world-class multinational corporations. The Italian workforce also lacks technical expertise and has therefore missed out on growth in high-tech and knowledge-based industries that support higher wages and benefit labor productivity. Global Competitiveness Rankings
5.50 5.25 5.00 4.75 Score 4.50 4.25 4.00 3.75 Slovak Republic Luxembourg Belgium Netherlands Germany Slovenia Finland 3.50 Portugal Estonia Cyprus Ireland Austria Spain France Italy Malta Greece Score Global Rank 10 20 30 40 50 60 70 80 90 Global Rank

Source: GCI Global Competitiveness Index 2010-2011, World Economic Forum

This lack of competitiveness is prevalent in the South, where public sector employment dominates, though also omnipresent nationally (public employment accounts for 17% of national employment). In fact, government expenditures made up over 51% of GDP in 2009 (see graph below), which was mostly for wages. These public wages are 13% above the average private sector jobs, yet the average public employee has more generous time off (an average 30 days of vacation and 20 sick days per year). Rigid labor rules also make firings quite difficult, with common stories of employees seldom appearing due to working another job to collect a second paycheck. Italian Government Expenditures to GDP
56% 54% 52% 50% 48% 46% 44% 42% 40% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: IMF


As shown in the following graph, pension spending is also problematic; Italy spends the most of any country in the Europe (and even among the 34 countries in the Organisation for Economic Co-Operation and Development, or OECD) at 14% of GDP and growing. This pay-as-you-go scheme allows for retirement as early as age 60 for men and 55 for women. Funding comes via the highest payroll taxes in the OECD at 32.7% versus and average of 21%. Pension reforms are a political hot button throughout the country, but powerful trade unions and older workers have successfully blocked most attempts. European Pension Expenditures to GDP
16% 14% 12% 10% 8% 8% 6% 4% 2% 0% Austria OECD Switzerland Spain U.K. Italy Netherlands Germany Greece Ireland France 7% 7% 6% 5% 3% 14% 13% 12% 12% 11%

Source: OECD

Despite Italy’s economic stagnation, the high debt loads (total public and private debt are 268% of GDP) should be sustainable if the government can lower fiscal deficits and maintain access to capital markets. Italy’s fiscal deficit is expected to decrease from 4.5% of GDP in 2010 to 3.3% by 2013 due to austerity measures implemented (estimated at €24 billion) that froze public wages and cut wages for highly paid officials. The austerity program did not raise the already high taxes. While total debt and estimated deficits seem manageable, Italy faces serious funding risks with approximately €220 billion of debt maturities for the remainder of 2011 and more than €230 billion in 2012. Due to Italy’s global importance as a borrower, with 5% of global government debt outstanding, any significant increases in credit costs could have dire implications, and would likely be immediately countermanded by collective government action. However, Italy’s slow growth economy, high government debts, and challenging maturity schedule could produce volatility in sovereign bonds.

% of GDP


Country Snapshot – Italian Republic
(Billions of €, unless otherwise noted) 2003 1,335 1,218 0.0% 104.4% -3.5% -1.3% 8.5% 2.5% 2004 1,392 1,237 1.5% 103.9% -3.6% -0.9% 8.0% 2.4% 2005 1,429 1,245 0.7% 105.9% -4.4% -1.7% 7.7% 2.1% 2006 1,485 1,270 2.0% 106.6% -3.3% -2.6% 6.8% 2.1% Macro Summary 2007 2008 1,546 1,568 1,289 1,272 1.5% -1.3% 103.6% 106.3% -1.5% -2.7% -2.4% -2.9% 6.2% 6.8% 2.8% 2.4% 2009 1,520 1,206 -5.2% 116.1% -5.3% -2.1% 7.8% 1.1% 2010 1,549 1,221 1.3% 119.0% -4.6% -3.5% 8.5% 1.9% 2011E 1,594 1,234 1.1% 120.3% -4.3% -3.4% 8.6% 2.0% 2012E 1,649 1,250 1.3% 120.0% -3.5% -3.0% 8.3% 2.1% 2013E 1,705 1,267 1.4% 119.7% -3.3% -3.0% 7.9% 2.0% 2014E 1,763 1,285 1.4% 119.3% -3.2% -3.0% 7.6% 2.0% Nominal GDP Real GDP Real GDP Growth Public Debt to GDP Surplus/(Deficit) to GDP Current Account to GDP Unemployment Rate Inflation Rate

Source: Eurostat, IMF, Ministry of Finance

Unicredit SPA Intesa Sanpaolo Banca Monte Dei Paschi Siena Ubi Banca SCPA Banca Carige SCPA
Source: Bloomberg, Banca d'Italia

Largest Banks Mkt. Cap. 12-Mo Share Price ∆ 33 -23% 28 -21% 6 -24% 4 -43% 3 -18%

Loans/Deposits 1.6x 1.9x 2.1x 2.1x FALSE

Banking Sector Total Banking Sector Assets % of GDP Loans/Deposits
Source: Banca d'Italia

3,782 244% 0.8x

Central Bank: Sov. Credit Rating (S&P/Moody's Fitch): Global Competitiveness Score: Share of Government Debt Held Abroad:
World Economic Forum

Other Banca d'Italia A+/Aa2/AA- ; Outlook: stable/stable/stable 4.37 (48th ranking out of 139 countries) 47%

Sources: IMF, Global Stability Report April 2011 and Joint BIS-IMF-OECD-WB Statistics,

Tenor 2-Year 3-Year 5-Year 10-Year
Source: Bloomberg

Bond Yields Yield 12-Month ∆ (bps) 3.1% 175 3.5% 176 4.0% 136 4.8% 80

Tenor 5-Year 10-Year

CDS Spreads Spread 149 157

Creditor Country France Germany U.K. Netherlands Ireland Japan U.S. Spain Belgium
Source: BIS

Cross Exposure Exposure % Debtor GDP 308 20% 122 8% 45 3% 33 2% 30 2% 29 2% 29 2% 23 1% 17 1%

€ 70 € 60

Monthly Maturity Profile for Sovereign and Largest Bank (with combined amounts as % of GDP) Italian Republic Largest Bank 4.3% Combo % of GDP

6% 5% 4% Debt/GDP

€ 50 Billions € 40 € 30 € 20 € 10 €0 0.6% 2.1% 2.2% 1.3% 0.5% 2.4% 1.6% 0.6% 0.4% 0.2% 0.3% 3.0% 2.7% 2.8%

3% 2.1% 1.3% 0.9% 1.0% 1.5% 1.0% 2% 1% 0%

Apr-11 May- Jun-11 Jul-11 Aug- Sep-11 Oct-11 Nov- Dec-11 Jan-12 Feb-12 Mar- Apr-12 May- Jun-12 Jul-12 Aug- Sep-12 Oct-12 Nov- Dec-12 11 11 11 12 12 12 12
Source: Bloomberg

€ 350 € 300

Annual Maturity Profile for Sovereign and Largest Bank (with combined amounts as % of GDP) Italian Republic Largest Bank 20.9% Combo % of GDP 18.5%

30% 24% 18%

€ 250 Billions € 200 € 150 € 100 € 50 €0


13.7% 10.1%

12.2% 7.4% 7.7%

12% 6% 0%

2011 Remainder
Source: Bloomberg








BELGIUM – 23% Implied Probability of Default on 10-Year CDS
Belgium is a more recent entrant to the list of troubled sovereigns, facing issues of high sovereign leverage and political instability. The political situation has evolved from the long-challenging union of Flanders in the north (Flemish speaking, 58% of the population) and Wallonia in the south (French speaking, 32% of the population); Brussels, the bilingual capital of the country (and the EU), contains the last 10% of the population. Historically, Flanders was more agrarian while Wallonia was more industrial, with major steel production since the 1800s. In recent decades, the country’s economic center migrated northward as Walloon steel lost its competitive edge, while the North benefited from investments made by U.S. firms in the 1960s and 1970s in automotive, chemical, and other industries. By 2005, the economy of Flanders was considerably stronger than Wallonia, with GDP per capita of €27,300 versus €19,800 (Brussels has €54,900), and an unemployment rate of 6.9% versus 11.8%. Beyond its economic variations, Belgium is also politically divided. Belgium is a representative democracy with a constitutional monarchy. Albert II serves as King of Belgium and Head of State but the Prime Minister heads the government. The bicameral federal Parliament consists of the Senate and the Chamber of Representatives. The 71 members of the Senate include 40 directly elected politicians, 21 appointed by local parliaments, and 10 appointed by the first two groups of senators. The 150 members in the Chamber of Representatives, or lower house, are allocated to districts based on population and elected by public vote. The political tensions between the southern Walloons and northern Flemings have grown beyond linguistic problems and socio-economic differences, leading to the inability to form a functional government. Since the general election in June 2010 and a no-confidence vote, Belgium has been operating under a caretaker government (this also occurred in 2007). Belgium recently passed Iraq’s contemporary record among democratic countries by surpassing 250 days without an elected government leader. The New Flemish Alliance (N-VA) party, whose main pillar is full Flemish independence, won sufficient seats in recent elections to become the largest political group in Parliament. Since then, the N-VA has pushed to transfer justice, health, and social security services to their respective regions, which would effectively end €7 billion of annual transfer payments from the richer Flemings to poorer, French-speaking Walloon minority. In addition to political uncertainty, Belgium has excessive debt, a huge banking system relative to the country’s size, an inflexible labor system, and a bloated public sector. Belgium’s total public and private debt-to-GDP of 385% ranks behind only Spain, U.K., and Japan. Banking assets are 513% of GDP, higher than Spain and Ireland’s domestic levels. Government debt, at 97% of GDP, is above the 90% threshold that generally corresponds to stifled economic growth and increased difficulties in deleveraging. Also, government expenditures are a large 53% of GDP (up from 48-50% during 1998 to 2008) due to its full medical system, unemployment coverage, child allowances, and pension and other social benefits, making an improvement in deficits unlikely unless austerity measures are taken. Belgium also has problematic labor inflexibility, with 53% of all public and private employees unionized. These fundamental weaknesses of Belgium, coupled with the present political vacuum and the government’s dependency on capital markets (with government refinancing and financing needs nearly 20% of GDP in 2011) have the ability to trigger volatile changes in credit spreads and heightened concerns about debt repayment abilities, especially in the unlikely event that the N-VA achieves their desired division of the country.


Country Snapshot – Kingdom of Belgium
(Billions of €, unless otherwise noted) 2003 276 308 0.8% 98.5% -0.1% 3.4% 8.2% 1.7% 2004 290 317 3.1% 94.2% -0.3% 3.2% 8.4% 1.9% 2005 303 324 2.0% 92.1% -2.8% 2.0% 8.5% 2.8% 2006 319 332 2.7% 88.1% 0.2% 1.9% 8.3% 2.1% Macro Summary 2007 2008 335 344 342 344 2.8% 0.8% 84.2% 89.6% -0.3% -1.3% 1.6% -1.9% 7.5% 7.0% 3.1% 2.7% 2009 339 335 -2.7% 96.2% -6.0% 0.8% 8.0% 0.0% 2010 351 342 2.0% 97.1% -4.6% 1.2% 8.4% 3.3% 2011E 365 348 1.7% 97.3% -3.9% 1.0% 8.4% 2.9% 2012E 380 354 1.9% 97.4% -4.0% 1.2% 8.2% 2.3% 2013E 395 361 1.9% 97.8% -4.1% 1.5% 8.2% 2.1% 2014E 411 368 1.9% 98.2% -4.1% 1.9% 7.9% 2.0% Nominal GDP Real GDP Real GDP Growth Public Debt to GDP Surplus/(Deficit) to GDP Current Account to GDP Unemployment Rate Inflation Rate

Source: Eurostat, IMF, National Bank of Belgium

KBC Groep NV
Source: Bloomberg, Nationale Bank van België

Largest Bank Mkt. Cap. 12-Mo Share Price ∆ 10 -27%

Loans/Deposits 1.2x

Banking Sector Total Banking Sector Assets % of GDP Loans/Deposits
Source: National Bank of Belgium

1,799 513% 0.6x

Central Bank: Sov. Credit Rating (S&P/Moody's Fitch): Global Competitiveness Score: Share of Government Debt Held Abroad:
World Economic Forum

Other Nationale Bank van België AA+/Aa1/AA+ ; Outlook: neg./stable/stable 5.07 (19th ranking out of 139 countries) 68%

Sources: IMF, Global Stability Report April 2011 and Joint BIS-IMF-OECD-WB Statistics,

Tenor 2-Year 3-Year 5-Year 10-Year
Source: Bloomberg

Bond Yields Yield 12-Month ∆ (bps) 2.6% 163 3.1% 161 3.7% 101 4.3% 80

Tenor 5-Year 10-Year

CDS Spreads Spread 142 147

Creditor Country Netherlands U.S. Germany U.K. Japan Switzerland Spain Ireland Italy
Source: BIS

Cross Exposure Exposure % Debtor GDP 85 24% 24 7% 28 8% 21 6% 13 4% 10 3% 3 1% 4 1% 3 1%

€ 16

Monthly Maturity Profile for Sovereign and Largest Bank (with combined amounts as % of GDP) 3.8% Kingdom of Belgium 3.8% Largest Bank 2.8% 2.8% 2.2% 2.3% 1.9% 0.9% 0.7% 0.7% 0.0% 0.9% 0.7% 0.5% 0.1% 0.1% 0.1% 0.4% 0.3% 0.0% Combo % of GDP

4% 4% 3% 3% 2% 2% Debt/GDP

€ 12 Billions




1% 1% 0%


Apr-11 May- Jun-11 Jul-11 Aug- Sep-11 Oct-11 Nov- Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 May- Jun-12 Jul-12 Aug- Sep-12 Oct-12 Nov- Dec-12 11 11 11 12 12 12
Source: Bloomberg

€ 50 € 45 € 40 € 35 Billions € 30 € 25 € 20 € 15 € 10 €5 €0 2011 Remainder
Source: Bloomberg

Annual Maturity Profile for Sovereign and Largest Bank (with combined amounts as % of GDP) 14.0% 12.0% 12.7% 9.9% 7.8% 7.2% 12.8% Kingdom of Belgium Largest Bank Combo % of GDP

16% 14% 12% 10% 8% 6% 4% 2% 0% Debt/GDP








Having summarized the background of the financial crisis and the critical borrowers of concern, this section provides an overview of the key government-related entities involved in the complex web of decision-making and rescue financing for European sovereigns and banks. These critical groups include the European Union (EU), the Economic and Monetary Union (EMU), the International Monetary Fund (IMF), the newly created supranational European Financial Stabilisation Mechanism (EFSM) and inter-governmental European Financial Stability Facility (EFSF), and the European Stability Mechanism (ESM), which could provide the longer-term solution to the crisis and potentially pave the way for sovereign debt restructurings.

The European Union (EU) is an economic and political union of 27 member states throughout Europe established in the present form by the Maastricht Treaty in 1993. With a combined population of 500 million inhabitants, the EU had GDP of €12.2 trillion in 2010, accounting for 20% of the global economy. The EU traces its origins from the European Coal and Steel Community (ECSC) and the European Economic Community (EEC) formed by six countries in the 1950s. In the intervening years, the EU has grown in size by adding new member states, and grown in power by adding policy coverage areas. The EU has developed a single market through a standardized system of laws applicable to all member states. This includes the requirement to abolish passport controls within the Schengen area, which includes 25 EU countries that signed the Schengen Agreement (named after the town in Luxembourg where the agreement was signed in 1985), plus three non-EU members (Iceland, Norway and Switzerland). Ireland and the U.K. are the only EU members outside the Schengen area. This system ensures the free movement of people, goods, services, and capital, enacts legislation in justice and home affairs, and maintains common policies on trade, agriculture, fisheries, and regional development. The EU also has a limited role in external relations and defense through the Common Foreign and Security Policy. As summarized in the following table, a subset of 17 EU countries (the Euro-Zone) share the euro as a common currency as members of the Economic and Monetary Union (EMU, discussed later). The EU’s membership has grown from the original six countries (Belgium, France, (then-West) Germany, Italy, Luxembourg, and the Netherlands) to the present 27 members as additional applicants acceded to the required treaties, pooled their sovereignty in exchange for representation in the governing institutions, and met the Copenhagen criteria (defined at the 1993 Copenhagen European Council). These criteria require a stable democracy that respects human rights and the rule of law, a functioning market economy capable of competition within the EU, and accepting EU law, among other obligations of membership. There are five official candidate countries (Croatia, Iceland, Macedonia, Montenegro, and Turkey) and three officially recognized potential candidates (Albania, Serbia, and Bosnia & Herzegovina). No country has ever left the EU, although Greenland (an autonomous province of Denmark) withdrew in 1985. The Lisbon Treaty (effective December 2009) provides for how a member could voluntarily leave the EU, but no legal provision currently exists to expel an EU member.


EU Members
Austria Belgium Bulgaria Cyprus Czech Republic Denmark Estonia Finland France Germany Greece Hungary Ireland Italy Latvia Lithuania Luxembourg Malta Netherlands Poland Portugal Romania Slovakia Slovenia Spain Sweden United Kingdom

EMU Member
Yes Yes No Yes No No Yes Yes Yes Yes Yes No Yes Yes No No Yes Yes Yes No Yes No Yes Yes Yes No No

Governance – The EU operates through a hybrid system of supranational institutions and decisions negotiated among members. Important institutions of the EU include the European Commission (these 20 people propose legislation and manage the EU’s budget), the Council of the European Union (also known as the Council of Ministers, representing the national governments of EU members), the Court of Justice of the European Union, the European Central Bank (discussed later), the European Parliament (with officials elected every five years by citizens), and the European Council. The European Council is comprised on the Heads of State and Government (i.e. Presidents and Prime Ministers) of all member countries, plus the President of the European Commission (currently José Manuel Durão Barroso of Portugal, whose five-year term ends in 2014). The European Council is the highest-level policy-making body in the EU and is responsible for evaluating a country’s fulfillment of the eligibility criteria for membership; it generally meets four times per year to set EU policy, review progress, and uphold the collective interests of members.


Treaties and laws are created by the triangle of The Council of Ministers, Parliament, and the European Commission. The power to initiate laws is held by the European Commission and in a limited capacity by the European Council (which is empowered under the Maastricht Treaty to settle issues when the Council of the European Union fails to agree). The EU legislature is principally composed of Parliament and the Council of Ministers, with duties for scrutinizing, approving, and amending legislation usually divided equally. National parliaments also have a minor delaying power. Legislative proposals generally need to be approved by both the Parliament and the Council of Ministers to become law. The relative power of a particular institution in the legislative process depends on the legislative procedure used (as dictated by EU treaties), which in turn depends on the policy under legislation. The power to amend the Treaties of the EU, sometimes referred to as the EU’s primary legislation, is reserved to the member states and must be ratified by each member state in accordance with their respective constitutional requirements. An exception to this are so-called passerelle clauses in which the legislative procedure used for a certain policy area can be changed without formally amending the treaties. Powers can be held exclusively by member states, the EU, or shared between them (see following table). While both can legislate, member states can only legislate to the extent to which the EU has not. In other policy areas the EU can only co-ordinate, support and supplement member state action but cannot enact legislation with the aim of harmonizing national laws. Distribution of Legal Authority Between the EU and EU Members EU Exclusive Competence International agreements Customs Competition rules for the internal market Monetary policy among EMU members Conservation of marine resources Common commercial policy Shared Competence Members cannot exercise competence in areas where the Union has done so: The internal market Social policy, Transportation Economic and social cohesion Agriculture and fisheries Environment, Energy Consumer protection Freedom, security, justice Common public health concerns Members shall not being prevented from exercising competence in research, technological development, space, development of cooperation, or humanitarian aid EU coordinates policies not covered elsewhere such as economic, employment, social, foreign, security, and defense policies. EU Supporting Competence Protection and improvement of human health Industry Culture Tourism Education, youth, sport and vocational training Civil protection and disaster prevention Administrative cooperation


Members of the European Union (Blue) and European Economic and Monetary Union (Gold)


The creation of a single European currency became an official objective of the European Economic Community in 1969. However, it was only with the advent of the Maastricht Treaty in 1993 that member states were legally bound to start the European Economic and Monetary Union (EMU) no later than January 1, 1999, at which point the responsibility for monetary policy (including interest rates, currency exchange rates, and monetary supply) would be transferred from the National Central Banks of joining EU member states to the European Central Bank. The euro was launched in 1999 by 11 of the then 15 member states of the EU, but remained an accounting currency until January 1, 2002. At that point, euro notes and coins were publicly issued and national currencies began to phase out in the adopting countries, referred to collectively as the Euro-Zone. The Euro-Zone has since grown to seventeen countries, after Estonia joined on January 1, 2011. Share of Euro-Zone 2010 GDP
Finland 2.0% Austria 3.1% Belgium 3.8% Netherlands 6.4% Spain 11.6% Portugal 1.9% Greece 2.5% Slovak Republic Slovenia Ireland 0.7% 0.4% 1.7% Luxembourg Cyprus 0.5% 0.2% Malta 0.1% Germany 27.2%

Italy 16.9%
Source: IMF

France 21.2%

To join the EMU, countries have to fulfill economic and legal pre-conditions referred to as convergence criteria (also known as the Maastricht criteria, as defined in Article 121(1) of the European Community Treaty) which aim to maintain price stability within the Euro-Zone. EU member countries outside the Euro-Zone continue to have their own national currency and thus still can control their monetary sovereignty through exchange rates, interest rates, and monetary policy. All EU members except Denmark and the U.K. are legally bound to join the EMU when the convergence criteria are met. However, only a few countries have set target dates for accession, and others have circumvented the requirement (Sweden has done so by intentionally not fulfilling the membership criteria). Among the most critical criteria for EMU membership (see following table) are fiscal deficits below 3% of GDP and government debt below 60% of GDP. However, after joining the EMU, penalties for noncompliance with these criteria have proven minimal, especially after the recent recession and financial crisis left virtually every member out of compliance.


EMU Admission Criteria Government finance: The ratio of the annual government deficit to GDP must not exceed 3% at the end of the preceding fiscal year. If above, it should remain close to 3%, with only exceptional and temporary excesses excused. The ratio of gross government debt to GDP must not exceed 60% at the end of the preceding fiscal year. If above, the ratio must be decreasing satisfactorily. Inflation rates: Interest rates: Exchange rates: Inflation must be no more than 150 bps higher than the average of the three EU members with the lowest inflation rates. Long-term interest rates must be less than 200 bps above the average for the three EU members with the lowest inflation rates. Applicants should have prepared for conversion to the euro by joining the exchange rate mechanism (ERM II) under the European Monetary System for two consecutive years and should not have devalued during this period.

The introduction of the euro led to significant improvements in economies, with rising incomes, trade, and confidence. Creating the euro as a common currency was intended to help build a cohesive market by easing travel of citizens and goods, eliminate exchange rate problems, and serve as a political symbol of integration and stimulus for additional progress. The euro also was intended to provide price transparency, a single financial market, price stability, low interest rates, and an international currency protected against shocks by the large amount of internal trade within the Euro-Zone. The main criticism directed at the euro is the growing “contradiction” between having one currency and monetary policy with disparate national policies on taxes and spending, different fiscal needs, and vastly divergent economic performance of EMU members. The ongoing debate is thus focused on the need for a deeper fiscal union among EMU members to improve economic stability and performance, and therefore ensure the euro’s long-term survival.

The European Central Bank (ECB) is the central bank for the Euro-Zone, consisting of the 17 members that have adopted the euro as members of the EMU. The ECB controls monetary policy for the Euro-Zone – which includes setting interest rates, managing currency exchange rates, controlling monetary supply, and providing liquidity lines for banks of member countries – with an explicit focus on maintaining “price stability.” Although pricing stability was not defined in the Maastricht Treaty, the Governing Council of the ECB defined it in October 1998 as “a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below be maintained over the medium term.” In practical terms, the ECB aims to maintain annual inflation rates near or below 2% over the medium term. The ECB is at the center of the European System of Central Banks (ESCB), which is comprised of the National Central Banks (NCBs) from each of the 27 EU member states. The ESCB was established in 1993 by the Maastricht Treaty and the Statute of the ESCB under the assumption that all EU member states will adopt the euro. However, until all EU countries have joined the EMU, the “Eurosystem” remains the key actor. The Eurosystem is a subset of the ESCB, comprised of the ECB and the NCBs of EMU members. The ECB’s decisions and policies apply to EMU members and are carried out though the Eurosystem.


The ECB’s €10.8 billion of capital comes from the NCBs of all EU member states, not just members of the EuroZone (see table below). The capital contribution of each NCB is calculated based on an equal weighting of each country’s respective shares of EU population and GDP, which are adjusted every five years and whenever a new country joins the EU. Central banks of EMU members are required to contribute their subscribed capital in full, while NCBs of countries outside the Euro-Zone only have to pay a minimal percentage of their subscribed capital. The ECB increased its subscribed capital for the first time in 12 years during December 2010; this €5 billion capital addition increased the ECB’s subscribed capital by nearly 100%. The Eurosystem NCBs must fund their €3.5 billion share in equal installments during December 2010, 2011, and 2012. This capital increase was deemed prudent to bolster the ECB’s capacity in view of increased credit risk, uncertainty surround sovereign financing, growth of the financial system in recent years, and recently increased volatility in foreign exchange rates, interest rates, and gold. Capital Contribution to European Central Bank as of December 31, 2009
(in millions o f €) Euro-Zone National Central Ba nks Deutsche Bundesbank (Germany) Banque de France Banca d’Italia (Italy) Banco de España (Spain) De Nederlandsche Bank (Netherlands) Banque Nation ale de Belgique (Belgium) Εθνική Τράπεζα της Ελλάδος (Greece) Oesterreichische Nation albank (Austria) Banco de Portugal Suomen Pankk i (Finland) Central Bank of Ireland Národná banka Slovenska (Slovak ia) Banka Slovenije (Slovenia) Banque Centrale du Luxembourg Central Bank of Cyprus Central Bank of Malta Subtotal Subscribed Capital 2,038 1,530 1,345 894 429 261 211 209 188 135 120 75 35 19 15 7 7,510 1,562 527 265 243 160 156 149 93 46 31 19 3,251 10,761 % Total 18.9% 14.2% 12.5% 8.3% 4.0% 2.4% 2.0% 1.9% 1.8% 1.3% 1.1% 0.7% 0.3% 0.2% 0.1% 0.1% 69.8% 14.5% 4.9% 2.5% 2.3% 1.5% 1.4% 1.4% 0.9% 0.4% 0.3% 0.2% 30.2% 1 00.0% Paid-Up Capital 1,407 1,056 928 617 296 180 146 144 130 93 82 52 24 13 10 5 5,183 59 20 10 9 6 6 6 4 2 1 1 122 5,305 % Total 26.5% 19.9% 17.5% 11.6% 5.6 % 3.4 % 2.8 % 2.7 % 2.5 % 1.8 % 1.6 % 1.0 % 0.5 % 0.2 % 0.2 % 0.1 % 97.7% 1.1 % 0.4 % 0.2 % 0.2 % 0.1 % 0.1 % 0.1 % 0.1 % 0.0 % 0.0 % 0.0 % 2.3% 100.0%

National Central Banks outside Euro-Zone Bank of England Narodowy Bank Polski (Poland) Banca Naţională a României (Romania) Sveriges Riksb ank (Sweden) Danmarks Nationalbank (Denmark) Č eská národní banka (Czech Republic) Mag yar Nemzeti Bank (Hungary) Българска народна банка (Bulgaria) Lietuvos Bankas (Lithuania) Latv ijas Banka (Latvia) Eesti Pank (Estonia) Subtotal Total


The ECB is led by a President (Jean-Claude Trichet, the former President of the Banque de France, until his term expires in October 2011) appointed by the European Council and the NCB governors within the EU. Governance of the ECB is organized into three decision-making bodies, as detailed below. • The Governing Council is the ECB’s highest decision-making body. It is comprised of the six members on the Executive Board (described below) and the heads of the 17 NCBs within the Euro-Zone. It is chaired by the President of the ECB. Its primary mission is to define the monetary policy of the EuroZone, and to set interest rates at which commercial banks can borrow from the ECB. The Executive Board is comprised of six people (the President of the ECB, the Vice-President, and four others) appointed to non-renewable eight-year terms by the Presidents or Prime Ministers of Euro-Zone member states. The Executive Board is responsible for implementing monetary policy, as defined by the Governing Council, day-to-day management of the ECB, and for giving instructions to the NCBs. The General Council is comprised of the ECB’s President, Vice-President, and the heads of the NCBs from all 27 EU member states. The General Council contributes to the ECB’s advisory and coordination work and helps prepare for the future enlargement of the Euro-Zone. The General Council will exist only as long as there are EU member states which have not yet adopted the euro as their currency (at which time they all will be members of the Governing Council).

This governance structure fulfills the objective of maintaining price stability by exercising the ECB’s capital and resources across numerous initiatives described below, including open-market operations, standing facilities, minimum reserve requirements, and non-standard measures. • Open market operations are the centerpiece of ECB monetary policy, serving to steer interest rates, manage liquidity in money markets, and signal monetary policy. These operations include the main refinancing operations (providing one-week financing under repurchase agreements to provide liquidity), longer-term refinancing operations (three-month financing offered monthly), fine-tuning operations (executed as needed to manage money market liquidity and steer interest rates), and structural operations. These structural operations adjust the longer-term liquidity position of the Eurosystem relative to the financial sector through repo transactions, outright operations, or buying/issuing ECB debt as needed. The standing facilities provided by the Eurosystem address overnight liquidity requirements. Interest rates on these facilities normally provide a ceiling and floor for overnight money market rates. These facilities can be structured as either marginal lending facilities (allowing counterparties such as banks to obtain overnight liquidity from the NCBs collateralized by eligible assets) or deposit facilities (used by counterparties to make overnight deposits with NCBs). Requiring minimum reserves for private credit institutions to be held by NCBs allows the Eurosystem to stabilize money market interest rates and address a structural liquidity shortage. Non-standard measures, including virtually any initiative compatible with the Maastricht Treaty, can be used in times of extraordinary financial market tensions to achieve the Eurosystem’s objectives. These measures are critical tools within the Eurosystem’s monetary policy implementation “toolbox” but are exceptional and temporary in nature. These measures are usually aimed at the banking sector given the heavy reliance of European companies on bank financing (as opposed to capital markets). These measures can include the following: • Securities Markets Programmes (SMP), including interventions by the Eurosystem in public and private debt markets to address malfunctioning securities markets and ensure the proper

• •

transmission of monetary policy initiatives to maintain price stability and influence the wider economy. This program has been critical in the present crisis. Although the ECB claims that increases in money supply resulting from bond purchases are sterilized to prevent inflation, this is unverifiable and therefore virtually indistinguishable from the more transparent quantitative easing adopted by the U.S. Federal Reserve. • Fixed-rate, full-allotment liquidity provision – In normal circumstances, the Eurosystem allots liquidity through open market operations with variable rate tenders (i.e. banks pay the interest rate they bid for funding). Fixed rate tenders can be used in times of stress, meaning the Eurosystem sets the interest rate and banks designate the volume of liquidity desired. Changing collateral requirements to expand or contract bank borrowings from the Eurosystem. For example, the ECB removed the minimum credit rating requirement to allow Greek sovereign bonds to remain eligible collateral rather than inadvertently restrict credit. Providing more frequent and longer-term liquidity than the standard three-month facilities. Providing liquidity in foreign currencies, potentially if banks have difficulty accessing liquidity in such currencies. Outright purchases of covered bonds (i.e. backed by hard collateral such as real estate mortgages) to infuse liquidity into banks, rather than just accepting certain assets as collateral.

• • •

The €440 billion European Financial Stability Facility (EFSF) was the largest element of the headlined €750 billion Financial Stability Package agreed by the EU Council, IMF, ECB, and Euro-Zone member states in May 2010 to address market uncertainty surrounding peripheral European sovereign debt. This package also included €60 billion from the European Commission’s European Financial Stability Mechanism (EFSM) and €250 billion from the IMF (or up to 50% of the combined contribution from the EFSM and EFSF). The IMF funding is determined on a case-by-case basis and is subject to a mutually acceptable austerity program, meaning its presence is far from guaranteed. Further, any IMF loan provided under the Financial Stability Package would have preferred creditor status, thus ranking ahead of other sovereign debt (including EFSF borrowings). Importantly, the EFSM is funded under the EU’s budget, and thus can provide immediate funding to all 27 EU members; this is unlike the EFSF, which requires unanimous voting approval of funding commitments and is only available to the 17 Euro-Zone countries. The stated purpose of the EFSF is to “to collect funds and provide loans in conjunction with the IMF to cover the financing needs of Euro-Zone member states in difficulty, subject to strict conditionality.” These conditions will vary among borrowers, and are negotiated among the European Commission, the ECB, and the IMF. The EFSF would finance itself by issuing up to €440 billion of debt instruments (including bonds, notes, commercial paper, or other securities) guaranteed by the 17 EMU members in proportion to their share of paid-up ECB capital. The EFSF effectively expires as a lending vehicle in mid-2013, since Euro-Zone guarantees apply to EFSF debt created only through June 30, 2013 (though EFSF debt can mature later). As shown in the following table, the largest EFSF guarantors are Germany, France, and Italy. Any country requiring financial assistance will reduce the commitment size of the EFSF and would “step out” of any prior guarantees (subject to unanimous agreement from the remaining guarantors). The EFSF’s size was reduced to €428 billion after Greece dropped out (as anticipated from inception of the EFSF), to €421 billion after

Ireland required assistance (see following table), and will decrease after the rescue of Portugal. Guarantees for countries that step out can be redistributed to the remaining participants pro rata, up to their individual commitment limits. To account for such changes, and provide an additional layer of credit enhancement, the participating countries “over-guaranteed” their respective allocations by 120%, which serve as their individual commitment limits. Beyond the potential reductions as countries step out, the EFSF’s lending capacity is further reduced from the headlined €440 billion since the rating agencies indicated they would only grant the desired AAA rating to EFSF bonds if countries rated below AAA set aside cash reserves to collateralize their guarantees. Since there are only six AAA-rated countries providing EFSF guarantees, and no other country is willing to provide cash collateral, the EFSF is more realistically limited to the €256 billion of commitments from AAA-rated countries. In aggregate, this suggests that the Financial Stability Package at inception was closer to €474 billion than the headlined €750 billion, comprised of €256 billion from the EFSF, €60 billion from the EFSM, and €158 billion from the IMF (50% of the contribution from the EU). After usage of €17.7 billion by Ireland and estimated usage of €30 billion by Portugal, in addition to losing €30 billion of commitments from countries that requested rescues, the EFSF has roughly €362 billion of undrawn commitments, with €226 billion from AAA-rated countries. Contribution to EFSF
(in billions of €) Adjusted After Rescues ECB Capital ESFS Contribution Maximum ESFS (incl. Portugal) Subscription Key Key (a) Commitments Commitment Undrawn 18.9% 27.1% 119 119 105 14.2% 20.4% 90 90 79 12.5% 17.9% 79 79 70 8.3% 11.9% 52 52 46 4.0% 5.7% 25 25 22 2.4% 3.5% 15 15 14 1.9% 2.8% 12 12 11 1.3% 1.8% 8 8 7 0.7% 1.0% 4 4 4 0.3% 0.5% 2 2 2 0.2% 0.3% 1 1 1 0.1% 0.2% 1 1 1 0.1% 0.1% 0 0 0 2.0% 2.8% 12 0 0 1.8% 2.5% 11 0 0 1.1% 1.6% 7 0 0 69.8% 100.0% 440 410 362 40.5% 58.1% 256 256 226 Current Contribution Key 29.1% 21.9% 19.2% 12.8% 6.1% 3.8% 3.0% 1.9% 1.1% 0.5% 0.3% 0.2% 0.1% 0.0% 0.0% 0.0% 100.0% 62.3%

Country (Credit Ratings) Germany (Aaa/AAA) France (Aaa/AAA) Italy (Aa2/A+) Spain (Aa2/AA) Netherlands (Aaa/AAA) Belgium (Aa1/AA+) Austria (Aaa/AAA) Finland (Aaa/AAA) Slovakia (A1/A+) Slovenia (Aa2/AA) Luxembou rg (Aaa/AAA) Cyprus (A2/A-) Malta (A1/A) Greece (B1/BB-) Portugal (Baa1 /BBB-) Ireland (Baa3/BBB+) Total Total of AAA-rated

(a) Contribution Key is calculated as the percentage of paid-up ECB capital from Euro-Zone member states.

Borrowing Mechanics – In order to access financing under the EFSF, a Euro-Zone member must agree to a Memorandum of Understanding (MoU) with the European Commission, in liaison with the IMF and the ECB. This MoU specifies the budgetary and economic policy conditions which the applicant must follow in order to receive financial assistance. Technically, a country applies to the EU’s Economic and Financial Affairs Council (ECOFIN) for financing under the EFSM and to the Eurogroup (i.e. the group of finance ministers for Euro-Zone members) for financing under EFSF. Approval from ECOFIN requires a qualified majority vote (QMV), while the Eurogroup requires unanimity.

As shown in the cases of Greece and Ireland, any lending is likely to come with considerable strings attached. The detailed terms and conditions would be established in a loan facility agreement subject to the consent of all the EFSF guarantors. Raising funds for this loan facility is the responsibility of the EFSF’s management team, led by CEO Klaus Regling, a former German Finance Ministry official who has also held senior positions at the European Commission and the IMF. The EFSF’s Framework Agreement clearly states that it can only start raising funds after a formal request is made by an EMU member (i.e. countries cannot initiate the process on another’s behalf) and after reaching agreement on terms with the IMF and ECB. These restrictions on preemptive fundraising could create a critical delay when countries need assistance with immediacy.

The IMF is a not-for-profit institution funded by members, as conceived at a United Nations conference convened in Bretton Woods, New Hampshire, USA in July 1944. The 45 governments represented at that conference sought to build a framework for economic cooperation that would avoid a repetition of the vicious circle of competitive currency devaluations that contributed to the Great Depression of the 1930s. The IMF’s primary purpose is to ensure the stability of the international monetary system, incorporating the systems of exchange rates and international payments. The IMF describes itself as “an organization of 187 countries...working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world.” Since inception, the IMF has developed a reputation for providing financial and debt restructuring assistance to developing countries, with initiatives and activities including the following: • • • providing advice to members on policies to help prevent or resolve a financial crisis, achieve macroeconomic stability, accelerate economic growth, and alleviate poverty; providing members with temporary financing to help address balance of payment problems, as when countries are short of foreign currency due foreign payments exceeding foreign earnings; and offering technical assistance and training to help members build expertise and institutions to implement sound economic policies.

The IMF is accountable to and funded by the governments of its member countries (see following table). The relative share of funding by members is based on “quota subscriptions”. These subscriptions are allocated by the IMF’s Board of Governors to countries based broadly on their relative position in the world economy. The quota is determined by a country’s GDP (50% weighting), openness (30%), economic variability (15%), and international reserves (5%). For this purpose, GDP is measured as a blend of GDP based on market exchange rates (60% weighting) and GDP adjusted for purchasing power parity (40%), which accounts for different economic standards and wages across countries; the formula also includes a “compression factor” that reduces the dispersion in calculating quota shares across members. Quotas are denominated in Special Drawing Rights (SDRs), which represent claims on foreign exchange reserves. As highlighted in the table below, the U.S. is the IMF’s largest member with 37.1 million SDRs (equating to roughly $56 billion); the smallest is Tuvalu, with 1.8 million SDRs (equating to $2.7 million). A country’s quota determines its financial and organizational relationship with the IMF, including its maximum financial commitment, its voting power, and has a bearing on its access to IMF financing. A member must pay its quota-based subscription in full upon joining the IMF, with 25% paid in SDRs or widely accepted currencies (such as U.S. dollars, euros, yen, or British pounds) and the remainder paid in the member’s local currency. The

share of SDRs can differ slightly from voting share; each member has 250 basic votes plus one additional vote for each 100,000 SDRs. As for access to IMF borrowings, a member is limited to a maximum of 200% of its SDRs annually and 600% cumulatively, subject to certain exceptions. Summary of IMF Members
Country U.S. Japan Germany U.K. France China Italy Saudi Arabia Canada Russia Netherlands Belgium India Switzerland Australia Mexico Spain Brazil South Korea Venezuela Subtotal of Top 20 Others Total Special Drawing Rights (billions) 37.1 13.3 13.0 10.7 10.7 8.1 7.1 7.0 6.4 5.9 5.2 4.6 4.2 3.5 3.2 3.2 3.0 3.0 2.9 2.7 154.8 62.6 217.4 % of Total 17.1% 6.1% 6.0% 4.9% 4.9% 3.7% 3.2% 3.2% 2.9% 2.7% 2.4% 2.1% 1.9% 1.6% 1.5% 1.5% 1.4% 1.4% 1.4% 1.2% 71.2% 28.8% 100.0% Voting Share 16.7% 6.0% 5.9% 4.9% 4.9% 3.7% 3.2% 3.2% 2.9% 2.7% 2.3% 2.1% 1.9% 1.6% 1.5% 1.4% 1.4% 1.4% 1.3% 1.2% 70.0% 30.0% 100.0%

The IMF has often deployed its capital to provide sovereigns with liquidity to operate during crises, to refinance maturing debts, and to assist with debt restructurings. In addition to providing capital to facilitate restructurings, the IMF has also provided leadership, including serving as an intermediary between sovereigns and lenders during debt crises. This service can be an important means of working through a crisis given the lack of global restructuring rules or standards to govern sovereign defaults or restructurings, the limited rights of lenders within sovereign debt contracts (e.g. lacking collective action clauses (CACs) that specify lender rights to change terms), the variety of interests between local and foreign investors, the transition of sovereign financing from banks to the international securities markets, and the many types of sovereign investors and borrowings. The IMF’s Sovereign Debt Restructuring Mechanism (SDRM) outlines the general means for orderly restructurings to improve creditor recoveries and expedite the process of returning the debtor to solvency and growth. When providing capital in connection with restructurings, the IMF can impose strict conditions including fiscal, monetary, and capital reforms. These could include austerity of government spending programs, devaluing the currency, maintaining certain currency reserves, implementing capital controls to hinder investor flight and reduce pressure on exchange rates, and/or reducing debt service requirements by reducing interest due (lowering coupons or principal) or extending debt maturities. The IMF is generally better positioned than individual investors to monitor sovereign progress after restructurings and evaluate compliance with such financing conditions.

The IMF generally provides financing to governments through their National Central Banks using either stand-by arrangements (SBAs) or supplemental reserve facilities (SRFs). SBAs are generally for smaller and shorter-term borrowing needs, while SRFs are generally for larger and longer-term borrowing needs. SBAs generally require repayment beginning no later than 3.25 years from inception, with full repayment within five years; SRFs generally require repayment within three years. Both SBAs and SRFs generally have penalties and surcharges that encourage earlier repayment. The IMF’s €250 billion commitment to the recently announced €750 billion European Financial Stability Package far exceeds its financing commitments in prior sovereign crises. As shown in the following table, the IMF committed $35 billion or less in historical sovereign crises, which amounted to 7% of GDP on average (Turkey was the highest at 17%). These commitments were utilized an average of 76%, leaving some cushion to spare; only Indonesia utilized 100%, but only 44% of that was drawn in the first year. Given the stressed conditions of sovereigns requesting aid, an average of 77% of the amounts utilized were drawn in the first year, with several drawing close to 100% of total utilization during the first year. Of course, the present European sovereign crisis is far larger than any solved with IMF aid historically, which fuels more questions than answers about their role this time, especially given the governance structure (discussed below) and the fact that, for the first time, major SDR owners could need rescue financing. IMF Financing in Selected Sovereign Crises and Restructurings
(in billions of U.S. dollars) Financing Commitment % of % of Amount IMF Quota GDP $ 18.0 688% 4.4% $ 3.9 505% 2.2% $ 11.3 557% 5.0% $ 20.8 1938% 4.0% $ 18.4 600% 2.3% $ 15.1 186% 3.5% $ 22.1 800% 7.8% $ 35.1 900% 6.9% $ 2.7 694% 14.5% $ 33.8 2548% 17.0% $ 181.2 942% 6.8% Financing Disbursed % of % of % of Amount Commitment IMF Quota GDP $ 13.1 73% 501% 3.2% $ 3.7 95% 479% 2.1% $ 11.3 100% 557% 5.0% $ 19.4 93% 1808% 3.7% $ 13.4 73% 437% 1.7% $ 5.1 34% 63% 1.2% $ 12.7 57% 460% 4.5% $ 30.1 86% 772% 5.9% $ 2.2 81% 565% 11.8% $ 23.1 68% 1741% 11.6% $ 134.1 76% 738% 5.1% Year 1 Disbursement % of % of Amount Commitment Disbursed $ 13.1 73% 100% $ 2.8 72% 76% $ 5.0 44% 44% $ 18.9 91% 97% $ 11.1 60% 83% $ 5.1 34% 100% $ 12.7 57% 100% $ 13.3 38% 44% $ 1.7 63% 77% $ 11.9 35% 52% $ 95.6 57% 77%

Country Mex ico Thailand Indonesia South Korea Brazil Russia Argentina Brazil Urugay Turkey

Year 1995 1997 1997 1998 1998 1998 2000 -2001 2001 -2002 1999 -2001 1999 -2002

Total $ / Average %
Source: IMF and Eurostats.

Governance – The 24-member Executive Board handles the IMF’s daily affairs and represents all 187 members of the IMF. One director is appointed by each of the five largest members; the other 19 directors are elected by the remaining members. The Chairman of the Executive Board and head of the IMF is Dominique Strauss-Kahn, who became the tenth Managing Director of the IMF in November 2007. The Board of Governors is the highest policy-making body of the IMF, consisting of one governor and one alternate governor from each member country. The governor is appointed by the member country and is usually the Minister of Finance or the Governor of their National Central Bank. The Board of Governors meets once each year at the IMF-World Bank Annual Meetings; they have the authority to admit or expel members and amend the IMF’s Articles of Agreement and By-Laws. The Board of Governors is advised by two committees, the International Monetary and Financial Committee (IMFC) and the Development Committee. The IMFC usually meets twice a year; it is composed of 24 IMF governors, ministers, or others of comparable rank (reflecting the

composition of the Executive Board and representing all IMF members). This committee advises and reports to the Board of Governors on the management and functioning of the international monetary system, proposals by the Executive Board to amend the Articles of Agreement, and any sudden disturbances that might threaten the system. The Development Committee is similarly composed, but maintains an overview of countries’ development, reports to the Board of Governors of the World Bank and the IMF, and provides suggestions regarding the transfer of resources to developing countries. The IMF’s Board of Governors generally conducts quota reviews every five years (ad hoc reviews are rare). Any changes in quotas must be approved by an 85% super-majority of the total voting power, and cannot be changed for any member without its consent. Given the 16.7% voting share of the U.S., it is the only country able to block a supermajority on its own; this will continue after the pending changes from the quota review in December 2010, which produced a number of far-reaching reforms to be implemented over time: • • • Increasing quotas roughly 100% to 477 billion SDRs (worth roughly $750 billion). Shifting more than 6% of quota shares from over-represented to under-represented member countries. Shifting more than 6% of quota shares to dynamic emerging market and developing countries (EMDCs). Realigning quota shares. China will become the third largest member; four EMDCs (Brazil, China, India, and Russia) will be among the 10 largest members.

Following the Board of Governors’ approval of these reforms, the next step is for member countries to accept the proposed quota increases and the amendment to the IMF’s Articles of Agreement. Since this requires parliamentary approval in many cases, the goal is to have members complete this before the annual meeting of the Board of Governors in October 2012.

The ESM has a critical role in the present sovereign crisis by permanently providing liquidity to sovereigns and facilitating potential Euro-Zone sovereign debt restructurings. The ESM, established in principle by Euro-Zone members in November 2010, is still being negotiated but is intended to supplant the EFSM and EFSF after their effective expiration in June 2013. The ESM’s structure and governance is expected to resemble the EFSF. The ESM is expected to provide conditional financial assistance to ailing Euro-Zone members, likely in conjunction with IMF assistance. The creation of the ESM follows an initiative from Germany, supported by France, in favor of a greater degree of “burden sharing” which could open the door to sovereign debt restructurings and losses for bondholders. Markets will surely take this into account if any fiscally weak sovereign attempts to access private credit markets in 2013 and thereafter. Many details of the ESM remain to be specified, but certain attributes have been clarified in recent months: • • The ESM will be permanent, unlike the present Financial Stability Package. The ESM will be sized at €500 billion, provided by EMU countries, with another €200 billion committed to provide cushion. The €700 billion of total commitments will include €620 billion of guarantees from Euro-Zone members, but also €40 billion of cash contributed before July 2013 and another €40 billion of cash contributed over time. The ESM financing providers will receive “preferred creditor status” in order to protect taxpayers. This implies that a country’s borrowings from the ESM will be repaid before other creditors in the event of default, although this claim is likely to be subordinated to any loans taken from the IMF.

• •

The ESM will have the ability to buy sovereign bonds in the primary market. All Euro-Zone sovereign bonds issued from 2013 onwards will include collective action clauses (CACs) for the first time. These will require a qualified majority of bondholders to agree before a borrower can impose unfavorable changes to payment terms such as standstills, maturity extensions, reducing coupons, or reducing principal balances. It is likely that the CACs will allow all debt instruments issued from 2013 to be aggregated into a single creditor vote, which will dramatically improve the logistics of debt restructurings and negotiations, rather than requiring time-consuming negotiations with each creditor to garner voting consent.

One interpretation of how the Euro-Zone will transition from the present crisis and convoluted governance and financing regime to a stabilized future structure is that any Euro-Zone sovereign in need of liquidity or financing support after mid-2013 would be subjected to debt sustainability analysis by the European Commission, the ECB, and the IMF. This analysis would seek to determine whether the sovereign is suffering from a liquidity crisis or a solvency crisis. Then ESM could help address a liquidity crisis, but solvency issues would involve debt restructurings with private creditors (in line with existing IMF practices) to restore sustainable debt service obligations. The ESM could provide liquidity support during the restructuring if needed.


As discussed in prior sections, the European sovereign crisis has developed over many years through a combination of economic weakness, declining competitiveness, reallocating control over foreign exchange rates and monetary policy to the ECB, continuous and growing fiscal deficits (including large pension and entitlement spending), excessive levels of government debt, and aggressive private lending that fueled a bubble in asset valuations and an over-leveraged banking system. The high debt loads for certain European sovereigns could remain manageable if market confidence in repayment was unwavering (meaning lending rates would be low), but with large sovereign refinancing requirements colliding with serious investor concerns, the resultant higher borrowing costs have the potential to conflagrate a self-fulfilling sovereign crisis. As a result, the market has witnessed a litany of supranational initiatives to restore investor confidence and provide funding for countries in need. The present crisis is the latest in the long history of sovereign financial crises across the globe. Historically, sovereign debt problems have played critical roles in some well known market crises, even in developed markets, when debt outgrew economies and means of repayment. For example, both market collapses in 1720, the “South Sea Bubble” in England and the “Mississippi Company” in France (described below), are well known in the histories of equity speculation but actually sprung from sovereign debt problems. Such bubbles and crises may be unavoidable, as John Kenneth Galbraith has said: “Recurrent speculative insanity and the associated financial deprivation and larger devastation are, I am persuaded, inherent in the system.” A common feature of historical speculative bubbles is the recurrent exaltation that the wheel has been reinvented; the wheel in these cases is usually a new form of debt, often collateralized in some novel manner. As Galbraith says: “Such seeming innovation is merely some variant on an old design, new only in the brief and defective memory of the financial world.” These new types of debt, well before the markets ever developed for high yield bonds or ABS CDOs, include the following episodes that were related to broader governmental financial problems: • England’s “South Sea Bubble” resulted from an overly indebted government in search of more funding. In exchange for commitments to purchase more government debt, the government granted the South Sea Company exclusive rights over trade with South America, and permission to issue shares publicly. Raising equity proceeds allowed the company to buy more government debt. A bubble in the shares caused by excessive optimism and speculation (with higher prices encouraging ever more bidders) eventually collapsed, despite Parliament passing the Bubble Act in 1720 to purportedly protect the public. Similarly, France granted John Law, a well known gambler and economist, a banking charter to form Banque Royale in the early 1700s in order to provide the heavily-indebted government a new and badly needed buyer of sovereign debt. The bank was allowed to fund such purchases of sovereign debt by issuing notes supposedly backed by either gold or shares of Compagnie d’Occident (better known as the Mississippi Company), a company given a government grant for a monopoly on trade with the New World. The speculative fervor for shares of the Mississippi Company, and hence the bank’s ability to raise capital to purchase more government debt, ended with large losses for investors. Notes issued by U.S. banks in the 1800s were traded as currency due to a shortage of national currency. These bank notes were supposedly backed by reserves of gold or silver. However, following a regulatory consequence of the War of 1812 that abolished the requirement of such metal reserves, banks printed notes beyond all reasonable bounds, thus creating excess money supply and encouraging speculation. This ended with a banking and real estate crisis in 1837, along with ensuing defaults by Mississippi, Louisiana, Maryland, Pennsylvania, Indiana, and Michigan.

Investors with historical perspective understand that numerous countries have experienced major financing, confidence, and economic crises that required extensive efforts to address. Such crises were resolved either by (i) reforming fiscal, monetary, and structural policies, (ii) receiving bailout financing to address maturing debt, or

(iii) combining these initiatives with various forms of debt restructuring. The resulting policy changes could include currency devaluations to improve competitiveness of labor and exports, privatizing industry to improve efficiency and growth incentives, increasing tax revenues by experiencing economic recovery or changing tax rates, cutting government spending on salaries/benefits/programs to decrease budget deficits and reduce financing needs, reforming government entitlement programs to reduce future spending obligations, creating inflation (often through monetary policy) to decrease the effective debt burden, and issuing new types of debt such as bonds backed by specific tax income streams or certain assets. It is worth noting that inflation has been a recurring means of addressing excessive sovereign leverage and fiscal deficits, ranging from the currency debasement by Dionysius of Syracuse in the 4th century to the German hyperinflation following World War I. While inflation can be a politically practical means to effectively reduce debt loads, this redistribution of wealth from lenders to borrowers has costly side effects such as introducing pricing instability, product shortages, and credit contraction. The credit contraction, potentially resulting from the aforementioned wealth transfers, are often seen via higher interest rates as investors require higher rates of return to offset the increased uncertainty and reduced value of future fixed incomes. For countries that encountered crises, either self-inflicted (e.g. from policies or borrowings) or from external forces (e.g. investor behavior or economic shocks), the IMF has played an important historical role in providing liquidity and financing commitments since its founding in 1944 (as discussed in Section 6). IMF financing has been a critical first response to sovereign crises over the past 60 years, helping to rebuild confidence and halt investor flight by allowing governments to replenish foreign exchange reserves or meet debt maturities when market yields became prohibitively expensive to refinance. This often helps governments avoid defaulting on debts, so long as the sovereign is not excessively leveraged and if the government is committed to reform. However, IMF financing often comes with harsh and unpalatable conditions, as seen with the recent packages for Greece and Ireland, such as requiring fiscal austerity and structural reforms that can have negative economic and political consequences. Another condition of such financing, particularly for countries with solvency problems rather than liquidity problems, could be to restructure the sovereign debt by reducing principal, reducing coupons, and/or rescheduling maturities. The high costs of restructurings make this the last choice; these costs include economic weakness, limited access to financing markets for extended periods, investor flight and other capital outflows, runs on banks and the currency, reputational damage for the country and it politicians, and of course, losses to investors (including citizens). The IMF’s role in past restructurings has been critical since there is no global regime or code of conduct for restructuring sovereign debt, there are highly disparate interests involved (e.g. local versus foreign owners, denomination in local versus foreign currency), and sovereign debt contracts usually lack typical investor rights and protections (e.g. collateral, seniority, disclosure, guarantees, or amendment/voting provisions). Since no court can enforce debt remedies or impart absolute debt priorities on countries (a government could prioritize spending on defense or healthcare or wages well before interest expenses), and sovereign debt documents provide little recourse anyway, the IMF can serve to coordinate investor claims and negotiations with the government. These claims can become convoluted given that emerging market sovereign debts generally follow the laws of the U.S., Germany, or the U.K., which have different standards for debt restructurings. (European sovereigns generally follow their own laws, which also can be changed to suit the circumstances.) For example, sovereign debt following U.S. and German law has no collective action clauses (CACs) that specify voting requirements to change documentation, although the jurisdictional standard for debt generally is that 100% of lenders are required to approve changes in payment amounts and timing, whereas a majority can change non-payment terms and other creditor rights; these laws also generally grant any holder the right to sue the borrower. In contrast, sovereign debt following U.K. law (which is a smaller proportion of the global sovereign debt market) generally has CACs, but litigation can only be initiated by groups holding over 25% of the relevant debt. In any case, without a court having jurisdiction to rule on countries or sovereign debts, no judge can force acceptance of a restructuring plan on lenders that refuse to consent (in the corporate world, judges can “cram down” such investors). Further, lenders have no means to seize a borrower’s equity or assets as in the corporate world; besides, the government’s

the most significant asset is its intangible taxing authority. Any non-consenting holdouts can forever claim they are owed in full, though this can entail costly litigation and holding illiquid instruments that could prove worthless. Such holdout claims remain present from Mississippi’s debt that defaulted roughly 170 years ago, Argentina’s default in 2001, and Peru’s default in 1995. Given the lack of a cram down option, debt exchanges must be voluntarily accepted by lenders, though coercion and penalties (such as stripping covenants) can be influential determinants in acceptance. History provides an extensive array of countries that had to pursue such debt restructurings, often after failing to resolve refinancing needs, or running out of time in pursuing suitable economic and policy changes. These restructurings, occurring after payment default or under implicit threat of imminent default, have included many forms, all of which share the goal of improving a country’s debt servicing capabilities and providing future stability. As for corporate borrowers, debt servicing for sovereigns is a function of cash inflows compared to cash outflows. For corporates, this means generating profits or net cash flows from operations sufficient to cover interest expense. For sovereigns, debt servicing is mostly a function of income from taxes and state-owned enterprises compared to fiscal expenditures. Both corporates and sovereigns running cash flow deficits must raise capital or tap reserves in order to fund ongoing debt servicing costs. Such capital raises for many corporates and nearly every sovereign come in the form of issuing debt, which requires reasonable confidence among lenders regarding repayment. This confidence is subject to market whim, but generally is driven by fundamental risk factors including the outlook for net cash inflows. For sovereigns, estimating future net cash flows and fundamental borrower attractiveness is a combination of views regarding the economic and governmental factors. These economic factors include the outlook for consumer incomes and spending, economic prospects and volatility (including the exposure to commodity cycles and prices), competitiveness of labor and technologies, the level of private indebtedness, the structure and stability of the banking system, the inflation outlook, and the susceptibility to depreciation of asset values. The governmental factors include analysis of tax policy, collectability of taxes, the stability and sensibility of fiscal budgets, social welfare obligations, performance and scale of state-owned enterprises, political stability, currency stability, the level of public indebtedness and debt servicing requirements, access to capital markets, and critically, the ability to control foreign exchange rates and monetary policy to address economic weakness and over-heating. Any borrower, corporate or sovereign, on the wrong side of these risks could be unable to achieve a positive balance of net cash flows over time (producing ever-growing debt loads) or be unable to access funding (producing inability to fund deficits or refinance debt maturities). Any country with ever-growing debts could find itself in a “debt spiral.” Investors can evaluate this risk by the change in debt versus the change in nominal GDP over time. Debt growth comes mainly from financing primary budget deficits in addition to interest expenses, while GDP growth is mainly a function of inflation, performance and competitiveness of industry, and confidence. If debt continuously grows faster than GDP, the debt spiral will eventually end in default and restructuring of debts. The long list of sovereigns that have conducted such debt restructurings spans the globe across both developed and emerging markets, though the last developed market to restructure its debts was West Germany in 1948, as they annulled debt of the former Nazi government and reformed the currency (exchanging 10 Reichsmarks for one new Deutschmark) to eliminate excess money supply and restore currency stability and functionality. Nevertheless, there have been significant financial crises and other problems among developed markets since then including Spain (1977), Norway (1987), Finland (1991), Sweden (1991), and Japan (1992). These challenging times were surmounted with considerable intestinal fortitude and by restoring confidence, which enabled the countries to continue accessing capital markets at reasonable interest rates. There were also numerous milder financial crises and false alarms about fiscal solvency in industrialized countries, often involving housing and banking industries accompanied by equity depreciation and economic recession, including Germany (1977), Canada (1983), the U.S. (1984), Iceland (1985), Denmark (1987), New Zealand (1987), Australia (1989), Italy (1990), Greece (1991), the U.K. (1974/1991/1995), France (1994), and ongoing concerns about Japan’s debt load.

These examples of stress were often rectified through economic recovery, tax hikes, and to a lesser extent, applying austerity measures to government spending. Austerity measures must be applied delicately since they have often proven difficult to maintain given their deflationary and recessionary nature, and their potential to foment civil unrest. In contrast to the eventual resolution of challenges for developed markets that preserved their perfect debt service record without default over the past 63 years (though often producing ever-higher debt loads), emerging market countries have defaulted with some regularity. The following tables highlight 68 defaults among emerging markets over the past 40 years (including Ivory Coast in 2011), which arrived in two main clusters (1976-1989 and 1998-2004) reminiscent of other historical groupings. Sovereign Debt Defaults and Restructurings by Region and Country Since 1820
Default Clusters Total 1824-1834 1867-1882 1890-1900 1911-1921 1931-1940 1976-1989 1998-2004 Latin America / Caribbean 93 14 13 11 10 16 18 7 Asia / Middle East 11 0 0 0 1 0 4 5 Europe 30 3 4 3 4 9 4 1 0 2 0 1 0 23 4 Africa 31 Total Defaults 165 17 19 14 16 25 49 17 Latin America / Caribbean Ecuador Mexico Paraguay Venezuela Uruguay Argentina Brazil Costa Rica Nicaragua Peru Chile Colombia Dominican Republic Guatemala Honduras Bolivia El Salvador Cuba Panama Dominica Grenada Asia / Middle East Russia Pakistan Ukraine Indonesia Jordan Philippines Vietnam Other 4 1 2 1 8

8 7 7 7 6 6 5 5 5 5 4 4 4 4 4 3 3 2 2 1 1 3 2 2 1 1 1 1

1832 1827 1827 1832 1830 1826 1827 1828 1826 1826 1826 1828 1827 1827

1868 1867 1874 1878 1876

1874 1876 1880 1879 1869 1876 1873 1874

1892 1892, 1898 1891 1890 1898 1895 1894

1911, 1914 1914 1920 1915 1915 1914 1911

1931 1932 1933 1930s 1931 1937 1932 1931 1931 1932 1931 1933 1931 1931 1933 1932

1982 1982, 1988 1986 1982 1983 1982 1983 1983 1980 1978, 1983 1983 1982 1981 1980 1982 1982

1999 1990 2003 2003 2001

2008 1859 1847, 1864

1900 1899 1894 1914 1921

2003 2004 1917 1981 1998 1999 1998, 2000 1999 1839

1989 1983 1985

Note: Generally excludes technical defaults and those triggered by wars, revolutions, occupations, and state disintegrations.


Sovereign Debt Defaults and Restructurings by Region and Country Since 1820 (continued)
Default Clusters Total 1824-1834 1867-1882 1890-1900 1911-1921 1931-1940 1976-1989 1998-2004 Europe Spain Turkey Austria Romania Serbia/Yugoslavia Bulgaria Greece Poland Portugal Germany Hungary Italy Moldova Africa Gabon Liberia Côte d’Ivoire Egypt Angola Cameroon Congo Gambia Madagascar Malawi Morocco Mozambique Niger Nigeria Senegal Seychelles Sierra Leone South Africa Sudan Tanzania Togo Uganda Zaire Zambia 5 4 3 3 3 2 2 2 2 1 1 1 1 3 3 3 2 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1831 1867, 1882 1876 1868 1895 1915 1824 1834 1893 1936 1892 1932 1931 1940 2002 1986 1980 1984 1984 1988 1989 1986 1986 1981 1982 1983 1984 1983 1983 1981 1977 1985 1979 1984 1979 1981 1976 1983 1999, 2002 2001 2011 1981 Other 1820, 1851 1915 1914 1915 1940 1932 1933 1933 1932 1978 1981 1983

1874 1876



Note: Generally excludes technical defaults and those triggered by wars, revolutions, occupations, and state disintegrations.

Many investors presume that public debt as a percentage of GDP is the main harbinger of doom for countries, but Japan leads the world with debt near 220% of GDP yet 20-year bonds of the Japanese government yield roughly 2%, which indicates there are no implied fears of default (or inflation), arguably due to the dominant share of bonds purchased inside the country. Similarly, Britain had debt-to-GDP near 250% in the 1820s following the Napoleonic Wars, but avoided default via low interest rates, economic recovery, ability to roll over debt maturities, and low private debts. In contrast, some emerging market countries that defaulted during the 19982004 wave had relatively low debt to GDP ratios. Other than Indonesia, no eastern Asian country defaulted in that wave despite the severe impact of the coinciding currency crisis, due partly to low beginning debt levels.


Although high public debt-to-GDP ratios are always concerning, historical sovereign defaults have been caused primarily by one of more of the following: inability to refinance maturing debt at sustainable interest rates, currency crises, fiscal/budgetary crises, banking crises from liquidity/funding issues or solvency/investment issues, economic weakness, commodity busts, deflating asset bubbles, shifting competitiveness, aggressive prior practices in private lending, reversals of capital flows (including trade flows and investor flight), excessive private leverage, nationalizations of private enterprise that added to public debts, excessive non-debt obligations such as guaranteeing bank liabilities, unproductive uses of borrowings, political changes, unwillingness to pay, and/or fractious relations with creditors. Examples of these factors are shown in the past sovereign defaults below: • Following a popular wave of lending to Latin American countries in London during the 1820s, which came to a screeching halt in London’s financial panic of 1825, many Latin American borrowers defaulted. This sort of cyclicality in the popularity of international lending, followed by sovereign default, was repeated in the 1870s, 1930s, and 1980s. These default waves included Austria’s Creditanstalt bank in 1931, which contributed to bank failures and broader sovereign debt crises across Central Europe. Aggressive lending practices almost inevitably produce questionable return profiles and heightened credit risk among both public and private borrowers. Such deterioration of credit standards is often seen when investors are quite optimistic and/or when prevailing interest rates are low enough to prompt investors to stretch for yield. The corollary to the U.S. sub-prime mortgage bubble of the 2000s was the bubble of U.S. lending to Latin American and Central European states and regions in the 1920s. Roughly 90% of the foreign bonds sold in the U.S. during 1929 subsequently defaulted. This followed earlier periods of aggressive lending in Latin America, which resulted in large losses for Baring Brothers and its rescue by the Bank of England in 1890. A large share of debt held by foreign lenders can presage default, since the pain to investors would be mostly beyond the borders. Other than aggressive lending by outsiders, high external debts can also indicate low domestic savings rates. From a political perspective, high external debts can be blamed on outsiders, with default marketed internally as shedding foreign influence. This is particularly evident if sovereign debt is denominated in foreign currency, which could result in much higher local currency debt levels if the government devalues the local currency to promote trade or competiveness. Among historical sovereign defaults since 1800, research by Reinhart and Rogoff found the number of defaults on external debts is 270% higher than on domestic debts. A country’s default history, political stability, and level of corruption among political and commercial functions, as well as the absolute size of the economy, are often factors producing repeated sovereign defaults. Smaller countries tend to be less prosperous on average, which can influence the level of corruption. Repeated defaults since 1800 include the following: eight times for Ecuador; seven times for Mexico, Paraguay, and Venezuela; five times for Brazil and Argentina; four times by Turkey and Chile; and three times by Russia, Romania, and Liberia. Spain also defaulted five times in the 1800s, making it unique among modern developed markets. Defaults can be attributed to or influenced by revolutions and wars, particularly if a new government repudiates debt of the previous administration (as occurred in Russia after the Bolshevik Revolution and in Germany before and after World War II). Another example of changing political will provoking default was when Ecuador’s new President in 2008 designated debts of prior governments as “immoral” and “contracted illegally.”

Despite the many causes of sovereign debt defaults, the results are virtually always reduced debt service obligations for the borrower, whether through extending maturities to address liquidity, changing coupons and maturities to reduce the obligation’s present value, and/or reducing principal. Restructuring a government’s debts and its other spending obligations is often a question of how the losses will be distributed among different lenders and the citizenry, which could be affected by tax increases, entitlement reform, and cutting government spending

and services under various austerity measures. The following sections provides examples of these solutions in practice – through the rescues, restructurings, and defaults of Russia, Argentina, Mexico, Uruguay, and various countries under the Brady Bond program – along with causes, implications, and lessons learned. The solutions range from Mexico receiving new financing lines that allowed them to meet all debt service requirements, to Uruguay’s extension of debt maturities, to defaults and principal reductions that disproportionately affected certain investors (as in Russia).

The 1980s was known as the lost decade in Mexico (and much of Latin America) after a heavy reliance on oil revenue to finance an expansive government budget led to severe recession, peso devaluation, nationalization of the banking system, and sovereign default in 1982. This default was rectified partly through a U.S.-led restructuring program that involved Mexico providing U.S. Treasury bonds as collateral for their postrestructuring debt, which became known as Aztec Bonds (this plan was the model for the Brady Bond Plan discussed later). At the height of the 1980s oil and peso crisis, Mexico’s total private and public debt as a percent of GDP reached 154%. The over-leveraged economy stagnated, with average 1.1% growth in real GDP from 1980 to 1987. Mexico concluded 1987 with a stock market crash (partly influenced by the U.S. crash) and an economy bordering on hyperinflation (the inflation rate reached 132%). After taking office in 1988, the incoming Salinas government pursued an economic liberalization program that included, among other key policy initiatives, (i) aggressive privatization of state enterprises, (ii) accelerated reduction in tariffs that ultimately led to the negotiation and implementation of the North American Free Trade Agreement (NAFTA) in 1994, and (iii) the implementation of the crawling peg exchange rate system (pegged to the U.S. dollar), design to address hyperinflation issues and promote a stable economic environment. Despite the early successes of the new policies, Mexico needed to use Brady Bond Plan in 1990 to restructure its debts. Still, in 1994, Mexico faced a currency and fiscal crisis influenced by political turmoil at the end of the Salinas presidential term, a ballooning current account deficit, and drained reserves of foreign currencies. Political Turmoil – The end of the Salinas presidency in 1994 was mired by political turmoil that greatly shifted the landscape for investment confidence and currency flows. Notable political events in 1994 included (i) the January 1st uprising (the same day NAFTA took effect) of the EZLN revolutionary group in Southern Mexico, (ii) the March 23rd assassination of the ruling party’s presidential candidate, Luis Donaldo Colosio, and (iii) the September 29th assassination of the ruling party’s high ranking official, Jose Francisco Ruiz Massieu. Unsustainable Sovereign Debt Burden – Prior to the 1994 crisis, 75% of Mexico’s sovereign debt was shortterm and denominated in pesos. After the Colosio assassination in March 1994, the government began issuing U.S. dollar-denominated debt (called “tesobonos”) to appease market concerns and protect investors against peso depreciation. Logic would suggest that the more foreign-currency debt issued by a country, the less likely the government would be to devalue the currency given the self-inflicted pain; thus the tesobonos reassured investors that the currency peg would be defended. With the large amount of dollar-denominated debt, and the inherent currency mismatch between liabilities and assets, any peso devaluation would only increase the debt burden. By November 1994, dollar-denominated debt accounted for 70% of the $25 billion in government debt. Current Account Deficit – The ballooning current account deficit, resulting from higher value of imported goods relative to exported goods, followed the Salinas liberalization policies and adoption of NAFTA, which attracted significant foreign direct investment (FDI) given the future export advantages into the U.S. (the world’s largest consumer market). This produced capital account surpluses from 1990 to 1994, before reversing in 1995 (see following chart). The strong FDI was also influenced by the pegged exchange rate, which inspired confidence of economic stability and depressed inflation by strangling monetary expansion policies. However, the growing current account deficit pressured the currency peg and foreign exchange reserves.


Mexico’s Capital Account and Current Account
Capital Account $10 Current Account

$5 Billions of U.S. Dollars




$(15) 1990 1991 1992 1993 1994 1995

Loss of Foreign Currency Reserves – The shocks to investor confidence, mostly triggered by the political events described above, led to doubts about the sustainability of the currency peg. The government consistently intervened in the market through the use of international currency reserves to support the peso’s exchange rate. The loss of reserves (shown in the chart below) increased the uncertainty about monetary stability, creating a vicious cycle that eventually led to the unsustainability of the crawling peg exchange rate system. Mexico’s Foreign Currency Reserves
$30 $25 Billions of U.S. Dollars $20 $15 $10 $5 $Dec 93 Jan 94 Feb 94 Mar 94 Apr 94 May 94 Jun 94 Jul 94 Aug 94 Sep 94 Oct 94 Nov 94 Dec 94

The implications of these factors included currency devaluation, a lack of investor confidence, and a growing and unsustainable debt burden, as detailed below. This eventually led to an inability to refinance maturing debt, necessitating a bailout with funding again led by the U.S. Currency Devaluation – The sustainability of the peso’s peg to the U.S. dollar came into question as the deteriorating political environment increased risk aversion, and dwindling reserves of U.S. dollars hindered the government’s ability to maintain the preordained exchange rate band by selling dollars. The exchange rate was also challenged by a concurrent increase in U.S. interest rates, which decreased relative demand for pesos. The

creeping peso devaluation throughout 1994 (see graph below) also reduced the value of investments in Mexico. This culminated in the official devaluation in early 1995, with peso depreciation near 50%. Mexican Peso Devaluation
$9 $8 Mexican Peso / Dollar $7 $6 $5 $4 $3 $2 Dec 92

Mar 93

Jun 93

Sep 93

Dec 93

Mar 94

Jun 94

Sep 94

Dec 94

Mar 95

Jun 95

Sep 95

Dec 95

The Bailout – Approximately $10 billion of tesobonos were due to mature during the first quarter of 1995. The prospects of a potential default by Mexico rose as willing investors, which were increasingly scarce, required considerably higher interest rates on new debt issued to refinance maturing debt. This culminated in Mexico taking a credit line of $18 billion led by the U.S. government on January 2, 1995. This bailout package of dollardenominated direct loans was subsequently increased to $48 billion of availability, led by the U.S. and also including the IMF ($15 billion) and the Bank for International Settlements. Mexico borrowed approximately $22 billion under the package through mid-1995 as the economy weakened (real GDP fell 7.2% in 1995). Nevertheless, the bail-out provided stability and reinstated investor confidence, allowing Mexico to issue bonds in the open market beginning in July 1995. Lessons from Mexico – Lessons from this so-called Tequila Crisis and the resulting bailout included (i) the limits of addressing economic issues when subject to monetary policy constraints, (ii) hazards of denominating debt in a foreign currency, (iii) consequences of pegging exchange rates without fiscal restraint, (iv) highlighting the unintended repercussions of trade liberalization policies, (v) awareness that sovereign debtors with unstable politics and a history of default can be repeat restructuring candidates, and (vi) the importance of providing excess liquidity in a bailout, as seen by the need the upsize the initial bailout to restore investor confidence.

On the advent of 1997, Russia was expecting a year of economic progress after six years of painful economic transition following the fall of the Soviet Union. This transition included massive privatizations of state enterprises. The improving economy was signified by an improving trade deficit, access to additional liquidity (including a $3 billion credit line from the World Bank), and lower inflation (partly attributable to the ruble’s narrow exchange band versus the U.S. dollar). After earlier rescheduling debt service payments on its Soviet-era bonds, the country had even been allowed to join the Paris Club, the informal group of creditor countries that attempts to help overly indebted developing countries. However, the country faced a troubling outlook due to the quality of past reforms, contagion from weakening economies of neighboring countries and developing markets, declining prices for oil and other commodities, depletion of foreign currency reserves, a weak banking system, and excessive borrowings.


Debt Over-Indulgence – Although Russia’s structural and economic improvements in the early 1990s were debatable, their inclusion in the Paris Club improved their credit rating and granted access to cheaper financing to support economic growth. Russia seized upon such financing, increasing foreign liabilities from 7% of assets in 1994 to 17% in 1997. Also, debt as a percent of GDP increased from roughly 40% in 1995 to nearly 100% in 1999 (see following chart). This increase in borrowing greatly outpaced the government’s revenue generation, with a resulting weaker fiscal position characterized by higher national debts and fiscal deficits. Russia’s Public Debt
120% 100% % of GDP 80% 60% 40% 20% 0% 1995 1996 1997 1998 1999 2000 2001 2002

External Shocks – The currency crisis among certain fast growing Asian countries (the Asian Tigers) that began in 1997 highlighted the potential for volatility and political instability in emerging economies. Contagion from this crisis affected Russia (and Uruguay, as discussed later), particularly given its reliance on commodity markets such as crude oil, steel, aluminum, and other metals. In 1997, oil and non-ferrous metals represented 60% of the government’s hard-currency revenues. These revenues were hammered in 1998 as oil prices fell over 60% (see chart below) to multi-decade lows, inconveniently concurrent with the increasing risk aversion of emerging market investors. This required the government to pay higher interest rates on their ever-growing debt balances, due in part to fund their growing deficits. Crude Oil Prices
$35 $30 $25 Dollars / Barrel $20 $15 $10 $5 $0 1993











Waning of Investor Confidence and Currency Devaluation – Rumors of impending sovereign default and currency devaluation, in addition to serious economic weakness, prompted investors to withdraw $4 billion from Russia between January and August 1998, as the Russian stock market declined 75%. Once investors converted their securities into currency, they attempted to sell the rubles for safer currencies to avoid the impact of devaluation, putting downward pressure on the currency. The Central Bank of Russia depleted its reserves in a futile attempt to preserve the ruble exchange rate before the government adopted a floating exchange rate in August 1998, which resulting in over 80% depreciation within six months (see following chart). Russian Ruble Devaluation
$35 $30 Russian Ruble / Dollar $25 $20 $15 $10 $5 $0 Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan 96 96 96 96 97 97 97 97 98 98 98 98 99 99 99 99 00 00 00 00 01

Depletion of Currency Reserves – The government’s depletion of foreign currency reserves, largely from attempting to defend the ruble as foreign investor confidence waned, also resulted from many investors that earlier executed forward contracts to sell rubles to the Central Bank of Russia. These forwards were common hedges for investors (including Russian banks, which held $6 billion of forwards) in the government’s short-term ruble-denominated bonds called GKOs (the acronym for Gosudarstvennoye Kratkosrochnoye Obyazatyelstvo). These pressures complicated the government’s efforts to maintain their exchange rate band of 5 to 6 rubles per U.S. dollar, forcing the Central Bank to consume dollar reserves by purchasing rubles to maintain the target exchange rate. Between November 1997 and August 1998, the Russian government spent roughly $12 billion of reserves defending the ruble, as shown below. Russia’s Foreign Currency Reserves
$25 Billions of U.S. Dollars $20 $15 $10 $5 $0 Dec-96 Jun-97 Dec-97 Jun-98 Dec-98


Importantly, Russia’s currency reserves benefitted by running current account surpluses during the crisis (unlike many other countries that have defaulted). However, the overall decline in currency reserves, higher government debt loads, contagion from other emerging markets, and the declines in commodity prices had serious implications for the country. These implications included civil unrest, banking failures, political changes, currency devaluation, and default on ruble-denominated and Soviet-era sovereign debt, as detailed below. Importantly, they did not default on their foreign-denominated debts issued after the Soviet era. Civil Unrest and Bank Failures – The Russian public took to the streets to protest their lost savings after the government closed three major banks (Inkombank, Oneximbank, and Tokobank). The intention of the closures was to both stop an expanding bank run and to address the banks’ fundamental insolvency. Public demonstrations and protests were held in Moscow, Vladivostok, Krasnoyarsk, and other cities. Political Fall-Out – The worsening economy and bank failures were seen as another sign of government’s repeated failures in economic policy, producing an increasingly tense political environment. In March 1998, President Boris Yeltsin replaced key government figures and appointed Sergey Kiriyenko as Prime Minister. Yeltsin soon fired Kiriyenko (replacing him with Vikor Chernomyrdin) for failure to implement an anti-crisis plan that was needed to generate $12 billion of additional government revenue. Bailout and Default – In July 1998, the IMF approved an emergency aid package of $11.2 billion for Russia (later upsized to $15.1 billion), with $4.8 billion to be disbursed immediately. Despite the sizable bailout, the government announced in August 1998 a 90-day moratorium on payment of certain bank obligations and forward currency contracts, and the intent to restructure ruble-denominated government debts (price declines had already pushed some yields over 200%). The subsequent sovereign restructuring covered $17.2 billion of GKOs, longer term federal debt (OFZs or Obligatsyi Federal’novo Zaima), foreign-denominated debt, and other debt. The restructuring resulted in the repayment of $1.7 billion of debt, exchanging $3.5 billion of debt for three-year zerocoupon bonds, and restructuring the remaining $12.0 billion of debt into four-year and five-year variable-coupon bonds. Importantly, the Russian government maintained interest payments on the foreign-currency debt issued by the Russian Federation (15% of total debt) with repayment in full over time; in contrast, the GKOs and other debt effectively experienced a 17% reduction in principal on a present value basis. Also importantly, non-residents who decided not to participate in the exchange were repaid in full with the caveat that their ruble proceeds were held in “S-accounts” with a five-year repatriation restriction to reduce potential pressure on the ruble’s exchange rate. This default left the Russian government unable to access the international bond markets until 2010, despite a fairly strong economic recovery led by rebounding oil prices shortly after the default. Lessons from Russia – The Russian default and restructuring highlight (i) the propensity for sovereign default to reduce principal balances across many types of debt, while treating holders of various debt tranches very differently (e.g. ruble-denominated debt was impaired while external dollar-denominated debt was unimpaired), (ii) the double-whammy to foreign investors by reducing payments on local-denominated debt while depreciating the currency, (iii) contagion from external shocks can cause investor risk aversion, even if running a current account surplus, (iv) the fast and significant repercussions of economic weakness for governments of nondiversified economies, particularly those driven by volatile commodities, (v) the negative effects of excessive government borrowing, even if lower rates are offered by financing markets, (vi) the difficulty of maintaining a pegged currency exchange rate as investors flee, especially if the National Central Bank has already agreed to buy the domestic currency using forward contracts, (vii) spiraling economic effects and political ramifications caused by civil unrest and banking failures, and (viii) that penalties for default can include an inability to access capital markets for extended periods despite economic rebound.


Argentina was affected by the aforementioned emerging market crisis in the late 1990s, but also had longsimmering idiosyncratic issues. Shortly after the 1989 election, President Carlos Menem aggressively moved to address the country’s hyperinflation, which hit 3,300% in 1989. The government introduced the “Convertibility Law Plan” in 1991 to limit the money supply and eventually starve the inflationary pressures. The plan essentially pegged the exchange rate to one peso per U.S. dollar. For every peso in circulation, the Central Bank was required to hold the equivalent in gold and/or foreign currency reserves, minus the required reserves from the private banking system. These policies, along with other changes such as tax reform and privatization of public non-essential enterprises, allowed Argentina to post budget surpluses and positive GDP growth through the early 1990s. However, market sentiment turned sour after Mexico’s Tequila Crisis in the mid-1990s and emerging market troubles in 1998 and 1999 (including the Russian default and Brazil’s currency devaluation). The growing risk aversion of emerging market investors was paired with a weakening economy, as real GDP fell throughout 1999 and 2000 (see following chart). The continued economic weakness, investor flight, and constrained monetary policy led to strained government finances and eventually triggered currency devaluation, plunging sovereign bond prices, and default on roughly $82 billion of debt, the largest sovereign default in history. This also became one of the larger and more contentious restructurings ever, as it remains unresolved after ten years. Inflation, GDP Growth, and Exchange Rates for Argentina
Pesos/USD (Left Scale) $5 $4 Pesos / Dollar $3 $2 $1 $0 Dec-99 YoY Inflation (Right Scale) YoY Real GDP (Right Scale) 45% 35% 25% 15% 5% -5% -15% -25% Dec-02 Year-over-Year Change .






Limited Competitiveness and Strained Fiscal Situation – Brazil was a major importer of Argentinean products and competed with Argentina in exporting many products. The Brazilian currency devaluation in 1999 (over 50%) reduced the competitiveness of Argentinean product pricing and thus shrank Argentina’s exports to Brazil and other countries where they competed with Brazil. The weakened exports hurt the economy and government revenues, increasing the government budget deficit and requiring more borrowing just as bond spreads were spiking. This contributed to government debt increasing from 38% of GDP in 1998 to over 55% in 2001 (see graph on the following page). The implications of historical political decisions to cede monetary control, in addition to fundamental performance, had eventual negative impacts on the economy, competitiveness, and investor willingness to finance the government. This led to social unrest, bank runs, rescue attempts by the IMF, and eventual sovereign default with a series of attempted debt exchanges and restructurings, as detailed below. Increased Borrowing Costs – The Russian crisis in 1998 significantly impaired investor confidence in emerging markets. This investor flight, along with Argentina’s deepening economic recession, drove Argentinean bond spreads to U.S. Treasuries above 1,000 bps even before the runaway spike coincident with the default (see chart

below). The increased borrowing costs hampered the country’s ability to refinance upcoming debt maturities at serviceable interest levels. Argentinean Bond Spreads over 10-Year U.S. Treasuries
6,000 5,000 4,000 bps 3,000 2,000 1,000 0 May-98 Sep-98 Jan-99 May-99 Sep-99 Jan-00 May-00 Sep-00 Jan-01 May-01 Sep-01

Constrained Monetary Policy – Argentina’s Convertibility Plan required equal-value reserves for each peso in circulation. This forced the National Central Bank to consume reserves (see graph below) to cover the government’s debt maturities and increased interest rate burden. The reduction of reserves lowered assets of the NCB, thus requiring them to also reduce money supply on a one-to-one basis. Ultimately, the reduction in money supply had a negative effect on overall economic activity, as shown by the steep declines in GDP above in 2001 and 2002 in the earlier graph. The decreased money supply contributed to a vicious cycle of reducing government revenues and tax income, which further strained the economy and investor risk appetite. Argentina’s Fiscal Position
Public Debt 160% 140% 120% % of GDP 100% 80% 60% 40% 20% 0% 1996 1997 1998 1999 2000 2001 2002 $5 $0 $20 $15 $10 International Reserves - RHS $30 $25 Billions of U.S. Dollars

Social Unrest and Bank Runs – The depressed economic conditions and resulting deterioration in fiscal position led Argentina to impose austerity measures such as reductions in development projects, welfare, and social programs. Unemployment increased to over 13% in 1999 (reversing a favorable trend in prior years), leading to strikes and social unrest. These developments led to domestic concerns about the financial health of banks, prompting rapid withdrawal of deposits. To stem the bank runs, the government imposed a bank holiday in

December 2001 and subsequently limited the amount of money that could be withdrawn or transferred outside the country. Futile IMF Intervention – To “preemptively” address an already unsustainable fiscal position in late 2000, the government negotiated a $40 billion loan package led by the IMF referred to as “blindaje” (i.e. armor). This did little to assuage market concerns regarding Argentina’s solvency. The IMF later provided another $7 billion commitment to support the government’s efforts to extend debt maturities. Futile Debt Exchanges – The government also attempted to exchange outstanding debt for new debt with extended maturities to contain the crisis of confidence and avoid a full default. Their proposed “Mega-swap” would have covered debt equivalent to roughly 30% of 2001 GDP, with 11% from foreign-denominated and 19% from peso-denominated debt. Eventual Devaluation and Default – In November 2001, Argentina declared it would miss payments on foreign debt; they formally defaulted in 2002, beginning with a missed payment on an Italian lira-denominated bond. The accumulated pressures forced the government to drop the currency peg in January 2002, leading to 70% peso depreciation over the next six months (see following chart). The government also proposed a hostile restructuring of a record $82 billion of sovereign debt, with a focus on extending maturities. In a September 2003 meeting with bondholders in Dubai, the Argentinean government proposed a 75% haircut to foreign debt with payment of pastdue interest (PDI). After extended negotiations to reduce debt to a sustainable level after factoring in assumptions for GDP growth and currency devaluation, roughly 76% of debt holders approved a 65% haircut on principal in 2005. The new debt also had warrants tied to GDP (with value accretion if GDP growth exceeds 3%) that provided some potential upside to lender recoveries over time. During 2010, the government reopened the exchange offer to holders of the remaining $19 billion of defaulted debt (excluding PDI); this was accepted by roughly 75% of these holders (taking total consents near 95%). The remaining defaulted debt (roughly $5 billion) continues to prevent the government from access to international capital markets. Argentinean Peso Devaluation

Argentine Peso / Dollar





$0 Jan 00 Apr 00 Jul 00 Oct 00 Jan 01 Apr 01 Jul 01 Oct 01 Jan 02 Apr 02 Jul 02 Oct 02 Jan 03

Lessons from Argentina – The Argentinean sovereign default showed (i) the painful economic consequences of ceding control of monetary policy by pegging exchange rates and requiring hard reserves at central banks, (ii) the limited ability for a government or international entity such as the IMF to preemptively address solvency concerns with liquidity lines or debt exchanges, particularly when investor concerns are heightened regarding contagion from other markets, (iii) the susceptibility of private banks to deposit withdrawals, which can force a government response, (iv) the painful effect on sovereign funding costs as investors flee markets with or without cause, especially as countries face near-term debt maturities, (v) the repercussions of dropping a currency peg on

inflation, economic activity, and competitiveness, and (vi) the legal implications of holdouts and cramdowns given the legal structure of existing debt.

After economic instability in the 1980s, Uruguay experienced a period of extended growth in the early 1990s. Sound macroeconomic policies enabled Uruguay to boast one of the strongest economies in South America, improving the nation’s credit rating and enabling debt issuance with relatively low interest rates and long-term maturities, including 30-year dollar-denominated bonds in 1997. This put them in rare company among emerging economies able to issue investment-grade sovereign debt. With a crawling peg on foreign exchange rates keeping inflation down, capital inflows increased and the government was encouraged to finance the majority of their needs through the international bond market. However, the country’s debt servicing ability was affected by troubles from 1998 to 2002 including capital constriction to emerging markets following Asian currency crises, Russia’s default, reverberating economic effects as Argentina and Brazil devalued their currencies, excessive government spending and deficits, and a banking crisis. External Shocks – The 1998 financial crisis in Russia and currency crises in Asia detrimentally impacted Uruguay and other emerging markets by reversing the previously strong capital flows to emerging economies. Although this had minimal immediate impact on Uruguay, it significantly impacted Brazil and later Argentina, which forced them to abandon pegged currency exchange rates (resulting in significant devaluation) during 1999 and 2001, respectively. This made exports from Brazil and Argentina cheaper relative to those of Uruguay, leading to declines in Uruguayan exports. Also, the relative depreciation of the Brazilian and Argentinean currencies and their related economic difficulties impacted Uruguayan export and import volumes with these major trading partners during 2001 and 2002, as highlighted below. Uruguay’s Trade Balance
$4 Exports Imports Trade balance

Billions of U.S. Dollars





($6) 1998 1999 2000 2001 2002 2003 2004 2005

Government Largess – With these emerging market troubles, Uruguay’s real GDP fell roughly 17% from 1998 to 2002 (declining 3.4% in 1999, 3.7% in 2000, 3.9% in 2001, and 9.1% in 2002) while public debt continued to increase. The Uruguayan government continued to invest in economic expansion initiatives without regard to the decline in economic activity and the related to loss in competitiveness due to changes in exchange rates, leading to fiscal deficits over 4% of GDP in 2000 and 2001. Further, the government continued to borrow (even using foreign-denominated debt) under the erroneous belief that Brazil would quickly recover, which would enable a rebound in exports. This continued borrowing increased public debt as a percent of GDP from roughly 30% in 1999 to 40% in 2001, and to 100% in 2002 following the eventual currency devaluation (see graph below).


Uruguay’s Fiscal Position
Total Public Debt 120% 100% Debt as % of GDP 80% 3% 60% 2% 40% 20% 0% 1998 1999 2000 2001 2002 2003 1% 0% Fiscal Defict 5% 4% Deficit as % of GDP

Banking Crisis – Uruguay’s economic declines, mainly due to lower exports, affected the health of the major domestic banks. After a scandal at Banco Comercial del Uruguay, where an $800 million fraud was detected, declining public sentiment triggered a mass run of the banks that depleted roughly 33% of deposits. The bank runs left five banks insolvent and contributed to the 80% depletion of reserves at the National Central Bank in 2003 (see following chart). Uruguayan Central Bank Foreign Currency Reserves
$3.5 $3.0 Billions of U.S. Dollars $2.5 $2.0 $1.5 $1.0 $0.5 $0.0 1996 1997 1998 1999 2000 2001 2002 2003

The implications of Uruguay’s economic weakness, large government debt balance, and banking crisis included currency devaluation, a bailout of the banking system, and a voluntary exchange of sovereign debt over the course of 2002 and 2003, as detailed below. Currency Devaluation – The depletion of the National Central Bank’s foreign currency reserves from the banking crisis left the Uruguayan government unable to both sustain its currency peg to the U.S. dollar and simultaneously honor capital requirements on other liabilities. To protect the remaining reserves, the pegged exchange rate band versus the U.S. dollar was replaced by a floating exchange rate, as done earlier by Argentina and Brazil. Resultantly, the Uruguayan peso depreciated roughly 50% during 2002 (as shown below), ushering in an inflationary environment.

Uruguayan Peso Devaluation

$28 Uruguayan Peso / Dollar




$8 Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan 98 98 98 98 99 99 99 99 00 00 00 00 01 01 01 01 02 02 02 02 03 03 03 03 04

Banking System Bailout – The international community, to ameliorate the impact of the banking crisis, assembled a $1.8 billion aid package to replace public bank deposits and liquidate four insolvent banks. Voluntary Debt Exchange – The weakened state of Uruguay’s financial system and fiscal position impacted the government’s credit quality and ability to refinance maturing debt, which forced them to address debt obligations in an unconventional manner. The government wanted to preserve the nation’s prior status as a trusted creditor while simultaneously alleviating the nation’s debt burden. The government attempted to avoid the IMF’s strict restructuring policies under its Sovereign Debt Restructuring Mechanism (SDRM) by pursuing a voluntary debt restructuring. Instead of forcing creditors to take a haircut on coupon or principal, the government proposed a voluntarily election for investors to exchange their bonds for new bonds with a variety of maturity extensions, which would allow for economic growth and therefore improved ability to honor debt obligations over time. These new bonds also included features that incentivized the exchange, including (i) an exit consent, which effectively penalized holdouts by subordinating the non-exchanged bonds to the new bonds, and (ii) collective action clauses (CACs), which required a supermajority vote among new bondholders to approve any future restructuring of the government’s debt. Uruguay’s Debt Maturities Before and After the Restructuring
$900 $800 Millions of U.S. Dollars $700 $600 $500 $400 $300 $200 $100 $2003 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 2025 2027 2029 2031 2033 Pre Exchange Post Exchange


Other important factors that bolstered acceptance of the exchange included the equal treatment of domestic bondholders and foreign creditors (rather than Russia’s more favorable treatment of certain foreign debts), and the IMF’s provision of additional liquidity, which would improve the future stance of the country but was conditioned upon a minimum level of exchange consents. In the end, 93% of Uruguay’s eligible $5.5 billion of debt elected the exchange, which radically reduced near-term maturities (see preceding graph). Lessons from Uruguay – The multiple contributing factors to the Uruguayan sovereign crisis and its eventual peaceful resolution highlight (i) a country’s ability to complete a voluntary exchange to reduce near-term maturities without reducing principal owed, (ii) contagion from external shocks in other countries and trading partners can impact domestic economies, trade balances, fiscal deficits, relative debt loads, and capital inflows, (iii) monetary and fiscal inflexibility can reduce a nation’s ability to satisfy its debt burden and adopt to changing competitive dynamics, (iv) the importance of maintaining sufficient foreign reserves to support exchange rates, (v) the importance of maintaining confidence in the banking system, and (vi) bolstering acceptance of a restructuring by treating domestic and foreign investors equally and making participation voluntary, but with incentives to participate and penalties for holding out.

The Brady Bond Plan was a U.S.-backed plan to facilitate sovereign restructurings for struggling developing economies. This highly successful plan could prove a valuable guide for implementing potential European sovereign restructurings in years to come. The plan was formed in 1989, named for the sitting U.S. Secretary of Treasury (Nicholas Brady), to address U.S. commercial bank exposure to defaulted emerging market sovereign debt from the 1980s. The Brady Bond Plan called for the U.S. and multinational agencies such as the IMF and the World Bank to cooperate with commercial creditors to sovereigns. As sovereigns restructured their old debts, often including reductions in principal and/or interest rates on the new long-term debt (the Brady Bonds), they generally collateralized the new debt principal by holding equal-tenor zero-coupon U.S. Treasury bonds on deposit at the U.S. Federal Reserve. By the end of the 1990s, over $160 billion of Brady Bonds were issued to replace pre-existing debt in the restructurings of 17 countries, which are detailed at the end of this section. Mexico became the first participant in the plan in 1990, joined by the Philippines, Costa Rica, and Venezuela in 1990, Uruguay in 1991, Nigeria in 1992, Argentina and Jordan in 1993, and nine others from 1994 to 1997. Albania Argentina Brazil Bulgaria Costa Rica Participants in the Brady Bond Plan Dominican Republic • Nigeria Ecuador • Panama Jordan • Peru Mexico • Philippines Poland Uruguay Venezuela Vietnam

• • • • •

• • • •

• • • •

Benefits of the Brady Bond Plan – As the nations involved in the debt exchanges or restructurings through the Brady Bond Plan had defaulted on at least a portion of their debt, the plan provided a menu of restructuring options that enabled them to resolve their defaults. The critical benefits from the plan included the following: • Resolution of actual or pending sovereign defaults from non-payments of debt interest and/or principal. This could include partially repaying old debts and past-due interest (PDI), often at discounts, having such obligations officially forgiven, or exchanging old debt for new debt with sustainable terms. Debt service relief for emerging economies in exchange for commitments to economic reform. This relief could include major reductions in debt balances; even if principal was not reduced, the present value of future payments would be lower than the pre-restructuring claims due to the lower interest rates and extended maturities on Brady Bonds.

• • • •

Simplification of restructuring negotiations by creating a defined set of menu options for defaulted debt holders, which accelerated completion and recoveries. Enabling governments to access cheap financing with long maturities which would be otherwise unavailable given their deteriorated credit quality and market access. The non-discriminatory nature of the plan, which made it highly attractive to nations with perceived or actual high credit risks. Lenders received performing bonds in exchange for defaulted loans, along with collateral (generally) in the form of zero-coupon U.S. Treasuries that ensured future recovery value. The performing and collateralized nature of the new debt provided capital relief for banks. Brady Bonds were uniform and considered high quality, which effectively bolstered the liquidity of credit markets for emerging countries, in contrast to the illiquid, heterogeneous, and questionable prior loans. For example, the Emerging Markets Trade Association calculated that Brady Bonds accounted for roughly 50% of the emerging market bond trading volume of $2.0 trillion in 1993, and maintained such share as trading expanded to $5.0 trillion in 1996.

Lessons from the Brady Bond Plan – The Brady Bonds proved (i) a coordinated restructuring effort not only provided relief for struggling developing economies, but also capital relief for banks with significant exposure to the developing economies, (ii) the appeal to borrowers and lenders of efficiently resolving defaults through a flexible menu of options, (iii) coordinated restructuring efforts could provide a liquid market for otherwise illiquid/heterogeneous loans, and (iv) the benefits to lenders of assuring future claims would be honored since they were collateralized, even if lenders realized losses on prior debt claims, either in actual or present value terms. These lessons could be critical in considering longer-term solutions to the present European sovereign debt crisis. Details of the Restructuring Process – The Brady Bonds were issued in exchange for the outstanding sovereign bank debt. These new bonds allowed the banks holding the sovereign paper for higher quality debt while allowing the debtor nation to restructure. Through this process, the debtor nation was able to lower principal payments and/or lower coupons while extending maturities by up to 30 years. Importantly, the Brady Bonds were not explicitly guaranteed by the U.S. government; rather, the bonds were only collateralized (though some were not collateralized) by zero-coupon U.S. Treasuries purchased by the restructuring country and held in escrow at the U.S. Federal Reserve. Given yields near 8.0% on 30-year, zero-coupon U.S. Treasuries in the early 1990s, the cost for purchasing this collateral could be only 10% of the face value required. The exchange of sovereign loans for Brady Bonds would occur after a debtor nation and a bank advisory committee negotiated a Debt and Debt Servicing Reduction (DDSR) agreement. These agreements could provide lenders with a variety of repayment and resolution options for defaulted debts and past-due interest; these options could include discounted repurchases, forgiveness of obligations, reductions in principal, new bonds with fixed or floating coupons, and either bullet or scheduled amortization payments (usually after a grace period). The Brady Plan included a limited menu of bond restructuring options that facilitated the negotiation process between the borrower and creditors, and made large restructurings logistically palatable. The most common Brady Bonds were 30-year bonds with interest rates near LIBOR+80 bps and limited amortization requirements in the near term (see following tables for examples of the Brady Bond restructurings), though these could take a variety of forms including those below: • Discount bonds – Defaulted loans would be exchanged for bonds that required a haircut of principal in the restructuring (these are the only Brady Bonds requiring a haircut). These bonds typically had 20-30 year maturities, floating rate coupons (roughly LIBOR+80 bps), collateral, and an embedded grace period on amortization.

Par Bonds – Defaulted loans would be exchanged for bonds that required no haircut of principal in the restructuring, although the net present value of future payments to creditors would be reduced from prior claims due to the lower coupon. These bonds typically had 20-30 year maturities, fixed coupons, and collateral. These also could have coupons that changed over time, such as increasing slightly in outer years. Debt Conversion Bonds (DCBs) – Defaulted loans would be exchanged for these long-maturity bonds that required no haircut of principal (but lower net present values); however, lenders electing DCBs were required to extend additional loans called New Money Bonds to facilitate the restructuring (e.g. providing liquidity for fiscal initiatives or funding debt repayment obligations agreed in the restructuring). DCBs featured fixed, floating, or increasing rate coupons with non-collateralized interest, and required amortization after a grace period. New Money Bonds typically had a similar structure but were predominantly floating rate. Front Loaded Interest Reduction Bonds (FLIRBs) – Defaulted loans would be exchanged for these 20-30 year bonds that required no haircut of principal (but lower net present values). These bonds were intended to ease the borrower’s liquidity pressures in early years after the restructuring; these low interest rates would reset to floating market rates in later years. The bonds typically had collateralized interest for a certain period, and non-collateralized principal, with amortization after a grace period. Capitalization bonds (C-Bonds) – Defaulted loans would be exchanged for these bonds that required no haircut of principal (but lower net present values). C-Bonds received interest partially in cash and partially in additional bonds (i.e. resembling pay-in-kind interest on corporate debt), enabling borrowers to preserve liquidity. These bonds typically were fixed rate, with non-collateralized interest and principal, and amortization after a grace period. Options for paying past-due interest included Eligible Interest Bonds (typically for interest in arrears) and Floating Rate Bonds (typically for holders of interest in arrearage claims). These bonds had floating-rate coupons, non-collateralized interest and principal, and amortization after a grace period.


Summary of Restructurings Under the Brady Bond Plan (figures in billions of U.S. dollars)
Country Albania Argentina Date Jun-95 Apr-93 Restructured Amount $0.5 Debt $19.3 Debt Description of Restructured Debt and Past Due Interest (PDI) Repurchased $0.4 of debt at 73% discount funded by capital from donor countries; converted $0.1 into long-term bonds. Exchanged $19.3 at 35% discount for either 30-year bonds with rate of LIBOR+81 bps or 30-year FLIRBs with 4% rate in the first year, rising to 6% in year 7. Repaid 7%, wrote off 4%, and exchanged 89% for 17-year bonds with rate of LIBOR+81 bps and rising annual repayments after 6 years. Exchanged $11.2 of debt at 35% discount for 30-year bonds with rate of LIBOR+81 bps. Exchanged $10.5 for 30-year FLIRBs with 4% coupon, rising to 6% in year 7. Also restructured another $8.1 debt and $1.4 debt held by Brazilian banks. Exchanged $7.1 for 20-year C-Bonds with 4% coupon, paid in kind for 6 years. Exchanged $1.7 for 15-year FLIRBs with 4% coupon, rising to 6% in year 7; no repayments required for 9 years. Exchanged $1.7 for 15-year FLIRBs with 4% coupon, rising to 6% for years 5 and 6, then LIBOR+81 bps; no repayments required for 9 years. Exchanged $1.6 for 15-year bonds with rate of LIBOR+87 bps; no repayments required for 7 years. Exchanged $0.3 for 18-year C-Bonds with rate of LIBOR+87 bps; no repayments required for 10 years. Exchanged $0.1 for 20-year interest-reduction bonds with rate of 4%, 5% in year 5, then LIBOR+81 bps; no repayments required for 10 years. $6.0 PDI Bulgaria Jul-94 $6.2 Debt PDI was also restructured. Exchanged $3.7 for 30-year bonds at 50% discount. Exchanged $1.7 for 18-year FLIRBs with rate of 2%, 3% in year 7, then LIBOR+81 bps; no repayments required for 8 years. Repurchased $0.8 at 75% discount. $2.1 PDI Costa Rica Dominican Republic May-90 Aug-94 $1.6 Debt $0.9 Debt $0.3 PDI Repaid 10%, wrote off 10%, and exchanged 80% for 17-year bonds with rate of LIBOR+81 bps and no repayments required for 7 years. Repurchased $1.0 at 84% discount; restructured another $0.6. Repurchased $0.4; exchanged $0.5 at 35% discount for 30-year bonds with rate of LIBOR+81 bps. Repaid 20%, wrote off 40%, and exchanged 40% for 15-year bonds with rate of LIBOR+81 bps and no repayments required for 3 years.

$9.3 PDI Brazil Apr-94 $43.7 Debt


Summary of Restructurings Under the Brady Bond Plan (figures in billions of U.S. dollars - continued)
Country Ecuador Date Feb-95 Restructured Amount $4.5 Debt Description of Restructured Debt and Past Due Interest (PDI) Exchanged $2.6 at 45% discount for 30-year bonds with rate of LIBOR+81 bps. Exchanged $1.9 for 30-year bonds at discounts with rate of 3%, rising to 5% in year 11. $3.2 PDI Jordan Dec-93 $0.7 Debt Repaid 3%, wrote off 20%, exchanged 7% for interest-equalization bonds, exchanged 70% for 20-year bonds with graduated repayment schedule. Exchanged $0.5 for 30-year bonds with rate of 4%, increasing to 6% in year 7. Exchanged $0.2 for 30-year bonds at 35% discount, with rate of LIBOR+91 bps. $0.2 PDI Repaid 20%, wrote off 20%, and exchanged 60% for non-collateralized 12year bonds with rate of LIBOR+81 bps and no repayments required for 3 years. Repaid $1.0 with New Money Bonds. Exchanged $20.5 for 15-year bonds at 35% discount. Exchanged $17.1 for 15-year bonds with rate of LIBOR+81 bps and no repayments required for 7 years. Exchanged $5.3 for 15-year DCBs with rate of LIBOR+81 bps and no repayments required for 7 years. Nigeria Panama Jan-92 May-96 $5.3 Debt $2.3 Debt Repurchased $3.3 at 60% discount; exchanged $2.0 for 30-year bonds with 5.5% coupon for 3 years then 6.25%. Exchanged $0.1 for 30-year bonds at 45% discount. Exchanged $0.3 for 30-year bonds with reduced coupon. Exchanged $1.6 for 18-year FLIRBs with no repayments for 5 years. $1.9 PDI Peru Nov-96 $4.2 Debt Repaid 5%, wrote off 30%, exchanged 65% for 20-year bonds with rate of LIBOR+81 bps and no repayments required for 7 years. Exchanged $1.8 for 20-year FLIRBs with no repayments required for 8 years. Repurchased $1.3 at 62% discount. Exchanged $0.9 for 30-year bonds at 45% discount. Exchanged $0.2 for 30-year bonds with reduced interest rate. $3.8 PDI Repaid 10%, repaid 30% at 62% discount, and exchanged 60% for 20-year bonds with rate of LIBOR+81 bps and no repayments required for 10 years.



$43.9 Debt


Summary of Restructurings Under the Brady Bond Plan (figures in billions of U.S. dollars - continued)
Country Philippines Date Jan-90 Dec-92 Restructured Amount $1.3 Debt $3.2 Debt Description of Restructured Debt and Past Due Interest (PDI) Repurchased $1.3 at 50% discount. Exchanged $1.9 for collateralized 25-25.5 year step-down/step-up bonds with 6.5% coupon after year 5. Exchanged $0.8 for 15-15.5 year FLIRBs with rate of LIBOR+81 bps after year 6 and no repayments required for 7 years. Exchanged $0.5 for 17.5-year bonds with rate of LIBOR+50 bps. Poland Oct-94 $14.4 Debt Exchanged $5.4 for 30-year bonds with rate of LIBOR+50 bps at 55% discount. Repurchased $2.4 at 60% discount. Exchanged $1.8 for 30-year bonds with rate increasing from 2.75% to 5% in year 21. Exchanged $0.4 at 65% discount for 25-year DCBs with rate of 4.5% increasing to 11.5% in year 11, no repayments required for 20 years. $3.6 PDI Uruguay Feb-91 $1.7 Debt Repaid 2%, wrote off 22%, exchanged 76% for 20-year bonds with 3.25% coupon increasing to 7% in year 9, and no repayments required for 7 years. Repurchased $0.6 at 44% discount. Exchanged $0.5 for 30-year, 6.75% collateralized bonds. Exchanged $0.5 for 16 year bonds with rate of LIBOR+87 bps and no repayments required for 7 years. Repurchased $0.1 using 15-year New Money Bonds with rate of LIBOR+100 bps and no repayments required for 7 years. Venezuela Dec-90 $19.7 Debt Repurchased $1.4 using 91-day collateralized notes. Exchanged $7.5 for reduced-coupon fixed-rate bonds. Exchanged $6.0 for Conversion bonds. Exchanged $3.0 for step-down rate bonds. Exchanged $1.8 for bonds at 30% discount. Vietnam Dec-97 $0.8 Debt Exchanged $0.5 for 30-year bonds with rate of LIBOR+50 bps. Exchanged $0.4 for 16-year bonds with rate of LIBOR+87 bps, and no repayments required for 7 years. Exchanged $0.2 for 30-year bonds with rate of 3% coupon (5.5% after year 20), and no repayments required for 15 years. Repurchased $0.02 at 56% discount. $0.5 PDI Repaid 3%, repurchased 4% at 56% discount, wrote off 30%, exchanged 63% for non-collateralized, 18-year bonds with step-up coupon, and no repayments required for 7 years.


Given the breadth and depth of the sovereign debt crisis, any successful solution will take substantial cooperation and coordinated efforts involving political leaders, central banks, the banking system, and the global financial markets. These efforts will need to focus on liquidity for countries and the banking systems in the near term, while the focus over the longer term will shift to solvency. Efforts to address both liquidity and solvency will entail fiscal reforms, social reforms, and improving real economic performance. The improving economic stance will require increasing demand, private employment, and competitiveness while maintaining reasonable price levels for wages, commodities, and assets. All of these factors must be delicately balanced in order to maintain investor confidence and hence capital availability while sovereigns and banks are afforded sufficient time to implement their reforms and initiatives. There are multiple alternatives to achieving recovery and stability within the countries of concern in developed Europe, with various probabilities of occurring and success. We group these alternatives as the “Preferred European Solution” (which entails working through the crisis on an incremental basis without a debt restructuring), “Restructuring Solutions,” and “Other Solutions.” In addition, we will discuss the potential political landmines and macroeconomic uncertainties within and across countries relating to foreign exchange, debt levels, and fiscal and regulatory policies.

The predominant preference of European political leaders is that the EMU work its way through the current crisis by continuing the spirit of incrementalism exercised thus far, by (i) allowing member states continued access to the capital markets to meets funding needs, (ii) avoiding a substantial default or restructuring of sovereign debt obligations, (iii) reforming fiscal policies to maintain the discipline intended for EMU members, including limits of 3% for fiscal deficits to GDP, and (iv) promoting monetary policies that support the stability of the euro and EMU. Lorenzo Bini-Smaghi, a member of the ECB’s Executive Board, has stated that a default or restructuring would “endanger the soundness of the financial system.” Given that public debts are widely held by other governments and foreign and domestic banks (not to mention citizens), any shortage of confidence in the sovereigns could trigger runs on bank deposits, which could force take-overs of susceptible banks to avoid a collapse and permanent wealth destruction; such actions would only compound the governmental debt burden and could jeopardize all of Europe. Similarly, removing any country from the EMU (note that no legal code exists to force a country out, though any country still could effectively leave) would actually be no solution at all since it would produce economic turmoil in reestablishing an independent currency, almost surely lead to devaluation of the new currency, and trigger debt defaults that could result in huge losses for the international and intertwined investor base (including European banks and governments). This shock could easily and rapidly spread to imperil the entire European sovereign and banking system. To prevent such shocks, as well as ensuring that sovereigns have sufficient liquidity to meet near-term debt maturities and finance fiscal deficits, there have been substantial measures implemented by European governments, the IMF, and the ECB that have included bond purchases and providing financing lines. In the Preferred European Solution, the existing mechanisms for financial support (including the IMF and EFSF) would remain the focus for providing sufficient liquidity support for countries and confidence to financial markets in the immediate term. The international provision of adequate liquidity can calm markets and grant the time necessary to implement the fiscal and structural reforms necessary for longer-term solvency. These “soft restructurings” could involve no change in required payments, but provide credit enhancement or investor protections such as guarantees or liquidity from international parties, as seen Mexico’s Tequila Crisis and the EFSF; this also applied to Korea’s sovereign guarantee of interbank payments to address the 1997-1998 banking crisis to stem the roll-off of bank lines and reduce refinancing risk. Along these lines, Greek Finance Minister George Papaconstantinou stated in January 2011 that “All the major mechanisms that need to be put on the table will be there to convince the markets that the Euro-Zone will defend itself, will defend its currency, will defend the countries that do what they have to do to be fiscally responsible

and also competitive in the European common currency area.” As discussed in Section 6, the Eurosystem (the ECB and central banks of Euro-Zone countries) has multiple mechanisms to support Euro-Zone countries in times of need. The ECB has substantial capabilities to support the market through open market operations, financing facilities, and in times of financial market tensions, any non-standard measures compatible with the Maastricht Treaty. Among their non-standard tools, two have been the most significant: changing credit rating requirements for eligible collateral assets when accessing the ECB’s funding facilities (this allowed Greek sovereign bonds to qualify and thus prevented a shortage of funding for banks), and the Securities Markets Programme (SMP). The SMP has come to prominence during the current financial crisis by allowing the ECB to purchase public and private debt; this allowed them address the malfunctioning securities markets and restore appropriate monetary policy transmission mechanisms. Under this program, the ECB became an active purchaser of peripheral European sovereign debt during May and June 2010 (before the approval of the EFSF). The ECB then significantly slowed such purchases despite market turmoil in late 2010, though seems to have reengaged recently with purchases of Portuguese debt. According to the ECB, the increased monetary supply created by SMP purchases is formally “neutralized” or “sterilized” by increased ECB one-week term deposits in banks, though this claim is unverifiable. Further, one-week banking deposits are very close substitutes for overnight deposits, even though they are excluded from the conventional monetary base definition. Thus, the purported sterilization of SMP purchases is cosmetic or semantic, rather than substantive or effective, meaning their economic impact is virtually indistinguishable from transparent quantitative easing or monetization of the public debt. Such quantitative easing is counter to the ECB’s price stability mandate, with their recent increase in interest rates evidencing their anti-inflation focus. In any event, the SMP has made a significant impact in limiting sovereign bond spreads in the marketplace. Beyond the ECB, the other critical crisis response tool is the headlined €750 billion Financial Stability Package, which includes one-third from the IMF and two-thirds from European governments (under the EFSM and EFSF). This program, as well as bilateral aid from stronger EU members outside the Euro-Zone and potentially other countries globally, has supported and will continue to support the financing needs of weaker Euro-Zone nations. Discussions are ongoing to potentially (i) expand the absolute size of these existing facilities, as the vast oversubscription for the EFSF’s first bond, at €5 billion, could suggest the potential for incremental capacity, (ii) finalize terms of the ESM to replace the EFSM and EFSF and provide permanent capital available to struggling European governments, and (iii) broaden the use of rescue financing programs, such as to supporting the EuroZone banking system, buying new sovereign bonds without needing a formal request for assistance (as required under the EFSF), or buying sovereign or banking debt in the secondary market. The purchases of new debt or existing discounted debt could produce the “virtuous cycle” of decreased interest spreads and increased market confidence, assuring market access and time for government policy measures to take hold. Given the current trading prices of certain sovereign obligations (e.g. prices for Greece’s long-maturity bonds have been near 50% of par), there appear to be market opportunities to execute discounted bond purchases, which could then be exchanged for new debt with reduced principal. This strategy (often executed in corporate debt restructurings) would allow the sovereign to deleverage and therefore improve liquidity and solvency, although those participating in the exchange could demand certain concessions from the borrower. However, such positive exchange announcements can also be self-defeating by relieving markets to an extent that the large discounts on certain bonds disappear; however, if existing owners are willing to enter into discounted exchanges, then the plan could still work. This could be the case for Greece, as Marathon estimates that approximately 50% its public debt is held between the ECB, European governments, and European banks. While this type of debt reduction strategy is a restructuring in practice, we include it under the preferred incremental solutions since it could leave independent third party investors unimpaired. Under the Preferred European Solution, the benefits to a recipient sovereign’s liquidity from existing and potentially new programs will come with the cost of required fiscal and social reforms that vary for each country. These required austerity measures aim to reduce the large fiscal deficits and thereby limit debt growth. The

austerity measures (see following table) can include multi-year freezes or reductions in public sector salaries and pensions, increased retirement ages, tax increases (e.g. income, capital gains, fuel, alcohol, and VAT), decreased minimum wages, increased healthcare co-pays and reduced spending, and decreased budgets for infrastructure and local governments. Although Euro-Zone members cannot devalue their currency, austerity measures can serve as a type of internal devaluation that lower wages and improve competitiveness. Selected Austerity Measures Planned in Europe Greece Retirement age increased to 63.5 from 61.4 years Public sector salaries cut 6%; salaries and pensions frozen for three years Pensions cut 7% between 2010 and 2030 Civil servants earning €36,000 annually lose two bonus payments Public sector allowances cut 20% Fuel, alcohol, tobacco taxes up 10%; VAT up 4% Public sector pensions over €12,000 annually cut 4% 10% pay cut for entrants to public service; other cuts to social and unemployment benefits Tuition costs up from €500 to €2,000 Income tax bands lowered 10%, bringing 139,500 people into the tax base Capital gains and capital acquisitions taxes increased 25% Public sector salaries cut 5% VAT up 3% to 23%; income taxes up 2%; corporate taxes up 5% Tax rates increase to 45% by 2013 for those earning over €150,000 Military spending cut 40%, infrastructure projects delayed The rescue package will likely require additional austerity measures to restrict spending (e.g. public wages, pensions, healthcare, infrastructure), increase taxes, improve banking solvency, improve competitiveness (e.g. end wage indexing to inflation), and privatize industry (e.g. selling stakes in oil, media, electricity, and transportation companies). Increasing retirement age from 65 to 67 (phased in over time). 5% wage reduction for civil servants and reductions in pension obligations. Incentives to hire younger workers. Funding for city and regional authorities cut €13 billion Freeze in public sector pay and cuts in hiring for three years Progressive pay cuts of up to 10% for high earners in public sector Retirement delayed six months for those who reach retirement in 2010 Eliminate provincial governments servicing fewer than 220,000 inhabitants All ministries to cut spending 10%; increased taxes on toll taxes Pension contributions from employees increasing to 10.55% from 7.85% Income tax rate for highest income group increased 1% Eliminate corporate tax breaks introduced with earlier stimulus Capital gains tax rate increased 1% Ending most fiscal stimulus measures Considering three-year freeze on public spending






Selected Austerity Measures Planned in Europe (continued) Germany Cost cutting measures of €80 billion by 2014 Air travel surcharge of €8 to €45 per ticket, depending on destination Tobacco tax increased Ending retirement insurance for long-time unemployed Ending housing benefits, including heating allowances for some unemployed Parent benefit for children ending for richest recipients and reduced for the poorest Healthcare insurance rates up 15.5% for most citizens

In addition to these measures, the ECB and European Parliament are pushing for increased automatic sanctions on governments that exceed the Maastricht Treaty’s limits on deficits (3% of GDP) and debt (60% of GDP). However, these penalties (if any) are likely to provide little motivation since all Euro-Zone countries violated the deficit limit in 2010, and minimal improvements are expected in 2011 (see following graph). Euro-Zone Budget Deficits for 2010 and 2011
Slovak Republic Luxembourg Netherlands Germany








Ireland 0% -5% -10% as % of GDP -15% -20% -25% -30% -35%
Source: IMF



EMU countries also must implement structural reforms of pension systems to decrease “off balance sheet” liability risks, which are estimated at 330% of GDP in France, 190% in Germany, and 130% in Italy. One potential model for the pension system reform would be Australia’s privatized retirement system, which created “superannuation” funds and changed pension contribution requirements (conceptually similar to replacing American defined-contribution retirement plans with defined-benefit plans). These plans have mandatory worker contributions augmented by tax-favored voluntary contributions with a safety net guaranteeing all retirees a minimum income. While a radical departure from the standard European pension system, it has proven highly successful.



Maastricht limit: -3%



Various incremental austerity programs and reforms are designed to improve budget deficits, strengthen longterm sovereign solvency, and inspire confidence within financial markets. Critically, this reinvigorated environment could promote perceptions of fiscal conservatism and therefore acceptance of new debt issues necessary to refinance the sizable debt maturities in 2011 and 2012. Still, by requiring countries with larger deficits and trade imbalances to “take their bitter medicine” in the form of fiscal reforms and austerity measures (which can negatively impact their economies and employment), politicians in the larger and more stable countries (i.e. Germany and France) can justify providing additional support. The sizing of the requisite support remains a circular question given the dependence on market receptivity; support must grow to match higher contagion concerns. Risks to this incrementalist approach include (i) economic or market contagion spreading to other countries and their banks, (ii) uncertainty as to the sufficiency in scale of the present rescue financings and commitments relative to future needs if additional countries such as Spain need assistance, (iii) the under-capitalized nature of many European banks, especially with unrecognized real estate losses, which could require their own rescues, (iv) the absolute and relative scale of sovereign debt loads, along with volatility of market sentiment while many countries need recurring market access to refinance large upcoming debt maturities, and (v) the impact of austerity measures and social reforms on the economy, employment, and political stability. Contagion to Larger Economies – If economic or market contagion spreads from the smaller countries of Greece, Ireland, and Portugal (collectively under 7% of Euro-Zone GDP and €620 billion of public debt) to much larger countries, the existing rescue financing facilities could be overwhelmed. For example, Spain and Italy are both larger than the sum total of Greece, Ireland, and Portugal; Spain and Italy represent 12% and 17% of EuroZone GDP and have €640 billion and €1,840 billion of public debt, respectively. This type of contagion would require immediate and immense financial support packages, especially since Spain and Italy would no longer be able to honor their €131 billion of commitments to the EFSF (roughly 30% of the total EFSF). The undrawn EFSF commitment has already shrunk from the original €440 billion to €362 billion due to announced and expected rescue packages; the withdrawal of Spain and Italy would reduce the EFSF capacity to €231 billion. This €231 billion could be added to the estimated €17.5 billion available under the EFSM, and another €125 billion from the IMF (representing 50% of the combined funds from the EMU). The resulting combined rescue capacity of €375 billion would clearly be inadequate to cover Spain, much less Italy. A Spanish or Italian financing crisis (countries with a combined GDP greater than Germany) would therefore place immense incremental pressure on Germany, France, the ECB, and the IMF to increase their support in the rescue or conceive new solutions. Uncertainty in Sizing Rescue Facilities – The initiatives to address the solvency crisis to date have increased incrementally as primary actions proved insufficient in scale. For example, the EU originally estimated Greece might need a €10 billion support program, which eventually grew to €110 billion. Ireland’s bailout package in November 2010 crystallized at €85 billion despite limited concerns from other European governments just months earlier, when Irish officials were denying the need for aid. Similarly, Portugal’s leaders repeatedly declared that the country would not need a bailout, though diminished investor confidence forced the government to request rescue financing in April 2011 (announced at €78 billion) as market financing costs increased to unserviceable levels. Given the speed and ferocity with which the financial markets can move, sufficiently sizing any rescue facility in the event of broader contagion could be a herculean task. Further, bailouts can fail almost irrespective of size due to investor flight created by liquidity concerns, as shown in the empirical work of Jeronim Zettlemeyer. Sovereign Links to the Unhealthy Banking System – Any major concerns about a country also have the potential to infect its banking system, with creditors removing financing lines and citizens pulling deposits. Given the complex international interconnections between sovereigns and banks throughout Europe (e.g. German banks lending to Greece’s government and banks), the sovereign credit concerns and solutions are intertwined

with those of the banking systems. Credit concerns in one country can quickly spread elsewhere, causing a widespread removal of liquidity from the markets and foreign banking systems. This could include the risk that higher sovereign rates, as they must refinance a wall of debt maturing in coming months as years (see graph on following page), could crowd out financing for banks. The banks in many European countries will be further challenged by the tenuous state of their capital bases – especially with the ECB changing collateral requirements and Basel III standards increasing capital requirements – and the speed of potential sentiment changes, which can outpace the speed of negotiations for government rescues. To inspire confidence in the banking system’s health, the European banks are being subjected to another round of stress testing (the third in two years) to evaluate their financial condition and depositor safety under less favorable circumstances. The first stress test results were announced for Ireland in March 2011, which unveiled significant capital shortfalls; the stress test results for other European countries are due in June 2011, though it remains to be seen if they will (for the first time) assign any potential losses on sovereign debt holdings or instill confidence in depositors and buyers of bank credit. The restructurings of under-capitalized banks will have to be undertaken concurrent with the restructuring of countries’ debts and fiscal and social policies. Any bank restructurings could result in major losses to holders of subordinated debt and equity, and even senior debt holders (though Ireland has relaxed such plans), as governments could be the only willing providers of capital. Debt Levels and Maturity Schedule – High sovereign debt levels generally correspond with weak economic growth, due partly to the reflection of inefficient spending and questionable fiscal management. With public debt-to-GDP near 100% (or greater) for certain European sovereigns, there are legitimate solvency questions, especially with the weak outlook for GDP growth and competitiveness. Further, the massive private debt level levels (which are far larger than public debts for most countries) will prove challenging to rectify, especially since much of this debt is from banks that could become wards of the state. Sovereign Monthly Debt Maturities for 2011 and 2012
Belgium € 90 € 80 € 70 € 60 Billions of € € 50 € 40 € 30 € 20 € 10 10/31/11 11/30/11 12/31/11 10/31/12 11/30/12 Rest of Apr-11 12/31/12 5/31/11 6/30/11 7/31/11 8/31/11 9/30/11 1/31/12 2/29/12 3/31/12 4/30/12 5/31/12 6/30/12 7/31/12 8/31/12 9/30/12 €0 Greece Ireland Italy Portugal Spain

Source: Bloomberg

High debt levels often leave countries particularly subject to refinancing risk. Since national debts are nearly always refinanced (they are rarely ever repaid), countries are always subject to some roll-over risk due to market conditions when they need to raise debt. As long as the capital markets remain open and the quality of a government’s credit profile is maintained, the debt can be easily refinanced. However, if investor risk aversion or

sovereign fundamentals have changed, a nation could face major challenges in refinancing, which can lead to a liquidity crisis or restructuring. Countries with large debt maturities in the near term are particularly vulnerable to such liquidity crises, as repeatedly seen in emerging market crises as well as the corporate world (e.g. assetliability mismatches were drivers in the bankruptcy of General Growth Properties and the government rescue of General Electric). The concerning countries of Europe have large debt maturities throughout 2011 and 2012, as shown above, and have actually shortened their maturity schedules since the financial and economic crisis began. Note that Italy is by far the largest (as its total debt is the largest), and that near-term refinancing needs of Greece and Ireland are covered under their respective rescue packages. Also, the large refinancing requirements for sovereigns impact the availability of capital for the private sector, which can increase the borrowing costs for banks, companies, and households. Given the elevated levels of public and private debt in many European countries, increasing interest costs could damage a borrower’s ability to pay; the ECB’s recent decision to increase rates for the first time since mid-2008 will add to financing costs across Europe. Impact of Fiscal and Social Reforms – Withdrawals of government spending through austerity measures are inherently recessionary and deflationary, which can potentially weaken employment, incomes, and trade. The austerity measures required to improve solvency could, according to multiple economic analysts, reduce annualized GDP growth by approximately 3-10% over the next one to three years. Similarly, it is possible that these moves to improve fiscal health will not have the desired impact on competitiveness or GDP growth. Further, the reductions in wages and employment can produce civil unrest, volatile popular sentiments, and greater political uncertainty (discussed further below). The public reactions to changing the deeply engrained social entitlement programs in European countries (which run far deeper than emerging markets) were highlighted by the recent violent Greek protests regarding the initial austerity efforts required by the rescue financing. These financing conditions included reducing the budget deficit from 14% of GDP to 3% by 2014 by reducing public expenditures, cutting pension payments, increasing the retirement age, raising taxes, and structural reforms. It should be noted that the required adjustments for Greece represent more than the annual government spending on military, healthcare, and education combined and directly hit entitlement programs that have become expected to sustain a certain lifestyle. Political and Public Will – The amount of coordination and cooperation necessary within the EU for a nondefault plan to be successful is a highly politicized topic that will require cooperation among the highly indebted countries and the stronger economies taking a leadership role in the union. The complexity in crafting incremental steps toward resolution of the crisis is furthered by the divergent political agendas, economies, and concerns across the countries involved. These differences include variations in domestic economic health, unemployment rates, levels of global competitiveness, anti-inflation regimes, and current account deficit levels. For example, Germany continues to push additional austerity measures as the key to a successful plan and is highly focused on an incrementalist approach (though with some willingness expressed recently to consider a Greek restructuring), while other Euro-Zone countries are pushing for a greater fiscal union and a larger backstop funding mechanism. The ECB is currently disputing the French/German view that relaxed budget rules should be in place until the crisis is resolved, seeking more automatic sanctions on high deficit nations. In addition, there is substantial political pressure and populist sentiment in certain countries to share some of the burden (and blame) on lenders to the sovereigns and banks, meaning investors could be exposed to losses rather than purely benefit from rescue financings. For example, the leader of Ireland’s Sinn Féin party (Gerry Adams) has stated the no citizen should have to pay for the “sins of the bankers.” The logistics and timeframe required for a coordinated rescue plan given the disparate domestic politics adds an additional layer of complexity in reaching resolution. The political ramifications of the austerity measures and weak economies could include voters removing leaders seen as responsible for national problems, and ushering in new leaders with no loyalty to the previously agreed rescue and austerity programs. This sort of political turnover makes the sustainability of and commitment to any rescue plan rather tenuous, despite the critical need for a

solution to stabilize national economies, liquidity, and the banking systems. Examples of this political instability include the following: • Ireland’s new government, with the Fianna Fail party losing control of Parliament after nearly 80 years of dominance, could push for changes in the terms of their recent rescue and austerity plan. The new leaders, including Enda Kenny as Prime Minister, seem more willing to compromise on tax rates and bank restructurings than prior leaders. Portugal’s Prime Minister Jose Socrates has announced plans to step down following Parliament’s rejection of his proposed austerity plan, which directly contributed to the country’s required rescue, and likely imposition of even harsher austerity measures. The ongoing negotiations of the rescue financing package will be complicated by political turnover, since the elections now scheduled for June 5, 2011 could leave certain politicians without credible authority to negotiate or form longer-term commitments for the country given they could soon be out of office. Spain’s ruling Socialist Workers Party has an extremely small majority in Parliament. The party’s leader, Prime Minister Jose Luis Rodriguez Zapatero, has declared he will not run for reelection in March 2012. Given the probability for elections in mid-2011 in a majority of Spain’s indebted semi-autonomous regions, as well as continued pressure from the conservative People’s Party (led by Mariano Rajoy Brey), Zapatero’s rule could come to an early end if austerity measures or any structural reform of pensions cause a political backlash. Belgium faces a political vacuum without an elected government leader. The N-VA party, which recently won a majority in Parliament, is openly pushing for a division of the country. Clearly, such a development would create considerable uncertainty surrounding the assumption of existing sovereign debt. Germany’s Chancellor Merkel has faced substantial pressure over decisions to support the EFSF and other rescue programs, which have been criticized as bailing out irresponsible and undisciplined governments. While her next election is not until 2013, her political power has weakened with defeats to her political party in recent regional elections. Although Finland is a small EMU member (under 2% of GDP of the EMU), the recent electoral victories of the conservative True Finns party could upset negotiations regarding the financial rescue of Portugal and future government rescues. The True Finns have campaigned on firm opposition to government rescues, which generally require unanimous approval among EMU members. Even the leadership of the ECB has been called into question with current President Jean Claude Trichet’s term ending in October 2011. The front-running candidate to replace Trichet, Germany’s Axel Weber, bowed out of the process and was removed from his position as President of the Deutsche Bundesbank, further complicating the succession process. This could lead to further fragmentation in the countries bearing the burden of austerity.

Notwithstanding the political risk to the parties in power with a weaker economy and sustained decline in entitlements, the public tolerance to enable multiple years of frugality is highly suspect. Elections are often decided by the strength of a country’s economy and level of unemployment, with weaker nations often experiencing political turnover as citizens and leaders call for new elections to unseat incumbent officials. The conflicts between countries and the complicated logistics for resolution is a major challenge to avoid contagion which would produce negative consequences for economies within Europe and potentially around the globe. Market Sentiment and Bad Luck – John Maynard Keynes stated in The General Theory of Employment, Interest and Money, “there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, where moral or

hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits.” These “animal spirits” are critical, yet highly subjective and potentially volatile, elements of sentiment that influence human behavior and consumer and business confidence. In times of economic crisis, such changes in sentiment can turn investors away from certain borrowers and financial markets based on either rational or irrational fears. For the Preferred European Solution to work, these critical yet highly subjective and potentially volatile animal spirits must remain tethered to maintain a certain level of confidence and prevent a self-fulfilling crisis as governments and banks face large near-tem debt maturities that require orderly refinancing markets. Additional Shocks and Uncertainty – Additional shocks that could impact market sentiment or the economic outlook include the recognition of banking losses, political and economic problems in non-European countries (e.g. Egypt highlights that political turmoil in the region could impact the flow of oil supplies), higher inflation that could prompt the ECB to raise interest rates, the impacts of large and long-term unemployment, to name just a few. These types of risks factor into the longer-term likelihood of success for the various rescue and reform initiatives. These longer-term questions include the following: • • • • • • • • • • What impact will austerity measures have on the economic performance of affected nations? What would be the political and financial repercussions of another potential European recession? What will be the effect on economies and sentiment of removing the government financing packages? What levels of support and rescue facilities will be deemed adequate by the financial markets? What levels of support will governments within or outside Europe be willing to provide? What will be the financial role of the ECB and IMF? How will upcoming elections affect the political will to sustain the austerity plans? How will under-capitalized banks be repaired (particularly in Spain and Ireland) given the circular ties to sovereign stability? Will investors continue to support refinancing requests to prevent a sovereign liquidity crisis? Beyond addressing near-term liquidity, how will over-leveraged sovereigns ever achieve sustainable debt service on market terms?

Given these and many other unknowns combined with the magnitude of the problems and public intolerance for reduction in entitlements, there is a considerable likelihood that certain sovereigns could face fundamental debt restructuring over the longer-term, although the preferred incremental solutions are likely to address liquidity concerns and market sentiment in the near term. Debt restructurings are likely to produce losses for investors; however, a well implemented plan that is executed to avoid shocks to the system, and well communicated to the capital markets, can be deemed both cooperative and friendly to investors.

There is a meaningful probability that certain countries in the Euro-Zone will be unable to avoid restructurings of either sovereign debts or banking system obligations over the longer term given the excessive leverage, questionable prospects for growth and fiscal deficits, political changes, public opposition to austerity measures, and the subjectivity of market support. Greece exhibits a classic debt spiral, with historical and projected debt growth exceeding nominal GDP growth, producing a more unsustainable leverage profile over time (debt-to-GDP is expected to exceed 159% in 2012). If history is any guide, a longer term solution for Greece and other similarly challenged countries will entail both internal policy actions on deficit reduction, long term strategic changes affecting pensions and public entitlements, and some form of debt restructuring. As experienced by many emerging markets historically, debt restructurings are realistic means to rectify unsustainable debt service

obligations and a lack of refinancing capabilities to address liquidity and solvency issues over the near and long term. These restructurings have included various combinations of debt forgiveness, discounted debt repurchases, coupon reductions, principal reductions, and maturity extensions. Restructurings could occur piecemeal on a country by country basis, or allow multiple countries to utilize a common restructuring plan as occurred under the Brady Bond Plan. This also applies to the banks, where restructurings could be handled individually or across a broader network of financial institutions. Greece is the most likely sovereign to need a restructuring in the near term, which seems likely to take the form of debt maturity extensions, potential with reduced interest rates coupled with principal reductions. Among banking systems, Ireland is farthest along the restructuring path, with various principal reduction, rate reductions, and maturity extensions underway. Another possibility for a distressed country is to withdraw from international financial markets and fund internally, though this is less likely in the present crisis given the scale of the problem, continuing funding needs, the inability to conduct monetary policy, and the likely ensuing debt default, capital withdrawal, and negative impact on trade, businesses, and the citizenry. For example, Argentina repudiated outstanding debt and withdrew from the global financial marketplace in 2001; this hostile approach prevented them from accessing markets for nearly a decade. Logistically, the improvements to debt servicing abilities through such a restructuring strategy could be executed through multilateral negotiations with creditors prior to default, although a wholesale default can also precede restructuring discussions. These historical negotiations have often been coordinated by the IMF, which could play a similar role in the future. The most common historical method of restructuring sovereign and bank obligations is a coercive exchange of existing debt for new debt which results in a substantial present value savings at the expense of the creditors. The exchanged debt generally has lower coupon payments, extended maturities, lesser amortization requirements, and/or lower principal amount owed. The main element of debt service is the required repayment of principal, thus the most critical element of restructuring is the timing of these required payments; lowering coupons on nearterm debt that cannot be refinanced anyway would accomplish very little. As seen in the Uruguay crisis described in Section 7, the debt exchange could treat domestic and foreign lenders equally and provide lenders with longer maturity bonds with no reductions in coupons or principal. This form of restructuring would provide troubled European sovereigns the requisite time to improve current account deficits and fiscal deficits and remove nearterm liquidity and refinancing issues while minimizing harm to investors. Given the current low interest rate environment, this type of restructuring could lock in the current low rates for much longer dated instruments. While this can solve liquidity issues in the near term, it does not address fundamental underlying issues of solvency or fiscal deficits given that interest costs remains unchanged. In contrast, Russia’s default in 1998 and Argentina’s in 2001 led to reduced principal owed through exchange offers. These par reductions could be paired with some ability for lenders to mitigate their losses by providing participation in a country’s recovery, such as Argentina’s attachment of warrants tied to GDP growth on restructured debt.

Unlike the typical solutions to sovereign debt crises – either default or providing incremental liquidity as needed – other solutions up for discussion include issuing Euro-Zone bonds (obligations for the collective EMU rather than individual countries), a rescue resembling the Brady Bond Plan, a country leaving the EMU, pursuing inflation to effectively reduce to debt burden, government issuance of new debt ranking ahead of existing debt, and governments raising capital by selling state-owned enterprises to reduce debt. These options are discussed below. Brady Bonds for the Euro-Zone – A plan similar to the Brady Bond Plan (described in Section 7), could allow countries to resolve burdensome debt obligations by extending maturities to 30 years; this could achieve net present value savings of approximately 30% of the pre-existing obligation by reducing coupons and/or outstanding principal. These EU Bonds would be backed by support from some or all other Euro-Zone countries

(or potentially other international groups), allowing for higher ratings and lower interest costs on the debt. This plan presumes that the support (whether consisting of guarantees or collateral, which could be long-dated zerocoupon high-rated sovereign bonds) would provide comfort to investors, but would ultimately not be needed given an expected economic recovery or deficit controls of the government in question. Only in the case of default on the new notes would the guarantors or collateral be called upon. The country issuing the new notes would hypothetically benefit by lowering their interest burden (compared to the open-market rate), while banks would also benefit via capital relief since the newly exchanged debt would carry AAA ratings rather than the country’s present sovereign rating. The Chairman of Eurogroup (Jean-Claude Juncker), which is the group of finance ministers for Euro-Zone members, has discussed a version of this plan as a viable option (summarized graphically below). This proposed plan would allow countries to receive up to half of their borrowings (and up to 40% of GDP) from an EU debt agency capitalized by issuing bonds backed by all EU members. Investors could also exchange debt of the offending country in question for debt of this EU agency, if sovereign actual or perceived credit risks increased, at discounted levels determined on a case by case basis. How Euro Bonds Would Work

Source: Der Spiegel Online, December 2010.

Euro-Zone Bonds – For an individual country, the ability to lower high financing costs might be achieved by issuing debt backed by a broader group of sovereign entities seen as more creditworthy. In the present European crises, this could involve the collective Euro-Zone issuing bonds, with proceeds used to repay an individual country’s debt. However, this plan has naturally met staunch opposition from Germany and France given they represent nearly 49% of the Euro-Zone’s GDP and hence would be lending their creditworthiness to other countries, and providing major benefits to troubled countries while assuming more liabilities themselves. Also, this type of bond plan could increase the risk that the failure of one country or banking system could drag down the whole Euro-Zone. Clearly, this could endanger the credit standing of Germany and France, driving their borrowing costs higher. For example, an increase of 100 bps in Germany’s borrowing cost on their €2.0 trillion of public debt would cost them €20 billion of additional interest. Political leaders in Germany have spoken

against any joint bond plan, as the leader of the Christian Social Union party (Alexander Dobrindt) stated that “Euro bonds are just a code name for cash-strapped euro countries blatantly reaching into the pockets of German taxpayers.” Prime Minister Merkel said in December 2010 that joint bond sales are “not at all compatible” with EU treaties. For Germany to consider this type of plan, it could require direct oversight over other countries’ fiscal spending which would be very unlikely to be granted. Inflation or Currency Devaluation – Historical sovereign crises have been connected with eventual currency devaluations, particularly when countries had limited monetary policy flexibility such as constraints on currency exchange rates (e.g. effectively transferring monetary policy to another country or entity such as the ECB for the Euro-Zone or using a pegged band versus the U.S. dollar). While currency devaluation can improve the competitiveness of an economy and potential GDP growth over time, it almost universally leads to sovereign debt defaults for heavily indebted countries, especially if the country has significant debt denominated in a foreign currency. The currency devaluation effectively increases the scale of such foreign currency denominated debt. For lesser-indebted countries, pursuing devaluations to jumpstart growth or improve current account deficits can promote reactionary devaluations from competing countries and eventual currency wars. Europe is unlikely to promote any significant devaluation given this potential international reaction. Furthermore, unlike a small country pursuing devaluation, the euro’s role as one of the main global currencies, with the inherent massive and complex interconnections among global financial institutions and economies, would have large and potentially unintended consequences. Similarly, promoting inflation can be another means attempted by governments to grow an economy out of an overleveraged situation. This tends to have limited effectiveness due to resulting higher interest rates (which can damage fiscal budgets) and changes in exchange rates (which can hurt economic performance and capital flows). Also, pursuing intentional inflation often causes political destabilization along with fears of hyperinflation. Germany’s experience with extreme inflation after World War I has left them with staunch anti-inflationary policies, which have become the ECB’s strict policies to maintain a vigilant focus on inflation. As a result, it seems highly unlikely that Germany would allow such a policy within Europe. In fact, the ECB has recently raised interest rates for the first time since mid-2008 to counter increased commodity inflation, even though certain European economies remain quite depressed. Withdrawal from EMU – There are no provisions under the Maastricht Treaty at present for a member state to be expelled from the EMU; nor are there provisions stopping a country from dropping out of the EMU, which has been speculated for Greece and other troubled countries. Theoretically, a member country could choose to drop the euro and create a sovereign currency to regain control over exchange rates and other monetary policy matters to better influence its specific economy. This could be done as an attempt to improve competitiveness via currency devaluation, but for an overly leveraged country such as Greece, devaluation would virtually guarantee default since the then foreign-denominated debt would skyrocket. Still, the logistics to leave the EMU, or effectively leave by adopting a dual-currency regime, could be as simple the government passing a law that wages of public workers, welfare checks, and government debts would henceforth be paid in a new currency, convertible at an official fixed rate. Such a move would be convoluted at best, similar to trying to withdraw from international financing markets. Deciding to leave the EMU would have to consider continuing funding needs, capital withdrawal, likely debt default, negative economic impacts on businesses and the citizenry, impact on trade volumes with neighbors (e.g. currency devaluation for a weak country could help its exports but damage the exports of its neighbors), removal of travel benefits and trade efficiency within the EMU, political fallout, legal challenges, transaction/switching costs, and agreement on new exchange rates. Given these complications, this scenario is quite unlikely as it would carry highly negative consequences for the withdrawing country and the greater euro region. The exit or removal of a Euro-Zone member would defeat decades of efforts to promote economic and political unity among EMU members and trigger questions about who would next leave, potentially causing the downfall of the entire union which has proven so beneficial to so many for so long. However, a

country could still be willing to chance these disadvantages if they believed they had little international support and few attractive alternatives. Issue New “Priming” Debt – Although countries generally do not include absolute priority structure in their sovereign financing, this is the standard for corporate debt. As for strained companies in need of liquidity, new capital might only be available if it is better protected than existing obligations. Within the sovereign debt markets, this concept already exists as IMF debt is considered senior to existing obligations. The provision of this additional capital can also require that other debt holders, in order to receive the benefit of additional liquidity for the borrower, agree to restructure the amounts of their principal or the timing of their maturities. The superior positioning of this new capital can derive either from having (i) earlier maturities than other debt, (ii) explicit language stating its superior priority in payment, (iii) repayment from designated and assured tax revenue streams, or (iv) collateral in the form of specific assets which could include government stakes in utilities, banks, land, toll roads, phone companies, airport, train operators, casinos, or other assets. Asset Monetization of Non-Core State Assets – Rather than providing sovereign assets as collateral, another alternative for a country to meet debt service obligations would be to divest assets. Many sovereigns have vast wealth tied up in corporate entities, financial institutions, real estate, and infrastructure assets which could be monetized and used to improve liquidity or repay debt. We do not expect Greece to sell any of its national treasures or islands, but we do expect various countries to divest non-core assets in order to raise capital. For example, Greece has stated they will raise €50 billion from asset sales by 2015, including stakes in telecom companies, electric companies, casinos, train operators, and airports. Forcing Aid from Other Countries – Given the litany of unattractive alternatives facing overleveraged governments with few hopes of attaining solvency, pressured governments could also choose to do virtually nothing in terms of pursuing reforms or cooperating with neighbors. This could be a paradoxically effective means of negotiation if a government viewed itself as having little downside from delay tactics while possessing the ability to inflict major downsides on its neighbors. For example, a small country could be unwilling to compromise or pursue various austerity measures or necessary reforms if they believed such actions could jeopardize the entire EMU. This unlikely course of action would force others (particularly countries that massively benefit from the existence and policies of the EMU) to compile solutions for and potentially provide funding to these unreasonable countries.


The situation facing European sovereigns and banking institutions is critically important for investors given the ramifications for regional and global economies, currency exchange rates, and the prices and volatility of European assets and securities. Sovereign debt is the largest debt market in the world, exceeding $50 trillion. Within the Merrill Lynch Global Broad Market Bond Index, sovereign debt accounts for 50% of the $40 trillion par value, with quasi-government obligations accounting for another 12% or $5 trillion of the index. Given the size of the sovereign market and the usage of sovereign debt as the benchmark for nearly all other credit pricing, many investors have significant exposure to sovereign debt risk, whether intended or not. Although the U.S. and Japan each account for roughly 25% of the sovereign markets, the largest changes to sovereign risk pricing and global market volatility have emanated from the European countries that account for roughly 25% of the sovereign bond market. Sovereigns are a major component of the $23.4 trillion credit opportunity set connected to the present European debt crisis. As shown below, the opportunity set includes $5.0 trillion of sovereign debt and $4.9 trillion of non-financial corporate debt within the six European countries with the highest CDS spreads (note that this excludes other idiosyncratic corporate credit opportunities in less troubled countries). These six countries also account for $3.7 trillion of the $13.5 trillion debt of financial institutions in Europe, with the remainder from troubled banks of Germany, France, and the U.K. Opportunity Set for European Debt: $23.4 trillion
Sovereign Debt: $5.0 trillion
Ireland Greece Portugal Italy

Financial Debt: $13.5 trillion
Greece U.K. Ireland Portugal Spain

Corporate Debt: $4.9 trillion
Greece Ireland Portugal Belgium








Source: IMF, National Central Banks, Marathon estimates for corporate debt. Note: Using exchange rate of 1.45 U.S. dollars per euro and 1.65 dollars per U.K. pound.

Given the funding pressures facing peripheral European countries, yields and spreads on sovereign bonds will entail continuous monitoring as governments work to address the challenging fundamental and financing conditions. Increases in sovereign yields have the potential to create a cycle of increasing government debt service requirements, with heightened investor concerns increasing the probability of sovereign defaults. The numerous governmental programs to date have sought to mitigate investor concerns and the resulting credit spreads. Presuming that markets cooperate, the solution to the excessive debt levels and weak economic performance will require comprehensive coordination and extended funding commitments among governments, the ECB, the IMF, the EMU, along with the newly created EFSF and ESM. The most likely solution, and assuredly the solution preferred by European authorities, is to provide incremental liquidity from a combination of funding lines and monetary support, while allowing banks to deleverage and governments to pursue internal austerity measures and reform fiscal and social policies. However, if market conditions or a lack of liquidity complicate the ongoing stabilization efforts, one or more countries will likely face restructuring of sovereign debts in addition to the ongoing bank restructurings.

In the months and years to come, investors will be faced with both downside risks and upside opportunities across a variety of asset classes. Flexible investors with expertise in distressed situations and sovereign restructurings (all in emerging markets in recent decades) possess the requisite guideposts to capitalize on relative value mispricing, deep-value distressed opportunities, and hedging strategies in what could be a potentially volatile environment. As shown repeatedly in historical sovereign defaults, the risks facing investors also present opportunities spanning the sovereign, financial, and corporate sectors. Within sovereigns, there are likely to be long and short trading and investment opportunities in cash bonds and credit derivatives. Since banks are among the largest corporate entities in nearly every country, they are invariably connected to many of the trading and investment opportunities going forward, either through asset sales (single assets or portfolios), restructurings, capital raises, or liability management exercises. Within the banking sector, and the broader corporate debt market, opportunities are likely to include long and short positioning in credit derivatives and purchasing higher quality corporate bonds (benchmarked off sovereign debt) at distressed pricing due to actual or perceived contagion fears. We elaborate on certain potential trading and investment opportunities below. OPPORTUNITIES WITHIN BANKS Many of the opportunities among bank assets and capital structures are connected to both their under-capitalized position and regulatory reforms as required under Basel III standards. These standards are expected to be finalized during 2011 and phased in during 2012. These changes include more strict requirements for capital levels, asset liquidity, risk-weighting of assets, and reserves on assets available for sale. Further, the ECB changed collateral requirements effective January 2011 to reduce eligibility of riskier, less liquid, and longermaturity assets, which also requires banks to deleverage by selling non-core assets. These changes are intended to provide greater stability to the banking system by increasing cushions against losses and promoting confidence within capital markets; however, the near-term impact of these new standards could be muted since they are expected to be phased in gradually through 2019. Sample of Selected Asset Disposal Efforts
Institution Banco Espirito Santo (Portugal) Commerzbank (Germany) Erste Abwicklungsanstalt (Germany) Mechanism In-house activity In-house activity “Winding-up” agency established to process €77 billion of WestLB’s nonstrategic businesses/assets. “Winding-up” agency for €210 billion of assets from Hypo Real Estate In-house activity In-house activity Disposal Transactions €2.5 billion of project finance loans in Europe and U.S. Various Various

FMS Wertmanagement (Germany) Lloyds Banking Group (U.K.) Royal Bank of Scotland


Sold various leveraged finance positions €1.4 billion of leveraged loans; £400-500 million of mezzanine loans; £1 billion Spanish commercial property loans.

The over-leveraged and under-capitalized position of many European banks, particularly in Spain and Ireland (but also well evidenced in Germany, France, the U.K. and Italy), is expected to provide investment opportunities as

banks are forced to meet increased capital requirements under Basel III standards. This could result in either raising additional capital, restructuring debt, exchanges of junior securities, or selling assets. The asset divestitures would likely focus on non-core divisions and assets and/or assets assigned higher risk weightings; foreign and illiquid assets are expected to be the primary assets for sale. Purchasing large portfolios of discounted assets is generally reserved for larger investors that have the (i) capital to make such purchases, (ii) expertise to manage such assets, and (iii) relationships to source such opportunities. Asset divestitures can be sourced (i) directly from banks, (ii) from relationships with managers of segregated “bad assets” (e.g. NAMA in Ireland), and (iii) dealings with government officials and entities. Selected asset disposal efforts are underway, having already commenced with several transactions pending in 2011, as highlighted above. In addition to portfolio sales, the need to rectify the over-leveraged and under-capitalized position of many European banks will also provide trading, relative value, and liability management opportunities within their capital structures. These liability management exercises could simplify the overly complicated capital structures of many European banks to create more common equity (Core Tier 1 Capital) by tendering or exchanging multiple existing layers of subordinated term debt (Lower Tier 2 Capital), preferred and hybrid shares (Upper Tier 2 Capital), non-redeemable perpetual preferred equity (Lower Tier 1 Capital), and other junior securities. However, these exchanges can be complicated by (i) the European banking regulatory structure, which is driven by national bank regulators within each country and overseen by the supranational European Commission, and (ii) the favorable treatment of shareholders under various European regulations, which generally requires shareholders approval prior to dilution (though regulators can force an exchange in certain cases). This voting requirement for common shareholders, despite representing a potentially small relative market value, can disrupt a necessary exchange among the much larger tranches of Tier 1 or Tier 2 capital. However, completion of such exchanges can boost real equity cushions and improve overall value to investors, potentially presenting an opportunity to purchase undervalued discounted junior capital where such exchanges or other value creation events are more likely. These actions can also result in the recommencement of distributions on heavily discounted junior securities, leading to price appreciation. The opposite situations also appear, where over-valued junior capital provides for attractive short opportunities as certain securities could be impaired or heavily diluted in the restructuring, or the exchanges could fail and thus create significant downside price movement. CREDIT DERIVATIVES Credit default swaps (CDS) are the most common type of credit derivative. CDS allow buyers and sellers to either decrease or increase exposure to underlying sovereign or corporate entities over a specified timeframe. The buyer pays periodic fees in order to receive payments intended to offset losses on the underlying credit in the event of a defined credit event (a “default”) over a specified period. The default trigger is defined as any breach of payment obligations, any payment moratorium, and generally includes involuntary restructurings; debates about whether a default has occurred (e.g. voluntary exchanges by sovereigns) are settled by a vote among dealers. The CDS price implies a probability of default per year and cumulatively over the specified period, which roughly mirrors the changes in underlying bond spreads. Like sovereign bonds, sovereign CDS pricing has shown significant volatility over the past year (see following chart), with Greece’s 10-year CDS levels near record highs, implying a cumulative default probability of 83%. We discuss credit derivatives in greater detail in the Appendix given their relatively recent evolution and complexity in mitigating exposures or exercising directional views. Investment strategies using CDS on single credits or indices can include bullish or bearish credit views (e.g. shorting CDS with a view that spreads will decrease), basis trading (e.g. CDS spreads versus cash bond spreads), relative value views between credits, relative value within a capital structure (e.g. secured loan versus unsecured bonds versus equities), views on the timing and outcome of defaults, views on the credit’s yield curve or CDS curve, macro views (e.g. financials versus sovereigns), or views on credit volatility. With sovereign CDS, the most common strategies are outright views on the timing and probability of default, as well the basis trading and curve trading.

Ten-Year CDS Spreads for Selected European Sovereigns
Greece Ireland Portugal Spain Belgium Italy France Germany


1,000 CDS Spreads (bps)





0 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11

Source: Bloomberg

DISCOUNTED BONDS Investment opportunities in sovereign, corporate, and finance company debt can be created when significant risk premiums are built into the yield and price curves. Bond prices are sensitive to changes in yield, though when bond prices are heavily discounted, the larger driver of prices can be improvements in underlying credit quality. Investors purchasing discounted bonds (with possibilities evident for certain troubled sovereigns in the following graph) can exchange them with the borrower at higher price levels, though still a substantial discount to par, which could benefit both the borrower and investor depending on entry prices and circumstances of exchange. Price Curve (% of Par) for European Sovereign Bonds
110% Greece Ireland Portugal Spain Italy Belgium

100% 90% 80% 70%

60% 50%

40% 1 2 3 5 7 Years to Maturity 10 15 20

Source: Bloomberg Note: Calculated using market yields and assuming a 4.5% coupon.


SUMMARY OF INVESTMENT STRATEGIES Across the broad investment strategies in the potentially volatile environment to come, investors with the requisite long and short flexibility and experience with CDS and restructurings are likely to find many attractive opportunities in the gargantuan fixed income markets for banks, and corporates, and sovereigns. The main trading and investment opportunities can be summarized as follows: • Positioning through selected bonds and CDS of sovereign credits, focusing on the six challenged European countries discussed in this report. Opportunities include trading sovereigns based on credit levels, volatility, relative value, dislocated pricing, and catalysts such as debt maturities, political developments, and exchange offers. Long-biased opportunities are likely to emerge from distressed and restructuring sovereigns, focusing within the six peripheral European countries discussed in this report. These opportunities include capitalizing on pre-transaction discounts before exchange offers and buybacks, debt trading below recovery value, and proactive solutions negotiated directly with borrowers. Positioning in bank capital structures throughout the 27 EU countries based on asymmetric return profiles. This requires identifying the stronger and weaker institutions through fundamental bottom-up credit analysis. Opportunities within bank capital structures are expected as weaker institutions recapitalize via capital raisings, exchange offers, and liability management exercises. These opportunities are likely to be concentrated within Ireland, Spain, the U.K., and Germany. Purchasing assets from European banks as they deleverage in accordance with Basel III standards. Divestitures include performing and distressed single assets and portfolios such as corporate debt, real estate debt, and structured credit deemed either non-core or punitive in terms of required capital. Sourcing of such assets often involves direct, proactive, solutions-based dialogue directly with sellers. Sellers are largely concentrated in nine countries, including the six peripheral countries detailed in this report plus the U.K., Germany, and France. Positioning in corporate credit including idiosyncratic and special situations across dislocated credit, distressed credit, and capital structure opportunities including companies (i) in bankruptcy or facing restructurings and/or reorganizations, (ii) engaged in turnaround situations due to industry downturns or operational turmoil, and (iii) with other discrete and idiosyncratic events, situations, and attractive riskreward credit pricing. This strategy can provide deep value opportunities with significant discounts to fundamental or recovery value, including companies and securities adversely affected by sovereign contagion.


The European crisis among sovereigns and financial institutions developed as a confluence of factors building for many years. The fall-out from the severe recession of 2008 and 2009 further contributed to a banking liquidity crisis that broadened into impaired solvency of many European banks. Solvency concerns among banks also spread to selected European sovereigns (particularly Ireland), as they could be forced to rescue the troubled banks by providing capital or guarantees that could transfer large banking liabilities onto the government. Of course, certain countries already had their own significant longer-term problems such as declining competitiveness and high debt loads and deficits (particularly Greece). Increased market concerns led to higher sovereign bond yields that eventually forced rescue financing packages for Greece, Ireland, and Portugal (€100 billion, €85 billion, and €78 billion, respectively), and the unprecedented €750 billion rescue facility from the IMF and EMU members to allay contagion fears from spreading to Spain, Italy, and Belgium. Although this rescue facility initially calmed markets by boosting available liquidity, deeper concerns have emerged surrounding the solvency of troubled countries. Bond yields and CDS prices for Greece, Ireland, and Portugal remain near record highs as investors foresee considerable probabilities of fundamental restructuring. However, the much larger economies of Spain and Italy have seen improved market sentiment with decreased CDS prices and bond yields as contagion fears have ebbed. These countries (each with economies and public debts significantly greater than Greece, Ireland, and Portugal combined) are the critical lines of defense that must be maintained in order to stabilize the EMU. The concerns over EMU stability emanate from the insufficiency of the present financial rescue package, and possibly the successor plan, to handle the scope of a Spanish sovereign default, much less any necessary rescue of their banking system. A failure of Spain could produce a crisis of confidence jeopardizing Italy, and therefore affect many others in Europe and beyond given the interconnected financial relationships, which could threaten the entire political and economic union within Europe and all the benefits it has produced. As a result, European authorities have taken substantial preemptive measures to contain the fears of sovereign vulnerability. The resolution of the European sovereign crisis will require calming markets to avoid a liquidity crisis triggered by inability of any sovereign or major European bank to refinance maturing debt. The series of financing and austerity initiatives to date have calmed credit markets, though CDS spreads and bond pricing continue to indicate significant concerns about selective eventual defaults. The near-term solutions to prevent further contagion, narrow credit spreads, and resolve liquidity concerns will likely include definitive bank restructurings (as underway in Spain and Ireland) and additional financing packages from governments, the IMF, the ECB, and potentially new supranational agencies, somewhat consistent with the incremental initiatives announced to date. This additional funding will carry strict conditions for borrowers, without which countries such as Germany may be unwilling to participate. Risks to this plan include the unclear providers of funds and unclear amounts of funding required, especially given the count of countries facing growing debt loads paired with a weak economic outlook. The weak outlook results partly from the austerity measures, inability to control monetary policy, high unemployment, and weak competitiveness. Further, any solutions will take time, presenting additional risks as government stimuli and funding are eventually withdrawn, and the sustainability of political commitments is questionable with likely political turnover to come. The policy response thus far has been one of bail-out and containment. However, fundamental sovereign restructurings (especially for Greece) are increasingly likely. For investors looking to allocate capital in these potentially volatile times, there may be opportunities through long and short positions in sovereign debt, asset divestitures by financial institutions, banking restructurings and recapitalizations, and potentially within undervalued European corporate bonds, as seen in historical sovereign defaults. The lessons from past defaults within the emerging markets could provide critical guidelines for developed markets, including the importance of (i) providing excessive liquidity to quell concerns, (ii) the impacts of contagion and importance of addressing investor concerns, (iii) the economic, fiscal, market, and political consequences of excessive indebtedness and a troubled banking system, (iv) the multitude of causes, many of which are shared within Europe, including the dangers of foregoing monetary policy, and (v) the variety of restructuring alternatives, including the means to

pursue efficient and effective debt restructuring negotiations. While debt restructurings may be unavoidable, a deft handling of the restructuring process can minimize harm to investors and citizens, prevent further contagion, and enable European countries and banks to stabilize and recover.


The European Sovereign & Financial Debt Crisis: Evolution, Solutions, and Opportunity White Paper Second Quarter 2011 Written By Bruce Richards and Andrew Brady

With further contribution from Matthew Breckenridge Cynthia do Nascimento James Doswell Jason Friedman Louis Hanover Fernando Phillips Richard Ronzetti Gabriel Szpigiel Philip Thomas


APPENDIX: CREDIT DERIVATIVES A credit derivative is a financial contract between two parties allowing each to increase or decrease exposure to an underlying single credit or basket of credits, which can be either sovereign or corporate entities, over a specified timeframe. Among many types of credit derivatives, the most common is the credit default swap (“CDS”), which provides payment from the seller to the buyer in the case of default by the underlying credit (i.e. the reference entity). The CDS market has grown exponentially over the past ten years due to increasing acceptability, increased understanding, diversification of participants, liquidity advantages over the cash markets, the attractiveness of protection against defaults, standardization of documentation, and the growth and flexibility of product applications. Investors use CDS as a synthetic credit market to express views not easily available in the cash credit markets, and have advantages over cash bonds including known duration (whereas cash bonds can have embedded options that allow refinancing at unknown times, or allow investors to force bond repurchases prior to maturity), known cash coupons (paid quarterly in cash versus bonds generally paying interest semi-annually and potentially in non-cash interest), lower capital requirements, and purity of default pricing. Regarding this last point, CDS spreads reflect views of default risk, as do bond spreads. However, whereas bond spreads are the yield above a risk-free rate (which is a function of credit risk, funding costs, and interest rate risk), CDS spreads just reflect credit risk and therefore are more pure indicators of pricing for default protection. Further, principal losses on certain bonds trading at premiums or discounts to par can be very different from that implied by CDS. This would include bonds trading at low prices with below-market coupons and long-dated maturities; buyers of such bonds would face less principal loss upon default given the price is much closer to the recovery rate for pari passu bonds maturing earlier which had similar yields but higher prices. The CDS buyer is said to buy protection or short credit risk. The buyer pays a periodic fee in order to receive payments that make up for losses on a reference entity following a credit event. Credit events include bankruptcy, failing to pay outstanding debt obligations, or other debt restructurings such as reductions of interest or principal, postponement of interest or principal, changing currency of repayment, or contractual subordination. Buying protection is similar to shorting a bond in that the purchaser of CDS benefits if the reference entity exhibits higher credit spreads or defaults, assuming creditors would recover less than par in a restructuring. The CDS seller is said to sell protection, which has a similar profile to owning bonds or going long credit risk. The seller collects periodic fees and profits if the underlying reference entity exhibits narrower credit spreads or does not default during the CDS term. Given that credit derivatives are bilateral agreements between a buyer and seller, they introduce risk that the trading counterparty will not honor their payment obligations; this risk is mitigated by required collateral posting, and could be further mitigated in the future by forming a CDS clearinghouse. In addition to specifying a reference entity, CDS contracts between two parties cover a set notional principal, and have stated maturities, coupons, and payment dates. Although CDS can have any maturity, the most common is five years for corporate credit and ten years for sovereign credits. The periodic fees for CDS are generally exchanged in March, June, September, and December. These fees are called the CDS spread or price, and are expressed in basis points (bps) on an annual basis. These spreads are multiplied by the notional principal to determine the periodic cash flows. For example, if a CDS contract for $10 million of notional principal for a given high-yield reference entity has a CDS spread of 500 bps, the buyer is obligated to pay $125,000 or 125 bps each quarter.


Credit Default Swap Summary
Risk (Notional)

Reference Entity Investor B Protection Buyer -“Short risk” -Buy default protection -Buy CDS -Pay Periodic Payments
Credit Risk Profile of shorting a bond
Source: JPMorgan

Periodic Coupons

Investor 5 Protection Seller -“Long risk” -Sell default protection -Sell CDS -Receive Periodic Payments
Credit Risk Profile of owning a bond

Contingent Payment upon a credit event

CDS require no upfront payment if the stated coupon is equal to the market yield. However, with the standardization of CDS coupons at 100 bps for sovereign and investment-grade credit and 500 bps for high-yield credit, upfront cash flows are usually required. This payment is calculated as the present value of the difference in cash flows on the notional principal using the stated coupon and CDS spread. If the market spread is below the coupon rate, the CDS seller (long credit risk) must pay; if the market spread is above the coupon rate, the CDS buyer (short credit risk) must pay. To calculate the upfront payment, the CDS cash flows are discounted by both the risk free rate and the probability of default. The probability of default must be factored in since the periodic CDS cash flows would end upon default. For example, a seller of five-year CDS on $10 million notional principal at 500 bps would realize a profit of roughly $420,000 if the spread decreased to 400 bps. This profit is similar to that produced by a 100 bps tightening of spreads for the owner of five-year bonds with a 5% coupon and yield. This CDS profit is calculated by summing up the discounted net $25,000 quarterly cash inflows (i.e. the 100 bps annually on $10 million) over the next five years by the U.S. Treasury swap curve and multiplying each value by the survival probability through each period (i.e. 1 - default probability). The default probability per year is roughly calculated as the market spread divided by the loss rate (i.e. 1 - recovery rate). Given the 400 bps CDS spread mentioned above, and a recovery rate of 40%, the annual default probability would be 6.7% (i.e. 0.04 / (1-0.4)), and the cumulative default rate over the five year term would be 33% (i.e. 6.7% per year * 5 years), as shown in the following table. The market standard assumed recovery rate is 40% for corporate and sovereign bonds (25% for Latin American sovereigns), which provides uniform agreement on CDS pricing, although actual recovery rates will differ. Another way to think about cumulative probability of default is to consider that an investor should not pay more for protection than the likely value of that protection. As an example, if an investor believes that a credit is likely to produce a 50% recovery in the event of default, they should not pay over 1,000 bps per year over a five-year term since they would pay a cumulative 50% of the notional to counter a 50% loss, thereby ensuring a 50% loss rather than providing any mitigation of credit losses. As shown in the table below, paying 1,000 bps annually for five years implies a 100% probability of default over that term, assuming a 50% recovery rate.


Implied Cumulative Probability of Default Over 5 Years
CDS Spread 40% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50% 4.00% 4.50% 5.00% 5.50% 6.00% 6.50% 7.00% 7.50% 8.00% 8.50% 9.00% 9.50% 10.00% 10.50% 11.00% 11.50% 12.00% 12.50% 0% 3% 5% 8% 10% 13% 15% 18% 20% 23% 25% 28% 30% 33% 35% 38% 40% 43% 45% 48% 50% 53% 55% 58% 60% 63% 10% 3% 6% 8% 11% 14% 17% 19% 22% 25% 28% 31% 33% 36% 39% 42% 44% 47% 50% 53% 56% 58% 61% 64% 67% 69% 20% 3% 6% 9% 13% 16% 19% 22% 25% 28% 31% 34% 38% 41% 44% 47% 50% 53% 56% 59% 63% 66% 69% 72% 75% 78% 30% 4% 7% 11% 14% 18% 21% 25% 29% 32% 36% 39% 43% 46% 50% 54% 57% 61% 64% 68% 71% 75% 79% 82% 86% 89% 40% 4% 8% 13% 17% 21% 25% 29% 33% 38% 42% 46% 50% 54% 58% 63% 67% 71% 75% 79% 83% 88% 92% 96% 100% 100% Recovery 50% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100% 100% 100% 100% 100% 100% 60% 6% 13% 19% 25% 31% 38% 44% 50% 56% 63% 69% 75% 81% 88% 94% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 70% 8% 17% 25% 33% 42% 50% 58% 67% 75% 83% 92% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 80% 13% 25% 38% 50% 63% 75% 88% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 90% 25% 50% 75% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%

More specifically, CDS pricing is comprised of certain scheduled quarterly cash flows (the “fee leg”) and uncertain binary cash flows upon default (the “contingent leg”); the present value of the fee leg must equal the present value of the contingent leg. The contingent leg of CDS pricing is triggered by a defined credit event (a “default”) for the reference entity. The default trigger is defined as any breach of payment obligations beyond a defined grace period, any payment moratorium, and generally includes involuntary restructurings with unfavorable changes in payment terms such as coupon, maturity, or principal; any debates about defining what constitutes a restructuring and the voluntary or involuntary nature of exchanges would be settled by a voting committee of dealers. For example, a voluntary restructuring might not qualify as a credit event to trigger CDS on sovereign debt without CAC clauses (e.g. Greece’s debt operating under Greek law), whereas a credit event could be triggered on such sovereign debt with CAC clauses (e.g. Greece’s debt operating under U.K. law, which is roughly 10% of their total debt). This contingent leg obligates the CDS seller to buy the specified notional principal from the CDS buyer at par. Upon a default, the buyer can deliver any eligible bond issued by the reference entity, meaning they will deliver the cheapest bond ranking pari passu with other eligible bonds. In practice, the CDS buyer and seller can agree to make a settlement payment rather than actually exchange bonds for full payment, referred to a cash settlement rather than physical settlement. In that case, the CDS seller pays the CDS buyer an amount to boost recovery on the credit back to par. The amount to be paid is determined by an auction on the underlying credit 30 days after the default. As an example, if the reference entity files for bankruptcy and the auction sets a price of 80% of par for the credit, the CDS seller would pay 20% of par on the notional principal. This amount is called the recovery rate, though it can differ significantly from the actual recovery realized by investors over time.

Implications of CDS Curves The prices of CDS with different maturities can be mapped to form a swap curve, similar to a yield curve for cash bonds. CDS curves are usually upward sloping due to increasing probabilities of default over longer time periods. Technically, they are upward sloping due to increasing conditional probabilities (referred to as “hazard rates”) over time, meaning that the future probability of default given a lack of default until then increases over time. Entities with downward sloping CDS curves imply higher hazard rates in earlier years than later years, though the cumulative probability of default always increases over time. Such downward sloping curves are rare; they can be seen among entities with significant near-term default risk, but with improving prospects over subsequent periods if they avoid default. As shown below, the increasing CDS spreads for European sovereigns and the flat or decreasing term structures indicate significant default expectations in the market over time. Ten-Year CDS Spreads for Selected European Sovereigns
Greece Ireland Portugal Spain Belgium Italy France Germany


1,000 CDS Spreads (bps)





0 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11

Source: Bloomberg

CDS Curves for Selected European Sovereigns
Greece Ireland Portugal Spain Italy Belgium France Germany

2,000 1,800 1,600 CDS Spreads (bps) 1,400 1,200 1,000 800 600 400 200 0 6M 1Y 2Y 3Y 4Y 5Y 7Y 10Y

Source: Bloomberg


Given the evolution of the CDS market and its advantages over cash bonds, a broadening swath of participants have entered the market in recent years. Major CDS participants include banks, pension funds, insurance companies, mutual funds, hedge funds, and corporations. Investors that are generally long credit risk tend to be net buyers of CDS; these could include bank portfolio managers and corporations (e.g. those worried about payment from customers). Investors generally more inclined to add credit risk tend to be net sellers of CDS; these include insurers, pension funds, and credit asset managers. The underlying exposure for CDS can be either single credits or baskets of credits. Corporate “CDX” indices include baskets by region (e.g. U.S., Europe, Australia, and Asia), rating (e.g. high-yield, investment-grade, and cross-over, meaning those rated BB-equivalent by Moody’s and S&P or BB-equivalent by one and BBBequivalent by another), or industry (e.g. banks). The indices are constructed by MarkIt using an equally weighted credit portfolio (e.g. 100 and 125 credits for the U.S high-yield and investment-grade indices, respectively) every six months to allow investors to maintain a steady portfolio duration. These indices drop out credits that default, with a cash settlement payment made based on its recovery. For sovereign credit, the MarkIt “SOVX” indices include CDS on sovereigns of Europe, Western Europe, emerging markets, and Asia. Trading conventions are generally the same for single-name and index CDS, including a full term structure available for trading (with the most common being five-year contracts for corporates and 10-year for sovereigns), and using 100 bps as the CDS coupon for sovereigns and investment-grade corporates, and 500 bps for high-yield credit. However, pricing for indices is based on supply and demand, which can diverge from the simple average of the underlying CDS, similar to a closed-end equity fund trading at a discount or premium to its net asset value. Investment strategies using single name or index CDS could include basis trading (e.g. CDS spreads versus cash bond spreads), relative value views between credits, relative value within a capital structure (e.g. secured loan versus unsecured bonds versus equities), bullish or bearish credit views, views on the timing and outcome of defaults, views on the credit’s yield curve, macro views (e.g. investment-grade versus high yield indices), views on credit volatility, or correlation trading (e.g. positioning for moves in single-name credit versus an index, or correlated default risk in a portfolio versus index tranches). With sovereign CDS, the most common strategies are outright views on the timing and probability of default, as well the basis trading and curve trading, which are discussed below. Basis Trading – Basis refers to the difference between a CDS spread and the underlying cash bond spread with the same maturity dates on a par-equivalent basis (i.e. adjusting for bond prices above trading above or below par) after adjusting for funding costs. Basis can be zero, positive (bond spreads below CDS spreads), or negative (bond spreads above CDS spreads). Negative basis can occur when there are excess protection sellers (i.e. going long risk), which can be due to lack of liquidity in the cash bonds, high funding costs to buy bonds, or due to new bond issues offering above-market yields. In negative basis trades, an investor could theoretically purchase the cash bond and buy CDS protection to lock in positive spread income (bond income is greater than CDS expense) without downside credit risk. The opposite strategy could be used if the basis is positive, where CDS spreads exceed bond spreads, although this is less common. This could be caused by CDS buyers having the option to deliver the cheapest bond after default, bond covenants that give bond owners rights lacking for CDS buyers, the ability for credit events to trigger CDS without actually defaulting, or from excess CDS buyers. This excess could arise from greater CDS liquidity, CDS use by investors hedging credit risk in convertible bonds, increasing default concerns, or if bonds are not available for shorting. A positive basis strategy could be to short the bonds and short CDS (i.e. long credit risk) to lock in positive spread income (CDS income is greater than bond interest expense) without downside credit risk. Curve Trading – Trading credit curves can involve expected timing of defaults or expected changes in the shape of CDS term structures. As for default timing, if an investor viewed default as unlikely over two years they could

short two-year CDS. If they supplemented the view by expecting default within five years, they could add a long position in five-year CDS. The five-year CDS expenses would be partly offset by income on the two-year CDS, thus lowering the cost to the investor. Alternatively, an investor could expect a CDS curve to steepen or flatten over time due to changes in default expectations. For example, an investor could buy 10-year CDS and short five-year CDS for a given credit if they viewed the ten-year spread as too low relative to five-year spreads; this steepener trade, meaning investors expect spreads on longer-term CDS to increase more than shorter-term CDS, is often done if long-term default risk is increasing. Conversely, flattener trades generally assume decreasing default risk as CDS curves become less upward sloping. Examples of Credit Default Swap Curve Trades
1,000 900 800 700 600 500 400 300 200 100 1 2 3 4 5 6 Years to Maturity 7 8 9 10 Flattener Trade Steepener Trade

Curve trading strategies can include equal-notional strategies (i.e. “forwards”), duration-weighted strategies, or carry-neutral strategies. To understand the risk of such curve trades, investors must factor in carry costs, the passage of time (e.g. aging of the trade shifts positions down the term structure, which generally is steeper for shorter maturities, and one position will expire before the other), different notional amounts for the contracts, exposure to default risk, and sensitivity to spread changes through both duration and convexity, among other items. Given that long-term CDS have higher duration (i.e. sensitivity of price changes for a given change in spread) than short-term CDS, the duration-neutral trade would use lower notional for the longer-term CDS than the shorter-term CDS. Also, the change in duration for each contract for a given change in spreads (called convexity) will change as spreads change (e.g. duration decreases as spreads increase, as for cash bonds), which also could require adjustments in notional par among the contracts to maintain the intended exposures. Equal-notional strategies eliminate default risk, meaning the cash flows for each contract in the event of default are equal; however, they are market dependent (exposed to duration and convexity risk) and have carry costs. Assuming upward sloping CDS curves, equal-notional curve steepener trades have negative carrying cost (i.e. cash outflows from the investor), while flattener trades have positive carrying cost (i.e. cash inflows to the investor). Duration-neutral trades use different notional amounts for the two CDS terms, which introduces default risk since the cash flows upon default would differ based on the size of the contracts. In these types of trades, steepeners are long credit risk and generally have positive carry costs, while flatteners are short credit risk and generally have negative carry costs. This is the same for carry-neutral trades, though of course without carry costs (cash income equals expenses for the long and short CDS positions), since they use more notional in the short-dated than longdated CDS; these trades are also exposed to duration and convexity risk.

CDS Spreads (bps)

GLOSSARY Bail-out – Crisis lending or grant of capital usually from external creditors to provide liquidity and enable payment of near-term obligations. Basis trading – Trading based on the difference between CDS spreads and the underlying cash bond spread. Bps – Abbreviation for basis points. Basis point – 1% of 1%. Basis points are commonly used to quantify the spread between two fixed income yields; for example, investment-grade bonds could trade with yields 100 bps above U.S. Treasuries. Brady Bonds – Sovereign bonds issued by developing countries in connection with restructurings, mostly in the 1990s, usually collateralized by zero-coupon, long-maturity U.S. Treasury bonds. Bund – Bonds issued by the German government. Caja – a regional not-for-profit savings bank in Spain, often run by political figures through a Board of Directors. CDS – please see credit default swap. Chapter 11 – A chapter of the U.S. Bankruptcy Code which allows reorganization of a company’s obligations. Coupon – Interest payment on a bond. Credit default swap – Also known as CDS. A credit derivative effectively providing payment to the buyer for any losses upon default of the underlying reference obligation. Credit derivative – A financial contract between two parties allowing each to increase or decrease exposure to an underlying single credit or basket of credits. Current account – A country’s total balance of trade (exports minus imports of goods and services), net factor income (such as interest and dividends), and net transfer payments (such as foreign aid). Curve trading – Trading CDS positions of differing maturities. Default – A breach of payment terms on debt obligations; could also include technical default of indenture terms without breach of payment. ECB – Please see European Central Bank. EFSF – Please see European Financial Stability Facility. EFSM – Please see European Financial Stability Mechanism. EMU – Please see European Economic and Monetary Union. ESM – Please see European Stability Mechanism. EU – Please see European Union. Eurogroup – The group of finance ministers for Euro-Zone members. European Central Bank – Also known as ECB. The central bank for the Euro-Zone, and lead party in the Eurosystem. European Economic and Monetary Union – Also known as the EMU. A union of 17 European countries that have adopted the euro as a common currency and the European Central Bank to manage monetary policy. European Financial Stability Facility – Also known as the EFSF. The €440 billion financing package committed by EMU members in May 2010 along with the EFSM to promote financial stability and liquidity for weak sovereign credits.


European Financial Stability Mechanism – Also known as the EFSM. The €60 billion allocation of the EU’s budget in May 2010, along with the EFSF, to promote financial stability and liquidity for weak sovereign credits. European Stability Mechanism – Also know as ESM. Intended as a permanent crisis resolution mechanism; successor to the EFSM and the EFSF expiring in July 2013. European Union – Also known as EU. An economic and political union of 27 European countries. Eurosystem – The group of central banks for Euro-Zone countries, including the European Central Bank. Euro-Zone – Another name for countries in the EMU. Fiscal deficit – When a government’s expenditures are greater than the government’s revenues for a fiscal period. FROB – The Fund for the Orderly Restructuring of the Banking Sector created by Spain’s National Central Bank to inject capital into banks and cajas. GDP – Please see gross domestic product. GKO – Abbreviation for Gosudarstvennoye Kratkosrochnoye Obyazatyelstvo, the short-term zero-coupon debt introduced by Russia to finance the budget deficit. Gross domestic product – Also known as GDP. The value of goods and services produced within a country during a given period. IMF – Please see International Monetary Fund. Insolvency – When a debtor’s assets, including future income streams, are insufficient to meet liabilities. International Monetary Fund – Also known as the IMF. The not-for-profit financial institution funded by countries around the world to promote financial and monetary stability and economic progress. NAMA – please see International National Asset Management Agency. National Asset Management Agency – Also known as NAMA. The Irish “bad bank” created in April 2009 to acquire troubled loans from Irish banks in return for government bonds. NCB – national central bank. Pari passu – Of equal rank in priority of payment; usually applied to debt obligations. Primary budget – The fiscal budget before accounting for interest expense. Private debt – Debt of banks, financial institutions, non-financial companies, and households (including mortgage and credit card liabilities). Public debt – Debt issued by government entities. Repo – A source of short-term financing from selling assets (usually debt securities) under an agreement to repurchase them at a specific time. Roll-over risk – The risk of refinancing debt coming due. Run – The rushed withdrawal of investors, or bank depositors. SIGIP – Acronym for Spain, Ireland, Greece, Italy, and Portugal. Tesobonos – A Mexican government bond denominated in pesos, with coupons and principal indexed to U.S. dollars at the spot rate in effect at issuance. VAT – Value-added tax; a tax on the estimated market value added to products at each stage of manufacture or distribution that is ultimately passed on to the consumer.

INDEX OF FIGURES AND TABLES Credit Stress in Developed Europe.............................................................................................................................4 Summary of Western European and Reference Credits .............................................................................................7 Sovereign Credit Deficiencies..................................................................................................................................11 Yield Curves for Greek and Irish Sovereign Debt – March 2011 versus March 2010.............................................12 Yield Curves for European Sovereign Bonds...........................................................................................................12 Summary of Commitments and Availability under Europe’s Financial Stability Package......................................14 10-Year Sovereign Bond Spreads to German Bonds (bps) ......................................................................................15 10-Year Sovereign Bond Yields...............................................................................................................................15 CDS Curves for Selected European Sovereigns.......................................................................................................16 Debt by Sector as Percent of 2010 GDP...................................................................................................................18 Public Debt as % of GDP – 2010 versus Average from 2000 to 2008.....................................................................19 Consumer Debt and Unemployment for 2010..........................................................................................................20 Household Debt to Disposable Income ....................................................................................................................21 Inflation Adjusted Real Estate Prices by Country ....................................................................................................22 Domestic Bank Assets to 2010 GDP........................................................................................................................22 European Borrowers and Lenders by Nationality ....................................................................................................23 ECB Lending in 2010...............................................................................................................................................23 2010 Current Account Balance and GDP Growth....................................................................................................24 Change in Competitiveness Ranking from 2000 to 2010 (among roughly 130 countries) ......................................25 Share of Public Debt Held Abroad or Domestically ................................................................................................26 Annual GDP Growth from 2007 to 2010 .................................................................................................................26 Sovereign Debt Maturity Profile ..............................................................................................................................27 Growth of European Sovereign Revenues and Expenditures...................................................................................28 Government Expenditures as a Percent of 2010 GDP..............................................................................................28 Rating Agency Actions Since December 2008 ........................................................................................................29 European Sovereign Debt Issues ..............................................................................................................................30 2010 Euro-Zone GDP Contribution .........................................................................................................................30 Historical and Projected Economic Statistics for Selected Sovereigns ....................................................................31 Public Debt to GDP..................................................................................................................................................31 Sovereign Debt Maturities to GDP...........................................................................................................................31 Real GDP Growth.....................................................................................................................................................31 Unemployment Rate.................................................................................................................................................31 Fiscal Surplus/(Deficit) to GDP ...............................................................................................................................31

Current Account to GDP ..........................................................................................................................................31 Greek CDS Levels and Bonds Spreads vs. Germany - Past 18 Months...................................................................34 Country Snapshot – Hellenic Republic (Greece) .....................................................................................................35 Average Irish House Prices ......................................................................................................................................36 Annual Change in Irish House Prices.......................................................................................................................36 European Periphery Share of GDP versus Share of ECB Funding – November 2010 ............................................38 Country Snapshot – Republic of Ireland ..................................................................................................................41 Portugal Private Debt to GDP ..................................................................................................................................42 2010 GDP per Capita (with % of the EMU average) ...............................................................................................43 Country Snapshot – Portugal Republic ....................................................................................................................45 Cumulative Excess Housing Starts versus Change in Population ............................................................................47 Spanish Banking Assets as a % of GDP...................................................................................................................47 Breakdown of Potential Problem Loans in Spanish Banks ......................................................................................48 Real Estate Prices Among Over-Built Countries .....................................................................................................48 Spanish Unemployment Rate and Government Expenditures..................................................................................49 Spanish Economy: Recent Performance and Forecasts............................................................................................49 Yield on Spanish Government 4.8% Bond due January 2024..................................................................................50 Country Snapshot – Kingdom of Spain....................................................................................................................52 GDP Growth for Italy and the EMU ........................................................................................................................53 Regional Italy GDP per Capita.................................................................................................................................53 Global Competitiveness Rankings............................................................................................................................54 Italian Government Expenditures to GDP................................................................................................................54 European Pension Expenditures to GDP ..................................................................................................................55 Country Snapshot – Italian Republic........................................................................................................................56 Country Snapshot – Kingdom of Belgium ...............................................................................................................58 EU Members and EMU Members ............................................................................................................................60 Distribution of Legal Authority Between the EU and EU Members........................................................................61 Members of the European Union (Blue) and European Economic and Monetary Union (Gold) ............................62 Share of Euro-Zone 2010 GDP ................................................................................................................................63 EMU Admission Criteria..........................................................................................................................................64 Capital Contribution to European Central Bank as of December 31, 2009..............................................................65 Contribution to EFSF ...............................................................................................................................................68 Summary of IMF Members ......................................................................................................................................70 IMF Financing in Selected Sovereign Crises and Restructurings ............................................................................71

Sovereign Debt Defaults and Restructurings by Region and Country Since 1820 ..................................................77 Mexico’s Capital Account and Current Account .....................................................................................................81 Mexico’s Foreign Currency Reserves ......................................................................................................................81 Mexican Peso Devaluation .......................................................................................................................................82 Russia’s Public Debt.................................................................................................................................................83 Crude Oil Prices .......................................................................................................................................................83 Russian Ruble Devaluation ......................................................................................................................................84 Russia’s Foreign Currency Reserves........................................................................................................................84 Inflation, GDP Growth, and Exchange Rates for Argentina ....................................................................................86 Argentinean Bond Spreads over 10-Year U.S. Treasuries .......................................................................................87 Argentina’s Fiscal Position.......................................................................................................................................87 Argentinean Peso Devaluation .................................................................................................................................88 Uruguay’s Trade Balance .........................................................................................................................................89 Uruguay’s Fiscal Position.........................................................................................................................................90 Uruguayan Central Bank Foreign Currency Reserves..............................................................................................90 Uruguayan Peso Devaluation ...................................................................................................................................91 Uruguay’s Debt Maturities Before and After the Restructuring ..............................................................................91 Participants in the Brady Bond Plan.........................................................................................................................92 Summary of Restructurings Under the Brady Bond Plan (figures in billions of U.S. dollars).................................95 Selected Austerity Measures Planned in Europe....................................................................................................100 Euro-Zone Budget Deficits for 2010 and 2011 ......................................................................................................101 Sovereign Monthly Debt Maturities for 2011 and 2012.........................................................................................103 How Euro Bonds Would Work ..............................................................................................................................108 Opportunity Set for European Debt: $23.4 trillion.................................................................................................111 Sample of Selected Asset Disposal Efforts ............................................................................................................112 Price Curve for European Sovereign Bonds...........................................................................................................114 Ten-Year CDS Spreads for Selected European Sovereigns ...................................................................................114 Credit Default Swap Summary...............................................................................................................................120 Implied Cumulative Probability of Default Over 5 Years......................................................................................121 Ten-Year CDS Spreads for Selected European Sovereigns ...................................................................................122 CDS Curves for Selected European Sovereigns.....................................................................................................122 Examples of Credit Default Swap Curve Trades....................................................................................................124


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