From friend of Alhambra Brian Cronin:
Greece is old hat for the time being. The world held its breath until the Greeks had their say. The center right pro-bailout party won with 80 seats (plus another 50 for coming in first) and by midweek a new coalition government was sworn in under New Democracy leader Antonis Samaris. But even they want more time to try and do some arm twisting so that the austerity provisions can be relaxed somewhat.
Nothing has changed and the powers that be are still left with the dilemma of deeply indebted nations who have borrowed too much and don’t want to swallow the bitter pill of austerity. That concern caused a sharp move lower in equity markets this week. Chancellor Merkel wants to keep the debtors’ feet to the fire. One suspects she might have wanted a different outcome so that Greece could be sent on its way thereby teaching other recalcitrants a lesson.
It’s going to be a long, hot summer. The problems still persist and are not going away any time soon. Whether the Greek people can place their trust in a coalition, two of whose members have been responsible one way or another for the mess the country finds itself in, is problematical. The new finance minister, Vassilis Rapanos, collapsed in a heap during his first day on the job and was hospitalized for tests. Little wonder. And to add insult to injury, Germany defeated Greece 4-2 in the quarter finals of the Euro 2012 soccer championship. The match and the result has huge political overtones.
At the same time and almost unnoticed was the second round of parliamentary elections in France in which new president François Hollande’s party secured power by a substantial margin in the national assembly. He can now move ahead with growth-led policies and higher taxes to tackle France’s own substantial problems. He has an uphill climb at home so we will see how much he can accomplish.
But it does strengthen his hand with Angela Merkel in pushing his strategy for growth over austerity. He got the Spanish and the Italians on his side in Rome this past week and he will present his “Covenant for Growth” and revisit the question of eurobonds at the Brussels summit this coming week. The tax on financial transactions, which the Brits don’t like, didn’t get any traction. Who would have thought that growth via more government spending would now be the talk of the town? At any rate, what the “Big Four” finally agreed on was a package of measures to boost growth equivalent to 1% of the eurozone’s economic output.
But now for something completely different but not completely unrelated. Time for another trip down Memory Lane. The credit quality and reliability of your counterparty in any trade is of utmost importance. Those who lent money to southern Europe are finding that out the hard way. The anniversary of an event that took place 38 years ago this coming Tuesday reminds us of that.
The motto of the foreign exchange dealer is “your word is your bond”, a quaint sounding notion to some these days, but in the FX market it is a vital part of the daily fabric. You have to be able to trust that the entity you are dealing with will deliver the countervalue of whatever you have traded with him. That is the basis on which all trades are made. You do not deal with any entity until a thorough investigation as to credit has been done. Assuming that a bank comes through that process satisfactorily, you expect him to act responsibly and keep his word.
But on Wednesday, June 26,1974, that did not happen, not because someone’s word was broken but because the entity in question acted recklessly. On this day the whole world of German banker Iwan David Herstatt came crashing down as the German authorities stepped in and closed down Bankhaus I.D. Herstatt. The Bundesaufsichtsamt für das Kreditwesen (BAKred), the federal German watchdog, decided to terminate Herstatt’s operation and it caught several money center banks on the hop. To explain why necessitates getting down into the weeds.
BAKred had been watching Herstatt because it had been engaging amongst other things in the practice of historical rate rollovers. Here’s how it works: bank A buys dollars on a forward basis from bank B, i.e. for delivery at some point in the future. In the meantime, the dollar loses value. When the contract comes due, it can either be settled at a loss or extended for a future period. If the contract is extended, bank B can do two things. It can extend (or rollover) the contract at current market rates, in which case bank A would have to realize its loss, or it can extend the contract at historical rates, i.e. the rate at which the contract was first agreed before the dollar declined.
If the latter course is taken, Bank B is in effect taking a credit decision and making an interest free, margin free loan to bank A who has now deferred any loss until a future date in the hopes that the dollar will recover its losses and get back up to the level of the original trade. It may be that bank A has cash flow problems and cannot come up with the money to settle the losing trades. By doing so continually over an extended period it also pushes potential tax liability forward into a future year.
Bank A in this example was Herstatt and BAKred had been watching them for some time extending contracts at historical rates, not taking their losses. At the time, such trades were perfectly legal and acceptable as long as the practice was not abused. But on that fateful day in June 1974, it decided to act and it threw the foreign exchange world into turmoil.
Because of the six hour time difference between Germany and the United States, a bank buying dollars against marks for spot delivery (two days hence) will have those dollars credited to its account in New York long after the countervalue in deutschemarks has already been credited to the selling bank’s account in Germany. But that’s OK because delivery is expected – your word is your bond – and you do not doubt that it will happen.
But in this particular case, BAKred stepped in right in the middle of the trade, withdrew Herstatt’s banking license, shut its doors and prevented them from paying the dollars it was obligated to deliver. Several well known banks had irrevocably paid out the marks and did not get their dollars in return. It took two years for the matter to be settled through the courts.
The practice of historical rate rollovers is not now sanctioned by most regulatory authorities though it did continue after the Herstatt debacle. On December 26th 1991, the Foreign Exchange Committee in New York, a group that “provides guidance and leadership to the global foreign exchange market”, explicitly stated that “non-market rates should not be permitted in interbank dealing and should be permitted in other circumstances only with strict management oversight”. In effect, most banks decided it wasn’t worth the risk and prohibited the practice. Some banking centers around the world, like Australia and New Zealand, still do permit such trades but the vast majority have outlawed it.
The case is famous not just for the turmoil it caused in the markets but it is perhaps the best example of settlement risk. It threw a light on other banks too. Four months after the Herstatt collapse, on October 8th1974, the Franklin National Bank, the Michele Sindona owned bank, also went down due, in part, to fraudulent currency trades. For a long while thereafter, banks reviewed more carefully their credit risk and took account of actions that might raise red flags to future problems. But it is not the only example.
What do you do if foreign exchange transactions are interrupted not by banking authorities but by Saddam Hussein? That happened on Thursday, August 2nd1990. More than 100,000 Iraqi troops and 700 tanks invaded Kuwait and Kuwaiti bank staff, if they were able, put all their computer and transaction records in the trunks of their cars and sped across the border to Saudi Arabia. But while the banking world cheered their plucky spirit, banks were left scratching their collective heads. Spot and forward contracts were coming due and there was nobody to talk to find out where and how our counterparties in Kuwait wanted settlement assuming they still existed as viable entities. A prime example of counterparty risk and force majeure combined!
All of a sudden however, weeks after these unsettled maturing trades were place in suspense, entities purporting to be the trading arms of the plundered Kuwaiti banks turned up in Paris inside the trading rooms of French banks. In order to be sure that they were who they said they were, banks insisted that monies owed to them were paid before any countervalue was delivered. They were not going to see a repeat of Herstatt again and be caught with their pants down.
I was lucky (or unlucky) enough to be appointed by my bank, Security Pacific Bank in Los Angeles, to oversee the smooth delivery of funds and to make sure we were not disadvantaged. But the problem was that before any funds could be released it had to be filtered through OFAC, the Office of Foreign Assets Control, in Washington DC. OFAC is a part of the U.S. Treasury and “administers and enforces economic and trade sanctions based on US foreign policy and national security goals against targeted foreign countries and regimes, terrorists, international narcotics traffickers, those engaged in activities related to the proliferation of weapons of mass destruction, and other threats to the national security, foreign policy or economy of the United States”. All well and good.
However, if you have ever had to explain to government bureaucrats how a foreign exchange forward contract works and assure them that you are not attempting to pay Iraqi agents disguised as Kuwaiti bankers vast sums of money so that they can buy armaments, then you have not lived. It was, shall we say, a character building exercise and took all of my old world European charm to assure them that it was all on the level.
Finally, another strange example of counterparty risk, which strictly speaking, is a judgment as to whether your counterparty will default on you, and not who your counterparty is. In this case, however, it was a combination of the two. In the early part of 1979, Shah Reza Pahlavi left Iran in rather a hurry and the Ayotollah Ruhollah Khomeini eventually became Supreme Leader. We knew who the new political leaders were but it was unclear who was running the central bank, Bank Markazi Iran.
Bankers Trust London, where I then worked, was used by Iran and many of the Arab central banks to diversify their newly acquired petrodollars. Communications in those far off days was by telex and not by phone and you could not be sure whether what you received was genuine and you could not act on it unless it was authenticated. Even so, we were told in no uncertain terms by our lords and masters in New York not to respond to requests from Bank Markazi because it might very well be from the janitor or some such, newly promoted to head of the central bank. Bankers Trust, of happy memory and before they went over to the dark side, was taking no chances until they had investigated further. Those were the days!