Should the EU require bailout loans to countries with excessive deficits to be collateralised? Is it in the best interest of the Euro area to make emergency funding available on an unsecured basis? This question was raised in a recent debate in the Finnish Parliament.
The loans paid out to up to now have been unsecured, but the final terms of the 440 billion euros support programme for rescuing Greece and other heavily indebted countries remain to be agreed. Lending against a signature - a mere promise to repay - could erode confidence in the future economic management of these countries at a time when the stated objective is to strengthen budgetary discipline in the Euro countries.
Loan collateral gives the creditor the right to repossess and realise the assets pledged. If a loan has been extended on an unsecured basis, typically against a loan contract under which the debtor covenants to run its business in an orderly fashion, the creditor does not have recourse to the assets of the debtor and cannot instigate an enforced sale in order to recover moneys owed.
In day-to-day commercial lending it is common for natural persons as well as incorporated entities to pledge assets as security for loans. Unsecured loans are typically only extended to the most financially sound borrowers. If Greece were a natural person or a company its ability to raise unsecured loans would be severely curtailed.
Why should the members of the Euro area extend loans to Greece on an unsecured basis? The question is relevant as it is not unusual for governmental entities to raise debt on the strength of assets. As for Greece, the Hellenic loan programme established in 2004 provides an example. It is backed by receivables from house loans of extended by a state-run fund to Greek public sector employees.
In this instance, the collateral could come from the Greek state's extensive holdings in hotels, ski resorts, casinos and the like - in short, public sector investments in commercial activities, which do not belong to the core functions of a progressive welfare state but instead reflect opaque links between Greek politicians and businessmen. Pledging such assets as collateral would create a strong incentive for the Greek Government to focus on the primary responsibilities of a modern state and untangle itself from a shady maze of patronage.
But would the Greek government be prepared to give up involvement in varying business activities to which government involvement has harmfully strayed, or would the interest groups behind them be able to defend their privileges?
A recent example of the use of collateral can be found in the United States. The terms of the emergency support schemes set up by the authorities there involved collateral and other financial structures to help safeguard the claims of the American taxpayers. The taking of security was most dramatically executed in the case of banks.
The then Treasury Secretary Hank Paulson summoned the Chief Executives of the largest banks at a day's notice. Every one was presented with document to sign. The document laid down the size of a rights issue, which each of the banks would give out in favour of the government. Any resisting chief executive was advised that his bank's license would be revoked the following day in the event that the document remained unsigned. The U.S. Department of the Treasury has since been able to sell the shares so received at a profit, the crisis is over and the taxpayers' funds are safe.
Thus far, Europe has chosen a different path, one relying on promises to repay and bureaucratic sanctions. In rationalising the decision various arguments have been cited. The most credible justification put forward in EU-circles concerns the possible negative market reaction. There is a fear that if the new loans to Greece were extended on a secured basis, the value of old unsecured loans would plummet. This would be counter the objective of the support package. Moreover, European banks and pension funds are big holders of Greek bonds and would stand to book significant losses.
In practice, the significance of the threat to the value of the old loans depends on how Greece would employ the funds raised from the new loans. If the fresh funds were used to maintain spending, the threat would be very real. Were the funds primarily applied to repay of old loans, the markets would take a favourable view.
Why did the United States proceed differently from Europe? In the U.S. the rescue plan was created by top players from the hard core of financial markets under the leadership of Hank Paulson, a former chief executive of Goldman Sachs. Europe's plan was put together by macro economists and there was no top notch banker comparable to Hank Paulson among the finance ministers. The respective roles of politicians and market practitioners in shaping public financial measures should also be clarified in Europe as soon as possible. It is suffices for a politician to be able to ask the right questions.
In this instance the question is simple: How can the emergency loans be secured without causing the value of old loans to tumble?
As the problem countries hold a wealth of assets, the correct solution is equally straightforward. In keeping with traditional banking principles the bailout loans should be made against collateral, which is realisable in practice, and the loan proceeds used to repay old debts.
Particular attention should be paid to the ease with which the collateral can be realised. As security only assets outside the core functions of a welfare society should be accepted - accordingly there should be no hospitals or schools but rather casinos and hotels among the assets pledged. This way the bailout loans would be credibly secured and the funds of the European taxpayer better protected.
This article first appeared in the Finnish newspaper Helsingin Sanomat in Finnish. Translation into English by Facts & Arts. Published here with the permission of the Helsingin Sanomat and the author.