An Existential Referendum

By Roy C. Smith

The referendum may be the best way for ending the drama in Greece, but it comes at a price.

Last week the European “Troika” finally put its take-it-or-leave-it terms on the table. It was generally assumed that Prime Minister Tsipras would grudgingly accept the deal and life would go on. Instead, Mr. Tsipras surprised everyone with a 1am announcement on  Saturday that he would ask parliament for a referendum to determine whether Greece should accept the deal (he thinks it should not), but, not necessarily with the presumption that if it did not, it would be forced to withdraw from the euro, and maybe the EU.

There has been general agreement among statesmen and economists for months that, although it is entitled to try for the best deal it can get, both Greece and the Eurozone would be better off if Greece remained in the euro.

This proposition is certainly debatable.  Greece has never been a first-world economy, so its entrance into a union with other countries that are may have been a mistake.  After five years of budget cuts and a variety of other austerity measures, massive additional borrowing from ECB, and a cram-down restructuring of private sector debt, the Greek economy, unlike other countries receiving similar assistance, has failed to achieve a “normal” recovery.

And, from the beginning its politics have been far more confrontational and uncooperative than those of the other aid recipients. Even if Greece should accept the last offer made by the Troika, there is no assurance that it won’t be back in the future acrimoniously demanding further concessions.

Better to recognize the economic and political realties of the Greek situation, many have concluded, and arrange for it to leave to euro.

But the referendum play has changed things.

Yes there will be a technical default, but it can be resolved within 30 days with impunity.  Yes there will be a run on the banks, but this can be halted by a weeklong bank holiday. And, yes if the Greeks vote to accept the deal to stay in the euro, the Troika will be willing to extend the current deal to the (probably new) government that will be mandated to accept the reforms and other measures to normalize the economy.

If recent polls showing a substantial majority of Greeks wanting to stay in the euro, (despite approving Mr. Tsprias’ efforts to negotiate a better deal) are right, then the referendum could settle things once and for all.

But as US statesman and economist Larry Summers has said on the subject, “this may be an experiment you don’t want to run.”

First, because the Europeans might lose. Maybe there will be a “Zorba” moment among the electorate and Greeks will decide they would rather die than accepted humiliation, especially if the pros and cons are not properly explained to them in the few days that remain before they have to vote.

A no vote would be especially harsh on Greece, at least for a few years. But it has consequences for Europe too. The European Financial Stability Fund, the European Central Bank and possibly other European banks will have to shoulder large write-offs.  There will be market turmoil for a while, although this may be offset by the relief that the external part of the Greek tragedy has finally ended. (Greece’s influence on world financial markets has vastly exceeded the value of expected write-offs and other consequences).

There is also a fear that a cut-loose Greece may collapse into a failed state subject to all sorts of undesirable political consequences. Greece has been through political chaos several times in its relatively short life as an independent nation, including civil war and conditions that ended in military rule.  Chaos might also, as the Greek negotiators threatened, attract Islamic terrorists into the country, hoping to breach the territorial wall of Europe.  If so, this would raise hard questions about Greece’s ability to remain in NATO.

And finally, and perhaps most insidiously, a referendum in Greece on continuation in the Eurozone, together with the promised British referendum on remaining in the EU, could create further political demands for similar referenda in other countries that belong to the Eurozone or the EU.

The outcomes of such referenda have almost always been unpredictable. In 2005, referenda on approving the then proposed European Constitution, though passed in several countries, were defeated in France and The Netherlands, after which the Constitution was abandoned.

Recent public opinion polls in the UK show as much opposition to the EU as support for it. Other polls have convinced many European politicians that popular support for the EU is significantly less than among the better informed political and business leadership. Referenda, therefore, are risky events. A couple of defeats could send the EU and Eurozone back to drawing boards, from which, like the Constitution, they may never reappear.

So the Greek drama has a powerful and existential final act to go.

What to Expect in Greece (June 2015)

By Roy C. Smith

On June 30^th, Greece is due to repay €1.5 billion of the €9.7 billion it owes to the IMF this year. An additional €6.7 billion is due to the European Central Bank (ECB) during July and August.

In 2012 Greece forced a restructuring of approx. €200 billion of its “private sector” creditors (i.e., banks), an action that was declared an “event of default” by rating agencies. This crammed-down restructuring, however, excluded “public sector” creditors such as the IMF and the ECB, and did not constitute a default on public sector debts.

Defaulting on payment to public sector creditors is a big deal. No country has ever defaulted on IMF loans in its 70-year history (though several basket-case countries, e.g. Zambia, have gone through a slow-pay-in-arrears process). Public sector creditors are required by their charters to deny additional credit to defaulting governments.

The presumption by European officials is that a default on the IMF loans, would constitute a default on the ECB and European Financial Stability Fund (EFSF) loans that have comprised the €240 billion Eurozone rescue package for Greece that began in 2010.

Background of the Crisis

The EFSF rescue package was put together on the fly by the 18 countries that (then) utilized the euro (the Eurozone) to assist Greece in restructuring its debt and its economy so as to be able to remain in the group. It was based from the start on partial payments being made as required restructuring and reform “conditions” were met. Since 2010, many of the partial payments have been delayed or argued over by Greek governments protesting the severity of the conditions required.

In 2008, Greece’s economy sank 4.5%. After a brief recovery in 2009, it remained in negative territory until 2014 (averaging about -1.5% over five-years), when it became positive for about 6 months, indicating a turnaround. But the turnaround did not hold and the economy sank again into modestly negative growth rates. The prolonged recession in Greece (which was considerably less severe than the recessions in Ireland, Spain and Portugal and other small Eurozone countries) imposed economic hardship on the country that resulted in the election in January of 2015 of an extreme left-wing party, Syriza, whose leaders have insisted that the terms of the EFSF loans be relaxed to ease the hardship that Greeks were experiencing.

In 2010, the European Union authorized a negotiating group (the “Troika,” consisting of the European Commission, i.e., the administrative arm of the EU, the ECB and the IMF) to deal with the Greek government on these issues.  The Troika negotiated the rescue package and the conditionality under which it was to operate. These required lowering the Greek fiscal deficit (largely by reducing large government payroll and pension costs), debt restructuring (to extend maturities) and macroeconomic reforms (improved tax collection, privatization, etc.).

The austerity imposed by the conditionality has not, however, resulted in sufficient economic recovery to enable higher tax collections and other deficit reduction efforts.

The Troika has expressed some sympathy for this situation, but (reflecting the views of other Eurozone member countries) is not satisfied that Greece’s efforts to manage the restructuring process has been what it should have been, and fears that more loans that do not meet conditionality requirements will be a long-term waste of Eurozone taxpayer’s money.

High Stakes of Default

So the existential question is whether, even with further assistance from the EFSF, Greece will ever get back to being a normal Eurozone country. (Despite the aggressive negotiating practices of the Syriza Party, recent polls show that 70% of Greeks want to remain in the euro. German polls, however, show support for Greece remaining in the euro to have dropped to 40%).

Five years of negotiating with the Greek government has tired out the Troika. Many in Europe believe that the admission of Greece into the Eurozone was a mistake – Greece was never a first-world, developed economy – and if Greece won’t comply with the terms of assistance, then it should leave the euro even at the cost of large write-offs being absorbed by the EFSF and the ECB.

There is consensus among economists, however, that Greece would be better off to accept the conditionality imposed on it rather than face the economic chaos of a default and probable exit from the euro. A default would mean a cut off of future EFSF funds, a denial of all forms of external credit, a run on domestic banks and financial institutions (as depositors try to protect themselves against devaluation), the collapse of the internal credit and payment system as banks run out of money and cannot rollover maturing obligations, a further plunge in securities and real estate values, and a likely substantial increase in inflation as the government resorts to printing money to cover expenses.

Under such circumstances, remaining in the euro would greatly increase the hardships; Greece would have to devalue its currency in order to achieve some kind of international payments equilibrium (e.g., tourism and exports could be increased, and wage rates and prices would adjust to what they have to be). But, the only way Greece can devalue is to leave the euro (a “Grexit,” or Greek exit), the cost of which to the Greek economy is hard to assess but it certainly will be steep in the short to intermediate term.

If it leaves the euro, it will be required to impose capital controls (a violation of EU Single market rules) and its economic refugees may flood the rest of Europe, which could pressure Greece’s ability to remain in the EU, which it needs to preserve agricultural and other export privileges.

Even if Greece does not chose to leave the euro, the rest of the Eurozone countries could force it out by refusing further loans and triggering the defaults that would initiate economic collapse, or by voting Greece out of the group. There are many economists who believe this is the right step to take because Greece has shown neither the will nor the capacity to sort itself out under the rules of the assistance programs. Recognize the mistake for what it was and move on.

Yes, Europe could get rid of Greece and the euro and the EU might actually be better for it (despite some large write-offs of public funds). But would this be the most sensible and mature political solution?

Complications of a “Grexit”

The longer the Greek negotiations go on, the more the so-called European “solidarity” issues will be clarified. From the beginning, the Eurozone countries and the EU felt that their great experiment in continental economy unity would be endangered if a member were forced out because of an economic crisis or emergency. A union requires mutual assistance even if is not written into their contractual agreement. Solidarity means helping the weak to recover so as to preserve the whole.

But how long does the solidarity clock run for emergencies or crises? Greece is a small economy, but still the 13^th largest of the 28 EU member countries. Other EU countries (principally Ireland, Portugal, Spain, and Cyprus) have been forced to suffer economic adjustment after the 2008 financial crisis. These countries have received assistance too, but have begun to recover and made their requirement payments on time without a lot of theatrics. By now there are questions about Greece’s willingness to endure the economic pain of the adjustments that are necessary. Certainly the negotiating tactics of Syriza have isolated Greece from the rest of the Eurozone and EU.

Increasingly it seems that more Europeans are accepting the fact that if Greece leaves the system it does not mean a “domino effect” that could destroy the euro and/or the EU will occur and other countries will end up leaving too.

But, chucked out, Greece would most likely plunge into political chaos—Syriza would fall, the country might not be able to agree on a replacement government that was any better, and the chances of civil conflict or a military takeover would increase. At worst, Greece could become a failed state in a region of the world beset with extremism, something no Western government wants to see happen.

Negotiating Strategy

Yanis Varoutakis, Greece’s Finance Minister is an economics professor with a long interest in game theory.  This is basically a way of analyzing an optimal strategy in a multi-party negotiation in which failure to agree results in a very bad outcome, and the winner is the one that emerges with a better relative outcome than others. Most observers believe that Varoutakis’ abrasive negotiating strategy is an effort to apply game theory, but it is essentially a method of bluffing -- he knows that no agreement would produce a very bad outcome for Greece, and that his tactics increase the probability of no agreement, but it would also create a bad outcome for Europe that it very much wants to avoid.

Varoutakis, however, is likely to believe that there is no benefit in striking an agreement before the last possible minute. And that may be after missing the required payment to the IMF on June 30. There is always a catch-up period in which late payments will be counted and default avoided. And this could go on with each required payment through the summer. The Troika is not likely to pull the plug once and for all if it believes that Greece is still bluffing and will in the end come to terms.

The Troika, however, has the money and still controls things. It is also subject to political pressures to no longer tolerate Greece’s obnoxious behavior. At some point there will be a take-it-or-leave-it moment and Greece will likely accept the terms then offered, claiming some success. But that will not be the end of the drama. Greece is likely to fall behind future payments and resume the negotiations in the future, though, perhaps in time, with a more collegial government.

All in all, it seems that Greece is likely to press the possibility of default to the last possible point, even after June 30, in hope of getting something it can claim to be a negotiating success to its supporters in Athens. But it is a dangerous road past June 30 as market forces may take over and begin the plunge into chaos before Varoutakis’ game theory based tactics have run their course.

Already there has been a massive withdrawal of deposits from Greek banks that now rely on assistance from the ECB to stay afloat. The interest rates on Greek government debt (owned almost entirely by Greek banks) have shot up again to unsustainable levels. Market forces are gutting the Greek economy, making the negotiations seem academic. Greece’s best hope is that Syriza recognize this and accept the latest terms on offer before it is too late.

A European summit showdown is scheduled for Monday June 22. With Greece, there have already been several showdowns. It could be that things will get worse, but if so, that might result in a new government more willing to negotiate realistically. By now, Europe has little more to lose by patiently (however disagreeably) waiting for the Syriza Party to run out of support. Better this than throwing everything into chaos with an unpredictable outcome.

Europe can use game theory too.

Market Forces Axe Deutsche’s CEOs

By Brad Hintz and Roy C. Smith

 From eFinancial News, June 10, 2015

Deutsche Bank’s Supervisory Board’s decision last week to oust its co-chief executives, after their ”new” strategic plan bombed at its annual general meeting on May 21 should have been no surprise.  The plan reaffirmed the bank’s status quo commitment to capital markets that everyone knew had failed and nearly destroyed Germany’s largest and once most esteemed universal bank.

The surprise was that the market reacted so sharply (the share price dropped by 9% immediately after the meeting), and that the Supervisory Board, headed by former Allianz CFO and Goldman Sachs partner Paul Achleitner, was actually listening. 

Since the financial crisis the CEOs of eight of the top ten originators of capital market transactions have now been replaced (three of them replaced twice) because their boards wanted to show accountability or the need for a strategic change of direction.

This may be the first such change motivated by a clear sign of impatience by market investors. The co-CEOs were, of course, already under considerable pressure from regulators, labor unions and litigants, but in the end, the Board’s action, so soon after the AGM, was triggered by recognition that market forces could not be ignored any longer.

John Cryan will take over at Deutsche Bank at the end of the month – the same time that Tidjine Thiam will do the same at Credit Suisse. Both have been appointed to bring an unbiased mind to the problem of sorting out their bank's future. Should they split up the bank, which we recommend Deutsche Bank do in Financial News on April 29th, or drastically cut back on “risk-weighted-assets” and resize the capital markets business - like UBS and Barclays are doing.  

Credit Suisse’s asset management business gives Mr. Tijane some time to consider further changes, but Mr. Cryan cannot delay. Investors are anxious to know how Deutsche Bank will improve shareholder returns (currently 8% less than the bank’s cost of equity capital) and what business lines it will focus on in a totally changed capital markets business environment.

The key issue for investors is the enormous discount to break-up value that the current market price of the bank represents. Deutsche’s current depressed price to book valuation represents the market’s continuing dissatisfaction with the risk-adjusted earnings potential of its capital markets business.

Deutsche Bank’s current capital markets business has been made unviable by regulatory changes that have permanently changed the core business model of investment banking, reducing returns on assets and limiting risk-taking.

Balance sheet intensity remains high at the bank relative to its competitors. This constrains returns on equity. “Liquidity coverage ratios” and “net stable funding” targets have substantially increased the liquidity costs of OTC market-making. New leverage targets are pressuring matched book, inventories and unclear derivatives positions. Moreover, the Volcker rule in North America, new standardized risk weightings, and more stringent EU and US stress tests are expected to further squeeze operating performance.

However, institutional investors can be confident in the earnings potential of Deutsche’s other businesses -- transaction processing, asset management, wealth management, and trade finance activities. In these areas, the bank is globally positioned and has a loyal corporate client base.

Since the crisis, Deutsche Bank has delayed making difficult decisions. Now it is up to Mr. Cryan to make them. Though General Electric has decided to sell off most of its GE Capital unit, and American Express spun off its Lehman Brothers subsidiary in 1994, no major bank has been willing to go that far. Mr. Cryan will have to take a hard look at spinning off the capital markets unit, or explain to investors why he didn't do so.

Deutsche Bank’s long suffering shareholders want a return to steady profitability and dividends. In his new role, Mr. Cryan will have to devise a credible plan to do so, and then execute it. Neither are easy assignments; we wish him good luck.

Wall Street’s Elite “Analysts” Programs

By Roy C. Smith and Charles J. Murphy

Andrew Sorkin’s June 2, 2015 article about the death of Sarvshreshth Gupta, a 22 year-old first-year analyst at Goldman Sachs has created a lot of buzz at NYU Stern where many undergraduates have long sought similar jobs as Wall Street analysts.

These jobs are very highly valued for the training, prestige and future opportunities they provide. They are widely sought by the best and the brightest and most competitive undergraduates from all over the world. They also pay very well (for 22 year-olds).

But, they do come with an expectation of 80-100 hour workweeks, and a total immersion in the firm that allows very little time for developing a “real life.” It has been this way since anyone can remember.

Part of the reason for this is the unpredictability of activity in capital markets, which includes prospecting for and executing new issues of securities, IPOs and mergers and acquisitions. This year’s activity level, for example, is considerably higher than last year’s; when activity levels surge it is “all hands on deck.” The work has to get done, something everyone knows and pitches in to help achieve as a team effort.  

Periodically there are quiet periods, which don’t get discussed much, though these too can be consumed by greater marketing efforts.

But another part of the reason for the high workload for young “analysts” (those with Bachelor degrees) and “associates” (MBA’s) is cultural. The firms believe that having a relatively small staff of high-grade junior employees to handle the business provides a more intense form of training that produces a cadre of highly professional mid level employees with long-term career potential.

Analyst positions originally were awarded with a two-tear contract, after which the individuals were expected to go back to school for a MBA. In recent years, the two-year contract has been replaced with an open-ended job offer with the understanding that some, but not all, of the analysts will be upgraded to associates.

The first two years at the elite firms is focused and intense to a degree that most twenty-somethings have never experienced. It is a tough, sink-or-swim process that separates out those that have the aptitude, personality and preference for this type of work that requires balancing the needs of several different deal-teams against moveable deadlines. It can be nerve-wracking and physically demanding; in some ways it is similar to the elite military training for Seals or Special Forces units.

It is tough, especially for foreign-born individuals to whom the high-pressure American work environment is completely alien, but that doesn’t mean people are expected to work themselves to death.

Of course the firms have a responsibility to provide some sort of watch over their young analysts to be sure they are not loaded down with more than they can be expected to deliver. Some sort of mentoring has to be part of the package with intervention from time to time to shift the work around to spread out when deliverables are due so they are not all due at once, a common nightmare.

Most of the firms recognize this and indeed have attempted to ease the pressure by hiring larger analyst classes, reducing weekend work and by offering counseling and other support services. Nevertheless much of the pressure on the analysts is self-induced and too often individuals struggling with their jobs are unwilling to seek help for fear of appearing weak or falling behind.

But the analysts themselves need to understand a few basics too.

First is the simple fact that the training is all about establishing a reputation for being professionally reliable, which means getting the work done accurately and on time, without pestering others with a lot of questions about how it is to be done. Reliable analysts get promoted, those that aren’t don’t.

Second, its about handling chaos and disorder.  Most analysts work on several deal-teams at once, the requirements for deadlines, meetings, etc. change from week to week, sometimes creating convergence or overloads on the system. It can certainly seem chaotic, but successful analysts learn to look ahead a week or two, prioritize and anticipate what has to be done, and plan accordingly. If conflicts emerge (you can’t be in two places at once), let your boss know well ahead of time, maybe suggesting an alternative way out. This also means that there are times when the analyst has to say he or she is too busy to take on a new assignment.

Third, a tough training environment is going to have to be endured before you can really judge whether or not the work (and the career) is what you want. The analyst programs are supposed to test endurance, but you probably won't really know whether this type of work is for you or not until you have completed the intended two-year training cycle. You can always decide to do something else later, but, for most people, the best advice is to stick it out.

There are many benefits to completing a two-year hitch as an analyst. Some then decide to seek MBAs or other graduate degrees with the expectation that their analyst experience will help them gain a coveted position as an associate in a top financial firm. Others may stay on, being promoted to associate without going back for an MBA. And many decide to go on to hedge funds, private equity firms or other non-financial destinations where they can establish the kind of work-life balance they want.

Mr. Gupta may have committed suicide, for reasons that may have been job related but could have involved other factors as well. He apparently did not adjust well to the job he had, and tragically, neither he, his family, nor his superiors at Goldman Sachs were able to recognize his distress and help him deal with it. It was a horrible misfortune that should result in closer attention to struggling analysts in the future.

But the overall success of the analyst programs at Goldman Sachs and other top firms in not in dispute. They produce very well trained and competent finance professionals that can go on to very rewarding work at their original firms or elsewhere.

Messrs Murphy and Smith are former investment bankers who are Professors of Finance at NYU Stern School of Business.