James Saft

James Saft is a Reuters columnist. The opinions expressed are his own.

Just when it looked like Spain would force the euro zone to get serious about destroying its crippling debts, here comes plucky Belgium, hobbling its way to history.

While some are focusing on whether Portugal will take a bailout (hint: they will) and how to extinguish the burning firewall around Spain,  markets are steadily losing confidence in Belgium, which is big enough, ugly enough and heart-and-soul-of-Europe enough to change the game, potentially forcing sovereign defaults and bank recapitalization.

Investors imposed an all-time-high risk premium on Belgian bonds relative to German ones on Monday amid political chaos. Belgium’s parties have for the past 212 days been unable to agree a government, forcing King Albert II to step in and ask for a cost-cutting budget for 2011. Gross government debt is very high, hovering around 100 percent of GDP, leaving Belgium very vulnerable to a loss of market confidence.

Given that Portugal is likely to soon apply for help and rising concern about Spain, contagion to Belgium could be the catalyst that forces European authorities to rethink their approach.

This latest round of euro zone risk aversion may have been touched off by a proposal released last week that may mean senior lenders to banks would in future be forced to share in losses in the event of failure, so called “burden sharing.”  A feature of the sovereign bailouts thus far, notably in Ireland, is that the authorities have refused to force bank senior creditors to share in the pain, no doubt because to do this would be to reveal many banks as insolvent.

This means Ireland and Greece have not been relieved of debt, only allowed to remain in debt for longer on better than market terms. The budget cuts this impels only worsens their economies, making those debts harder to service over the longer term.

However, investors can read and as soon as they learn that there may be burden sharing, even in the fuzzy future, they react by selling out of current government debt positions in weak countries, potentially increasing the size and scope of the bailout which is needed.

Europe is really a prisoner of this policy. It does not want to acknowledge that many banks are insolvent and need massive new capital, but being unwilling to do this forces it into politically impossible positions and will only in the end lead to sovereign defaults which will, you guessed it, reveal the banks to be insolvent.

CUTTING THE GORDIAN KNOT

If Ireland, for example, had its own central bank and its own currency it could try and inflate its way out of its debt difficulties, a back-door default, but one which would allow the banks to slowly heal. This is the policy of the U.S., where the banks may not fail but the economy will pay a heavy tax while they recover.

This just isn’t going to work for the euro zone, especially given that so much of the debt is held abroad.

“For a number of euro area sovereigns the consolidated position of the sovereign and the banking sector looks unsustainable. This means that either the unsecured debt of the banks will be restructured or the sovereign debt or both,” Citigroup economist and former Bank of England Monetary Policy Committee member Willem Buiter wrote in a note to clients.

The U.S. will hate this, as it goes in the exact opposite direction of its own back-door bailout of the banking system, and will fight it tooth and nail. If you have any doubt of this, note the appointment of Davos Man and J.P Morgan banker Bill Daley as Obama White House chief of staff.

A restructuring of sovereign debt — a polite default, combined with a restructuring of bank debt and a recapitalization of weak banks offers the best hope for the euro zone. Besides being fair, as foolish creditors will share in the pain with taxpayers and citizens, it also has the potential to leave the euro zone on a solid footing, with a level of debt that is manageable and will not sink the economy, and with a banking system that can play its role in a recovery.

This is neither simple nor uncontroversial; huge losses will be taken and it will not be easy either to gain consensus to recapitalize swaths of the banking system, or to turf out current management.

We end in the same place in either event; the debts are unsupportable unless reduced and ultimately the sovereigns and the banks they backstop will fail.

Better to get on with it, get an early start on real recovery and avoid a couple of more years of legal looting by the financial sector.

Let it come down.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

From Dublin to Paris to Budapest to inside those brown UPS trucks delivering holiday packages, it has been a tough few weeks for savers and retirees.

Moves by the Irish, French and Hungarian governments, and by the famous delivery company, showed that in the post-crisis world retirees, present and future, will be paying much of the price and taking on more of the risk.

This goes beyond merely cutting back on pension benefits, rising to actual appropriation of supposedly long-term retirement assets to help fund short term emergencies.

Let’s start with Ireland, which is kicking in 10 billion euros from its National Pensions Reserve Fund into an 85 billion euro package of support for its banks.

Trust me, this does not reduce the risk profile of the NPRF, which was set up as a sovereign wealth fund to help pay for state retirement benefits.

Putting aside jokes about sovereignty and wealth, of which there is appreciably less in Ireland than formerly, this is effectively a transfer of wealth from the Irish people to its banks. Or rather, to the institutions, mostly European banks, which hold Irish bank debt, none of whom as senior creditors will share in the pain.

In many jurisdictions if Ireland were a corporation and the NPRF part of the corporation’s pension fund, then making such a move would be illegal, and quite rightly so.

Of course this is not the first time that the NPRF has been used in this way. It has already “invested” 7 billion euros into Irish banks and has pledged another 3.7 billion to struggling Allied Irish Banks.

Also under consideration is a regulatory move that would effectively compel some private Irish pension funds to hold more Irish government debt, thereby providing the state with a captive investor base but hugely raising the risks for savers.

On to Hungary, which is seeking to cut its very high level of public debt as it prepares for entry to a euro single currency which may well self-destruct before it ever gets the chance to join. Hungary’s government last week finalized new rules designed to force members of private pension plans to opt back into a state controlled pay-as-you go option.

The idea, such as it is, is that participants in the private plans will fork over their $14 billion or so in savings, equal to about 10 percent of Hungary’s GDP, to the government in exchange for a pledge of a pension from the state. Hungary plans to use the funds to make pension payments to current retirees this year and next as well as to pay down government debt.

It is, in short, an outrage.

PACKAGES SOMETIMES GET LOST
Earlier this month France launched a move similar to Ireland’s as part of legislation that raised the age of retirement.

France is transferring more than 20 billion euros of assets belonging to its Fonds de Reserve pour les Retraites (FRR), a funded portion of its retirement system, to Cades, a fund designed to be run down to pay for social benefits.

The transfer will take place over a number of years and the mix of assets held by the FRR in the meantime will shift radically, implying a large shift to government debt. Very convenient for the French Treasury but perhaps not so good for future retirees.

Finally, let’s turn to UPS, which earlier this month became one of the most notable of a string of U.S. companies to sell bonds in order to fund its obligations to its underfunded pension fund. UPS sold $2 billion of bonds due in 2021 and 2040, with the longer dated portion yielding about 5.0 percent.

A decade of paltry equity market returns and current low bond yields, which are used to calculate future liabilities to retirees, have left many firms, including UPS, with funding deficits.

Debt financing pension obligations is in essence a plan to try and make a spread between the cost of financing and the returns the company is able to make on its pension assets.

Borrowing to speculate in financial markets to make up for a lack of previous saving; what could possibly go wrong?

To be fair, UPS, which is one of many large U.S. corporations making similar moves, can’t be equated with Ireland or Hungary. UPS has the same legal obligation to its pension fund no matter how it chooses to fund it, so the bond issue from that perspective does not raise the risk for retirees.

That said, a participant in a company pension plan is dependent on the ability of the company to meet its obligations. The more debt the company takes on, the higher that risk is.

Savers of all types are being asked to shoulder risks they did not sign on for, the costs of which they will inevitably bear.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.email James Saft at jamessaft@jamessaft.com)