Solutions: FINA 5500 / Spring 2012 / Quiz 4 (take home) In the light of what you learnt from Chapter 2, combined with the assigned reading material (on the Greece, Ireland, and Iceland), describe the causes of each financial crisis, in your own words, using no more than 100 words for each answer. Greece: With an incompetent and corrupt administration, a huge public sector, and massive tax evasion, Greece was already running an out‐of‐control budget deficit and mounting national debt. Naturally, Greece had a strong incentive to join EU, because that would reduce their cost of borrowing from 18% (in Drachma) to 5% (in euro), and their debt would be effectively guaranteed by EU. But to do so, they had to show low debt‐to‐GDP ratio and moderate inflation – which they did not have. So the Greeks used deceptive reporting practices to keep liabilities off their books. They also manipulated price indices, and froze commodity prices, to reduce reported inflation. In addition, through the help of investment bankers, they securitized future government receipts (lotteries, tolls, taxes, etc.) to issue more international debt. It was just a matter of time before the Greek government would default, unless bailed out by the ECB or IMF. Ireland: Ireland’s three biggest banks borrowed some 80 billion euros from global money centers (mostly in Germany, France and US) and over‐invested in Irish commercial and residential construction. This produced a real estate bubble that turned Ireland into the richest country in Europe in a very short period. The bubble finally burst once real estate stopped appreciating. As the banks were facing default, the Irish government guaranteed their bondholders (in Europe and US), instead of guaranteeing its deposits made by its own people. So in the end, the Irish government nationalized the banks losses at the expense of its taxpayers. Iceland: World rates (mostly yen and swiss) were close to 3% while Iceland rates were above 15%, and krona was appreciating. Seeing this as an opportunity, the three major banks started borrowing heavily in the international markets, and invested in expensive condos, soccer franchise, department stores, airlines, media companies, banks, power plants, etc. In most cases they took ownership /management stakes without understanding the underlying business, and so ended up paying inflated prices for bad assets. It created false wealth in their balance sheets, unrelated to the real sector of their economy (fishing and energy). Total bank asset ($140 billion) was many times more than Iceland’s GDP. The presumption was these assets will continue to appreciate, and the Korna would hold steady. But they did not, and especially the Krona crashed. Hedge funds saw this coming, and started shorting the Iceland banks and their holdings. Iceland’s economy crashed with the collapse of Lehman brothers in September 2008. How do these crises challenge the stability of euro? The stability of euro depends on member countries following consistent economic policies and experiencing symmetric business cycles. In this system, if one group has a crisis another group could end up paying for it. Greece acted irresponsibly, but other member nations, especially Germany had to absorb the cost. The Irish banks made bad investments and financing decision, yet their own government protected the European investors so that the Irish taxpayers took the fall. Iceland is not part of the euro, but they ignored foreign exchange risk, and paid dearly for it. Such episodes are likely to become more frequent, as member countries of EU start following independent, and sometimes conflicting, fiscal, monetary, and political goals. This in turn will adversely affect the stability and reputation of euro in the global market.