AFTER FAILING TO abide by its own internal guidelines, sidestepping industry best practice, and ignoring internationally agreed standards, a one-time star borrower is brought low. Underlying this is a combination of highly structured financing – often suggested and effected by competing investment banks – and inconsistent accounting. This has disguised the true, excessive extent of the borrower's debt. All of the deals involved might have been legal, but their revelation has left investors shocked and out of pocket.
It sounds like the depressingly familiar tale of corporate accounting in the Enron era: but the sort of borrower we are talking about is a government not a corporate. And the governments involved are the very ones that have explicitly set themselves the task of borrowing responsibly – western Europe's EU members.
Governments have always been two-faced in these matters. They like to borrow and spend money liberally while maintaining a reputation for fiscal prudence. In Europe the combination of the recently reformed Stability and Growth Pact and an economic downturn that has made deficits worse has increased the pressure that governments are under. Now, it is the administrations of Berlusconi, Blair, Chirac and Schröder, not corporates, that are stretching out along the razor's edge of what is acceptable in financing and accounting. It is finance ministers such as France's Breton, the UK's Brown, Germany's Eichel and Italy's Siniscalco, not CFOs, that are looking at ways to massage the books. And it is government borrowing officials, and the agencies that borrow for many governments, rather than corporate treasurers, that are having to come up with the trade ideas to achieve it.
"There is a huge amount of creativity going on right now," says an analyst at a European bank.
That raises the question: is there enough transparency? And is the entire European government bond market, totalling €2.94 trillion, trading on the basis of a misrepresentation of the true extent of government indebtedness?
Back to basics
There is a whole range of things governments are doing that investors and taxpayers should be paying more attention to. "You go from the basic tricks through to genuinely creative stuff like some of the pension transfers," says the analyst.
The basic tricks are truly basic. When the EU's statistical agency, Eurostat, announced revised figures for Greece's general government debt and deficit last year, one reason it increased the debt to 110% of GDP at the end of 2003 up from 103% was that Greece had been under-reporting military expenditure and over-estimating social security surpluses. It confirmed long-held suspicions, after a time when Greek government bond yields had all but converged with those of core European governments. "We've always known Greece was obligations as revenue. If a corporate tried using such gimmicks it might send a sell signal to sceptical investors who, post WorldCom and Parmalat, are increasingly vigilant. Have governments been getting away with tricks corporates no longer dare use?
"You have to think about government accounts as you think about corporate accounts," says Gary Jenkins, European head of credit research and fundamental strategy at Deutsche Bank. That means looking not just at the headline numbers but in some detail at the notes outlining what accounting techniques have been used to allow those numbers.
Of course, this is not entirely new. "In the 1990s, it was alleged that the French government took responsibility for funding France Telecom's pensions and pocketed the assets," says Stephen Yeo, senior consultant at pensions consultancy Watson Wyatt. "But by keeping them off balance sheet, France got a windfall gain. In accounting terms, that is absurd."
In 2003, Belgium assumed Belgacom's pension liabilities. Rather than transfer Belgacom's funded scheme, its assets were liquidated and paid to the government in cash. Although the government can use the cash to cut its debt, the unfunded pension liabilities are not incorporated under the Maastricht definition of general government debt. Hey presto! Without the deal, Belgium would have had a budget deficit in 2003. With it, it recorded a 0.2% surplus.
Belgacom's future pension liabilities are estimated at €5 billion, or 1.9% of GDP. That makes it the biggest one-off measure by any EU country relative to GDP. It's not just the Club Med countries (Greece, Italy, Spain and Portugal) that are testing the limits. "Belgium has been transparent and worked hard to bring its deficit down with surpluses," says Price. "To suddenly find them relying on one-off measures was a little bit sad." Investors should be on the look-out for more of this.
Growing pressure on governments to address the problem of unfunded pensions has resulted in similar deals elsewhere.
More systematically, many governments borrow large sums not in their own name but through state-supported or implicitly guaranteed vehicles. This is beyond accounting gimmickry, it's a bold-as-brass casting off of government liabilities. Germany's KfW is state-owned and state-guaranteed. "How that isn't on the German government's balance sheet I don't know," says a debt syndicate banker.
Off-balance-sheet transactions also include sovereign ABS deals. Italy has done a series of them, and even Germany is becoming increasingly active. Last year it securitized Russian bilateral debt receivables through the €5 billion Aries transaction. Sovereign ABS deals must be cleared by Eurostat, although sovereigns have jumped the gun by booking them as cutting Maastricht debt while waiting for a Eurostat ruling. Where they have succeeded in treating the proceeds of securitization as revenue and not borrowing, sovereigns have arguably got away with accounting sleight of hand that corporates today can only dream of using.
Some types of infrastructure finance create contingent liabilities that should appear in some form on a government balance sheet but don't always do so, because the borrower is a private contractor or an SPV. The most prominent examples are found under the UK's private finance initiative (PFI), which at March 1 this year had clocked up projects with a combined capital value of more than £34 billion ($61 billion) completed and operating. Several commentators reckon that the UK's off-balance-sheet liabilities under PFI and similar public-private partnerships are worth about £40 billion .
Governments don't just create new borrowing and funding vehicles. They can change the status of existing bodies. Cassa Depositi e Prestiti (CDP), the Italian treasury's bank, was part privatized in 2003. It remains 70% state-owned. Since then it has arranged a $20 billion covered bond programme. The money CDP borrows will be used to buy state assets and for public sector lending. As Fitch noted in a report in March this year: "CDP is being used as a vehicle to off-load government expenditure." What accountant would sign this off had it been a company rather than a sovereign?
European sovereigns have also synthetically cut their budgets in various ways. Reducing interest rate payments on debt burdens via derivatives is one popular trick. Now, one senior sovereign borrower reports that investment banks are pitching more subtle "Maastricht" derivative structures to European governments. This is beginning to cause concern. One member of the European Parliament told Euromoney: "Central banks and banking supervisors should be trying to get a handle on this, but I would be surprised if they have."
A common thread runs through these disparate deals. They either disguise government borrowing by keeping it off balance sheet, or limit it by creating liabilities that might be realized at a future date.
Deutschland über Libor
Many European governments are getting more creative, not less so. Some are close to exhausting the one-off measures that are available to them. Italy has used one-off measures including tax amnesties, sales of future revenue streams, real estate asset sales and the CDP deal to keep its deficit within 3% of GDP in four of the past five years, according to Fitch. It will probably rely on them again to avoid breaching the limit in 2005 (without them its deficit, says Fitch, will be about 3.9% of GDP). Italy has announced that it is phasing out one-off measures in 2006: the decision has in part been forced on it. "The easy stuff is off the table," says Moritz Kraemer, director in the sovereign ratings team at Standard & Poor's.
The easy stuff from Italy has included several securitizations that can be defended as a halfway house to privatization. It can be quite appropriate for a government to try to take a step back from non-core economic activities or reduce its holdings in specific assets and cast light on parts of the economy and assets that would otherwise remain murky and inefficient.
But while many securitizations aim to achieve this, others fail. The merits of Germany's two highest-profile transactions are, from a structural and accounting perspective, highly questionable. The irony of this situation is that, behind the scenes, German officials were some of the most strident critics of the ABS deals executed by other European sovereigns before 2002.
In May, €8 billion of civil servant pension rights backed by payments from Deutsche Telekom, Deutsche Post and Deutsche Postbank were sold off by the government. "It was a very short-sighted play," says one senior ABS originator. This was only a securitization in the loosest terms. It is impossible to argue that the finance ministry's motivation in the pension deal from May was anything other than purely revenue-raising over the very short term. The securitization uses future company payments from BPS-BT, the entity responsible for collecting and paying pensions to the former civil servants and the retired workers of the three Post successor companies, Deutsche Telekom, Deutsche Post, and Deutsche Postbank. Following privatization, the former civil servant workforce went from the public to the private sector. These three have a legal obligation to pay pension contributions. The same law requires any shortfall of payments made by BPS-BT to the three companies be covered by the government. It is this legal requirement that supports the notes – not the deal's structure. Therefore the underlying risk is the Federal Republic of Germany.
The deal merely delays the day of reckoning for the German taxpayer. "The government will have to pay more eventually. It is increasing financial flexibility today at the expense of financial flexibility in the future," says Kai Stukenbrock, an analyst at S&P.
Just over a year ago, the whole market was taken aback by the Aries issue – a €5 billion multi-tranche issue that shifted €20 billion of Russian debt off Germany's balance sheet. The notes were rated double B, reflecting the underlying risk of the SPV, Aries. The unfavourable economics for the German taxpayer make it clear that Germany was under pressure to sell non-core assets if possible. The Russians were not being that helpful. But in the rush to get the assets off the balance sheet Germany cut itself a very poor deal. Many market participants argue that Germany received at least €120 million less than it could have on the transaction.
The one positive outcome is that Russia has subsequently prioritized repayment of Paris Club debt. After the transaction, Russia's curve was hit by serious volatility and moved wider by two basis points.
What are the consequences of these transactions? "Fiscal flexibility is gained in the short run, as receipts from the transactions reduce deficit-financing needs. In the long run, however, fiscal flexibility is constrained, as future receipts from financial assets are reduced synthetically – in the case of Aries – and as future pensions expenditure is increased, in the case of German postal pensions securitization," says S&P's Stukenbrock.
In layman's terms, it's selling off the family silver in the hope that good times are around the corner. At least recent ABS issues from Italy have been conducted under the cover of an alternative economic rationale. For instance, the Italian treasury can plausibly argue that July's €3.3 billion Fondo Immobili Publici (FIP) was designed to help develop the closed property fund market in Italy. But there is little doubt that the real driving force for all this activity is less to do with market reform, more to do with prettying up the national finances.
France takes a chance
Few European governments are blameless. Although Italy is known for its aggressive use of securitization – with €90 billion of deals – France has been among the more innovative users of the capital markets. Take Erap, which was originally the holding company for Elf. Until 2002 it was moribund. But the government changed the law to allow Erap to provide just under €10 billion of debt finance for the recapitalization equity issue to bail out France Telecom. By doing so, it neatly side-stepped the fiscal hit to its budget.
In 2003 the government changed the law to allow the unemployment fund, Union Nationale pour l'Emploi dans l'Industrie et le Commerce (Unedic), to raise €4 billion with the explicit guarantee of the state.
It's arguable that France kicked off the whole budgetary scam back in 1996, when it created Caisse d'Amortissement de la Dette Sociale after it became clear that social security debts would wreak havoc with the government's budget and debt levels. Cades borrowed €41 billion last year. The total size of its off-balance-sheet capital- raising since its inception in 1996 amounts to €110 billion.
Cades was created to refinance and amortize the debt mountain of the French social security system. Initially it was only meant to refinance debt accumulated in 1994–96 but the directive keeps changing.
"When Erap bailed out France Telecom, there was a government guarantee," says a debt syndicate banker. "Cades and Unedic don't even have that, they are implicitly guaranteed. Erap was one of the masterful French fudges of all time, but these two [Cades and Unedic] really took the biscuit!"
Eurostat strikes back
Governments have got away with so much that corporates would no longer dare to try that one wonders whether anybody cares. Have investors been bought off by the convergence trade and falling yields? Have governments themselves suborned the process of regulating their own financing activities?
In July 2002 Eurostat drew up rules on what securitization techniques the governments could use and several transactions were ruled illegitimate. Until that point, the ESA 95 rule book had been unclear on what structures were legal.
The biggest problem the statisticians had was with future-flow ABS deals from the Italian and Greek governments. In future these would be regarded as pure government borrowing. Unsurprisingly these types of trades immediately disappeared from the landscape.
The other rules that Eurostat introduced three years ago put conditions on government guarantees to SPVs, capped the amount that assets are discounted before sale (15%), and limited the value from an ABS that governments could record to the actual sum of cash the SPV pays to the government. Italy, Greece and Austria were all affected, with a total of €12 billion placed back on their balance sheets. Although this Eurostat action made the financial headlines and stopped some types of deals dead, governments have continued to seek assets to securitize or monetize.
Eurostat continues to struggle to keep the sovereigns in line. Italy suffered a recent setback when debt issued by Infrastratture SPA (Ispa), its infrastructure financing vehicle for the high-speed railway link between Turin, Milan,
Rome and Naples, was ruled as government debt. The exact size of Ispa's activities has yet to be fully determined but expectations were that it would be at least €20 billion.
Ispa was an attempt to replicate the agency model that Germany and France have long operated. The government owns Ispa and the railway operator, Rete Ferroviaria Italiana. Eurostat took the unusual step of publishing the full opinion of the Committee on Monetary, Financial and Balance of Payment Statistics (CMFB) online. The opinion argued that the guarantee offered by the Italian state was very likely to be called.
CMFB is independent of Eurostat and includes two officials from each of the 15 pre-expansion EU countries – one a central banker, the other a statistician from the relevant national institute. Although Eurostat is independent, insiders say it will rarely overrule a clear-cut majority decision by CMFB. And with CMFB's members appointed from within the ranks of the borrowers themselves, some would argue that the EU's statistical infrastructure is designed to allow self-regulation by member state borrowers.
Transfer of risk is an important consideration for these officials. They argue that the rules explicitly state that there must be a real transfer of risk. There is little proof that there has been a true transfer of risk to Ispa, says Eurostat, as monies had to be rerouted to either the government or the railway company.
The statisticians and governments now argue that shifting risk off the balance sheet is fine as long as risk is transferred. But the lack of real risk transfer on government-linked ABS transactions was highlighted by three new tranches issued by Italy's SCIP 2 earlier this year. This was a €4.4 billion refinancing that protected investors from slower-than-expected collection rates that put the soft bullet redemptions under threat.
The Italian government was forced to act. Leaving investors with a bad taste in their mouths would have hindered its huge securitization programme. Italy has many more deals in the pipeline. Next up is SCIP 3, a €1billion MBS. The government has also sent out a request for proposals on an innovative deal for Gestore della Rete Trasmissione Nazionale, which runs the electricity transmission network. In reality sovereigns cannot afford to see their deals fail.
Derivative dodge
These are the trades in the public domain. But there is much more going on behind the scenes. Off the record, derivatives bankers will talk about sovereigns entering into swaps in an attempt to hide the true state of their finances. When used to hedge exposures or manage risk, derivatives are innocuous and useful tools – prudent even. But they have in the past been used to disguise budget deficits. Famously Italy and Greece used these techniques to get into the euro zone.
For instance, a finance ministry can execute a swap on an old high-coupon bond that has a few years to run to maturity. Investment banks will then offer an EU sovereign an upfront payment in return for a regular income stream for the next 10 years. Some governments have been tempted to pass these up-front payments off as income, when they are in fact more akin to loans.
In 2002, for example, Greece executed an off-market cross-currency swap on yen and dollar debt via Goldman Sachs that effectively provided the sovereign with a €1 billion loan.
While one senior national debt manager suggests the Club Med countries are guilty of using derivative contracts to bolster their fiscal positions, Eurostat does use full accrual accounting methodology for the purposes of the excessive deficit procedure and therefore does capture the effects of swaps on interest expenses.
It is hard to blame investment banks for doing this business. All banks want to play in the derivatives sector and all are keen to offer innovative solutions to clients. In fact many bankers are adamant that what they are helping governments to achieve is completely appropriate liability management.
Accounting for nothing
Almost all of Europe's governments use historical accounting for their domestic versions of the national accounts. There is no reason why European governments should be wedded to a system of accounting that is so opaque. For instance, Canada's accounting framework has encompassed a full accrual framework since 2002–03. All revenues and expenses are recorded when they are incurred, regardless of when the actual cashflows occur. Perhaps Canada can afford to be more open. Over the past 10 years Canada's debt burden has fallen by the fastest rate among the Group of Seven countries.
Analysis of the fiscal performance of European countries relies on data supplied by each of those country's national statistics offices. "For us the issue has been the extent to which countries have been distorting their data," says Lionel Price at Fitch. "Our confidence in the data varies from country to country. On sovereign rating visits you get an impression of competence, as you do when you visit anyone. Within Europe we assume that the numbers are honestly given, but how much are people bending definitions?"
This has been a concern for some time. In a report published in 2002, Price wrote: "As with corporate accounting, increasingly detailed budgetary rules may be unable to prevent the key data series becoming less reliable measures of a 'true and fair' view of a government's finances... If governments are tempted to honour the letter rather than the spirit of the [Stability and Growth] Pact, its observance could become a charade."
The rating agencies find Eurostat a useful starting point when collating and comparing sovereigns' fiscal data. But Eurostat is also dependent on data supplied by the countries it is assessing. So the rating agencies do not rely wholly on Eurostat's statistics. "When we tabulate government debt we do just use the Eurostat figures," says Price. "If we didn't, we would confuse people. But in the analysis, we address the issue of data reliability."
Their scepticism about official data has enabled the rating agencies to show Eurostat up. "Eurostat is changing the rules so that, for example, Italy now has a deficit above 3% of GDP," says S&P's Kraemer. "We never bought into that. We always recorded a much higher deficit and we changed Italy's outlook as early as 2003."
Similarly, the European Commission's reliance on official statistics can result in it missing mistakes by individual sovereigns. "Greece is the most prominent example where the [deficit] numbers were reversed. They were off every year by 2% or 3% of GDP," says Kraemer. "We reflected this in the lowest eurozone rating, despite high nominal growth numbers. If we depended on the EC to detect excessive deficits, we would not be doing our job."
S&P says that by and large it is happy with the numbers it gets from EU governments, although it does sound a note of caution for the immediate future. "With trends toward being more creative on the funding side, you have to be more careful taking a general government debt number, based on Maastricht criteria, and running with it," says Konrad Reuss, S&P's managing director, sovereign ratings.
Damn lies and Euro statistics?
As the body that decides whether government debt is on or off balance sheet for Stability and Growth Pact purposes, Eurostat has a key role in keeping government borrowing transparent. If national data is wrong or misleading, what can Eurostat do about it?
As one senior public sector banker asks: "What binds individual sovereigns to Eurostat? What constitutes transparent behaviour? If you try to fool the IMF in your Article IV submissions, you don't get IMF money. There's got to be a credible sanction."
The EU is taking steps to ensure that the data it collates is accurate and consistent. Last December, the European Commission published a paper entitled "Towards a European governance strategy for fiscal statistics". This proposed that, to make the excessive deficits procedure work, Eurostat should get the authority to carry out effective checks on data supplied by member states, which it could not do under existing law; that Eurostat and the European Commission's economic and financial affairs unit, DG Ecofin, undertake lengthier and better planned visits to member states; and that all of Europe's national statistics institutes should meet the same standards of independence, integrity and accountability.
In short, "Eurostat, as a statistical authority, must be able to actually verify the figures provided." It needs the right to directly examine public accounts and to carry out spot checks without obstruction from member states. And it needs the resources to do so. The EC intends to draft legislation to achieve this.
The result is a proposed amendment to a regulation that the European Central Bank and the CMFB have welcomed. At national level, member states should publish sources and methodology for compiling their fiscal data.
Eurostat itself is building a database that will collate all public finance statistics that members submit to it under EU law. With new tools and new powers, it will be better equipped to persuade and cajole European governments to play by the rules. The first signs are encouraging. Last year, its rulings on Italy's ABS deals suggested that different EU members were learning to abide by Europe-wide standards. "Eventually the Italian government accepted Eurostat's and the EC's view," says Lorenzo Codogno, co-head of European economics at Bank of America. "That confirmed that Europe is more important than national interests."
Through its numerous working groups, and in conjunction with the statistical programme committee of the different national statistics offices, Eurostat needs to keep improving how it measures sovereigns' fiscal performance. "There has been some improvement since the Portugal case and since Greece cooked the books, but the situation is not yet optimal," says Codogno. "There is still work to be done to narrow the margins in which governments can manoeuvre."
Much remains to be done to bring governments under anything like the same kind of effective scrutiny to which corporates became subject in the wake of their accounting scandals.
In the long run
Lack of transparency is not good for anyone in the long run, taxpayers or investors. It is becoming increasingly difficult for anyone to really know who owes what and to whom. It is clear that the European fiscal policy framework and safeguards are failing. Both the bond markets and the EC have failed to censure spendthrift nations. Arguably, one of the reasons the ECB has followed such a relatively robust monetary policy is because of the loose fiscal policy most of the eurozone has followed in recent years.
Traditionally a lack of fiscal discipline by a sovereign has limited access to international capital, or incurred a substantial cost, but that has not proved the case in recent years. But just because there is a surfeit of capital in desperate search of a home does not mean these fortuitous conditions will continue for ever.
The critics, including rating agencies, believe that many of the sovereigns' operations are similar to a household selling or pawning the family silverware because of an unwillingness to address the need for more fundamental reform of spending and income.
The corporate/sovereign comparison only goes so far. Enron, for example, lied about its finances by hiding its losses, pure and simple. It's impossible to prove that EU sovereigns are doing the same. Some even suspect them of being too forthcoming. "National budgets these days are incredibly complex," says a London-based sovereign credit analysts. "There's an element of hiding in the open by giving people too much information."
For now it is entirely possible – even likely – that the bond markets are fundamentally mispricing credit risk. However, it is hard to judge debt positions given the lack of transparent data. Yet investors remain resolutely indifferent to disguised government borrowing. For some, the more pseudo-government debt that is out there, the better. "Investors don't care," says a syndicate manager. "It's free money. Within the bond market, it's not in anyone's interests to question this." It takes very big headlines, like those that followed Italy's Liga Norte politicians calling for the return of the lira, to rattle investors.
Debt capital markets bankers, of course, are not in the business of whistle-blowing on their best clients. They defend their lucrative structuring businesses. As one of them asks: "Is doing sovereign ABS deals really more unfair to the public than other borrowing? Are they mortgaging the future in a more nefarious way than by issuing the hell out of the unsecured markets? Is it more of a violation of public trust?"
As far as the eurozone is concerned, the bond market seems to assume that a one-for-all and all-for-one policy will buoy up individual credits: that the prudent will bail out the imprudent. But financial gimmickry has spread far. Who is really prudent here? And the bailout assumption is a false comfort. One banker says: "People don't care because they make assumptions about communal support and the purpose of EMU which they somehow put a value on. In fact there is no communal support in the EU Treaty. Indeed, the ECB's mandate forbids it from bailing out EU members by buying government debt."
The rating agencies are confident that they can detect the worst offences. "The basic principle is that we really look through these devices where we know about them," says Fitch's Price. "And increasingly we do know about them." But European sovereign debt needs to be monitored and made more transparent. And one-off measures cannot be a substitute for fiscal discipline.
Lack of enforcement
Will EU governments stop stretching the rules? Can the EU itself make them stop? Back in November 2003, when Ecofin decided not to impose sanctions against France and Germany over their excessive deficits, it gravely damaged the credibility of the EU's enforcement system. In particular, the failure of non-EMU members like the UK to press for sanctions was disappointing. "The UK wilted in 2003 when the investigations into France and Germany got called off," says Kraemer.
Ecofin launched excessive deficit procedures in July against Italy, which should shed light on how the revised Stability and Growth Pact is working in practice. But Italy could be a diversion. "The European Commission makes a lot of noise and says that Italy is the test case. But the real test case is France and Germany, and the Commission has to tackle this at its September meeting," says Kraemer. "I don't think they will be able to find a majority to go after France and Germany. You won't get a majority voting to go after core European countries."
If core Europe continues to treat fiscal rules as burdens to be shirked, one day bond fund managers – and those who have entrusted their savings to them – will have to start asking some very serious questions.