Satyajit Das is too shrewd to call the European Financial Stability Facility, informally described as a €440 billion sovereign bailout fund, a mere sleight of hand. But it’s hard not to draw that conclusion after reading his Financial Times comment today.
Central banks and governments have developed an alarming fondness for the very sort of fancy financial structures that investment banks used to camouflage and transfer risk and engage in regulatory arbitrage prior to the crisis. These students have quickly aped their teachers. The Fed used off balance sheet vehicles (Maiden Lane, Maiden Lane II and Maiden Lane III) to obscure the fact that it was circumventing Constitutionally-mandated budgetary processes and creating funding vehicles for the Treasury. These entities also served to hide the degree and nature of the risks absorbed from the public.
The Eurozone has taken this affinity for financial structuring legerdemain even further, drawing on the most abused structure of the crisis, collateralized debt obligations, to create (as before) super duper AAA credits from less promising material. As Das reports:
In order to raise money to lend to finance member countries as needed, the EFSF will seek the highest possible credit rating – triple A. But the EFSF’s structure raises significant doubts about its creditworthiness and funding arrangements. In turn, this creates uncertainty about its support for financially challenged eurozone members with significant implications for markets.
The €440bn ($520bn) rescue package establishes a special purpose vehicle, backed by individual guarantees provided by all 19 member countries. Significantly, the guarantees are not joint and several, reflecting the political necessity, especially for Germany, of avoiding joint liability.
Yves here. Got that part? So the Club Med countries that are the parties who might draw on this facility, are all expected to fund it. It’s sort of like being expected, at the time of an accident, to contribute blood to your own transfusion. Back to Das:
The risk that an individual guarantor fails to supply its share of funds is covered by a surplus “cushion”, requiring countries to guarantee an extra 20 per cent above their ECB contributions. An unspecified cash reserve will provide additional support.
Given the well-publicised financial problems of some eurozone members, the effectiveness of the 20 per cent cushion is crucial. The arrangement is similar to the over-collateralisation used in CDOs to protect investors in higher quality triple A rated senior securities. Investors in subordinated securities, ranking below the senior investors, absorb the first losses up to a specified point (the attachment point). Losses are considered statistically unlikely to reach this attachment point, allowing the senior securities to be rated triple A. The same logic is to be utilised in rating EFSF bonds.
If 16.7 per cent of guarantors (20 per cent divided by 120 per cent) are unable to fund the EFSF, lenders to the structure will be exposed to losses. Coincidentally, Greece, Portugal, Spain and Ireland happened to represent around this proportion of the guaranteed amount. If a larger eurozone member, such as Italy, also encountered financial problems, then the viability of the EFSF would be in serious jeopardy.
Yves here. I wonder whether there are other downside scenarios. Most people deem Italy as low risk (even thought its sovereign debt level is high, it also has a very high savings rate. so most analysts do not see it as a source of risk. But Italy is the third biggest sovereign debt issuer in the world. If anything were to go awry there, all bets are off).
For instance, say strikes and riots start in a Club Med country (Greece is the most likely, but it could be any one) and an austerity-opposing government is voted in. What if it decides to repudiate its commitments to the EFSF, perhaps as way to precipitate its exit from the Eurozone (treaty rules do not allow members to leave). Wild card events could also rock these arrangements.
And Das points out a critical weakness: the entire structure is vulnerable to the almost-certain downgrade of member states:
There is the potential risk that if one peripheral eurozone member has a problem then others will have similar problems. The structure faces a high risk of rating migration (a fall in security ratings). If the cushion is reduced by problems of one eurozone member, the EFSF securities may be downgraded. Any such ratings downgrade would result in mark-to-market losses to investors.
Unfortunately, the global financial crisis illustrated that modelling techniques for rating such structures are imperfect. Rapid changes in market conditions, increases in default risks or changes in default correlations can result in losses to investors in triple A rated structured securities, ostensibly protected from this eventuality. Given the precarious position of some guarantors and their negative ratings outlook, at a minimum, the risk of ratings volatility is significant…
Major economies have over the last decades transferred debt from companies to consumers and finally onto public balance sheets. A huge amount of securities and risk now is held by central banks and governments, which are not designed for such long-term ownership of these assets. There are now no more balance sheets that can be leveraged to support the current levels of debt. The effect of the EFSF is that stronger countries’ balance sheets are being contaminated by the bail-out. Like sharing dirty needles, the risk of infection for all has drastically increased…..
Deeply troubled members of the eurozone cannot bail out each other as the significant levels of existing debt limit the ability to borrow additional amounts and finance any bail-out.
The EFSF is primarily a debt shuffling exercise which may be self defeating and unworkable. The resort to discredited financial engineering highlights the inability to learn from history and the paucity of ideas and willingness to deal with the real issues.
Marshall Auerback has pointed out that yet another layer of budgetary finesse is at work:
With little fanfare, the ECB has been responding to the EMU’s solvency mess by conducting large-scale bond purchases in the secondary market (which, unlike direct purchases of government debt, is not contrary to the Treaty of Maastricht rules) for the debt of the EMU nations. As Bill Mitchell has noted, it is remarkable how little press coverage this has generated, but despite saying there would be neither be bailouts, nor unsterilized bond purchases, the ECB is now buying huge amounts of PIIGS debt to ensure the funding crisis in the EMU is contained. Given that this substantially reduces the insolvency risk, this is probably a wise policy, although it does little to address the underlying design flaws in the system which we have discussed before….
The Eurocrats, who have always found democracy to be antithetical to “sound economics” and “good policy”, now have the opportunity of using this crisis to ram through their vision of Europe, which is fundamentally anti-labour and pro capital.
In economic terms, this action is the same as Warren Mosler’s proposed revenue sharing proposal, although it is not done on a per capita basis, and is potentially rife with moral hazard, since it can theoretically mean that the biggest spenders – who will issue the most government bonds, which can then be bought by the ECB in the secondary market – are rewarded However, the ECB can eliminate this moral hazard problem simply by indicating to miscreant countries that it will refuse to buy their debt in the secondary markets if it does not continue to adhere to “responsible” fiscal policy. By embracing this quasi-fiscal role, the ECB in effect becomes the “United States of Europe”. The ‘distributions’ the ECB will make will be via buying enough national government debt in the secondary markets to keep the national governments solvent and able to fund their deficits, at least in the short term markets.
The reality, then, is that the ECB has become the political arbiter for fiscal decisions made by each of the euro zone national governments. If the ECB determines that any member nation is not complying to their liking, they will start threatening to stop buying their debt, thereby isolating them from the ECB credit umbrella, while allowing the remaining nations to remain solvent. And soon the bureaucrats who run the ECB will realise that the non-sterlisation of the bonds doesn’t create inflationary pressures and they will keep doing it, as they will find it to be a very powerful tool to keep national government spending plans which they don’t like in check. ECB spending on anything is not (operationally) revenue constrained as the member nations are, so this policy is nominally sustainable, even if fundamentally undemocratic.
Yves here. In other words, this three card monte, like many other cons, could work for quite a long time. But Das has exposed one major source of vulnerability, that of the impact of ratings downgrades. Auerback points out another: a revolt by workers in the Austerian nations, who will recognized, intuitively, perhaps explicitly, that the sacrifices demanded of them are a transfer to bankers in other countries. Riots in Greece helped put markets in a tailspin in May. It may be protests that break the perhaps too clever funding mechanisms devised by the Eurocrats.