By Satyajit Das, a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2010, FT-Prentice Hall).
In the first half of 2010, angst about European sovereign debt receded and market volatility eased. In the second half of 2010, concerns about Greece, Ireland, Spain and Portugal returned to dominate headlines.
Greece passed its initial inspections on its restructuring plan from the supervising “Troika” (made up of the European Central Bank (“ECB”), European Union (“EU”) and International Monetary Fund (“IMF”)). In truth, there was no choice, as money had to be made available to enable Greece to continue to function.
Despite progress, the Greek economy slipped into a deep recession, impeding the recovery plan. As the government implemented austerity measures, the Greek economy shrank around 3% to 4%. The government is behind on its program to shrink its budget deficit from over 13% to 8%.
Tax revenues are weak, growing 3.3% well below the targeted 13.7%. This is despite tax increases including a rise in the VAT rate to 23 per cent. Faced by a collapsing economy, rising unemployment, increased numbers of Greeks leaving the country and social unrest, the Greek government even announced a cut in corporate tax rates from 24% to 20%. How this was going to help correct the budget deficit remains a mystery.
The “cure” may be worse than the disease. After implementing similar austerity measures, Ireland’s nominal gross domestic product (“GDP”) has fallen by nearly 20%. The budget deficit as a percentage of GDP has doubled to 14% from 7% Government debt as a percentage of GDP has increased to 64% from 44% at the start of the crisis. It is forecast to go to over 100% having been around 25% during the boom years. The cost of bailing out Ireland’s banking system has risen and may reach 20-30% of its GDP. Ireland’s credit rating has fallen.
In late September 2010, Ireland announced that in the second quarter the economy contracted by 1.2%, against expectations for 0.4% growth raising renewed concerns about European sovereign risk. Similar scenarios are playing out in Spain and Portugal.
Slowing growth in North America and China complicates the problems. Even Germany’s recent strong growth appears to be petering out. The effects of a weak Euro, government stimulus packages and exports of machinery as many industries retooled to lower production costs may have run their course. Real underlying demand remains weak.
Negative or low growth, savage budget cuts and economic restructuring will need to continue for years. Despite the Greek Prime Minister’s impossible MBA spin that the crisis represents a “historic opportunity”, it remains to be seen whether this is feasible. The willingness of government to impose and citizens to bear the decline in living standards necessary to avoid a debt restructuring remains uncertain.
The CDO Solution
In an effort to resolve the problems, Europe announced its version of economic “shock and awe”. Steps include an Euro 110 billion package for Greece, a Euro 750 billion “safety net” for all Euro zone members, ECB funding to vulnerable European banks, particularly in peripheral countries, and ECB purchases of around Euro 60 billion of bonds issued by some of the troubled countries. By late September 2010, risk margins on Greek, Irish, Portuguese and Spanish debt (relative to German government bonds) were above to the levels prior to the announcement of the European rescue plan. In short, the problems remain largely unresolved.
European sovereign debt problems are likely to remain prominent. Economic data, like growth, unemployment, budget position, and debt issuance will be key indicators on the trajectory of the crisis.
Increasingly attention may focus on the European Financial Stability Facility (“EFSF”), a key component of Europe’s financial contingency plan. Klaus Regling, the head of the EFSF and known informally as the CEBO (“Chief European Bailout Officer”), had a brief stint at Moore Capital, a macro-hedge fund, consistent with the fact that the EFSF is placing a historical macro-economic bet.
In order to finance member countries as needed, the EFSF will need to issue debt. The major rating agencies have awarded the fund the highest possible credit rating AAA.
The EFSF structure echoes the ill-fated Collateralised Debt Obligations (“CDOs”) and Structured Investment Vehicles (“SIV”). The Moody’s rating approach explicitly draws the analogy and uses CDO rating methodology in arriving at the rating.
The Euro 440 billion ($520 billion) rescue package establishes a special purpose vehicle (“SPV”), 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. 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% beyond their shares. A cash reserve will provide additional support.
Given the well-publicised and deep financial problems of some Euro-zone members, the effectiveness of the cushion is crucial. The arrangement is similar to the over-collateralisation used in CDO’s to protect investors in higher quality AAA 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 AAA. The same logic is utilised in rating EFSF bonds.
If 16.7% of guarantors (20% divided by 120%) are unable to fund the EFSF, lenders to the structure will be exposed to losses. Coincidentally, Greece, Portugal, Spain and Ireland happen to represent around this proportion of the guaranteed amount. Greece whilst an Eurozone member will not participate in EFSF’s lending programs as a provider of guarantees for the obvious reason that nobody would seriously place much value on any such guarantee.
Unfortunately, the Global Financial Crisis illustrated that modelling techniques for rating such structures are imperfect. The adequacy of the cushion is unknown. If one peripheral Euro-zone members has a problem then others will have similar problems. If one country requires financing, guarantors of the EFSF will face demands at the exact time that they themselves will be financially vulnerable.
The rating analysis published by the Agencies highlights subtle but extremely significant features in the structure designed to ensure the desired AAA rating.
Where an Eurozone member draws on the facility, the amount of funds on lent by EFSF will be adjusted by the following deductions:
A 50 basis point service fee
A percentage equal to the net present value of EFSF’s on-lending margin. For example, the Greek financing package had a margin of 300 basis points. This would translate into a deduction of around 13-14% (depending on the discount rate applied).
[1 and 2 constitute a fungible general cash reserve ("the Reserve") which will support all EFSF debt.]
An additional reserve specific to each loan made by EFSF (“the Buffer”) will be created. The exact methodology of determining this buffer has not been disclosed but will determined by several factors. The first factor will be the borrower and it credit condition. The second will be the position EFSF itself and the level of credit support available for its existing obligations.
The Reserve and Buffer are to be invested in liquid AAA rated government, supranational, or agency securities to be available as credit support for the EFSF’s obligations.
The requirement for the Reserve and Buffer significantly reduces the amount of funds available from the EFSF. Standard & Poor’s (“S&P”) estimated that after adjusting for the guarantee overcollateralization and the exclusion of Greece from EFSF’s program, the EFSF can raise up to Euro 350 billion (20% lower than the announced amount). After adjustment for the fact that borrowing governments cannot guarantee EFSF bonds and deduction of the Reserve and Buffer the potential available EFSF lending is further reduced.
Assuming a Reserve of say 13.5% and a Buffer of 10%, this would reduce the amount available to around Euro 270 billion (39% lower than the announced amount). Assuming an equivalent reduction in the IMF component of the package, the total amount available is around Euro 460 billion. The EFSF’s ability to lend compares to the forecast budget financing need of Greece, Ireland, Portugal and Spain of over Euro 500 billion in the period 2009 to 2013.
The structure outlined also increases the cost of the funding for borrowers drawing on the EFSF facility. This additional cost is generated by the fact that the Reserve and Buffer has to be invested in securities that may earn less than the interest paid by EFSF on any issue.
In order to attain the coveted AAA rating, the EFSF structure has been “tweaked” subtly. For example, Moody’s states that “the Buffer is to be sized so that the remaining portion of the debt issue that is not fully backed by cash will be fully covered by contributions from Aaa-rated member states.” In essence this appears to confirm that the EFSF’s rating relies heavily on the support of the guarantees of AAA countries – currently Germany, France, The Netherlands, Austria, Finland, and Luxembourg. In reality this means that significant reliance is being placed on the larger parties such as Germany, France and the Netherlands.
If the EFSF is drawn upon and increasing reliance is placed on cornerstone guarantors such as Germany and France, it is not clear whether politically it will be possible for these countries to continue the facility beyond its original 3-year maturity. Interestingly, S&P state that: “… we consider it likely that its mandate would be extended if market conditions remained unsettled.”
For investors, there is a risk of rating migration, that is, a downgrade of the AAA rating. If the cushion is reduced by problems of an Euro-zone member, then there is a risk that the EFSF securities may be downgraded. Any such ratings downgrade would result in losses to investors. Recent downgrades to the credit rating of Portugal and Ireland highlight this risk.
Given the precarious position of some guarantors and their negative rating outlook, at a minimum, the risk of ratings volatility is significant. The rating agencies indicated that if a larger Euro-zone member encountered financial problems, then the rating and viability of the EFSF might be in jeopardy.
Investors may be cautious about investing in EFSF bonds and, at a minimum, may seek a significant yield premium. The ability of the EFSF to raise funds at the assumed low cost is not assured.
Ironically, the actual structure of credit enhancement encourages troubled countries to access the facility early to ensure its availability. The structure embodies an accelerating “negative feedback loop”.
As market conditions deteriorate, market access becomes limited and countries draw on the EFSF facility (eliminating them from the guaranty pool), increased financial pressure will be exerted on the AAA rated Eurozone countries. The need to maintain adequate coverage to preserve the EFSF’s AAA rating on existing debt will mean that the Buffer will increase and the capacity of the EFSF to lend may become impaired. Moody’s rating analysis indicates that in the event that a large number of countries simultaneously lose market access and draw on the facility, the current lending capacity of the EFSF would likely be overwhelmed. Moody’s believes that it would be unlikely that the EFSF would start issuing under those circumstances.
At this stage, the EFSF have indicated that they don’t plan to issue any debt, as they do not anticipate the facility being used. The facility also has a very short maturity, three years till 2013. The importance of these factors in the grant of the preliminary rating is unknown.
S&P correctly inferred that the “EFSF has been designed to bolster investor confidence and thus contain financing costs for Eurozone member states.” The agency indicated that if its establishment achieved this aim then the EFSF would not to need to issue bonds. However, if as pressures mount and market access becomes problematic for some Eurozone members, then the EFSF and it structure will be tested.
The EFSF’s structure raises significant doubts about its credit worthiness and funding arrangements. In turn, this creates uncertainty about the support for financially challenged Euro-zone members with significant implications for markets.
Inconvenient and Ignored Truths
The real rationale of the European Bailout package and the EFSF is different to that generally assumed. The measures are not designed to assist Greece or the other troubled countries. In reality, they are designed to support banks that have lent heavily to them.
The exposure of Germany and France to troubled European countries remains around $1 trillion. According to the Bank for International Settlements, as at the end of 2009, French banks and German banks had lent $493 billion and $465 billion respectively to Spain, Greece, Portugal and Ireland. Default or restructuring would result in large losses to the banks, potentially triggering a return to the apocalyptic conditions of late 2008.
European banks remain vulnerable. The recent bank stress tests did not seriously test likely losses in case of sovereign debt restructuring and realistic falls in commercial real estate prices. The tests did not apply to the bulk of bank’s holdings, only testing around 20% of the sovereign bonds held, making the test of limited value. The definition of capital was generous. It was effectively a car “crash test” where the testing authority deems the car cannot crash.
In the best case, the measures taken by the EU and ECB will force deeply indebted European countries to take steps to bring their economic houses in order, allowing an orderly debt restructuring. The EFSF and other facilities will also underwrite vulnerable country’s ability to re-finance maturing debt and finance budget requirement.
Banks and other lenders can also build up reserves and capital to absorb any write-offs that are required in such a restructuring. If successful this would minimise losses and limit disruption in the global economy.
The position of Greece highlights the underlying logic. According to the EU’s projection, Greek debt will increase from Euro 270 billion in 2009 to Euro 337 billion in 2014, from 113% of its Gross Domestic Product to 149%, even with the successful execution of the economic actions required. Given that Greece cannot sustain its current level of debt, it is unclear how it will be able to carry 25% additional debt (Euro 67 billion) with an economy that is expected to shrink by 5% during that period.
Discussion about losses lenders to these countries will have to bear are already evident. In extending guarantees of borrowings by its troubled banks, Ireland indicated that junior or subordinated lenders might not receive the face value of their investments. As in any debt restructuring, it is unlikely that lenders will be able to avoid losses entirely.
Major economies have over the last decades transferred debt from companies to consumers and finally onto public balance sheets. The reality is that a problem of too much debt cannot be solved with even more debt. Deeply troubled members of the Euro-zone cannot bail out each other as the significant levels of existing debt limit the ability to borrow additional amounts and finance any bailout. As Albert Einstein noted: “You cannot fix a problem with the kind of thinking that created it.”
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 European bailout and the EFSF is that stronger countries’ balance sheets are being contaminated. Like sharing dirty needles, the risk of infection for all has drastically increased.
The European bailout is primarily a debt shuffling exercise which may be self defeating and unworkable. George Bernard Shaw observed that “Hegel was right when he said that we learn from history that man can never learn anything from history”. The resort to discredited financial engineering to solve the European sovereign debt problems highlights the inability to learn from history and the paucity of ideas and willingness to deal with the real issues.