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Europe Readies Its Rescue Bazooka

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It’s one thing to fail to recall relevant events that are genuinely historical, quite another to refuse to learn from recent failed experiments.

Remember Hank Paulson’s bazooka? The Treasury secretary, in pitching Congress to give him authority to lend and provide equity to Fannie and Freddie, argued, “If you have a bazooka in your pocket and people know it, you probably won’t have to use it.”

but the Treasury’s new powers did not do the trick. Less than two months later, Treasury and OFHEO put the GSEs into conservatorship.

If the latest rumors prove to be accurate, the latest Eurozone machinations make Paulson look good. The Financial Times reports that the Greek deal is being reworked, with bondholders being “asked” to take 60% haircuts. The critical bit is the word “asked”. Recall this restructuring is supposed to be voluntary to avoid triggering a credit event under credit default swaps. The old deal with a mere 21% haircut, had a takeup below the 90% sought and the 80% deemed the minimum acceptable. With haircuts this deep, how pray tell will the authorities force banks to go along with an allegedly voluntary deal? Any party that was hedged is going to want to see a bona fide default so he can cash in his credit default protection. But Greek banks were big protection writers (why anyone would accept them as counterparties is beyond me), so breaking them (which is what I assume would happen) would necessitate bailouts by the broke Greek state, which would worsen the national insolvency, which is what the deeper haircuts were supposed to avoid.

And some parties are concerned about even worse outcomes, since no one knows who the CDS protection writers are. Per the Financial Times:

Officials said some countries, including Germany, were less concerned about a so-called credit event – an explicit default that would trigger CDS contracts. But others, including the IMF, feared consequences similar to the collapse of Lehman Brothers in 2008.

This is what you get when you let banks innovate to their hearts’ content: more cleverly designed minefields, and the taxpayer picks up the damage inflicted on innocents or greedy chumps who wander into them.

The next element of the rescue apparatus being wheeled into place is a trillion euro facility. That sounds great, until you understand that a trillion euros is probably too light by at least 50%, and the bloody scheme probably won’t work anyhow.

The details are still hazy, but it is largely along the lines of an idea floated earlier, that of having the EFSF leverage up to expand the total bailout authority. From Der Spiegel (hat tip Joe Costello):

German Chancellor Angela Merkel has told German lawmakers that the financial strength of the euro rescue fund, the European Financial Stability Facility, is to be leveraged to €1 trillion ($1.39 billion)….

The type of leveraging planned remains unclear, with a number of versions being discussed. It emerged earlier on Monday that the controversial measure to increase the firepower of the €440 billion rescue fund will be put to a full votein the German parliament on Wednesday, rather than just a vote by the budget committee as initially planned.

Given the intense public debate on boosting the EFSF, Merkel’s center-right coalition decided to seek a broader mandate than just budget committee approval.

In a meeting with leaders of her own coalition and of the opposition parties, Merkel also said that the intended recapitalization of European banks would amount to some €100 billion, with German banks accounting for around €5.5 billion of that, to meet the increased core capital requirement of 9 percent and prepare banks for the writedowns resulting from a Greek debt cut.

Note that these machinations are to avoid the one route that clearly will work and will not involve political approvals, which is having the ECB monetize debt. Instead, the EFSF, and any of its son of Frankenstein spawn ultimately rely on guarantees of member states. Let’s see, this vehicle will bailout out Italy when Italy is a guarantor of its own bailout?

As Satyajit Das wrote when this idea was first mooted:

If as Albert Einstein observed insanity is “doing the same thing over and over again and expecting different results”, then the latest proposal for resolving the Euro-zone debt crisis requires psychiatric rather than financial assessment…

The proposal has a number of problems.

The EFSF does not have Euro 440 billion. After existing commitments to Greece, Ireland and Portugal, its theoretical resources are at best around Euro 250 billion, assuming that the increase to Euro 440 billion is ratified by European parliaments.

The EFSF must borrow money from the markets, relying on its own CDO like structure, backed by a cash first loss cushion and guarantees from Euro-zone countries. In fact, some investors actually value and analyse EFSF bonds as a type of highly rated CDO security known as a super senior tranche. This means that the new arrangement has features of a CDO of a CDO (CDO2), a highly leveraged security which proved toxic in 2007/ 2008…

The 20% first loss position may be too low. Unlike typical diversified CDO portfolios, the highly concentrated nature of the underlying investments (distressed sovereign debt and equity in distressed banks exposed to the very same sovereigns) and the high default correlation (reflecting the interrelated nature of the exposures) means potential losses could be much higher. Actual losses in sovereign debt restructuring are also variable and could be as high as 75% of the face value of bonds.

The circular nature of the scheme is surreal. Highly leveraged vehicles, in part backed by weakened nations like Spain and Italy, are to undertake the “rescue” of the same countries and their banks. Levering the EFSF merely highlights circularity in the entire European strategy of bailouts, drawing attention to the correlated default risks between the guarantor pool and the asset portfolio of the bailout fund. This is akin to an entity selling insurance against its own default. This only works if all commitments are fully backed by real cash and savings, which of course nobody actually has, requiring resort to familiar “confidence tricks”.

The proposal assumes that it will not need to be used, avoiding exposing its technical shortcomings. The EFSF too was never meant to be used, relying on the “shock and awe” of the proposal, especially its size and government backing, to resolve the crisis.

Paul Krugman last night focused on the same fatal flaw, the circularity of the scheme, invoking an old song, “There’s a hole in my bucket.”

The only possible deus ex machina, given that Germany is insistent that the ECB not ultimately provide the firepower for this vehicle, is that outside parties provide very substantial support. The IMF will participate, but it will not do heavy lifting. China in theory could, but given how controversial its US dollar holdings have become, a major role in a fragrant scheme is likely to prove even more controversial.

The Eurozone has managed to keep its desperate financial legerdemain going far longer than I thought possible. But its insistence on implementing self-defeating austerity policies and the impossibility of Germany continuing to want large trade surpluses yet refusing to finance its trade partners means an ugly end is inevitable.

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45 comments

    1. Flying Kiwi

      If you have a bazooka in your pocket and people know it, they will unless they are complete idiots find ways to circumvent it and beat you because you relied on your bazooka instead of out-thinking them.

      Oh, and quantum unpredictability means that doing the same thing over and again can produce different results.

    2. gs_runsthiscountry

      “A man has one hundred dollars and you leave him with two dollars, that’s subtraction” – Mae West

      The irony of that quote – I would say that is banking and austerity of our time. Ol’ Mae West must have dated a banker or two in here day – picked up a few things, eh?

  1. readerOfTeaLeaves

    The circular nature of the scheme is surreal. Highly leveraged vehicles, in part backed by weakened nations like Spain and Italy, are to undertake the “rescue” of the same countries and their banks. Levering the EFSF merely highlights circularity in the entire European strategy of bailouts, drawing attention to the correlated default risks between the guarantor pool and the asset portfolio of the bailout fund. This is akin to an entity selling insurance against its own default.

    Stranger than fiction. Recursively.

  2. Typing Monkey

    Sorry for being dense, but

    But Greek banks were big protection writers[...], so breaking them (which is what I assume would happen) would necessitate bailouts by the broke Greek state,

    Why does the state have to bail the Greek banks out? Why can it not just tell the CDS counterparties to go to hell?

    1. Yves Smith Post author

      You are right, they might be small enough to be allowed to fail, but my sense via John Dizard was that a lot did, and a bunch of banks failing is tantamount to the banking system failing. That is generally terrible for an economy and will lead the economy to fail even faster, blowing out government debt levels further.

      1. psychohistorian

        I don’t understand why there is all this weeping and gnashing of teeth.

        It is my understanding that there is a small number of global inherited rich that insist that the rest of the world’s population cover for their inhumane actions and be submissive about it. What a fucking joke is this? Oh, yeah, and rule-of-law only pertains to the little people.

        Screw this stupidity. Laugh the global inherited rich out of control of our society and into rooms at the Hague. Nationalized the banks. Declare all derivatives null and void and lets move forward with a more civilized world. Times a wasting.

        1. steelhead23

          Psycho – Dude, I’m right there with ya man. But, if you are going to depose the global elite, you will need a bazooka, and not the fictitious, storybook money bazooka, but a real rocket launcher. Watch out for those predator drones my friend.

          1. psychohistorian

            I am going to change my middle name to “cannon fodder”.

            While I didn’t make any along the way, my thoughts are out to our children’s children’s children.

            Humanity deserves better a better legacy than this.

      2. vlade

        Let them go bankrupt, cpties grab the collateral, and nationalize, let other parties eat the loss.

        The problem is, I have some doubts about quality of nationalization in Greece.

        BTW, I can see why someone would use Greek bank as a cpty – playing silly games with CVA to get a “protection” cheaply (that is, protection from the regulatory perspective and thus , even though all parties realise it’s no protection at all). I hope that’s the case, and that the greek banks go boom, as that should kill the silliness of CVA in B3.

        1. vlade

          “and thus reg cap relief as well as something prettying up the balance sheet/results” was what I left out..

  3. Andrew not the Saint

    It turns out that the supposed bazooka is an air pistol. And you have to find someone to borrow it from.

    1. Typing Monkey

      But for some reason, the stock markets seem ok with it so far.

      The bond markets, not so much…

  4. sleeper

    It looks as if we are seeing a slow motion global economic collapse.
    And nothing we do or that others whether they be China, Germany, France or the US is going to make one whit of difference bazooka or not.
    Although it will not solve the problem, a concerted world wide effort should be made to investigate, indict, and prosecute the bankers all the while making sure that folks understand the the international financial system and the bankers are two separate entities.

    1. Jerrydenim

      Are they different?

      Seems like a pretty cozy bunch to me. Central Banks, Investment Banks, treasury departments, and the supposed regulators the world over seem very tightly connected. They control the creation of money then they set the rules on how it can be used.

      This is more than a few bad apples. We need a total reset.

  5. gs_runsthiscountry

    Bazookas, counterparty risk..nah. Caterpillar raised its guidance today don’t ya know, and all is well in the global markets, everyone, quick, deploy your cash S&P1400 here we come[sarcasm].

    Market timing is tough, headline timing is near impossible. I think I will sit this out the next few days, week(s), – ?

  6. vlade

    “€1 trillion ($1.39 billion)”
    At this exchange rate, I don’t think EU needs any bailout, even the Greeks should be supercompetitive… ;)

    1. Yves Smith Post author

      Hah! A Freudian slip in Der Spiegel! Hyperinflation fears reflected in a bad currency conversion!

  7. hawkmoon

    If one considers the fact that all that leverage, that debt piled on debt is meant, ultimately, to bail out inept sociopathic bankers and wealthy investors, the whole scheme stops being circular and looks more like a straight line: a one way rip off. Corrupt politicians handing over billions of taxpayer’s money to people who by now are, at best, hopeless but spoilt gamblers, and at worst, just plain thieves. I just can’t understand how Germans are sitting this out instead of refusing to pay taxes like the Greeks. If I am not wrong the nominally socialist SDP virtually voted in support of the bailout by providing it with a veneer of democratic legitimacy – prior approval by a budget committee. There’s no doubt Merkel and probably her entire right wing party is committing political suicide, yet these supposedly left wing dunderheads choose to support her, so risking political oblivion. I wonder if, like their PASOK colleagues over in Greece and the many discredited post-Communists in Eastern Europe, they have always been in it just for the money.

  8. Jim Haygood

    ‘The only possible deus ex machina, given that Germany is insistent that the ECB not ultimately provide the firepower for this vehicle, is that outside parties provide very substantial support.’

    Right. Having the ECB print ‘money for nothin’ would be the path of least resistance. But Germany isn’t on board with such reckless inflationist shenanigans.

    Next to least resistance is the IMF, which sidesteps some of the circularity issue by having a capital call on nearly the whole planet. But the US, exercising effective veto power, apparently doesn’t want to go that route … yet.

    How to resolve this seeming impasse? Use the 2008 playbook: crash the markets, bankrupt a Lehman-style sacrificial lamb, then hold a gun to the head of parliamentarians and tell them, ‘Fork over the loot, or the banks close and your cities burn.’

      1. Jim

        Valissa, do you really think the US would accede to another capital call given the OWS demonstrations? If President Obama does so, it would virtually ensure that he lose next year.

        1. Valissa

          I assumed JH was talking about the behind the scenes string pullers of the EU and ECB copying the tactics that worked so well the US.

          Regarding what the US team tries next, I believe that you are correct that it would tough for them to pull a repeat here so soon. However, they could simply try and accomplish the same ends in some other nefarious manner and cover it up with a barrage of propaganda. And so what it they lose Obama as their front man… I assume Romney would suit them pretty well, although it would make the so-called left less compliant having a Repub as the front man.

    1. bobh

      Yes, the endless talk about plans and solutions is just to pass the time until the moment of truth comes, when the insolvent banks are bailed out by Euro and U.S. politicians with a massive commitment of public funds. It will once again be done in extreme haste and sold as the only way to avert a terrible crisis, with no time for niceties like limiting the ability of the banks to repeat the process again in the future. And then it will be repeated. The cycle won’t stop until all the money is gone and the politicians and the bankers and the bondholders have gone off to their islands with their private security forces to wait out the dark age.

  9. Hugh

    This is smoke and mirrors. There is no bazooka, only a crayon-drawn picture of one. If Europe’s elites had wanted a real solution, they would have done one a year ago. Focusing on Greece is simply a way to direct our attention away from all of the other problems/f*ckups European elites have engineered for themselves and their kleptocratic masters: a bankrupt banking system, unsustainable trade patterns, a corrupt political class, widespread sovereign exposure, and a broken currency. And of course the supreme insult is that the “bazooka” proposed won’t even fix Greece, which in so many ways is the least of Europe’s problems.

  10. Hugh

    A few questions, does anyone else think that the relentless rise in the stock markets over the last few weeks despite a forest of warning signs was just a way to pad the markets in anticipation of a Greek default or a bad Euro bailout plan, you know a 500 or 1,000 point drop would be easier to recover from if the starting point was closer to 12,000 than 10,500? Or are markets already being primed for end of the year bonuses?

    Are the Eurocrats going to try to sale larger haircuts on Greek debt under the rationale that taking a small bath on Greece is preferable to taking a huge one on Italy, Spain, and the rest of the periphery? And will the kleptocrats believe them, that contagion won’t happen or that the politicians they own won’t eventually bail them out?

  11. americangoy

    “This only works if all commitments are fully backed by real cash and savings, which of course nobody actually has, requiring resort to familiar “confidence tricks”.”

    UNLESS…

    Unless our beloved “Federal” “Reserve” will just print (or put a number on a spreadsheet on a computer) the money and gift it to the Europeans.

  12. Ron

    Follow the money is a good way to bring understanding to these events but the trail seems to be covered and the question I have been asking myself lately is why? Maybe the answer is the source of these dollars, oil money, anyone, plenty has flooded European banking, could that be the risk?.
    I have a hard time believing that France etc are that concerned with Greek banking or lifestyle but the flow of petrol dollars into European banking and investment now that is a relationship that must be maintained,no.

  13. Ishmael

    Twenty plus years ago if you were to tell someone these transactions you would have been laughed out of the room.

    All of this results from attempting to make economics a science and MBA’s who really have no understanding of accounting.

    It is going to end badly when the wheels finally do come off.

  14. Susan the other

    Irony wins. Thank you for this really good article, and funny too. I feel like a mother who is finally fed up with her manipulative kid. I don’t want to admit it, but I know it . We idolized and coddled Germany; we all learned German in high school! If Germany had joined the eastern bloc in the Cold War we would have been toast. We were the actual creators of the Berlin Wall. It was built at our strong suggestion because we couldn’t afford all those unnecessary refugees. It would have ruined our plans. And other facts. We shelled out money like we were being mugged. And up until the 70s/80s (I think) we still believed in capitalism. But gee, look what 30 years can do.

    It is time for us all to admit we no longer know what we are doing. For starters, we gotta declare that any “CDO2″ is financial pollution. And clearly, the goofy EFSF is a promise in search of a heart. If the US is now disillusioned with them (Germany mostly), what will happen? Will the ECB eject Germany? There’s no reason to keep them. They can’t hold themselves up and we’ve given up on cold wars. So that means there is no willing underwriter of last resort now, no taxpayer.

    So question: If there is no underwriter of last resort and Europe, and eventually the entire world after this morphs, is simply underwriting its own defaults, isn’t money itself absurd? How will “finance” evolve?

  15. Tim

    Yves,
    From the current headline EU article on Reuters:

    “Bank negotiators have offered a 40 percent write-down and warned that forcing them into deeper losses would amount to a forced default with what banks say will be devastating consequences for the European financial system.”

    Suspicions confirmed.

  16. TeraEuro

    hello Yves, fine post (as always), but my german blogger colleague Kantoos posted: Stop citing „Der Spiegel“! http://kantooseconomics.com/2011/09/14/stop-citing-der-spiegel/ . Maybe interesting for you and other non-german speaking people of your audience. Good read about the quality of “Der Spiegel” as a source of german news. My favorite quote “they are the drama queen of German journalism”.
    Playing around with my blog for a relaunch, i found an old post “Yves Smith special edition” http://tera-euro.blogspot.com/2010/03/yves-smith-special-edition.html
    (tip: antidote)
    Thank you for the good work and greetings from Germany!

  17. JasonRines

    Yves, wouldn’t the U.S. lease it’s gold to China as collateral? To me its all a facade anyways to hurry along the Chinese reserve currency, finish wealth transfer and then rebalance trade (which eases pressure on the masses for election) but before the masses start revolting.

    The 3d model doesn’t cut it in a 4d world. But if I understand this and completely forgive, it means evolution has made this crop of high priests irrelevant and still requires action to dismiss those agency managers.

    1. Jim

      Do you really believe that China, with a median age of 36 (compared to 37 in the US), per-capita income 20% of the US, and no democracy, can ever have a reserve currency?

  18. Jim

    Why would anyone support the monetization of debt? In the USA, I understand.

    But why should a German, who was explicitly promised that the ECB would never monetize, have to suffer through monetization?

    Wouldn’t the optimal path be for the dissolution of the EuroZone?

    I find it frustrating that the same Dems would would be up in arms if the GOP attempted to do something against the wishes of the voters are so complacent when it comes to the EuroCrats in Brussels ignoring public opinion.

  19. Tortoise

    “But Greek banks were big protection writers …” That’s news to me. Where is the evidence to support this claim?

Comments are closed.