Satyajit Das Examines Eurozone Stability Fund Three Card Monte

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.

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  1. jake chase

    All central bank operations are three card monte games. The money is entirely worthless, insiders get all they ask for and the rest are lucky if they can pay the mortgage and the electric bill. The problem is not economic but political, but politics remains a dead end.

    Good thing we still have television sports.

  2. Gavin

    Yves, love your work, but do you mean “sleight of hand” rather than “slight of hand” in the first sentence?

  3. tyaresun

    The revolving doors make the transition from private industry to govt. seemless. Isn’t a former GS executive running the Greek govt. finance now?

    Look at the state, county and city budgets in the USA. They have been using all the financial innovations for more than a decade now.

    I thought we had reached peak credit already but perhaps we might have a few more years to go if all the financial innovations have not been adapted by Club Med and eastern Europe.

  4. Eric

    Best maybe that Greece default now rather than later. Something big enough to help keep passions in check. A 15% haircut now? Maybe Spain, Portugal, Ireland all renounce part of the load now. I just don’t see holding this structure together without the much-maligned populations of the PIGS countries really seeing that others are the firing line also. Sure, you can argue that the EFSF is exactly putting others into “harms way”, but a partial default would be much more persuasive. Is this possible? No sense tilting at windmills if it can’t be done, but the chances that the current arrangement will work well seems to be diminishing the more one thinks about the details.

  5. Jackrabbit

    . . . 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.

    Who is the seller of the bonds that the ECB is buys in the secondary market? Itsn’t it the banks that have found that they are over exposed? So the bankers get out early (before the sh*t hits the fan) at a high valuation and the workers in the Austerian nations will be told that their sacrifice is for Europe not the bankers.

    So the sleight of hand go beyond transforming financial risk to transforming political risk! (while in the US Fed secrecy has been able to keep things from the public eye). As i on the ball patriot likes to say: “Deception is the strongest political force on the planet.”

    1. Jackrabbit

      To be fair, the elites in the PIIGS – politicians, business leaders, and others – share the blame. I don’t want to loose sight of that because US politicians are also guilty of giving too much to too many and in a lack of care and foresight (to see that some of what was given could lead to disaster). We need a political system that produces representatives that are not conflicted.

      But the “Euro rescue” is clearly a bank bailout. And just as in the US, ordinary people will suffer but the banks/bankers will not.

  6. Jim Haygood

    ‘There is the potential risk that if one peripheral eurozone member has a problem then others will have similar problems.’

    You don’t say! The history of global financial crises shows a STRONG contagion effect. When one Latin American borrower tips over (e.g., Mexico in 1982), others follow. When Thailand got into trouble in 1997, so did its neighbors. That’s why it was called the Asian crisis. Europe, if it comes to that, will be no different.

    It’s the same fundamental mistake that was made in rating mortgage CDOs. Under ordinary conditions, when house prices are rising, defaults are random — a borrower gets sick, loses her job, etc. But when house prices dip 50%, defaults are no longer random; they’re a direct function of the real estate cycle — correlated and ubiquitous.

    Rating models cannot possibly evaluate such cyclical risk. Essentially one would need a highly accurate global macroeconomic forecasting model, which could project the dynamics of the business cycle several years into the future. It doesn’t exist, except in my head. ;-)

    The lesson learned from mortgage CDOs is that ratings mean nothing if loans are backed by overpriced assets which are vulnerable to a business cycle downturn. The latter point, ‘business cycle downturn,’ certainly applies to the EFSF. If a double-dip recession should occur, debt levels and financial stress will rise in virtually all of the 19 member countries.

    Absent a high degree of macroeconomic forecasting nous [Brit-speak for ‘savvy’], one has to fall back on common sense: ‘The reality is that a problem of too much debt is being solved with even more debt. 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.’

    Common sense told observant analysts in 2006 that a milieu featuring zero-down, no-doc loans was a bubble. Today common sense says that overleveraged sovereigns seeking to increase their leverage ratio, even as their fiscal austerity policies heighten the risk of a fresh business cycle downturn, are entering a vicious spiral.

    Just as the appropriate measure to prevent a housing bubble would have been to enforce adequate initial equity and income qualifications, the appropriate measure to address excessive sovereign leverage is restructuring the debt burden to a manageable level, so that the country can grow out of it.

    Piling on more debt while pursuing fiscal austerity is a march in the wrong direction, which by delaying the inevitable, will increase the grief later.

  7. mannfm11

    My question is what do they do for an encore? Is the IMF going to become the SIV for Central banks? Also, if the ECB quits buying a country’s debt, then the country’s population quits buying the exports of other countries. There is a delusion that credit deflation can be avoided. It can’t. The system has to destroy itself, at which point there isn’t any money, credit, etc. Then you send lawyers, gun with no money and that don’t work too well.

  8. mannfm11

    This is an interesting statement.

    . . 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.

    The questions is, where do they get the money to pay if the bankers don’t give it to them? This tends toward what Michael Hudson says, which is the aim is to erect tollbooths on the economies. This amount debt peonage slavery for a privileged group, as bank charters, deposit guarantees and central banks are endowments of the populace. I have to believe this is where Marshall Auerbach, a protegee of Hudsons is headed with his statement. With this type tact, we will not only see a massive decline in living standards, but a defeat of any form of Republican government and to some extent democracy. Government will take a corporatist/fascist form and we will be ruled by bankers who can no more pay their debts to us than we to them.

  9. traderjoe

    I’ve always thought the EU rescue was a complete circle-jerk. I’d have two questions (somewhat rhetorical) to add:
    1. Who buys the bonds of the SIV? The same EU banks that are effectively insolvent with sovereign bonds and underwater construction loans?
    2. When the SHTF, is there really going to be any appetite at all for investors to buy the SIV debt at that time?

    Just like the EU bank stress tests, I’ve never really heard a thoughtful analyst explain why this thing was actually going to work. But, the Kool-Aid seems to taste better than the medicine.

  10. rf

    A couple of clarifications. The ECB has indeed purchased Club Med bonds from the secondary market but really much less that the market expected (well less than 100bn euros), it has ceased buying as of a week ago, and it has fully sterilized what purchases it has done. Repo operations have been its main tool for injecting liquidity into the financial system and indirectly supporting Club Med sovereigns. However a) sovereign bonds have represented only about 10% of the collateral banks have presented for repo and b) the ECB is in the process of reducing its repo book by shortening the tenor of the repos. As a result, EONIA and Euribor have risen sharply since the expiration of the first 1yr repo on 1 July. To conclude, the ECB has already begun its exit from extraordinarily easy monetary policy and is raising the structure of European money market rates, i.e. tightening monetary conditions. Given that these higher rates have helped to appreciate the euro exchange rate, they have amplified the overall effect on monetary conditions.

  11. rf

    Who will buy the EFSF bonds? Well, anyone who wants to, but this will most likely be a range of Europe’s institutional investors, its stronger banks, and foreign official reserve managers. Although the temptation is view this all as a scam of some sort, it must be remembered that the euro area is essentially a balanced current account economy. Put differently, unlike the US, it is self-funding. It does not need foreign financing. Its challenge is creating institutional mechansisms to transfer savings from the high savings, surplus parts of the area, namely Germany, to the low savings, deficit parts of the area, i.e. Club Med until fiscal austerity and relative deflation drive the former to consume more and save less and the latter to do the opposite. By transfer I mean lend, not give. The EFSF is not about German tax payers giving money to Spain, it is about facilitaing a lender of last resort for a Club Med country as bridge finacing in the initial stages of an austerity program.

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