Doubts About Eurobailouts Come to the Fore

A brief recap of a couple of useful sighting on the “rising anxieties in Europe” front. Edward Hugh has a very thorough update (bond spread trends, underlying drivers, an astute discussion of politics) leavened by a great deal of wry humor (“So, like former US Treasury Secretary Hank Paulson before them, Europe’s leaders, having armed their bazooka may soon need to fire it.”). His summary:

According to one popular analogy currently going the rounds, the Euro Area countries could be likened to a group of 16 Alpine climbers scaling the Matterhorn who find themselves tightly roped together in appalling weather conditions. One of the climbers – Greece – has lost his footing and slipped over the edge of a dangerous precipice. As things stand, the other 15 can easily take the strain of holding the Greeks dangling, however uncomfortable it may be for them, even if they cannot quite manage to pull their colleague back up again. But as the day advances others, wearied by all the effort required, start themselves to slide. First it is Ireland who moves closest to the edge, and gets nearer the abysss with each passing moment. But just behind comes Portugal, while some way further back Spain lies Spain, busily consoling itself that it is in no way as badly off as the others. But if all three finally go over, dragged down by the weight of those who precede them, then this will leave 12 countries supporting four, something that the May bailout package only anticipated as a worst-case scenario. In the event that this is finally what happens, Mr Reglin will find he has plenty of work to do, as will Mr Trichet’s successor at the ECB. In the meantime all the rest of us can do is wait and hope, firm in the knowledge that having come this far, we can only go forward, since there is no easy way back down to the point from which we started. But for heavens sake, the only thing we don’t need to be told at this point is that the danger has already past, even as we slide, inch by inch, onwards and downwards.

Wolfgang Munchau at the Financial Times takes a hard look at a piece of the puzzle most have avoided, namely the CDO structure that the Eurozone members used for their €440 billion bailout fund. He’s pushed some numbers around, and as far as he can tell, it will only be able to offer costly funding, and in much smaller amounts than advertised:

My numbers are extremely rough….The EFSF last week obtained a triple A rating….To obtain the rating, the EFSF had to agree to an over-collateralisation. In this specific case it means that the EFSF needs to obtain government guarantees of €1.2bn for each €1bn in bonds it wants to issue.

Once it raises the funds, the EFSF will not be able to lend on all of the €1bn, but only the portion backed by the collateral of those countries that themselves have a triple A rating. That reduces the amount available to the borrower to €700m…..

So what is the interest rate? The borrower essentially pays the sum of the EFSF’s funding costs, an administration margin and a lending margin. The triple A rating should ensure that the funding costs for the EFSF are not extremely high, but I doubt that the EFSF could obtain a funding rate as cheap as that available to the European Investment Bank…. I would…assume that the EFSF’s funding costs exceed those of the EIB by a good margin.

Let us assume the EFSF raises the €1bn at an interest rate of 4 per cent. With administration charges and lending margins of 350 basis points, the effective interest rate to the borrower would be 7.5 per cent. What about the cash buffer? The EFSF must reinvest the buffer in the best triple A rated securities in the market. So if its own funding costs are 4 per cent, and if it invests the cash buffer into German bonds at a hypothetical yield of 2 per cent, there is a loss of 2 percentage points. This also has to be paid for by the borrower. This comes on top of the 7.5 per cent interest. It is not all that hard to conceive of a situation in which the borrower would end up paying a total interest rate of 8 per cent….no matter how you twist this, it is hard to construct a cheap loan out of this.

Three issues arise from this set-up. The first is that no country would ever want to borrow from the EFSF, unless it was absolutely unavoidable…

The second is that the overall amount for lending is significantly reduced. The headline figure of €440bn is misleading. First, one should deduct the shares of Greece, Ireland and Portugal, then the effect of the over-collateralisation and then the share of countries without a triple A rating. A more realistic ceiling is thus €250bn on my calculations, and that is still probably way too high. This may be enough to help a couple of small countries but would be inadequate if a large country should get into trouble.

And finally, the whole edifice would collapse if France was downgraded. This is a non-zero probability event, to put it mildly. Without France, Germany would be the sole pillar of the system, a role Germany would probably not accept.

Having looked at this in some detail, I find it hard to conceive of a situation where a country would both borrow from the EFSF and live happily ever after.

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    1. Stelios Theoharidis

      The Germans and the French could not cut the ropes even if they wanted to, thus your analogy is problematic. A bunch of drowning people shackled together would be more appropriate. Then the Swedish are shackled to the accession states because their banks have huge exposures there.

      We try to play the situation out like the PIIGS are the weak ones. But, I am quite curious whether the German and French banks would survive a default and what their haircuts would be if a debt restructuring occurred.

  1. Jean

    […]if France was downgraded. This is a non-zero probability event, to put it mildly.[…]

    It is surprisingly hard to find recent news about this. France may not be the biggest economy around but I thought a downgrade of France credit rating would still be huge news.

    Even as a rumor it seems fairly elusive, enough so that the non-zero probability sounds a bit overrated. I could only find a few mentions in april/may and one mention in september.

    The beginning of the quote is interesting, the end sounds too much like fear mongering to me.

  2. Hubert

    I do find the metaphor with 16 alpine climbers somewhat unfitting.
    Yet if you think about it not in an up-moving-expedition but in an going-down-as-safely-as-possible-expedition it contains more truth.

    1. Ina Deaver

      Actually, I thought that the Alpine climber metaphor was extremely apt. Especially considering that experienced climbers roped together immediately drop to the ice and drive in their picks the moment that the rope goes tight: it is almost an instinct to take this immediate action, because those without the presence of mind to take it are weeded out of the gene pool quickly. If you watch video of climbers or an expedition where one member falls into a crevasse, the immediacy with which the remaining members dive to the ice as their picks swing up and then down in unison is striking. Friction will give even gravity a run for its money!

      The EU did not respond this way. Instead, they stood around bickering in their crampons while waiting for the beefiest guy in the group to establish a belay.

      Ok, I’m taking the metaphor a little far. . . .but it is the lack of this immediate, concerted response that has made the immediate situation perilous. Concerted, immediate emergency action could have kept the rest of the members of the team out of the crevasse. That is what I liked about the metaphor.

    2. attempter

      Yes, if they all agreed the climb was insane, impossible, and suicidal, they might have a chance of coming back down in reasonable shape. They’d have to be willing to leave behind lots of equipment and wild dreams, but they’d survive.

      But no, we know they’ll insist on heading up until they all freeze or are wiped out by an avalanche.

    1. Skippy

      I’m OK with that as long as we understand each other, and all reasonable remedies have been extinguished.

  3. FGR

    350bp for administrative costs seems huge. this is nonsense. I forecast it will be much less… it could be even 0 or negative… this is a non-profit organization…

    EFSF will not issue at 4% but as a AAA well collaterized entity much nearer to Euribor which means around 2.7-3% for 10Y, and much less for shorter maturities.

    so its feasible, the EFSF patch can work for quite a while, it wont solve any solvency problems, but it can sure delay the day of reckoning for quite a while…and save borrowing costs for peripheral countries.

    of course in the long run, all this is totally unsustainable, but politicians just care about the next upcoming elections

    1. fajensen

      “350bp for administrative costs seems huge”

      Tut-Tut, This is Europe we are talking about; No cost is too great as long as it is “wellfare” (taxpayers pick up the bill).

      Europe is doing “quantative easing”: The ECB will take as collateral any OTC dreck, as vile at the banks dare print up, for loans in fresh EUR at 1% interest. This new money is then used to buy government bonds so interest rates can be kept low (for governments) and the banks can earn spreads of 2-5% and be “recapitalised”. The OTC will self-destruct (default) inside the ECB – but it’s “price” is never discovered, wich is the second main goal of the excersize.

    2. Yves Smith Post author

      Munchau has a couple of sentences that I omitted where he went on about why this was complicated to figure out. There may be obligatory fees to the countries providing the guarantees. And there is alot of non-standardness in how this works. It was 350 bps for admin fees AND lending margins, not admin alone.

      1. Mr. E

        Sorry Yves, 350bps isn’t anywhere near likely – Countrywide charged less.

        Then as for the rest of this mess…4% base rate isn’t AAA. 4% is 1% more than Spain, right? I just checked bloomberg and Spains 5 year is trading at 3% yield.

        I have a hard time believing that for an overcollateralized (with cash!) bond that the rate is going to be 8%+

        Lets try this again with real numbers.

        2.5% for the bond.
        25bps for fees and trade spreads
        nothing else.

        350bps for lending margins and admin – impossible. Unless the idea is to recapitalize the banks through giving them fees.

        Then about the total money: We all know that nobody needs 100% of the money – they only need enough to make them solvent. Right now, Ireland gets back on its feet for less than E75B, Greece for less.

        Nobody in their right mind believes Spain is anywhere near a real default. Real rates are only like 2% there – not 15%.

        Then anyone with a mind realizes that the Eurozone will just change the rules when they need to. No need to borrow this money at all – they can just create it out of thin air by giving the ECB power to spend without borrowing. Disguise it by

        What – it will cause inflation? Yeah right – tell it to the mountain. A year of 20% inflation is what the Eurozone needs.

        1. Yves Smith Post author

          I suggest you take this up with Munchau. He has spent a lot of time reading the docs on this. Just because something sounds implausible does not mean it is incorrect.

          And have you seen our many posts on the mortgage mess? The securitization industry would have had to charge more, the estimates I have gotten are 100 to 200 bps more, to do the stuff in the pooling and servicing agreement correctly. So I’d tread lightly on the idea that you can extrapolate from norms in the securitization industry.

  4. Maju

    As I understand it, this “debt crisis” has been largely engineered in order to dismantle whatever welfare state is in EU and specially in peripheral Europe, where there is not much of that anyhow. Some of the worse suffering countries are not even in the Eurozone yet: Lithuania, Latvia, Hungary, Iceland (which is not even a EU member).

    Also to weaken the euro, so the USA can keep printing dollars like forever in order to pay their dollar-denominated black hole of debt caused by unsustainable military spending.

    It is noticeable that many US states, like California, have their own debt crisis and yet this is causing no big concerns.

    There is of course a problem with having a common currency without a common government, specially without a democratically elected government and without an effectively empowered parliament. This is a problem the USA does not have.

    There is also a problem in how the euro and much of the EU economy was conceived as a tool for Germany and other countries of NW Europe to have a huge market. This has caused ridiculous situations like the one of Greece, with workers having salaries maybe as little as a third of Germans and yet paying German prices or even higher.

    Anyhow, as I said some time ago: “Mr Volksvagen, how are we going to buy your cars if we don’t get decent salaries?” I really think that the approach that the EU is taking is essentially wrong, even within Capitalist parameters, because it’s cutting down demand radically, what can only cause greater stagnation. Instead emphasis should be put in driving prices down, at least a bit, specially in the housing market, still inflated.

    If budget has to be cut anyhow, EU members have a lot of troops in Afghanistan doing nothing of economic or any other type of value for instance. So cut military budget, cut surveillance and total police control budget, which adds nothing of value to the economy and detracts from civil freedoms, cut bureaucracy in Brussels, cut the salaries of the Eurobankers.

    But make an effort to keep purchase power or you will have to sell in Nigeria, where they are even poorer.

    In any case, the Spanish debt affair has been clearly hyped and manipulated. Everyone agrees that there is no immediate or even mid-term threat, that Italy or Britain are probably worse. So what is this about? Well, Spain is the 9th economy in the World (12th-13th by GDP(PPP)), ranking above Canada, India, Russia, Mexico, Australia or South Korea (at least in nominal GDP terms), but it’s not represented in the G-20. Canada, which ranks under Spain with all methods is member of the G7!!!

    Spain has such a weak political system, it’s so easy to push into disintegration, as happened with Yugoslavia, that is not even able to push its own interests in the international system, not even inside EU. Spain knows that its survival in its current borders is totally dependent from the benevolence of its allies: France, the USA and the other large European countries. Instead of solving its internal problems in a constructive manner and becoming stronger that way, Spain has chosen to keep the wounds open, to become dependent from her senior partners and therefore is now just a puppet of their games.

    However both France and the USA have strong interest in Spain being stable, France because it’s a neighbor holding a lot of influence (and debt) and fearing spread of ethnic problems across the border, the USA because it has two key bases in Southern Spain that allow it to control the access to the Mediterranean. So I don’t expect Spain falling in any kind of debt crisis while these two can afford to back it. However as the USA and France spiral into their own problems, Spain may see itself unsupported.

    But not tomorrow in any case.

    1. psychohistorian

      Maju said: “There is of course a problem with having a common currency without a common government, specially without a democratically elected government and without an effectively empowered parliament. This is a problem the USA does not have.”

      I would say that this is the same problem that our nonexistent world government has with the addition that it has a bull in the china shop World/Reserve Currency of the American dollar. Since the USA got to run the currency printing presses to bail out its financial sector why shouldn’t other countries do so to just regain par?

      This is a currency “war” precipitated by the financial immorality of Wall Street and the puppeteers behind the curtain…..these are the people who have committed war crimes and should be prosecuted internationally.

      1. Skippy

        Doctor reserve currency doesn’t like the treatment it gives out too others…when it catches a cold…err cancer…eh.

        Skippy…why did a relative (partner in a prestigious law firm) don his executive partner polo shirt, recouping (month or so) from a major car accident in hospital. Too send a massage…lmao.

  5. Hugh

    The whole of the world economy is either engaged in or dependent on those engaged in extend and pretend. There is a crisis, diddling, a succession of policies is announced until markets eventually quiet down, then a pause, then doubts, then a new crisis. Rinse, repeat, until it all falls in.

  6. Marshall Auerback

    Some have likened the three quarters of a trillion euro bail-out structure to the creation of one of those notorious special purpose vehicles that helped to bring on the global financial crisis. The largest component is the European Financial Stability Facility (EFSF), which has access to €440bn ($526bn) to lend to struggling eurozone members. The hope is that it will be able to issue triple A-rated debt guaranteed by all eurozone members except Greece (any nation seeking help is excluded). Ironically, as the number of eurozone nations receiving help from the EFSF grows, the number backing that debt decreases—making it less likely that EFSF debt can retain the highest rating. Details are still being worked out but it appears that any nation that cannot float debt at an interest rate less than 5% would be able to borrow from the EFSF at a lower rate. Portugal recently found itself in that category, after auctioning debt at 5.225% and while it has denied it would seek help, the better terms it could obtain at the EFSF must look attractive. In any case, only 40% of the nations that stand behind the EFSF’s debts are themselves rated AAA—so what we have is mostly lower-rated governments guaranteeing EFSF debt that hopes to get an AAA rating. At least on the surface, that arrangement seems fishy. If more countries get downgraded and if more need to seek assistance, it is possible that the guarantees will not be sufficient to allow the EFSF to issue the full €440bn precisely when the full amount is most needed.

    1. carol


      you write: “…. as the number of eurozone nations receiving help from the EFSF grows, the number backing that debt decreases..”

      That is one reason for the countdown.

      Another reason for the countdown is that countries refuse to back other countries debt. It has already happened!!

      As I commented before:
      trends often start small ….
      Last month Slovakia refused to pay its part of the bailout.

      “Slovakia’s new Prime Minister Iveta Radicova offered a spirited defence of her country’s decision to refuse to lend money to Greece under a joint EU-IMF bailout, in an interview published Friday.

      Radicova told the German daily Financial Times Deutschland that she believed Bratislava was speaking for a silent majority in the European Union that had serious reservations about the rescue.

      “Yes, we were the only ones who loudly said ‘no’,” she said.

      “But I am sure that our ‘no’ was also in the heads of all the representatives of EU countries.”

      There will be more countries not willing or not able to pay for others bailout. In the end the number of countries that could pay for the PIIGS, AND pay the share of the non-paying countries too, is reduced to 1.

      Probably, long before that chain of events, the single currency will have been split up.

  7. don

    Meanwhile, Ben is adding to the euro area woes by debasing the dollar, making harder the adjustments of the weakest members of the euro bloc. In my view, this is stupid, short-sighted policy.

    There seems to be a global urgency to deny the existence of insolvent borrowers. Looking at the extreme lengths to which lenders are going to avoid allowing defaults (look at Iceland, for heaven’s sake), one can only conclude that they fear that once the epidemic starts, it will be uncontainable. Greece appealed to such fears recently, trying to talk down the rate on its bonds by arguing that Greece would not be allowed to default, because the costs in financial market disruption for the entire euro area would be too great.

  8. joebhed

    We owe a lot to the number-crunchers and the fact-checkers along with this important post.
    I could be wrong, as usual, but to me it raises out loud the question of “how feasible is that?”.
    Which brings us back to the facade that things are OK with the global financial and monetary systems.
    But not out loud.

    Capital reserves will continue to build at the banks.
    People will have less access to the money supply.
    Because the bankers create the money supply.
    And keep it for themselves.
    Probably nothing there, though.

  9. /L

    The 16 alpine climbers tied them self together and promised etch other to climb together in harmony on a sunny day and all were delighted (despite warnings of the high risk adventure, that there wouldn’t be enough rope when the weather got worse, as it always will), and after a while it did get obvious that the rope was made to fit only a few of the climbers. Some needed a longer rope, some a shorter, but the rope was always adjusted for only a few of the climbers. Then the weather got worse…

  10. charles 2

    One feature that Munchau overlooks is that the statute of EFSF enables it to do maturity transformation (it can even borrow in foreign currencies!). They don’t have the capital constraint of a bank ; it won’t be a CDO : it will just morph into a commercial paper funded SIV as they will borrow using short term CD’s at a very low rate.

  11. Tyler

    The worst part about this whole Global financial crisis isn’t that its going to lead to a world wide depression– its that none of the world leaders have the courage to allow it to happen. The sooner we reach a true economic bottom, the sooner things can improve. But none of these evil, EVIL world leaders and bankers wish to allow this to occur.

  12. Rodger Malcolm Mitchell

    Because the EU nations (other than the UK) are not Monetarily Sovereign, they have no control over their money, meaning they all need money coming in from outside to avoid bankruptcy. Though they cannot service their loans, they continue to borrow.

    In this, they are like Illinois and California, which also are not monetarily sovereign, and always will need aid from the federal government.

    By contrast, the U.S. (and Canada, Australia, China et al) are monetarily sovereign, so cannot go bankrupt, for they have the unlimited power to create the money to service debt. Until the EU nations allow themselves to be monetarily sovereign, they will be in a perpetual state of financial crisis.

    Rodger Malcolm Mitchell

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