Satyajit Das: Euro-Zone’s Leveraged Solution to Leverage

Yves here. This article is as concise, accessible, and not surprisingly, not at all encouraging evaluation of the latest Eurorescue ruse mechanism.

By Satyajit Das, the author of Extreme Money: The Masters of the Universe and the Cult of Risk

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 sketchy plan entails Greece restructuring its debt with writedowns around 50% and recapitalisation of the affected banks. The European Financial Stability Funds (“EFSF”) would increase its size to a proposed Euro 2-3 billion from its current Euro 440 billion. This would enable the fund to inject capital into banks and also support Spain and Italy’s financing needs to reduce further contagion risks.

On proposal under consideration entails the EFSF using leverage to increase its size and enhance its ability to intervene effectively. Attributed to US Treasury Secretary Tim Geithner, the proposal is similar to the 2007 Master Liquidity Enhancement Conduit (“MLEC”) super conduit which was ultimately abandoned.

The EFSF would apparently bear the first 20% of losses on sovereign bonds and perhaps its investment in banks. This resembles the equity tranche in a CDO (Collateralised Debt Obligations), which assumes the risk of the initial losses on loans or bond portfolios. Assuming the EFSF contributes Euro 400 billion, the total bailout resources would be around Euro 2 trillion. Higher leverage, a lower first loss piece, say 10%, would increase available funds to Euro 4 trillion. The European Central Bank (“ECB”) would supply the “protected” debt component to leverage the EFSF’s contribution, bearing losses only above the first loss piece size.

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 ECB, the provider of protected debt, has capital of about Euro 5 billion (to be raised to Euro 10 billion), supporting around Euro 140 billion in bonds issued by beleaguered Euro-zone nations, purchased as part of market operations to reduce their borrowing cost. The ECB has also lent substantial sums (market estimates suggest more than Euro 400 billion) to European banks without access to money markets at acceptable cost, secured over similar bonds. While the Euro-zone central banking system has capital of around Euro 80 billion that could be available to support the ECB’s operations, this adds to the incremental leverage of the arrangements.

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.

The proposal is driven, in reality, by political imperatives – avoiding seeking national parliamentary approval at a time when sentiment is against further bailouts and lack of support for an increase in the size and scope of the EFSF.

It is also designed to reduce the increasing risk to the credit ratings of France and Germany. This last factor is increasingly important given concerns raised by rating agencies about the quantum of contingent liabilities being assumed by these countries. For example, after the increase in the size of the EFSF to Euro 440 billion, Germany’s commitment to the EFSF is over Euro 200 billion.

The scheme may also facilitate the ECB covertly monetising debt, “printing money”; to generate the protected debt to leverage the structure and also to cover the losses on its own exposures to distressed sovereign debt. It is simply another means of allowing the imply another way of requesting that the ECB to expand its balance sheet to absorb increased credit risk, without breaching existing treaties and regulations as well as avoiding political, especially German, opprobrium and the inevitable memories of Weimar.

Unfortunately, this new scheme like previous proposals is unlikely to succeed. As Sigmund Freud’s observed: “Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.”

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  1. SH

    “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”.

    MMT eliminates all need for real cash and savings so why worry about these concerns like Das presents? Indentured servitude still works. We can work it off.

    1. Tiercelet

      Okay, you’re probably trolling, but still —

      Most discussion of MMT you’re likely to see talks about countries in debt in currencies in which they are sovereign.

      The Euro is special because no country is sovereign in it. The Eurozone countries made themselves a gold standard based on imaginary gold, took away anybody’s ability to imagine more, and then hanged themselves on an imaginary-golden cross.

  2. vlade

    Re circularity – and? Baron Münchhausen (of the pulling-yourself-up-from-swamp-by-your-own-shoelaces) was German, after all…

  3. Linus Huber

    Debt is debt is debt. It does not matter where it is located; it simply is too large and cannot possibly be paid back. To simply increase its size to avoid dealing with the real problem at hand, namely too large a debt burden, will not produce any solution but rather put us deeper into the hole.

    What cannot be paid back will not be paid back. It is that simple and as faster we realize that as faster we can tackle the fallout from the write offs that are coming (whether next month or next year does not matter).

    The fun part is that politicians do not realize what kind of impact these schemes have on consumer sentiment. People do know what is happening (namely finding ways to transfer losses of banks to the tax payer) and start to worry and save. This actions only increase anxiety and consumption will collapse.

    1. Susan the other

      I beg to differ. Debt is credit is good will. And it is all forward looking, positive and hopeful. Otherwise it is nothing. I just had a terrible time trying to figure out what 7 billion times 2.5 million is. My electrical-engineer-husband had to use the computer and the final sum appears to be 17.5 quadrillion. Aha! This is the number that represents 7 billion people doing 50 years of productive work at 50K per year. This sum of money is heavenly. I can hear the harp. It represents 50 years, each worth .35 of a quadrillion in real time for every soul on earth – whether lucky or unlucky. For this amount of “money” we can take care of everyone on the planet and clean it up too. How delightful. And as the population gradually goes down to achieve better sustainability, we can sop up those dollars or whatever they come to be called. So, in short, Timmy Geithner is far too cautious. Our problem is not debt, it is lack of sufficient money to reflect the value of human endeavor.

      1. Ian Ollmann

        $2.5M per capita is indeed an impressive figure. Alas, most of humanity is nowhere near that productive. What is that lifetime net productivity of a goatherd in Somalia?

  4. jjohannson

    Roubini Says Europe Needs 2 Trillion-Euro ‘Bazooka’ Soon
    By Stefania Bianchi – Oct 3, 2011 12:35 AM PT

    “….The steps that need to be taken to avoid a dissolvent situation are massive,” said Roubini, a professor at New York University’s Stern School of Business.

    “Among the measures needed to resolve the European crisis is an easing of European Central Bank policy and rates, a lowering in the value of the euro, a recapitalization of European banks and an “orderly process to allow the exit of Greece from the euro zone,” Roubini said. There also needs to be fiscal stimulus at the core of the euro zone to avoid a recession for all European countries.

    “What is the likelihood of all of these things occurring in a coherent, consistent and realistic way to avoid the mess?” he asked. “I think it’s a low probability because of the political constraints.”

    “The European debt crisis could have consequences that would be “worse” than the collapse of Lehman Brothers, he said.

  5. Serious Sam

    Leveraging the EFSF “is the equivalent of putting explosives into a can, before kicking it down the road” (Wolfgang Munchau)

    1. Jim Haygood

      Hey, that’s why we’ve got two feet — use your spare one, and hop along under the authorities’ instructions!

  6. frequent

    Two trillion… never thought “who wants to be a millionare” would feel like playing for peanuts.

    Plus I’m still wondering on the efforts being undertaken to recapitalize failed institutions versus the efforts undertaken to ensure basic financial services are available, if all things fail.

    If one would calculate the amount of societal value generated from underwater institutions vs. the societal value being lost by keeping them alive on taxpayers’ burden, this makes even less sense.

    So I’m with Slovakia in at least demanding an insolvency plan for bankrupt countries (if I understand correctly) before ok-ing the 440 billion package. Would make a nice economic-recovery-package, too, wouldn’t it?

  7. Jim Haygood

    Dr Hussman takes a different analytical tack, but reaches the same conclusion as Dr. Das. Excerpt:

    The total amount of Greek debt alone represents nearly 80% of the size of the EFSF, which would leave only 20% of the commitment available to other states if the EFSF was to buy it up, as some have suggested.

    It is misguided to believe that Europe can save Greece from default and also contain contagion from Europe’s other distressed countries. if Greece is included in the ring-fence, then even if we assume a worst-case recovery rate of 90% on distressed non-Greek European debt, the maximum leverage of the EFSF would still only be 2-to-1. The idea of 7-to-1 or 10-to-1 leverage is a pipe dream that assumes the ECB will be complicit in destroying the euro through currency creation.

    The only real option for Europe is to allow peripheral defaults; to allow distressed and insolvent countries to exit the euro; and then for those countries to redenominate their own national currencies and peg them to the euro at a gradually depreciated level.

    Europe’s current delusion is that Greece ultimately can take a debt haircut of as much as 50% in a renegotiated deal, and remain within the euro.

    If this comes to pass, Greece will stay mired in depression, and will default again within a few short years on its still unbearable debt burden.

    Refusing the harsh remedy of amputating a gangrenous limb puts the entire body at risk. Europe’s economic doctors have no saw in their kit; only Band-Aids, eyewash and rose-coloured glasses. Serve the patient a bowl of ice cream and put her to bed!

  8. Rodger Malcolm Mitchell

    There are only two long-term solutions for the euro nations:

    1. Each to become Monetarily Sovereign by re-adopting their own sovereign currencies
    2. The EU to give (not lend) euros to member nations ala the U.S. federal government giving money to the monetarily non-sovereign states.

    My guess, the euro nations will be so desperate they finally will be ready to move away from their ridiculous “lend-more-money-to-cure-indebtedness” philosophy. One or two nations might opt for solution #1, but the majority will be dragged, kicking and screaming into #2.

    Rodger Malcolm Mitchell

  9. Jim Haygood

    Kurgman, still delusional and preparing for his eventual reincarnation as a dung beetle, cheers on Senate know-nothings such as New York’s Chuck-the-Schmuck Schumer:

    Given our economy’s desperate need for more jobs, a weaker dollar is very much in our national interest — and we can and should take action against countries that are keeping their currencies undervalued, and thereby standing in the way of a much-needed decline in our trade deficit.

    That, above all, means China. And none of the arguments against holding China accountable can stand serious scrutiny. Some observers question whether we really know that China’s currency is undervalued. But they’re kidding, right?

    Nope. Let’s just take a little straw in the wind, from what might be called the ‘periphery’ of the emerging markets. These quotes are from Bloomberg, via Doug Noland:

    Sep. 28 – Bloomberg (Camila Russo): “Argentina’s central bank paid the highest yields in almost two years on fixed-rate peso bonds sold at its weekly auction as investors switch their deposits to dollars and capital flight increases. Yields for fixed-rate bonds of the shortest maturity, due in 126 days, rose 26 bps from last week’s sale of 112-day bonds to 13.4% …”

    Sep. 29 – Bloomberg (Camila Russo): “Argentina’s central bank is selling dollars at the fastest pace in almost three years to meet increased demand for foreign currency, depleting the amount of reserves it can use to pay debt as capital flight picks up. Policy makers sold $1.98 billion of reserves from July 1 through Sept. 16 to prop up the peso … Average government dollar bond yields jumped 265 bps since the end of June to 11.95% on Sept. 26 …”

    Why is this surprising? Because since mid-decade, Argentina (like the BRIC countries) has been buying dollars to prevent its peso from appreciating as sharply as Brazil’s real has done. Now capital flows — in a process well documented by Michael Pettis in his book The Volatility Machine — seem to have reversed this summer … and peso suppression has flipped overnight to peso support — i.e., attempted revaluation.

    Is the developed core now repatriating its hot money capital from developing markets, including China? One could infer such from the action in stock symbol EEM, the emerging markets ETF, which is notably worse than US indexes. If this proves to be the case, then pressure to revalue the yuan at a time when inbound capital flows are diminishing or reversing would be badly timed.

    But as a partisan political economist, Kurgman is blind to such subtleties. A static supply-demand curve tattooed on his beetle-browed forehead, Kurgman linearly extrapolates the past into the future — the most basic newbie error of all in analyzing dynamic markets.

    Meanwhile the demand function for Kurgman’s commentary is pancaking into the x-axis like Benny Bubbles’ yield curve: the popeyed ideological pugilist can’t give it away!

    At least after he gets his hard exoskeleton, we won’t able to use poor Kurgman as a punching bag no more. Nor — thank goodness! — will he be able to type with his hairy little jointed legs. Kurgman is Gregor Samsa and doesn’t know it.

  10. Paul Tioxon

    The structural requirements of capitalism, of the financialized credit/debt expansion, are exceeding the nation state mechanism as a whole in confederation with attenuated sovereignty granted for the common currency. Tweeks and work arounds are not getting around the problem. The political response is something greater than can be faced by the political class to the open ended nature of radical change required. Even if the political restraints for the purpose of resolving this crisis are fully met and set aside, other demands on the political system immediately arise once the willingness to change is shown to a new feature of the political landscape and the new structural changes are firmly in place.

    Opening up fiscal integration opens up other demands, if not this week or month, beginning soon enough to cascade into other political crisis, separate from the economic ones, but shattering to the European Community just the same. For example, military treaties and command structures could drastically be modified. This leads to another set of problems involving other components of the international system, the relation of NATO with the USA for starters.

  11. Hugh

    Das does a good analysis here, but this sketchy plan as he calls it looks like it was run out mostly to goose markets that were turning south a few days ago. Its effect seems to have worn off given that markets are heading down again.

    I think Michael Hudson has this right. These schemes really amount to transfers to wealthy bondholders. Even those who might have to take 50% haircuts would still be doing better than 75%-100% losses they might otherwise expect and you could consider this a cost of doing business since it would protect contagion to other of their bond holdings.

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