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 per cent and recapitalization of the affected banks. The European Financial Stability Funds (EFSF) would increase its size to a proposed €2-€3-trillion from its current €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.
One proposal under consideration entails the EFSF using leverage to increase its size and enhance its ability to intervene effectively. The EFSF would apparently bear the first 20 per cent 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 €400-billion, the total bailout resources would be around €2-trillion. Higher leverage, a lower first loss piece, say 10 per cent, would increase available funds to €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 €440-billion. After existing commitments to Greece, Ireland and Portugal, its theoretical resources are at best around €250-billion.
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 analyze 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 €5-billion (to be raised to €10-billion), supporting around €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 €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 €80-billion that could be available to support the ECB’s operations, this adds to the incremental leverage of the arrangements.
The 20 per cent 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.
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.
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.
The scheme may also facilitate the ECB covertly monetizing 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.
Unfortunately, this new scheme like previous proposals is unlikely to succeed.
Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011)