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European economic woes & delusions of stability

September 02, 2010 12:44 IST

Eurozone's financial contingency plan is trying to solve the problem of excessive debt with even more debt, says Satyajit Das.

Pre-summer debt concerns of Greece, Spain and Portugal have receded. Market volatility and angst have eased. As markets return after the summer break and normal activity resumes, caution is the watchword.

Greece passed its initial inspections carried out by the supervising "Troika"-- comprising the European Central Bank, the European Union and the International Monetary Fund.

In truth, there was no choice but to pass the student since money must be made available to enable Greece to continue to function. Despite the progress, the economy is slipping into a deep recession, thus impeding the recovery plan.

Similar scenarios, albeit less urgent, are playing out in Spain, Portugal and Ireland. Slowing growth in North America and China is complicating the problem.

Negative or low growth, savage budget cuts and economic restructuring will need to continue for years.

The plan requires these countries to run a four-minute mile over and over again for years on a lower-than-subsistence calorie intake.

It remains to be seen whether this is feasible. The willingness of governments to impose and citizens to bear the decline in living standards necessary to avoid a debt restructuring remains uncertain.

The bank stress tests proved that the EU and the ECB believe in Father Christmas, the Easter Bunny and other munificent deities.

This exercise did not seriously test likely losses in the case of sovereign debt restructuring and realistic falls in commercial real estate prices.

As they were confined to trading books, the tests did not apply to the bank's banking books in which an estimated 90 per cent of the sovereign bonds are held, making the test of limited value. The definition of capital was generous. It was effectively a car "crash test" for which the testing authority deems the car cannot crash.

The exposure of Germany and France to troubled European countries remains around $1 trillion.

According to the Bank for International Settlements, as at the end of 2009, French and German banks had lent $493 billion and $465 billion, respectively, to Spain, Greece, Portugal and Ireland.

The ECB remains a key source of funding for vulnerable European banks, particularly in peripheral countries.

In short, the problems remain.

It is probable that in the coming months pre-summer concerns will resurface. Economic data, like growth, unemployment, budget position, and debt issuance will be key indicators of progress

Increasingly attention may focus on the European Financial Stability Facility, which is a key component of Europe's financial contingency plan.

Details of the structure reveal doubts about its efficacy.

The structure echoes the ill-fated Collateralised Debt Obligations and Structured Investment Vehicles (as pointed out by Gillian Tett in the Financial Times).

Klaus Regling, the recently appointed EFSF chief, also had a brief stint at Moore Capital, a macro-hedge fund, entirely consistent with the fact that the EFSF will be placing a historical macro-economic bet.

In order to raise money to lend to finance member countries, the EFSF is seeking the highest possible credit rating -- AAA.

The EFSF's structure raises significant doubts about its credit-worthiness and funding arrangements. This, in turn, creates uncertainty about its support for financially challenged euro-zone members with significant implications for markets.

The 440-billion pound ($520-billion) rescue package establishes a special purpose vehicle, backed by individual guarantees provided by all 19 member countries.

Significantly, the guarantees are not joint, thus reflecting the political necessity, especially for Germany, of avoiding joint liability.

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 beyond their ECB shares. An unspecified cash reserve will provide an 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 that is used in CDOs to protect investors in higher-quality, AAA-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 AAA. The same logic is to be applied to rating EFSF bonds.

If 16.7 per cent of guarantors (20 per cent divided by 120 per cent) are unable to fund the EFSF, the lenders to the structure will be exposed to losses.

Coincidentally, Greece, Portugal, Spain and Ireland happen to represent around this proportion of the guaranteed amount.

If a larger eurozone member also encountered financial problems, then the viability of the EFSF would be in serious jeopardy. There are significant difficulties in determining the adequacy of the 20-per cent cushion.

Investors will assume "wrong way correlation risk".

The potential risk is that if one peripheral eurozone member has a problem, the others will have similar problems.

This means if one country requires financing, guarantors of the EFSF will face demands at the exact time that they themselves will be financially vulnerable.

The structure also faces a high risk of a fall in the security rating. If the cushion is reduced by problems of a eurozone member, then the EFSF securities may be downgraded.

Any such ratings downgrade would result in mark-to-market losses to investors. The recent downgrade to the credit rating of Portugal highlighted this risk.

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 correlation can result in losses to investors in AAA-rated structured securities.

Given the precarious position of some guarantors and their negative rating outlook, at a minimum, the risk of ratings volatility is significant.

This means that investors may be cautious about investing in EFSF bonds and, at a minimum, may seek a significant yield premium.

The ability of the EFSF to raise funds at the assumed low cost is not assured. The acronym EFSF could stand for "Extremely Fanciful Silly Fantasies".

Over the last decades, major economies have transferred debt from companies to consumers and finally onto public balance sheets.

The reality is that a problem of too much debt is being solved with even more debt. Deeply troubled eurozone members cannot bail out each other as the significant levels of existing debt limit the ability to borrow additional amounts and finance any bailout.

As Albert Einstein noted: "You cannot fix a problem with the kind of thinking that created it."

A huge amount of securities and risk are now 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 ESSF is that stronger countries' balance sheets are being contaminated by the bailout. Like sharing dirty needles, the risk of infection for all has drastically increased.

The ESSF is primarily a debt-shuffling exercise that may be self-defeating and unworkable. George Bernard Shaw observed that "Hegel was right when he said that we learn from history that man can never learn anything from history." 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.

Satyajit Das is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives — Revised Edition (2010)

Satyajit Das