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 eurozone debt crisis requires psychiatric rather than financial assessment.
The sketchy plan entails Greece restructuring its debt with write-downs at around 50% and recapitalisation 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.
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 assume the risk of the initial losses on loans or bond portfolios. Assuming that EFSF contributes ?400 billion, the total bailout resources would be around ?2,000 billion. Higher leverage, a lower first loss piece, say 10%, would increase available the funds to ?4 trillion. The European Central Bank (ECB) would supply the ?protected? debt component to leverage EFSF?s contribution, bearing losses only above the first loss piece size.
The proposal has quite a number of problems.
EFSF does not have enough money. After accounting for its existing commitments to Greece, Ireland and Portugal, its theoretical resources are, at best, around ?250 billion.
EFSF must borrow money from the markets, relying on its own CDO-like structure, backed by a cash first-loss cushion and guarantees from eurozone countries. In fact, some investors actually value and analyse the 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), which is a highly leveraged security which proved toxic in 2007-08.
ECB, the provider of protected debt, has a capital of about ?5 billion (to be raised to ?10 billion), supporting around ?140 billion in bonds issued by beleaguered eurozone nations, purchased as part of market operations to reduce their borrowing cost.
ECB has also lent substantial sums (market estimates suggest more than ?400 billion) to European banks without access to money markets at acceptable costs, secured over similar bonds. While the eurozone central banking system has a capital of around ?80 billion that could be available to support ECB?s operations, this adds to the incremental leverage of the arrangements.
Amazingly, 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 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.
The proposal is driven, in reality, by political imperatives?avoiding seeking national parliamentary approval at a time when sentiment is against further bailouts and a lack of support for an increase in the size and scope of 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 EFSF to ?440 billion, Germany?s commitment to EFSF is over ?200 billion.
The scheme may also facilitate 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 another way of requesting that ECB expands its balance sheet to absorb the increased credit risk.
This new scheme, like previous proposals, is unlikely to succeed. As Sigmund Freud 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.?
Satyajit Das is the author of ?Extreme Money: The Masters of the Universe and the Cult of Risk? (to be published in India by Penguin in October 2011)