Economics 15/7/10: European bailout fund - set up to fail?

I thought it is worth sharing few thoughts on a superb article by Satyajit Das"Debt shuffling will be a self-defeating exercise" in July 12 Financial Times (sorry - no link) concerning the European bailout fund. All quotes are from the article, with some of my additions/explanations etc.

European Financial Stability Facility (EFSF) “…structure echoes the ill-fated collateralised debt obligations (CDOs) and structured investment vehicles (SIVs). …In order to raise money to lend to finance member countries as needed, the EFSF will seek the highest possible credit rating – triple A. But the EFSF’s structure raises significant doubts about its creditworthiness and funding arrangements…”

The €440bn bailout fund created a SPV, “backed by individual guarantees provided by all 19 member countries. …The guarantees are not joint and several…”

This means that SPV – an insurance fund against sovereign defaults – is in the need of an additional insurance mechanism against the risk that one or more of the funders fail to pay up into the EFSF. This is achieved by “…a surplus ‘cushion’, requiring countries to guarantee an extra 20% above their ECB contributions.”

One point, not mentioned to Das is that this ‘cushion’ fund is itself subject to risk as a call on the ‘cushion’ will require some states near default to supply even more funding to the fund. In other words, to any of the PIIGS participating in supporting one of their fellow member states, the cost of the EFSF bears a 20% premium reflective of the ‘cushion’. Just how this is going to be feasible for severely financially stretched states remains to unknown. Take one example – for Ireland this would mean that our €5bn exposure to the EFSF is, in reality, a €6bn exposure.

Das focuses on the overall risk transfer within the EFSF arrangement, saying that the ‘cushion’ “is similar to the over-collateralisation used in CDOs to protect investors in higher quality triple A rated senior securities.”

Das puts some numbers on this: “If 16.7% of guarantors (20% divided by 120%) are unable to fund the EFSF, lenders to the structure will be exposed to losses. Coincidentally, Greece, Portugal, Spain and Ireland happened to represent around this proportion of the guaranteed amount. If a larger eurozone member, such as Italy, also encountered financial problems, then the viability of the EFSF would be in serious jeopardy.”

There are other problems with the EFSF. Das notes the issue of ratings migration – the situation where if one eurozone member state experiences problems, then the ‘cushion’ will suffer to the proportion of that member state contribution to EFSF, thus reducing overall insurance pool and adversely affecting overall EFSF ratings.

There is an added and much more severe problem here that no one dares to talk about. If one of the PIIGS experiences problems contributing to the EFSF, then other eurozone states with tight borrowing constraints might have an incentive to ‘run on the bank’, attempting to hover up EFSF funds before they are depleted while simultaneously withholding all contributions to IFSF. First mover advantage here will guarantee a payoff, while staying on the sidelines guarantees at least an up to 120% hit on the member state own funding.

As Das correctly points, “any ratings downgrade would result in mark-to-market losses to investors. …Given the precarious position of some guarantors and their negative ratings 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.”

So the problem then is that from a political standpoint, EFSF might be borrowing in the markets at 3.5-4%, while lending out to PIIGS at 5%. Should interest rates rise, or inflation tick up, or Euro devaluation continues, the net of costs safety band of 75-125bps can be exhausted very quickly. As the safety band is being eroded, the pressure on triple A ratings will rise, triggering the need for further insurance provisioning. Which can, in turn, put pressure on the troubled states to cut provisions for the EFSS. The EFSF will then turn into a loss-making subsidy generator to the PIIGS.

Germans won’t be too happy to see this. The noises from Germany – the main underwriter of the EFSF will put added pressure on the PIIGS to act fast, increasing a probability of a run on EFSF and triggering ratings pressures once again. Notice that to get to this point won’t require an actual run on the fund – a simple rise in the probability of a run will do the damage.

Das’ superb analysis comes at the end of his article (emphasis is mine):

“Major economies have over the last decades transferred debt from companies to consumers and finally onto public balance sheets. A huge amount of securities and risk now is 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 EFSF is that stronger countries’ balance sheets are being contaminated by the bail-out. Like sharing dirty needles, the risk of infection for all has drastically increased.

The reality is that a problem of too much debt is being solved with even more debt.

The EFSF …may be self defeating and unworkable. 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.”

Of course, much of this criticism is pretty close to heart for Nama - an SPV with even lesser transparency, accountability and capability of management. Irony has it, the SPV has no insurance 'cushion' provisions and instead becomes a direct liability of the Irish state as its guarantor. Then again, we already know this much...