Saturday, November 13, 2010

Economics 13/11/10: EFSF, Ireland and a matter of contagion

let me ask the following question: if Ireland is nearing (or already in - see here) a bailout from the EFSF, what does this imply to the overall Euro area stability? Funny thing - it turns out that a little old Ireland can give a big young Euro quite a headache because of the way EFSF is structured.

Let’s step back and take a look at the promise EFSF attempts to deliver.

The fund, set up back in May this year, was supposed to provide an emergency funding backstop to countries finding themselves in a liquidity squeeze (unable to borrow in the markets).

There two basic problems with this idea from the point of view contagion from Ireland

  • Ireland’s crisis is that of insolvency, not of a liquidity squeeze 9although it is increasingly looking like the latter will come in the end). If EFSF were to be explicitly used to address Ireland crisis, then Irish Government will be de facto borrowing from the fund with no hope of repaying it ever back (recall – the lending rates under EFSF should be set close to the market rates, which means, say 7-8% currently, which in turn automatically means we can’t be expected to repay this). If so, then any borrower, I repeat – any borrower – from EFSF will not repay the funds borrowed. And this means EFSF borrowings will have to be covered collectively out of the joint funds of the entire Eurozone. You can pretty much count PIIGS out of funding it – they’ll be the very same borrowers. Which leaves it to France and Germany (Belgium hardly can pay much and Austria has it’s own problems etc) to cover the entire fund.
  • EFSF own structure implies high risk of contagion from Ireland.

That second point is slightly technical and requires some explaining to do.

One can make an argument that Ireland, if it borrows from EFSF, will trigger an increase in the Euro zone systemic risk. EFSF is set up similar to Collateralized Debt Obligation (CDO) with a "credit enhancement" that allows the senior debt tranche to retain higher risk rating because junior tranches are the ones that will carry the first hit on the whole package in the case of default.

The lags in the disbursement of funding and the capped nature, plus ‘enhancement’ bit of the CDO implies that countries in trouble will have to get into the funding stream as early as possible – as there is quick exhaustion of drawdown funds in the EFSF due to the knock on effect on CDO rating. This is known as an accelerated negative feedback mechanism – as sovereign comes under pressure, sovereigns are encouraged to race into EFSF, which removes their own bonds and capacity to carry debt out of the senior CDO tranche and increases their presence in the junior tranches.

So the guaranteed pool of liabilities increases by the amount country borrows from the fund, but the senior pool decreases by the contribution of this country to the fund. This means that as Ireland joint EFSF, it’s past ‘good credit’ rating falls to zero in the senior CDO tranche, its ‘bad debt’ risk contributes to the reduced quality of the liabilities held by the EFSF. Pressure rises on AAA rating of EFSF, unless EFSF draws more of AAA-rated countries debt into its senior tranche to offset this. EFSF will have to expand to be able to do both: lend out to Ireland and maintain AAA rating. Which, of course means that other EFSF contributors will need to issue more debt to recapitalize EFSF. Which means their own AAA ratings are becoming threatened as well.

You see where it all leads, now, don’t you?

The greater is the number of countries seeking help and/or the greater is the overall demand for EFSF funds, the greater the required buffer funding increases from the remaining EFSF-lending AAA-rated sovereigns. All of which, in plain English means that the EFSF will run into its own lending limits quicker if Ireland were to go into borrowing from it. Much quicker than a simple level of our borrowing would suggest.

Now, any sovereign with an once of sense now will know that a race to tap EFSF is on. The faster you get to it to borrow from it, the more likely you’ll arrive to the borrowing window before the limits are reached. Portugal, Spain and possibly even Italy are in the race.

This is why the markets have never been easy about the entire EFSF – they know that Ireland tapping into EFSF simply does two things:
  1. It delays the inevitable restructuring of the massive debts accumulated on the Irish economy side – either sovereign or banks or households or any two or all three. EFSF does not remove the need for such a restructuring. It simply delays it.
  2. It signifies an exponential increase in the probability of EFSF acting as a conduit for contagion from the PIIGS to the rest of the Euro area.


ellend said...

If the EFSF is a mechanism for solving temporary illiquidity, and we're clearly insolvent, why would they even consider lending to us?
And are these 'preliminary talks' designed to secure funding to keep the country afloat after June next year when the money runs out, or are 'we' looking for money now to pay back those mothertrucking bondholders?
And if, by giving us money, they risk spreading economic swine flu to the other PIIGS, again, why would they even consider it?

Plyskeen said...

Now (and please forgive me if I ask something really stupid), considering that the Irish government is not supposed to be going again to the public debt markets until march-june next year; and the only thing that would theoretically force it to go before that time is a considerable bank run (as was the case with Greece, actually); and considering as well that Bank of Ireland announced this morning that they had already suffered a significant flight of deposits, how misled would I be if I see the current main pages of BBC, Bloomberg ("Ireland Urged to Take Aid by European Officials ") and The Wall Street Journal ("EU Urges Early Irish Bailout") (all of them talking about the Irish bailout, although the BBC one is the probably the worst offender) as a way to speed up the Irish race into the EFSF?

ellend said...

I too apologise for the daft questions, every day I feel more and more like this guy:

The question is: does the fact that all market commentators THINK we've had to start negotiating an EFSF bailout make it a self-fulfilling prophecy as no-one else will consider lending to us? Is the international monetary system upon which our economies depend really such a game of chinese whispers?

Unknown said...

I think some saw this coming (mostly contributors and commentors to this blog). The vultures are waiting to pick over the carcass of what is left already, with several of my clients discussing their moves on resecuritizing renegotiated property debt once the banks go is already in play, my friends.....and NAMA was just the start.....

Fungus the Photo! said...

Taxes will eventually exact all the money needed to repay these debts. It might take 50 years. The most rational option is to leave for Australia unless you have a very secure well paid occupation. Sell off all land as buying back in two decades will be for a half/third of the price?

Imminent oil and gas production might make things better, but with current leadership, I doubt it!