Doubts About Eurobailouts Come to the Fore

Doubts About Eurobailouts Come to the Fore

A brief recap of a couple of useful sighting on the “rising anxieties in Europe” front. Edward Hugh has a very thorough update (bond spread trends, underlying drivers, an astute discussion of politics) leavened by a great deal of wry humor (”So, like former US Treasury Secretary Hank Paulson before them, Europe’s leaders, having armed their bazooka may soon need to fire it.”). His summary:

According to one popular analogy currently going the rounds, the Euro Area countries could be likened to a group of 16 Alpine climbers scaling the Matterhorn who find themselves tightly roped together in appalling weather conditions. One of the climbers – Greece – has lost his footing and slipped over the edge of a dangerous precipice. As things stand, the other 15 can easily take the strain of holding the Greeks dangling, however uncomfortable it may be for them, even if they cannot quite manage to pull their colleague back up again. But as the day advances others, wearied by all the effort required, start themselves to slide. First it is Ireland who moves closest to the edge, and gets nearer the abysss with each passing moment. But just behind comes Portugal, while some way further back Spain lies Spain, busily consoling itself that it is in no way as badly off as the others. But if all three finally go over, dragged down by the weight of those who precede them, then this will leave 12 countries supporting four, something that the May bailout package only anticipated as a worst-case scenario. In the event that this is finally what happens, Mr Reglin will find he has plenty of work to do, as will Mr Trichet’s successor at the ECB. In the meantime all the rest of us can do is wait and hope, firm in the knowledge that having come this far, we can only go forward, since there is no easy way back down to the point from which we started. But for heavens sake, the only thing we don’t need to be told at this point is that the danger has already past, even as we slide, inch by inch, onwards and downwards.

Wolfgang Munchau at the Financial Times takes a hard look at a piece of the puzzle most have avoided, namely the CDO structure that the Eurozone members used for their €440 billion bailout fund. He’s pushed some numbers around, and as far as he can tell, it will only be able to offer costly funding, and in much smaller amounts than advertised:

My numbers are extremely rough….The EFSF last week obtained a triple A rating….To obtain the rating, the EFSF had to agree to an over-collateralisation. In this specific case it means that the EFSF needs to obtain government guarantees of €1.2bn for each €1bn in bonds it wants to issue.
Once it raises the funds, the EFSF will not be able to lend on all of the €1bn, but only the portion backed by the collateral of those countries that themselves have a triple A rating. That reduces the amount available to the borrower to €700m…..
So what is the interest rate? The borrower essentially pays the sum of the EFSF’s funding costs, an administration margin and a lending margin. The triple A rating should ensure that the funding costs for the EFSF are not extremely high, but I doubt that the EFSF could obtain a funding rate as cheap as that available to the European Investment Bank…. I would…assume that the EFSF’s funding costs exceed those of the EIB by a good margin.
Let us assume the EFSF raises the €1bn at an interest rate of 4 per cent. With administration charges and lending margins of 350 basis points, the effective interest rate to the borrower would be 7.5 per cent. What about the cash buffer? The EFSF must reinvest the buffer in the best triple A rated securities in the market. So if its own funding costs are 4 per cent, and if it invests the cash buffer into German bonds at a hypothetical yield of 2 per cent, there is a loss of 2 percentage points. This also has to be paid for by the borrower. This comes on top of the 7.5 per cent interest. It is not all that hard to conceive of a situation in which the borrower would end up paying a total interest rate of 8 per cent….no matter how you twist this, it is hard to construct a cheap loan out of this.
Three issues arise from this set-up. The first is that no country would ever want to borrow from the EFSF, unless it was absolutely unavoidable…
The second is that the overall amount for lending is significantly reduced. The headline figure of €440bn is misleading. First, one should deduct the shares of Greece, Ireland and Portugal, then the effect of the over-collateralisation and then the share of countries without a triple A rating. A more realistic ceiling is thus €250bn on my calculations, and that is still probably way too high. This may be enough to help a couple of small countries but would be inadequate if a large country should get into trouble.
And finally, the whole edifice would collapse if France was downgraded. This is a non-zero probability event, to put it mildly. Without France, Germany would be the sole pillar of the system, a role Germany would probably not accept.
Having looked at this in some detail, I find it hard to conceive of a situation where a country would both borrow from the EFSF and live happily ever after.