Eurozone could be insuring its own downfall

In today's City AM we argue against the possible use of the EFSF to insure sovereign debt. here is the full piece:

As eurozone leaders gear up for their umpteenth summit to solve the Eurozone crisis, they seem to have reached the conclusion that what the Eurozone needs is more leverage. Not only that, but they seem to believe that the best way to achieve this would be through using the EFSF, the Eurozone’s bailout fund, to insure shares of Eurozone sovereign debt.

The irony is that many of the same leaders just agreed to pointless regulation of credit default swaps (a valid form of default insurance), which is likely to decrease liquidity in sovereign debt markets, increase borrowing costs for some countries and hamper risk management. This hypocrisy is sadly, and expectedly, lost on Eurozone leaders, who seem intent on taking with one hand and giving with the other – fiddling while the Eurozone burns.

The thrust of the plan is that €440bn worth of EFSF funds would be used to offer a guarantee of 20 per cent on new, mainly Italian and Spanish sovereign debt, therefore leveraging the coverage of the fund five times. Let’s put aside the legal issues relating to the Eurozone’s no-bailout clause and the recent German Constitutional Court ruling for a minute and focus on the economics – which just don’t add up.

First off, Spain and Italy represent 30 per cent of the EFSF guarantees. As a result, any EFSF insurance would prove ineffective, since these countries would be partly guaranteeing themselves through their membership of the fund and unable to make good on these guarantees if under threat of default – the exact moment when the guarantees would need to be called upon. Both countries could step out of their EFSF commitments (as bailed out countries already have) but this would reduce the size of the fund significantly.

This leads to a second problem – there isn’t that much money to be leveraged, even if the EFSF’s triple-A rating is abandoned in an attempt to access the full €780bn in guarantees underpinning it (which are currently needed to ensure €440bn effective lending capacity). After the second Greek bailout, around €115bn would be committed from the EFSF to bailout programmes in the Eurozone periphery. Add to this the need for a recapitalisation of European banks, which could cost the EFSF up to €200bn (as suggested by the IMF). Lastly, take into account that the guarantees of Italy and Spain along with Greece, Ireland and Portugal have to be discounted. This leaves only around €175bn to be leveraged, not exactly significant considering that Italian and Spanish funding needs amount to around €1.7 trillion over the next few years.

Thirdly, this plan offers little incentive to investors as the likely scenarios are ones of extremes – there will either be no default with no losses or significant losses under a significant default. But 20 per cent insurance falls somewhere in the middle of the two, which is rather like insuring only part of your house – and therefore unlikely to inspire much confidence. Furthermore, assuming that other countries would be able to fulfil their guarantees during a Spanish or Italian default is unrealistic, particularly given the contagion experienced so far throughout the crisis and the already fragile state of some government finances in the core of the Eurozone.

Additionally, since it looks likely only to apply to new issues of debt rather than the existing stock, it could at best only help Italy and Spain with their liquidity problems, but will do nothing to solve the underlying solvency problems in other Eurozone countries. A proposal that does not tackle the problem of contagion or existing debt levels cannot be seen as a solution. It could also encourage fiscal profligacy in those states which receive some insurance – something which the Eurozone can ill afford more of.

Even if this proposal were viable, the knock-on effects of its implementation would be undesirable. It would create a two-tiered bond market, since a large amount of new debt will involve some insurance (credit enhancement) with the aim of making it “safer”. This would introduce huge uncertainty into secondary markets, making it more difficult to price sovereign risks in the Eurozone – most would agree this is the opposite of what is needed.

Take these issues as a whole and a disturbing picture emerges, one that conjures images of the excessive leverage, unfunded liabilities and misleading credit enhancements that helped fuel the financial crisis. Putting these at the heart of the Eurozone sets the scene for another crisis. Moving forward with a restructuring of Greece and Portugal, a full bank recapitalisation and reforms to restore competitiveness across the Eurozone remains the only feasible short-term solution to this crisis. However, none of the options on offer, least of all this insurance plan, can tackle the underlying structural flaws in the Eurozone.