The euro zone’s self-inflicted killer


There were a lot of things that were supposed to save Europe from potential financial Armageddon. Chief among them is the EFSF, or European Financial Stability Facility. In the spring of 2010, European finance ministers announced the facility’s formation with great fanfare. In its inaugural report, Standard & Poor’s described the EFSF as the “cornerstone of the EU’s strategy to restore financial stability to the euro zone sovereign debt market.” The facility itself said in an October 2011 date presentation that its mission is to “safeguard financial stability in Europe.”
That of course hasn’t happened. And the evidence suggests that the EFSF may have only exacerbated the problems. In theory, the facility is supposed to provide a way for a country that the market perceives as weak to still borrow money on good terms. The initial idea was that instead of the financially troubled country itself trying to sell its debt to live another day, the EFSF would be the one to raise the money and lend it to the country in question. The logic was simple: country X might be shaky, but the EFSF deserved a triple-A rating.
For all of its would-be financial firepower, the EFSF isn’t much to see—it’s just an office in Luxembourg with a German-born economist CEO named Klaus Regling, who oversees a staff of about 20. Its power—and that rating—is derived from the assumption that any debt it issues is guaranteed by the members of the euro zone. Initially, each member pledged unconditionally to repay up to 120% of its share of any debt the EFSF issued. (A country’s share is determined by the amount of capital it has in the European Central Bank.)
On paper, it all sounded great.
The reality is that the EFSF wasn’t meant to be an active institution; it was supposed to be a fire extinguisher behind glass: never to be used. “The EFSF has been designed to bolster investor confidence and thus contain financing costs for euro zone member states,” wrote Standard & Poors in its initial report granting the triple A rating. “ If its establishment achieves this aim, we would not expect EFSF to issue a bond itself.” Moody’s, for its part, wrote that the EFSF “reflects the political commitment of the euro zone member states to the preservation of the euro and the European Monetary Union.” That show of commitment alone was supposed to be enough to reassure the market.
In granting the EFSF the all-important triple-A rating, the rating agencies were somewhat cautious. They weren’t willing to assume, as they did with subprime mortgages, that any subset of debt guarantees—no matter how small—made by countries that weren’t themselves triple-A rated would be worthy of the gold-plated standard. Instead, they insisted that the EFSF’s loans had to be covered by guarantees from triple-A rated countries and cash reserves that the EFSF would deduct from any money it raised before it passed those proceeds on to the borrowing country. Based on that, euro zone members initially pledged a total of 440 billion euros ($650 billion) in guarantees. However, S&P said in its initial report that the EFSF would be able to raise less than $350 billion of triple-A rated proceeds.
Of course the euro zone did break the glass: the fire extinguisher was used, first in support of Ireland, and then Portugal, and then Greece. This summer, the European Powers That Be agreed to bolster the EFSF’s lending capacity by increasing the maximum guarantee commitments of the member states to 165%, instead of 120%. That was supposed to enable the EFSF to borrow up to 452 billion euros “without putting downward pressure on its ratings,” according to S&P.
As we now know, that’s not nearly enough money to end the crisis, especially given that the EFSF’s commitments to Ireland, Greece and Portugal leave the facility with a lending capacity of just 266 billion euros, according to a recent report from Moody’s. (I found it difficult to add up where the money went.)
Hence the politicians’ latest idea: leverage the EFSF’s remaining ability to borrow. Either have the EFSF offer first-loss insurance when a country issues debt, or turn its remaining capacity into the first-loss tranche of a collateralized debt obligation, which would raise money by selling bonds to other countries like China.
Besides being undersized for the job, there’s a core structural problem with the EFSF: It is only as strong as its triple-A members—not just Germany, which according to that October 2011 EFSF presentation contributes 29% of the total value of the EFSF’s guarantees, but also France, which contributes 22%, and the Netherlands, which contributes 6%.
Some financial analysts have questioned why any European country deserves a triple-A rating, seeing as EU members can’t print their own currency to pay off their debts. As the financial turmoil has unfolded, it’s become clear that the only EU country the market views as a bona-fide triple-A is Germany. So as much of Europe crumbles, the EFSF’s triple-A, in the eyes of the market, is supported by a lone country. As one bond market participant says, “Eventually, only the German guarantee will matter, and it isn’t big enough to cover this.”
Indeed, Germany represents less than a quarter of the EU’s GDP, and obviously the nation’s economic health is to no small degree dependent on other members of the EU buying German goods. (Such interconnectedness was the whole point of the European Union—and that helps explain why the cost to insure against a German default has more than doubled since the summer, to $93,655 a year to insure $10 million of 5-year German debt.)
Not surprisingly, the EFSF’s last 3 billion euro bond sale, on Monday, November 7, met with what Moody’s called “significantly less demand” than a similar issue last spring. The issue was originally supposed to be 5 billion euros, and the spread, relative to German debt, that was required to lure investors was over three times the spread that was needed last spring. As Moody’s wrote in its report, “the demand for the EFSF bond issuance was dampened by a lack of confidence over the credit resilience of its guarantors.” Another way to think about this is that since the strength of the EFSF is dependent on the strength of its parts, the more individual countries have to pay to raise money, the more the EFSF itself has to pay.
In fact, it’s the definition of a vicious cycle.
The EFSF’s funding costs rise along with those of its guarantors, and perversely, bond market participants say that the very existence of the facility also causes its guarantors’ cost to rise. That’s because there aren’t many investors who are interested in buying European sovereign debt these days. Those who are demand a very high premium if they’re going to buy, say, Italian debt instead of EFSF debt. This is why the EFSF was going to be hurtful, rather than helpful, if it had to be used: it competes with its very creators for investment, driving spreads higher and higher. One hedge fund manager calls the EFSF a “self-inflicted killer” of Europe’s bond markets.”
The EFSF is due to expire, and is supposed to be replaced by the European Stability Mechanism, or ESM, in mid-2013. But the ESM looks like it’s going to have same problem the EFSF does: Its finances depend on the very same countries that it is supposed to bail out. In other parts of the world, this isn’t called stability; this is called a Ponzi scheme.