EFSF-Delusions of Safety

George Bernard Shaw observed that “Hegel was right when he said that we learn from history that man can never learn anything from history“. Emerging details of the European Financial Stability Facility (“EFSF”) bear testament to this.

The structure echoes the ill-fated Collateralised Debt Obligations (“CDOs”) and Structured Investment Vehicles (“SIV”) (as pointed out by Gillian Tett in the Financial Times). The recently appointed head also had a brief stint at Moore Capital, a macro-hedge fund, entirely consistent with the fact that the EFSF will be placing a historical macro-economic bet.

In order to raise money to lend to finance member countries as needed, the EFSF will seek the highest possible credit rating – AAA.

The EFSF’s structure raises significant doubts about its credit worthiness and funding arrangements. In turn, this creates uncertainty about its support for financially challenged Euro-zone members with significant implications for markets.

The €440 billion ($520 billion) rescue package establishes a special purpose vehicle (“SPV”), backed by individual guarantees provided by all 19-member countries. Significantly, the guarantees are not joint and several, reflecting the political necessity, especially for Germany, of avoiding joint liability.

The risk that an individual guarantor fails to supply its share of funds is covered by a surplus “cushion“, requiring countries to guarantee an extra 20% beyond their ECB shares. An unspecified cash reserve will provide additional support.

Given the well-publicised financial problems of some Euro-zone members, the effectiveness of the 20% cushion is crucial. The arrangement is similar to the over-collateralisation used in CDO’s to protect investors in higher quality AAA rated senior securities. Investors in subordinated securities, ranking below the senior investors, absorb the first losses up to a specified point (the attachment point). Losses are considered statistically unlikely to reach this attachment point, allowing the senior securities to be rated AAA. The same logic is to be utilised in rating EFSF bonds.

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 happen to represent around this proportion of the guaranteed amount. If a larger Euro-zone member, such as Italy, also encountered financial problems, then the viability of the EFSF would be in serious jeopardy. There are significant difficulties in determining the adequacy of the 20% cushion.

Investors also will assume – wrong way correlation risk. This is the potential risk that if one peripheral Euro-zone member has a problem then others will have similar problems. This means if one country required financing, guarantors of the EFSF will faces demands at the exact time that they themselves will be financially vulnerable.

The structure also faces a high risk of rating migration (a fall in security ratings). If the cushion is reduced by problems of an Euro-zone member, then the EFSF securities may be downgraded. Any such ratings downgrade would result in mark-to-market losses to investors. The recent downgrade to the credit rating of Portugal highlight this risk.

Unfortunately, the Global Financial Crisis illustrated that modelling techniques for rating such structures are imperfect. Rapid changes in market condition, increases in default risks or changes in default correlation can result in losses to investors in AAA rated structured securities, ostensibly protected from this eventuality. Given the precarious position of some guarantors and their negative rating 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.

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 bailout. 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. Deeply troubled members of the Euro-zone cannot bail out each other as the significant levels of existing debt limit the ability to borrow additional amounts and finance any bailout.

The EFSF is primarily a debt shuffling exercise which 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. As Albert Einstein noted: “You cannot fix a problem with the kind of thinking that created it.” The acronym – EFSF – could just stand for ‘Extremely Fanciful Silly Fantasies’.

An earlier version of this paper was published in the Financial Times.