The belief in miracles is primordial to humans. Although people tend to be rational and solve problems logically, there is always a willingness to suspend reality. Faith in miracles occurs during the darkest moments, when there is a need for divine intervention. The hope that the European Financial Stability Fund (EFSF) will resolve all of Europe’s economic problems is nothing more than miraculous. There are four primary types of miracles. The first one is the miracle over nature. The parting of the waters is a good example. The second one is the miracle of healing. This is a miracle that is often sought. The third is the miracle over demonic powers. Many Hollywood movies employ this genre as the parable of good over evil, and the last one is the miracle of supply. This is the type of miracle that is needed during times of need, such as famines or poorly planned wedding feasts. As we approach the holiday season, the endless reruns of “It’s a Wonderful Life,” delineates the role that divine intervention has in moments of financial panic. This is exactly where the EFSF fits in. It is nothing more than a miraculous supply of money that will solve all of Europe’s financial problems.
The EFSF was established in May of last year by the 27 members of the European Community to provide assistance to the 17 members of the Eurozone. Located in Luxemburg, it is staffed by a skeleton crew of less than a dozen employees. The initial mandate was to provide liquidity facilities for Eurozone countries that were in financial difficulty, but it was expanded to include the recapitalization of European banks and the repurchase of bonds. The EFSF is funded through bond issues that are guaranteed by €440 billion in commitments from the members of the European Community (EC). The composition of the commitments was based on the pro-rata capitalization of the European Central Bank (ECB). Not surprisingly, Germany is the largest contributor to the fund, with a commitment of €119 billion, or 27% of the funds. None of the funds were disbursed, but the strength of the commitments was enough to allow the EFSF to issue AAA-rated bonds. The EFSF can also obtain up to €60 billion in loans from the European Financial Stabilization Mechanism (EFSM) and another €250 billion from the IMF. This brings the EFSF’s total firepower to €750 billion. It is clear that ‘shock and awe’ was the main objective behind the EFSF, without making any actual monetary disbursements. So far, the institution issued €13 billion since January in three placements. A fourth bond issue for €3 billion was cancelled last week, due to the lack of interest. Spreads on EFSF bonds widened by more than 100 bps over bunds since they were first issued. The Japanese and Chinese were major investors in the first issues, but now they seem to be cooling off. There is concern that a possible downgrade of France could trigger a similar event for the EFSF, and this would be disastrous. Another question is the multiple pledging of the collateral. Should the EFSF increase its size to more than €1 trillion, as suggested by German Chancellor Angela Merkel, would this be a double pledge on the commitments that were backing the bonds that were already placed. Last of all, there is the issue of precedent. The Eurozone leaders assure investors that they will be protected for, at least, 25% of their investments in EFSF bonds, but the first sovereign restructuring (Greece) is already contemplating a 50%-60% haircut. This makes the guarantees a losing proposition. This is why investors are losing faith in the EFSF miracle.
At the same time, there is the issue of the use of funds. The Europeans are contemplating that a €106 billion recapitalization of the banks, but the total funding could reach €300 billion. Greece will need another €130 billion rescue package. Furthermore, EFSF funds needs to build a fire wall around Italy and Spain. The former has €300 billion that it needs to rollover during the next 12 months. Spain has to raise about two-thirds as much. However, the EFSF is having trouble getting its funding above €20 billion. Therefore, the thought that the EFSF will be able to leverage itself and supply all of Europe’s financial needs is no different than the miraculous multiplication of the loaves of bread and fishes.