Tuesday, September 27, 2011
Team Macro Man chuckled to themselves upon reading the A-Team's latest trial balloon, as the irony of an idea grown out of financial innovation and structured credit coupled with leverage is presented as the solution to a crisis caused by precisely the same things. But in seriousness, TMM are unconvinced that this particular implementation is going to work and give them a B- for effort and finally realising that the time has come to whip out the bazookas, but "must try harder".
The Eurocrats have certainly succeeded in making this plan to leverage the EFSF via the European Investment Bank (EIB) appear complex and thus fulfil the requirement of "pulling the wool over the eyes of electorates and the media", but there are a few problems with this particular implementation that in TMM's view make it a non-starter. As TMM have noted before, bailout complexity can be useful in addressing problems without political or electoral opposition, and they recommend readers take a look at Phillip Swagel's excellent account of the US Treasury under Hank Paulson. The key paragraph from that Brookings piece is:
"At Treasury, two additional lessons were learned: (1) we had better get to work on plans in case things got worse, and (2) many people in Washington, DC did not understand the implications of non-recourse lending from the Fed. This latter lesson was somewhat fortuitous, in that it took some time before the political class realized that the Fed had not just lent JP Morgan money to buy Bear Stearns, but in effect now owned the downside of a portfolio of $29 billion of possibly dodgy assets. This discovery of the lack of transparency of non-recourse lending by the Fed was to figure prominently in later financial rescue plans."
And this is where this plan falls down: it does not involve non-recourse lending. To see this, the plan diagrammatically looks like this (please excuse TMM's Noddy paint skills!):
So the leverage in this case would come from the SPV issuing bonds to the Eurozone banks which they could then repo with the ECB. As a result, the SPV, as a wholly owned subsidiary of the EIB, would have to be recapitalised by the EIB should its capital become depleted. And there are three serious problems here from what TMM can see. Either (i) the SPV is not guaranteed by the EIB, in which case its credit rating would be something like single-A, and therefore there would be few investors willing to buy its bonds, (ii) it would be guaranteed by EIB, and therefore in the case of it requiring more capital, EU members would be compelled to inject more and (iii), the UK is joint equal largest shareholder in the EIB (see chart below). The latter two possibilities are clearly very problematic as the leverage effectively comes in the form of more explicit exposures to EU governments - i.e. France and Germany lose their AAA ratings. But that is not all... The UK will also lose its AAA-rating. This just isn't going to fly in this form and TMM suspect the Dambusters will ruin the A-Team's attempt to build a Dam in front of the rest of Europe.
In TMM's view, the leverage HAS to come from the ECB, just as it did in the Fed lending programs like the Bear Stearns bailouts and TALF etc. And the lending *has* to be non-recourse, in order for losses beyond the initially capitalised 20% to accrue to an entity in such a manner that the EFSF bond and the SPV itself get a AAA rating (and therefore attract demand from SWFs). TMM think, therefore, that the structure needs to look more like this:
The trouble is, that the Bundeathstar really don't want to do this, and the Panzer tanks are firmly blocking the ECB lending to such an SPV. But, as mentioned yesterday, TMM get the impression that the Germans have overplayed their hand (for example, they don't have any friends at the G20), and unless they really are about to leave Europe, they are going to be forced to accept some such plan. The key thing with the above is that it maintains the cloak of complexity for the public, while showing markets where the money comes from, thus avoiding the need to put the plan to electorates. Because action is needed *now*, and there just isn't time there just isn't time to vote on this. Europe is unlikely to change its history of doing what it likes, regardless of voters' wishes.