Europe is now leveraging for a catastrophe

Written on October 25, 2011 by Ángeles Figueroa-Alcorta in Europe, Globalization & International Trade, Political Economy

By Wolfgang Münchau

Angela Merkel and Nicolas Sarkozy had sries of talks with Silvio Berlusconi over Italy's national debt. Photograph: Jesco Denzel/AFP

It is time to prepare for the unthinkable: there is now a significant probability the euro will not survive in its current form. This is not because I am predicting the failure by European leaders to agree a deal. In fact, I believe they will. My concern is not about failure to agree, but the consequences of an agreement. I am writing this column before the results of Sunday’s European summit were known. It appeared that a final agreement would not be reached until Wednesday. Under consideration has been a leveraged European financial stability facility, perhaps accompanied by new instruments from the International Monetary Fund.

A leveraged EFSF is attractive to politicians for the same reason that subprime mortgages once appeared attractive to borrowers. Leverage can have different economic functions, but in these cases it simply disguises a lack of money. The idea is to turn the EFSF into a monoline insurer for sovereign bonds. It is worth recalling that the role of those monolines during the bubble was to insure toxic credit products. They ended up as a crisis amplifier.

Technically, the EFSF monoline insurer would provide a first-loss tranche insurance for government bonds up to an agreed percentage. It sounds like a neat idea, until the recipients of the insurance realise their sovereign bonds have turned into hard-to-value structured products. One of the factors that will make them hard to value is the incalculable probability that France might lose its triple A rating. In that case, the EFSF would automatically lose its own triple A rating – which is derived from that of its guarantors. The EFSF’s yields would then rise, and the value of the insurance would be greatly reduced. The construction could ultimately collapse.

Leveraging also massively increases the probability of a loss for the triple A-rated member states, who ultimately provide the insurance. If a recipient of the guarantee were to impose a relatively small haircut – say 20 per cent – the EFSF and its guarantors would take the entire hit. Under current arrangements, they would only lose their share of the haircut.

The simple reason why there can be no technical quick fix is that the crisis is, at its heart, political. The triple A-rated countries have left no doubt that they are willing to support the system, but only up to a certain point. And we are well beyond that point now. If Germany continued to reject an increase in its own liabilities, debt monetisation through the European Central Bank and eurobonds, the crisis would logically end in a break-up. There is no way the member states of the eurozone’s periphery can sustainably service their private and public debts, and adjust their economies at the same time.

Each of Germany’s red lines has some justification on its own. But together they are toxic for the eurozone. The politics is not getting any easier. The behaviour of the Bundestag underlines the political nature of the crisis. Last month’s ruling of Germany’s constitutional court strengthened the role of parliament. But it also reduced the autonomy of the German chancellor, who now has to seek prior approval by the Bundestag’s budget committee before negotiating in Brussels. This power shift will not prevent agreements, such as the one currently negotiated, but it will make it harder to co-ordinate policy in the European Council on an ongoing basis. Read more…

As published in www.ft.com on October 23, 2011.


Rafael Graca October 27, 2011 - 1:16 pm

In my opinion, the Eurozone sovereign debt crisis shows no sign of abating and a default on Greek government debt now seems unavoidable. The key question is when this default will occur and how it will be managed.

According to both Sarkozy and Merkel behaviours, I think it is fair to assume that Eurozone governments will prepare this default in order to keep it controlled.

swami ramdev medicines February 5, 2012 - 6:54 am

It is possible for one to find affordable insurance. But, the uninsured has to be willing to take the time to get a health insurance quote from various insurers, in order to ensure that they are getting the best rates on the policy coverage. In many cases, you will find that you can find a great price disparity from one company to the next, for the slightest change in the policy.

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