The Eurocrisis has no silver bullet, but that does not stop the Europeans from trying to fire one anyway.
Yesterday, we heard the news or rumor from Der Spiegel that there was a plan to use leverage to quadruple the “firepower” of the ESM from its actual pledged capital of €500bn to €2tr. In the Eurocrisis, you should be suspicious whenever the terminology of war is used.
Using leverage means that the ECM will use its capital to borrow money. The borrowed money would come from selling private investors ECM bonds. The idea is that the ECM could borrow money at a lower rate than the country in distress and use that money to finance said country.
This scheme is riddled with problems. The German high court just ruled that Germany’s liability for the ECM is capped at €190, and raising this figure must be approved by the Bundestag. German patience with bailouts is wearing thin. With elections approaching in Germany within the year, it will be very difficult for a Bundestag member to approve more financial aid for distressed countries.
Another problem with this leverage plan is that it relies on selling ECM bonds to private investors, and ECM bonds do not appear to be a good investment. Countries who need to use the fund will not have to contribute to it, which lowers the proposed €500bn size. Furthermore, the fund will not get the AAA credit rating of Germany and the northern block. It will receive a rating reflective of the combination of all of the credit ratings of its contributors. This means that the bonds will have to pay a yield premium in order to attract investors.
So, we have a fund whose largest contributor is politically constrained from raising its contribution, that is not as large as advertised, and that will have less than a perfect credit rating. It will be difficult for the ECM to sell bonds to leverage itself.
Another method of leveraging the fund’s money is through offering bond insurance.
Among the EFSF’s armory, an as yet unused weapon is to offer private bond investors a guarantee that the EFSF would take the first part of any write-down in a debt restructuring.
If a country was to default like Greece, think of all the questions that would arise. How is the insurance payment to be calculated? Will the payment be based on just the principal or will the interest payments be included? What interest rate discount would be used to compute the value of future payments? If there was not a write down but a total default, would the fund have enough to pay everyone?
All of these questions make bond insurance too risky a proposition to aid in the bond sales of distressed sovereigns.
The Greek economy is in its death throes way behind this year’s projections with eight more years to go for the bailout. Spain has reached the point of no return and is trying to hold out on a bailout as long as possible to extract the best terms. Unfortunately, we will soon see what the ECM is capable of.