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.
The Financial Times has put this article behind a subscription wall.
I did find another ”free” article making very similar points.
There is no way the EU authorities can stop Greek default or equivalent writedown of its impossible debt load — from toppling the over-leveraged banks which will be rendered insolvent when forced to recognize their losses.
As we have seen in Greece, there is no patriotism to protect any EU country from the riots of its own ”citizens” when they are faced with austerity measures.
These riots are bound to spread.
Eventually the world bond market will abandon Europe, as we have already seen unlikely high rates of return for God-knows-what-level-of-risk if you buy a Greek or Spanish bond.
This will lead to more ratings downgrades in one EU country after another, eventually reaching France and Germany.
The Euro will be no more.