Therefore we need better tools to ensure that financial market reactions do not endanger countries while they are in the process of implementing reforms…
– François Baroin and Wolfgang Schäuble
Fear will keep the local systems in line. Fear of this battle station.
– Grand Moff Tarkin
Or, if that highfalutin’ stuff about mezzanine tranche risk in the EFSF and the single points of failure in its underlying sovereign guarantors didn’t convince you, maybe a Star Wars analogy will.
We (“we” being geeks like FT Alphaville) all know what a single proton torpedo did to the Death Star, ergo, the Tarkin Doctrine. Considering the EFSF is also a bit like ruling by the fear of force rather than by force itself…
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The step-up flaw
There were a few tape-torpedoes on Friday in the market, as it happens. Essentially, the EFSF can’t take over the Greece loan disbursements from September as planned, because of the time needed to secure bondholder “contributions” to the same bailout. Seems a technical hitch but bear with us.
Therefore it has to be done under the old bilateral loans scheme. However there is a step-out clause in this scheme that allows any guarantor to withdraw, if market rates on their bonds rise above rates charged to Greece. There are apparently at least talks on whether Spain and Italy should do exactly that. Even so, as Megan Greene notes, think how self-reflexive that sign of weakness may be for their borrowing costs for a fairly small saving in guarantees.
The point to remember though is this:
It’s not an EFSF flaw per se, because the step-out terms are very different there. You only step out if you are bailed out. We think this is the real problem. It’s already a feature having an impact on the EFSF’s lending capacity via Irish, Greek and Portuguese withdrawals of course. A chart via a recent CEPS paper — click to enlarge:
Naturally we’ve known, for a long time, that the EFSF can’t support full bailouts of Italy or Spain, given that they also guarantee a large part of its lending capacity. It’s interesting incidentally to consider the effect of the EFSF’s new powers to issue “precautionary” credit lines or to make loans for the purpose of capitalising banks. One way to read the addition of sub-bailout credit lines to the EFSF’s repertoire is as a means to side-step that unfortunate fact of full bailouts being impossible. It’s not as an improvement to the fund’s “flexibility.” It’s a complete distraction.
So, note the language of the EFSF provision on stepping out above. It’s not actually limited to a full bailout. So just how much could any EFSF help be given to Italy or Spain without stepping-out being a problem?
We think there is one more problem in the meantime, though.
What if the systemic problem isn’t just their falling out but also being forced to stay, and fester, within it? Here’s a theory:
Moody’s said in its review of Spain on Friday that its action was consistent with reviewing Italy at the same time. (Both are Aa2.) We think that’s significant. Obviously if that’s an indication ratings cuts will increasingly arrive en masse in the future – well, what brought down CDOs in the first place? That’s one very Death Star-like weakness.
And – however distressed Italy or Spain rates get, they can’t take a break from the EFSF. They just have to fester. We wonder about this from a ratings perspective. Because if Spain and Italy could legally withdraw guarantees, and instead of parcelling the difference out to other members, the eurozone upped the portion of AAA guarantees from eg. Germany, that’s safer for the EFSF’s top rating overall, surely. But since Italy and Spain can’t leave – therefore, the EFSF has to go on incorporating their falling ratings. Surely that’s a risk to the EFSF’s AAA rating itself. Death Star weakness two.
Seems a bit perverse, and we are probably wrong. But we do wonder.
Related links:
The economics of Death Star destruction – Overthinking It
Eurozone CDO – it’s triple-A time - FT Alphaville