Technical annexe to:

The European Financial Stabilisation Mechanism

 

 

After several discussions on the contents of my earlier paper I have been encouraged to explain, as simply as possible, the basis for my conclusions regarding the ratings of the securities to be issued by the EMU guaranteed Special Purpose Vehicle and its consequences.

 

The pro rata guarantee of EMU members is, for the sake of argument, assumed to be pro rata their respective share in the Capital of the ECB but,  if it turns out to be another key, it changes nothing to the arguments developed hereunder.

 

The securities to be issued by the SPV under the several guarantee is akin to a “derivative product” and can be compared to a “Collateralised Debt Obligation” (CDO) where the collateral is provided by the sum of the guarantees amounting to 100% of the amount issued. As was the case in American real estate related CDO’s, the guarantees are “packaged together” benefitting the holders of the SPV securities. (Thankfully it is not likely that some clever investment banker will suggest “squaring” one or more issues by repackaging them into tranches guaranteed by “similarly rated” EMU members, as was done in the United States RMBS market).

 

The securities issued by the SPV need, nevertheless, to be rated if they wish to achieve the broadest possible distribution. It is here that the lessons drawn from the subprime crisis need to be drawn: the consultation on the Rating Agencies held 2 years ago by the Commission (to which I contributed a lengthy response) showed that the Agencies had committed some major methodological errors in their evaluation of Real Estate backed structured securities. In particular, they failed to understand the differences between a “derivative product” and standard debt securities, both in terms associated with market liquidity and with correlations that significantly increased the number of “counterparties” involved and the ensuing risk profile of derivative securities.

 

As mentioned here above, the SPV bonds are similar to CDO’s and the methodology for Ratings must be adapted accordingly. In particular, the Agencies must take into account the plurality of individual counterparties (the 16 EMU Members) rather than their “cumulative” strength, including Germany, as would be the case in a traditional issue backed by an EU budgetary guarantee. This consideration must be understood by the Authorities who should not be tempted to believe that rating standards applicable to traditional Sovereign debt issues are relevant for the rating of the proposed SPV securities. In so doing they would be making the same mistakes that contributed to the “subprime” crisis. Incidentally, this factor also underlines another point, that I have made repeatedly in my papers, concerning the “systemic” risk created by any excess of Sovereign debt issuance, and in particular its accumulation on bank balance sheets. 

 

 

It is of course unthinkable that the managers of the SPV or any of the Member States would lean on the rating Agencies to convince them of the “soundness” of the SPV issue structure as such a behaviour would be reminiscent of the practices for which these same Authorities are blaming and investigating investment bankers in their dealings with the Rating Agencies. The slightest suggestion of a “deal” concerning the impending legislation reinforcing the supervision of the Agencies would kill definitively the latter’s reputation as well the integrity of the Issuer/Guarantors.

 

As mentioned in my earlier paper, a rating is an evaluation of the risk of the punctual payment of full interest and principal due on a security. This means that, if the beneficiary of the loan granted by the SPV is unable to meet its commitments, the investors holding the securities will (through the intermediary of a designated fiscal agent) turn to the guarantors for satisfaction of their claims. However, each of these guarantors is only liable, according to the agreement worked out in ECOFIN, for his pro rata share of the payments. If one of these guarantors faces itself difficulties, then less than 100% of the payments will be made causing the default of the entire issue and making the full amount of principal amount outstanding immediately payable. It is this contagion effect – together with the opaque structure of the securities - that brought down the “subprime” house of cards. This is all the more likely to happen that, by definition, the defaulting borrower will also be unable to meet its commitment as “guarantor”.

 

The result of the proposed structure is to incite the Rating Agencies to attribute to the security the rating of its weakest link, in the present case Greece, because a default by Greece to meet its share of the several guarantee is not covered by its partners in EMU. This is true despite the fact that the share of Greece’s commitment is quite small - around 1.2% of the total - so that in reality it is unlikely that the full payment would not be made one way or another in order to avoid acceleration of the repayment of the full amount of the loan. Even so and in light of this uncertainty, it is difficult to imagine that the Agencies would rate the SPV securities higher than “A” with the following very damaging consequences:

 

  1. Each time one of the EMU Member States was to be subject of a downgrade its effects would be transmitted automatically to the securities of the SPV. This could complicate enormously the orderly issuance process, particularly if – as is the case presently – some States are on the watch list with negative implications.
  2. It is likely that the amount of the commitments undertaken by each EMU member will be counted both by the Rating Agencies and Eurostat as debt, at least as far as the amounts actually drawn under the Facility. This will impair commensurately the ratings of individual States concerned, constrain their own borrowing capacity and increase their funding costs.
  3. The interest rate on the securities will reflect the rating and be considerably higher than if the issue had an EU budget guarantee that would confer automatically an AAA rating as the Treaty provides indirectly for the budget to be guaranteed jointly and severally by all Member States. This also deprives the borrowers of one of the main benefits of having recourse to the mechanism.
  4. There would be quite a lot of confusion in the market as to the status of EU securities: bonds issued by the EU, either under its existing €50 billion “Balance of Payments Assistance Facility” for on lending to non EMU members, or through the new € 60billion EU Facility set up within the overall €500 billion stabilisation package, would compete with bonds issued by the SPV. The confusion created would certainly reflect negatively on the higher rated bonds guaranteed by the EU.  There would also be a very high risk of contagion putting into jeopardy the status of EIB bonds that benefit from the support from the 27 Member States (through capital infusions and guarantees on loans made by the Bank) but also, in general, of all  direct or guaranteed issues by  EU Sovereign borrowers.
  5. Additional confusion will result from the impossibility for the SPV to issue “fungible securities” as the risk profile of each issue will depend more on the rating of the final beneficiary, rather than on a uniform “guarantee mechanism” that would be provided by a single EU budgetary guarantee for all SPV securities. This situation will make secondary market illiquid and non transparent translating into wide disparities of market prices underscoring the lack of true EU solidarity.
  6. The provision of the several guarantees by EMU Members implies a Parliamentary process in some countries (among them Germany and Belgium). This increases uncertainties which are feared by the markets as there is always a possibility that the necessary legislation will encounter difficulties jeopardising the whole construction. The EU budgetary guarantee avoids this problem as the obligations of Member States derive from the provisions of the Treaty itself which has been duly ratified.
  7. There is no benefit – on the contrary - accruing to the stronger EMU members by limiting their guarantee to their pro rata share of the SPV’s obligations because it substantially increases the likelihood that their guarantee will be called upon if one of the weaker States runs into trouble.

 

Conclusion:

 

From a practical point of view the existing €50 billion EU “Balance of Payments Facility” should be merged into the new “European Stabilisation Mechanism” totalling €500 billion and to which all 27 Member States would have access.

 

 This structure would alleviate all the difficulties mentioned above, reduce considerably the exposure of individual Member States (including Germany) to see their guarantee called upon and reduce significantly the cost of borrowing.

 

The emblematic amount of € 500 billion, that was received initially so well by the markets, would then be able to serve fully its purpose of reassuring investors and citizens as to the solidarity underpinning the EU and the Euro while, at the same time, reducing considerably the need to draw down significant amounts.

 

Failing to amend the proposed structure of the European Stabilisation Mechanism will only encourage the market to test the mechanism and, then, it is likely to be too late to correct the flaws in its conception.

 

In handling this very delicate problem, in which trust plays a major part, it is essential that rationality wins over emotion and that the political authorities realise that the stakes are too great to make another mistake.

 

Brussels, 14th May 2010

 

Paul N. Goldschmidt

Director, European Commission (ret); Member of the Thomas More Institute

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