(A poorly conceived time bomb on a short fuse!)
As details of the historic decisions reached by ECOFIN over the weekend emerge, the fears expressed in my initial analysis are unfortunately rearing their ugly head.
In the conclusions of ECOFIN it is stated that the main element of the European Stabilisation Mechanism, i.e. the €440 billion to be provided by the EMU Members, is to be structured by creating a Special Purpose Vehicle that will issue securities guaranteed “on a pro rata basis by participating Member States in a coordinated manner”. In other terms that means that the guarantee is “several” and not “joint”.
The market implications of this construction are extremely disturbing:
- A several guarantee implies that the rating (expected to measure the risk of receiving full interest and principal on a timely basis) will be set at the level of the weakest link (Greece) or close thereto in view of the very low level of the latter’s commitment. Additionally, other EMU Members are on some Rating Agencies watch list with negative implications: should these downgrades come to pass, the rating of the SPV’s securities would also suffer commensurately. Under the most favourable conditions a single “A” rating is the best that can be expected.
- The funding costs of the SPV will be sub-optimal depriving the beneficiaries of one of the main attractions of the mechanism, that is to say funding costs close the German rates.
- Sub-optimal ratings and funding costs have also detrimental long term implications for the market appraisal of EU securities (including possibly fairly rapidly those issued by the EIB). It will lead psychologically to a weakened image of EMU, the sustainability of the Euro and, ultimately, of the EU itself. The market will fail to understand the difference between EU securities benefitting from a budgetary guarantee (implying an AAA joint and several guarantee of all 27 Member States) and Eurozone SPV securities benefitting from a several guarantee of EMU Members, in particular because the Eurozone is supposed to comprise the most creditworthy EU Member States.
- The Rating Agencies are bound to become once against the target of – this time – unjustified criticism and together with “speculators” be the sacrificial scapegoats on which the politicians will blame the next attack by market operators. Once investors have taken the real measure of what is being proposed, a large part of the work of ECOFIN will prove to be not only useless but even counterproductive as it will underline, once again, the lack of understanding of markets by those who manage our affairs.
A more detailed technical analysis, underpinning the conclusions here above can be found in the annexe to this paper.
It is not too late, but is of the highest urgency to correct this structural flaw of the European Financial Stabilisation Mechanism. This is bound to prove politically difficult but is nevertheless indispensable. My preference, as stated earlier, is that the guarantees are provided by the EU 27 rather than the EMU 16, configuration that should make it easier for Germany to agree though it implies also the participation of the United Kingdom. At the end of the day, there will be little solace for Germany to have “limited its exposure” to its pro-rata share of the guarantee, if in the process the whole EMU construction is swept away. That is why it is in the interests of all 27 EU Members to rally around and show real solidarity that is needed to convince the markets and reassure public opinion.
The meeting of the ECOFIN Council on Monday 17th May, will provide a last ditch opportunity to rectify the structural flaws of the proposals. It is to be hoped that the right decisions will be forthcoming.
Brussels 15th May 2010
Paul N. Goldschmidt
Director, European Commission (ret); Member of the Thomas More Institute.
The pro rata guarantee of EMU members for the securities to be issued by the “Special Purpose Vehicle” 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:
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
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