Europe Readies Its Rescue Bazooka

It’s one thing to fail to recall relevant events that are genuinely historical, quite another to refuse to learn from recent failed experiments.

Remember Hank Paulson’s bazooka? The Treasury secretary, in pitching Congress to give him authority to lend and provide equity to Fannie and Freddie, argued, “If you have a bazooka in your pocket and people know it, you probably won’t have to use it.”

But the Treasury’s new powers did not do the trick. Less than two months later, Treasury and OFHEO put the GSEs into conservatorship.

If the latest rumors prove to be accurate, the latest Eurozone machinations make Paulson look good. The Financial Times reports that the Greek deal is being reworked, with bondholders being “asked” to take 60% haircuts. The critical bit is the word “asked”. Recall this restructuring is supposed to be voluntary to avoid triggering a credit event under credit default swaps. The old deal with a mere 21% haircut, had a takeup below the 90% sought and the 80% deemed the minimum acceptable. With haircuts this deep, how pray tell will the authorities force banks to go along with an allegedly voluntary deal? Any party that was hedged is going to want to see a bona fide default so he can cash in his credit default protection. But Greek banks were big protection writers (why anyone would accept them as counterparties is beyond me), so breaking them (which is what I assume would happen) would necessitate bailouts by the broke Greek state, which would worsen the national insolvency, which is what the deeper haircuts were supposed to avoid.

And some parties are concerned about even worse outcomes, since no one knows who the CDS protection writers are. Per the Financial Times:

Officials said some countries, including Germany, were less concerned about a so-called credit event – an explicit default that would trigger CDS contracts. But others, including the IMF, feared consequences similar to the collapse of Lehman Brothers in 2008.

This is what you get when you let banks innovate to their hearts’ content: more cleverly designed minefields, and the taxpayer picks up the damage inflicted on innocents or greedy chumps who wander into them.

The next element of the rescue apparatus being wheeled into place is a trillion euro facility. That sounds great, until you understand that a trillion euros is probably too light by at least 50%, and the bloody scheme probably won’t work anyhow.

The details are still hazy, but it is largely along the lines of an idea floated earlier, that of having the EFSF leverage up to expand the total bailout authority. From Der Spiegel (hat tip Joe Costello):

German Chancellor Angela Merkel has told German lawmakers that the financial strength of the euro rescue fund, the European Financial Stability Facility, is to be leveraged to €1 trillion ($1.39 billion)….

The type of leveraging planned remains unclear, with a number of versions being discussed. It emerged earlier on Monday that the controversial measure to increase the firepower of the €440 billion rescue fund will be put to a full vote in the German parliament on Wednesday, rather than just a vote by the budget committee as initially planned.

Given the intense public debate on boosting the EFSF, Merkel’s center-right coalition decided to seek a broader mandate than just budget committee approval.

In a meeting with leaders of her own coalition and of the opposition parties, Merkel also said that the intended recapitalization of European banks would amount to some €100 billion, with German banks accounting for around €5.5 billion of that, to meet the increased core capital requirement of 9 percent and prepare banks for the writedowns resulting from a Greek debt cut.

Note that these machinations are to avoid the one route that clearly will work and will not involve political approvals, which is having the ECB monetize debt. Instead, the EFSF, and any of its son of Frankenstein spawn ultimately rely on guarantees of member states. Let’s see, this vehicle will bailout out Italy when Italy is a guarantor of its own bailout?

As Satyajit Das wrote when this idea was first mooted:

If as Albert Einstein observed insanity is “doing the same thing over and over again and expecting different results”, then the latest proposal for resolving the Euro-zone debt crisis requires psychiatric rather than financial assessment…

The proposal has a number of problems.

The EFSF does not have Euro 440 billion. After existing commitments to Greece, Ireland and Portugal, its theoretical resources are at best around Euro 250 billion, assuming that the increase to Euro 440 billion is ratified by European parliaments.

The EFSF must borrow money from the markets, relying on its own CDO like structure, backed by a cash first loss cushion and guarantees from Euro-zone countries. In fact, some investors actually value and analyse EFSF bonds as a type of highly rated CDO security known as a super senior tranche. This means that the new arrangement has features of a CDO of a CDO (CDO2), a highly leveraged security which proved toxic in 2007/ 2008…

The 20% first loss position may be too low. Unlike typical diversified CDO portfolios, the highly concentrated nature of the underlying investments (distressed sovereign debt and equity in distressed banks exposed to the very same sovereigns) and the high default correlation (reflecting the interrelated nature of the exposures) means potential losses could be much higher. Actual losses in sovereign debt restructuring are also variable and could be as high as 75% of the face value of bonds.

The circular nature of the scheme is surreal. Highly leveraged vehicles, in part backed by weakened nations like Spain and Italy, are to undertake the “rescue” of the same countries and their banks. Levering the EFSF merely highlights circularity in the entire European strategy of bailouts, drawing attention to the correlated default risks between the guarantor pool and the asset portfolio of the bailout fund. This is akin to an entity selling insurance against its own default. This only works if all commitments are fully backed by real cash and savings, which of course nobody actually has, requiring resort to familiar “confidence tricks”.

The proposal assumes that it will not need to be used, avoiding exposing its technical shortcomings. The EFSF too was never meant to be used, relying on the “shock and awe” of the proposal, especially its size and government backing, to resolve the crisis.

Paul Krugman last night focused on the same fatal flaw, the circularity of the scheme, invoking an old song, “There’s a hole in my bucket.”

The only possible deus ex machina, given that Germany is insistent that the ECB not ultimately provide the firepower for this vehicle, is that outside parties provide very substantial support. The IMF will participate, but it will not do heavy lifting. China in theory could, but given how controversial its US dollar holdings have become, a major role in a fragrant scheme is likely to prove even more controversial.

The Eurozone has managed to keep its desperate financial legerdemain going far longer than I thought possible. But its insistence on implementing self-defeating austerity policies and the impossibility of Germany continuing to want large trade surpluses yet refusing to finance its trade partners means an ugly end is inevitable.

This post originally appeared at naked capitalism and is reproduced with permission.