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Europe – "The men without qualities"

Oct 29, 2011
The men without qualities
By Chan Akya

By far the biggest problem is the one involving the European Financial Stability Fund (EFSF), where the promise had been to increase its size from 440 billion euros (US$606 billion) to over 1 trillion euros. This appears to have been achieved as per the headlines, but not so well once we go into the details.

The mechanics of the funding increase are to offer “credit enhancements” to the issue of Italian and Spanish debt going forward. In other words, if the EFSF is rated at say triple-A, a bond investor buying Italian government debt can shrug off the impact of any downgrade because there is a triple-A backup facility that would pay him par should Italy ever go bankrupt. So far so good.

But think this one through the prism of the Greek default – wherein the European Union base camp have decided that a) only private sector creditors lose money, and B) the debt forgiveness of 50% is to be voluntary.

The idea for the latter was to avoid a “trigger” event for credit default swaps (CDS) and therefore avoid all protection sellers (mainly European banks) from paying out on the notional value to protection buyers (mainly American hedge funds). This is how the term voluntary has been used, in effect, to destroy the value of legitimate trades done by various investors.

So if you were an early buyer of Greek sovereign debt and decided say in 2008 that the country was heading in the wrong direction and therefore decided to buy CDS protection, you may have approached the last weekend thinking that your exposure is hedged, as the loss in the bonds would be offset by payments due on the CDS. Instead, you will now nurse a loss on the bonds, but without the corresponding offset gain in CDS. In other words, you have just been hosed, as your insurance is worthless.

That is precisely the same point where the idea of insurance or credit enhancement falls at the altar. Why should investors who just got burned on Greek bonds turn around and trust the same people who screwed them in terms of future credit enhancements on Spanish or Italian bonds? What is to stop a future European Union base camp from deciding on implementing a “voluntary” restructuring of Italian or Spanish bonds, and on the basis of which no payments would be forthcoming from the EFSF for losses suffered?

Hello, anyone home?

Then there is the counter-intuitive bank capitalization program. The idea is that to strengthen the European banking system, new capital would be required to the tune of 106 billion euros. Firstly no one with a clue actually believes that number – when the folks who do a stress test that comes up with the best bank in the region being Dexia, only for that bank to embrace a very quick tryst with destiny just a few weeks later, you have a serious problem with credibility. So when you say the “shortfall” is 106 billion euros, any reasonable person is going to assume 500 billion euros, give or take.

The follow-up question is – how are the losses on Greek sovereign debt now to be treated at the various banks? French banks got into trouble over the past few weeks because they had assumed a 21% loss on Greek bonds, but will now have to eat 50%. Many of them claimed to have “hedged” themselves through CDS – which is now worthless. So, what is the actual loss due to Greece, and how is it distributed across the various banks?

The mother of all questions though is one of where that money is to be raised, and more importantly how. There is loose talk in the base camp statement that private sector solutions must first be found, after which the states would intervene as necessary. Meanwhile, the banks would be encouraged not to cut their trading books or their loan books, in a panic attempt to reduce extraneous shocks of which there will be none – because the European base campers have said so.


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