29 Sep 2011

Leveraging the EFSF Bailout Fund would Leave European Taxpayers More Vulnerable

Economics, Financial Economics 3 Comments

This is such an obvious point, but I still haven’t seen anybody spell it out. So the context is the stabilization fund that the European powers are setting up to bail out the PIIGS:

As Europe continues to battle its debt crisis, Timothy Geithner has a suggestion. The Treasury secretary today called on euro zone officials to leverage the region’s roughly $600 billion bailout fund, an insider tells Reuters. Geithner didn’t provide details on how Europe should go about the move, nor did he point to the US TALF fund, created in 2008 to back lenders; some have suggested TALF could be a model for Europe’s bailout fund. Geithner conceded, however, that the US is “not in a particularly strong position to provide advice to all of you,” notes AP. “We still have our challenges in the United States,” he said, and “our politics are terrible… maybe worse than they are in many parts of Europe.”

Leveraging the fund would be a “radical” move, writes Jan Strupczewski, but it could be a way around some leaders’ opposition to expanding the fund itself.

Since I was just over in Europe, there was lots of buzz about this stuff. The above excerpt it typical of the coverage. The original size of the fund was 440 bn euros, but then in recent meetings ideas were floating to make it effectively up to 2 trillion euros. The German finance minister (I think?) clarified that they weren’t talking about kicking in more money, but rather they were going to guarantee up to 20% of the losses on PIIGS bonds, rather than buying the bonds outright. Thus, for the same 440bn euro fund, they could get five times the leverage.

What a great idea! Of course, the downside is, if those PIIGS bonds drop in value, then the EFSF will suffer five times as many losses.

Consider the scenario where the PIIGS bonds drop 20% in market value after the EFSF intervenes. Had the fund just bought 440bn euros-worth of the bonds in the first place, then the European taxpayers would be out 20% = 88bn euros.

But if, instead of buying PIIGS bonds outright, the fund guarantees the first 20% of 2.2tn euros of bonds, then if those bonds drop 20% then the European taxpayers are out the full 440bn euros.

Like I said, this is an incredibly obvious point, but after reading at least half a dozen articles on this, nobody has mentioned it. Everyone is acting like this is a neat way to provide more “help” for the same taxpayer liability.

3 Responses to “Leveraging the EFSF Bailout Fund would Leave European Taxpayers More Vulnerable”

  1. von Pepe says:

    Guarantees are free!…until they are not.

  2. AP Lerner says:

    Do we really have enough information to determine if leveraging the EFSF puts the European taxpayers at risk? How is the leverage being applied in your scenario? By who? Who is funding the EFSF in your base case? Do you have information I don’t have? If so please share, because what I’m hearing is a number of different options, and nothing has been settled. And most of the options I’m hearing that are legitimate options do not put the European taxpayer at more risk other than the original $440E

    One of the scenarios being floated is the EFSF becoming a bank and getting ECB funding since the ECB can write the check indefinitely. No taxpayers money beyond the original capital contribution is lost or at risk. FYI – the ECB can create an unlimited amount of Euros.

    Another scenario being floated is the EFSF, as a bank, levered 3 to 5x, and functioning much like a supranational (i.e. the EIB). Under this scenario, the original taxpayer capital is at risk but then investors who voluntarily participate in the capitalization are at risk. No taxpayer risk beyond original capital.

    Another scenario being tossed around is a transfer of assets to the ECB to be used as collateral. Collateralized funding. No additional taxpayer funds at risk.

    There is also an option being floated where the EFSF, as a bank, insures future sovereign issuance, but limits its losses to an absorption rate under a default…this is the only scenario I have come across thus far that could become an additional cash call for the local sovereigns, and nobody is taking this option seriously.

    Which of these scenarios above is your base case that makes it such an ‘such an obvious point’ that European taxpayers are more vulnerable? Or is there another scenario that is being discussed that is your base case? Is the German government going to supply all the funding to the ESFS? I must have missed that news….

    Also, when you say ‘But if, instead of buying PIIGS bonds outright, the fund guarantees the first 20% of 2.2tn Euros of bonds, then if those bonds drop 20% then the European taxpayers are out the full 440bn Euros.’ how is this accurate? The EFSF would only be on the hook under a default scenario, not changes in market values. Did anyone say anything about mark to market becoming the norm for this fund?

    I just don’t see the ‘incredibly obvious point’…but then again, I’m probably just missing something.

  3. MamMoTh says:

    They should consider issuing Mosler bonds insead