European Financial Stability Facility: The farce that could make 2008 seem like a fairy tale

Earlier in 2010, when it appeared like Greece was close to defaulting on its debts, members of the European Union created an emergency bailout fund called the European Financial Stability Facility.

This fund was put together in order to supply emergency liquidity to EU members that could no longer access the bond market under favorable terms (I.e. affordable interest rates). So far, the facility has been accessed by Ireland, which suffered a ‘near economic death’ experience. Greece also received a bailout earlier in 2010, but this pre-dated the facility. In both cases, it was deemed that a coordinated bailout would be more palatable than an outright default.

The lesson taken from the Lehman Brothers collapse illustrates why authorities wish to avoid the default of another highly interlinked entity. The default of a major nation could lead to another global run on the banks, which are highly exposed to sovereign debt. Also, as government bonds are historically viewed as low-risk, conservative public and private pension funds also have large sovereign debt exposures. A government bond default would simply shift the bail-out decision to the financial system and pension system. As the financial and pension systems include thousands of entities, a bail-out would, at this point, be a far more decentralized and complicated undertaking.

Bail-outs are the preferred route for most Treasury and central bank officials. However, bail-outs are becoming increasingly unpopular among the masses, as they watch the elite flourish by dipping into already depleted tax coffers. At some point, the political climate of democratic nations could either tip towards authoritarian control or democratic popularism. For now, crony capitalism and the bail-outs continue.

The European Financial Stability Facility ‘allocated’ €750 billion for future funding crises. This money, however, does not exist and will not appear out of thin air. The facility raises funds on an ‘as needed basis’ by selling bonds to large investors (e.g. foreign governments, pension plans, etc.). The funds are then pooled to provide bail-outs to members in trouble – a one-for-all and all-for-one approach. The bulk of the facility is ‘covered’ a €440 billion guarantee made by EU member states.

The value of these guarantees depends on the strength of the state providing the guarantee. When member states have to contribute to a bailout, they collectively tap into their own fiscal reserves and/or borrowing capacity via the facility. If the guarantor country has insufficient reserves they must issue bonds. Alternatively, funding nations can take (steal?) from long-term assets. For example, to fund part of its own bailout Ireland plundered the pension assets of its children and grandchildren, under the assumption that future growth will cover the re-payment. This is a giant logical leap for a country experiencing a devastating real estate collapse and massive unemployment. Asset-liability matching be damned…Ireland is swinging for the fences.

Frankly, Germany (and maybe France) is the only country holding the EU economy together so the EU guarantee (which encompasses many countries with economies far weaker than Germany’s) is tantamount to taking from the poor to give to the poor – most other EU members are themselves sub-prime borrowers of the sovereign kind.

So far we’ve only seen the relatively isolated, and manageable, cases of Greece and Ireland hitting the fan. What happens if/when the bond vigilantes hit Portugal, Italy or Spain? Each member that falls simply concentrates the obligations of remaining EU members, intensifying their own funding requirements and fiscal stress. The ‘all-for-one’ side of the equation weakens substantially as members drop into fiscal oblivion. The pro-cyclicality of the weakening process has the potential to quickly send the EU economy spiraling out of control.

In what amounts to a massive bluff, the entire fiscal condition of the EU is on the table. If the bluff is called, Germany could be left holding the bail-out bag. By this point, the market for EU bonds would have seized, the ECB could be running the printing presses at full speed and Germany would be on the verge of succession. If Europe burns, don’t expect the rest of the global economy not to feel the heat.

So what rating is a rating agency to give such a gamble? (This is where things get ridiculous.) The rating agencies see the European Financial Stability Facility as a triple-A investment. This view is similar to that used when analyzing the credit worthiness of CDOs and residential MBS that re-packaged sub-prime real estate loans of days past. The bail-out fund, which essentially re-packages the debts of fiscally-stretched, sub triple-A countries that could fall like dominos if the fund actually gets used to a significant extent, has been granted a rating that makes it eligible for even the most conservative widows and orphans pension fund.

To be clear, I’m not necessarily forecasting anything (positive or negative) for Europe. I am, however, attempting to illustrate the systemic risk introduced by such a shell game. Because of the bigger numbers involved, this is a farce of a much grander scale than the sub-prime CDO mess that unraveled and nearly destroyed the global banking system in 2008. In fact, we’ve manufactured a ponzified, securitized gamble of such massive proportions that the downside risk could make October 2008 seem like a fairy tale.