Bailout Fund Ratings And Snake Oil Don't Mix

The response to the downgrade of the Eurozone bailout funds from Aaa has yielded a fascinating political response from the head of the fund. 

Moody's, the ratings agency, says the €700bn European Stability Mechanism (and the the EFSF it replaces) is now a riskier proposition since France lost its Aaa rating earlier this month. It considers that, if the full fund were needed, France would have to stump up 20%. The whole purpose of the fund is to invest in the debt of weaker Eurozone member states whose creditworthiness is highly correlated. So, if one runs into economic trouble, they all do. That also makes for a "highly concentrated credit portfolio." And if push came to shove, Moody's doesn't think France would prioritise it's ESM contributions above its own debt payments. Similarly, in that event it would be unlikely that other member states would make up France's shortfall.

Both the chairman and managing director of the ESM were keen to claim political support for the fund. The ESM's chairman said:

"The 17 euro area Member States are fully committed to ESM [and EFSF] in political and financial terms and stand firmly behind both institutions."

And the ESM's managing director said:

“Moody's rating decision is difficult to understand. We disagree with the rating agency's approach which does not sufficiently acknowledge ESM's exceptionally strong institutional framework, political commitment and capital structure."

Of course, the political reality is actually the flaw in the single market and Euro fantasy: there's no credible plan to discipline profligate states, as the continuing Greek tragedy demonstrates. Those who negotiated the Maastricht Treaty foolishly believed such states would ultimately behave in the interests of the Zerozone, just as Alan Greenspan thought the boards of Lehman Brothers and others would refrain from driving their firms into a wall out of concern for the interests of shareholders and taxpayers... snake oil. 

The only real disciplinary option is for creditor states to 'send the boys around' to the debtor states. In that event all political solutions will have been exhausted, and the 'European Union' long gone. 

So Moody's is right to discount the politics - and the ESM's credit rating.

If the politics is not to further undermine the ESM, politicians have to demonstrate that the disintegration of the Euro zone is survivable. 

EU Rescue Fund: Build It, And "They" Will Come

Source: Allianz. Hat tip: Financial Times

The Zerozone's life and death struggle may be painfully slow, but it's weirdly entertaining. Comical proposals abound as to how far the dwindling European financial stability facility ("EFSF") - now eroded from €440bn to €250bn - might be leveraged to cover the risk of Zerozone countries going bust. Metaphors to date range from 'a burning building with no exit' to holding on to a 'rising balloon', and I've mixed a few more below. 

The latest instalment, as it were, involves a proposal from Allianz, the insurer, that the requisite leverage could be produced by guarantees (see diagram), so that the steadily shrinking €440bn could magically cover €2.9 trillion of shonky southern sovereign indebtedness. A previous proposal involved CDO-style leverage to €4 trillion. Both appear to suffer from the flaws outlined by Satyajit Das: that the credit risk is massively concentrated and the default correlation is high.

This is like watching turkeys fight over who's next at Thanksgiving. Mr Das is not alone in assigning a high probability to the guarantees being called, or 'CDOs' defaulting - the facility is also a giant magnet for recalcitrant Greek bureaucrats, hedge fund managers and bond traders alike. 

The vultures aren't so much circling, as landing and fastening napkins around their necks.

I guess you could say this makes the creation of the facility a self-fulfilling prophecy. And this just happens to be the reason leading Zerozone banks give for resisting requirements that they recapitalise on the back of stress-tests that factor in the risk of sovereign default (French banks complain they would be forced to raise capital at valuations that are too low, but who are they kidding?)

In truth, the banks are just playing for time until the EFSF gravy train finally rolls into town.

That seems to be what banking is all about.