Monday, 21 February 2011

Macro Eurozone risk - we’re all in this together, aren’t we?

While recent events in North Africa and the Middle East, especially the current bloodshed being seen in Tripoli, are creating the potential for a regional geo-political crisis with far reaching implications for the rest of the world, the received wisdom is that there is not enough at stake for the global financial system to have to really work itself into a lather – even if the price of Brent crude is now firmly established above $100 a barrel and the propensity of citizens to take to the streets over many “injustices” seems to have reached a possible “tipping point”

The main event at the moment for the global capital markets appears to be the relentless march upwards in US equities and the macro perception that there has been a rotation out of EM and BRIC exposure into the world’s developed markets. There are some that believe that this rotation has almost run its course and that it is now time to buy the BRIC’s and EM’s again while others, including myself, are of the view that it is hard to ignore global trade imbalances coupled with the inflationary consequences of QE2 (and potentially Qn), and that these factors suggest that the hoped for rallies in China and India may not prove as resilient as some are expecting. Just to focus on the Shanghai market for one moment the 3200 level on this index has proven to be a resistance level twice over the last year and the current rebound seems to be lacking the dynamism to take out this overhead barrier.

But where could the real surprise to the global financial system come from? It could, of course, come from many places, but let me suggest that it could come about as a result of a reasonably simple concept from jurisprudence which, in essence, hinges on the difference between joint and several obligations. To be more direct about it I shall state a view which is that the euro currency bloc faces an impossible dilemma. On the one hand, over the longer term (maybe five years, maybe more) the EZ is almost certainly doomed unless the German government is willing to underwrite a bail out system which makes them joint and several guarantors for all of the debt of the Eurozone nations collectively. On the other hand, there is increasing evidence that the German electorate want no such thing. Although of a different order of magnitude, recent geo-political events suggest that politicians should think very carefully about the consequences of not listening to the concerns of their constituents.

We’re all in this together – pro rata of course!

With news on Sunday (Feb 20th) that Angela Merkel’s coalition government suffered another setback at the polls when the CDU lost a local election to the Social Democrats in the city of Hamburg, there has been a rally in Germany’s ten year bunds. Here is how the development was described by Bloomberg

German 10-year government bonds advanced after Chancellor Angela Merkel’s Christian Democratic Union lost an election in the city-state of Hamburg to the Social Democrats.
Bunds also advanced before reports that are forecast to show German manufacturing and services growth slowed this month. The election result may weaken Merkel’s position as she negotiates a comprehensive plan to contain the euro-region’s sovereign debt crisis.

This article sets out to put this apparent celebration by German bund investors about Merkel’s slow attrition in her power base, into the larger context of the current ticking time bomb which is the hopelessly irreconcilable aims of different segments of the Eurozone in trying to devise a safety mechanism for future sovereign debt crises.

Beneath the surface, and as evidenced by the Hamburg result (and even more serious problems could confront Merkel if she loses Baden Wurttemburg at the end of March), there is a new subliminal slogan that is on the loose within Germany with regard to the Eurozone – which could be stated somewhat sardonically as “we’re all in this together – (pro rata of course).” The key thesis that will be proposed is that the German position on any rescue plan, no matter how contrived and shrouded in obfuscation, is fundamentally at odds with the kind of mechanism that investors would like to see and that will allow the funding facility to prevail with continued AAA support from the principal credit ratings agencies (CRA’s). To that extent the outlook for the EZ remains highly uncertain.

The EZ malaise is rising to the fore again

The tectonic plates of crisis within the Eurozone government debt market are rumbling again as the yields on Portuguese 5 year debt now seem to have established a foothold above 7% and the 10 year yield is currently at a record high above 7.5%.

As the three dimensional graphic above shows yields on the 10 year benchmark bonds for Germany, Spain, Portugal and Italy have all been on the rise during the last several weeks. In fact, notwithstanding the small drop in yields cited at the beginning of this article resulting from the Hamburg election result, German yields have moved up by more than 75 basis points since mid October of last year.

Particularly alarming is the rate now shown on the Portuguese 10 year which has a yield at the time of writing (Feb 21st) well above 7.5% and this is considered by most analysts to be above the critical level, and as such the Portuguese government will almost certainly have to turn to the EFSF for a bail out.

Fatal flaw in EZ’s legal architecture

There is a flaw in the legal/constitutional framework that underpins the way that the Eurozone is organized and it needs to be confronted without the usual shenanigans of smoke and mirrors that give most observers a false sense that it’s just a matter of more meetings that will solve the problems besetting the EMU currency union. The difficulties that crop up each time the matter of how to deal with rescuing the troubled nations, how to re-vamp a Euro stability mechanism, whether to increase the funding commitment, or whether indeed the current SPV vehicle known as the EFSF deserves a AAA credit rating which is what has been granted to it by the major CRA’s, can be directly attributed to this flaw.

As suggested the essence of the problem lies within the legal architecture which surrounds the whole Eurozone project and specifically the EFSF (or its successors). The best way to get a handle on structural flaw is to consider the difference between a joint obligation and a several obligation. The EFSF has a several obligation on the member states that are guaranteeing the obligations of the facility, but critically, not a joint obligation.

In simple terms the best way to contrast the difference is to consider the nature of a partnership – a form of business organization which used to prevail in the professional world, including until the 1980’s in the domain of investment banking.

A firm based upon a partnership deed is bound together legally under the concept of joint and several responsibility for all of the obligations of the firm or partnership. All of the partners are each fully liable for all of the sums that the firm could be obliged to pay out in the case of a financial mishap. There is not a pro rata agreement which says that the liability of each member of the partnership is limited in any fashion – for example in proportion to that partner’s net worth or other assets. If there is a judgment against the partners, requiring the obligations to be honored, theoretically the onus for meeting those obligations could fall on just one of the partners if he or she is the only one left standing after the others may be insolvent or may have declared personal bankruptcy. Admittedly this would be a limiting case but the key idea about joint responsibility – which overrides the notion of several responsibility – is that each and every person in the partnership is liable up to the full amount of the relevant obligation.

The next strand to the story is that the EFSF does not presently provide for joint responsibility of the guarantors of the SPV and its borrowings. The manner in which the structure was established only provides for several responsibility in which the liability of each of the EZ member states is limited to their capital contributions to the ECB.

The table showing this commitment to the current EFSF facility is as follows:

Member StateCapital Commitment Euros bnPercentage of Total
Federal Republic of Germany119,390.0727.1%
French Republic89,657.4520.4%
Italian Republic78,784.7217.9%
Kingdom of Spain52,352.5111.9%
Kingdom of the Netherlands25,143.585.7%
Kingdom of Belgium15,292.183.5%
Hellenic Republic12,387.702.8%
Republic of Austria12,241.432.8%
Portuguese Republic11,035.382.5%
Republic of Finland7,905.201.8%
Slovak Republic4,371.541.0%
Republic of Slovenia2,072.920.5%
Grand Duchy of Luxembourg1,101.390.3%
Republic of Cyprus863.090.2%
Republic of Malta398.440.1%

Total Guarantee Commitments440,000.00100%

Most notable about this table is that Germany and France together provide 47.5% of the total guarantee. They are two of the six AAA credits amongst the 16 EZ States listed (Estonia became the 17th member in January 2011 but is ignored for present purposes as its “contribution” to the funding guarantee would be minimal anyway).

Also notable is the fact that Spain and Italy make up almost another 30% of the guarantee and there are grounds for believing that their ability to comply even in pro rata fashion may not be a safe assumption – especially if the size of the guarantee is increased, or more ominously if either of these two member states becomes a rescue candidate. Indeed it is one of the sad ironies of the structure that included as guarantors of the funding are several candidates for rescue including two which have already proven themselves to be junk credits – Ireland and Greece. In headline terms there are just four countries which are responsible for more than ¾ of the total obligations of the fund.

When designing the architecture of the fund the Brussels technocrats decided in effect to emulate the structure of a CDO with some features that would make the ratings agencies look benignly on the risk parameters for the SPV. Credit enhancement features, especially over-collateralization were introduced into the capitalization model. In essence the fund is over-collateralized by 20% so that the relative contributions of each guarantor are actually 20% above the available funds that the facility can borrow against.

This has the effect of reducing the scope of the facility’s funding commitment, so the effective facility has actually been estimated at about Euro 300 bn. There are ongoing discussions about increasing this funding guarantee, but these are proceeding slowly and with quite a lot of acrimonious discussion amongst key players in the negotiations.

But there is a danger in trying to analyze and parse every new press release or comment from EU officials with regard to these deliberations about the size of the new facility, as we are in danger of losing sight of the forest for the trees, or more specifically, in this case, losing sight of the imperfections of the legal architecture of the facility, and instead becoming fixated on the monetary size of the facility.

The simple question needs to be asked – how should such a structured credit instrument be rated by a ratings agency? Even though the question was answered by the CRA’s in the summer of 2010, the answer is still worth asking again as the CRA’s have been known to get things wrong in the past!

The EFSF SPV was given a AAA rating by the three big agencies and largely (wholly?) as a result of that, when the facility went into the market to raise its first tranche of funding the deal was oversubscribed with keen participation from China and Japan and the initial issue was sold with a yield, according to the EFSF's own website of 2.89%.

So it would seem that all is going well for the EFSF and that the precedent set bodes well for further issuance. But, the argument here is that this is not to be assumed in the light of the events which are currently unfolding in Germany. The unsettling question that needs to be answered by the CRA’s is whether or not further bailouts by any rescue facility should also be granted a AAA rating? Even more serious is the question whether or not the role of a guarantor such as Germany to an enlarged bailout facility could even call into question the AAA sovereign rating given to that nation. It hardly needs to be stated- in fact I already have done so here - that the Germans don’t love the euro enough to see their own AAA rating in jeopardy.

Credit Enhancement Features of the EFSF

It will be recalled that when CDO’s were issued by US investment banks they also had credit enhancement features – such as “guarantees” from outfits like AMBAC. It may be redundant to point out at this stage that far from AMBAC being able to honor its commitments made to enhance the creditworthiness of CDO’s, the company filed and declared for Chapter 11 bankruptcy in New York on November 8, 2010. There was also the not insignificant problem faced by the US Treasury when it was faced by all of the guarantees made by AIG under various swaps and instruments designed to enhance the massive issuance of CDO’s during the 2003-7 period in the US and elsewhere.

The over-collateralization feature built into the EFSF was certainly a cosmetic sweetener providing an additional buffer of capital and gave the EFSF more breathing room if things got tight. But the troubling issue with over-collateralization and the concept of several obligation which is part of the legal fabric of the EFSF, is extraordinarily similar to the problem that arose for mortgage backed securities.

Just as in the case of the CDO debacle with real estate mortgages as collateral, where the possibility that real estate all over the US could suddenly decline in a uniform fashion was seen as a statistically insignificant “outlier”, it also appears to have been assumed by the CRA’s that the chances of several sovereigns running into difficulties and suffering impaired creditworthiness at the same time is equally as remote.

Several hundred books and articles have been written on the dangers implicit in the former assumption about the non-correlatedness of declines in US real estate, and, with that in mind, many asset allocators (not enough perhaps) are now questioning the assumptions behind the latter assumption. In fact articulate protagonists of the sovereign domino theory, for example Kyle Bass from Hayman Capital Advisers, are beginning to get prime time TV slots and plenty of coverage which, in view of the gravity of the consequences of sovereign contagion, is well deserved. It would not be an exaggeration, claims Bass, to say that defaults by even one major sovereign, with its cascade of impairments to the balance sheets of the major private sector banks (well private in the sense that the shareholders are still not in the majority of cases taxpayers, even if banks’ balance sheets are underwritten by the public sector), would trigger the ultimate systemic meltdown.

I don’t like to use hyperbole to get attention for its own sake and there is a danger in overstating the risks that are actually present, but the likelihood for further disruption in the EZ government bond markets is accelerating.

Consider for example some recent events as reported by Bloomberg

The European Central Bank is being forced to print money to bolster banks in bailed-out Greece and Ireland, leaving the region’s taxpayers on the hook as the final guarantors of those nations’ debts.

Greek and Irish banks have issued at least 70 billion euros ($95 billion) of bonds to create the collateral required to get cash from the ECB, according to the International Monetary Fund and regulatory filings, a figure that may rise to 100 billion euros after Greece said Feb. 11 it may extend another 30 billion euros of guarantees to its banks.

“What you have here is micro-quantitative easing, or money printing,” said Cathal O’Leary, head of fixed-income sales at NCB Stockbrokers in Dublin. “The banks are issuing unsecured loans to themselves.”

“This is a great example of bank risk moving to national government risk, and now to ECB risk,” said Jean Dermine, professor of banking and finance at INSEAD business school in Fontainebleau, France. “The ECB is increasing the money supply and that is raising inflationary pressure. There is also credit risk, the fact that default would lead to a loss for European taxpayers.”

A big headache for Angela Merkel

The fact that the ECB is going beyond its mandate and engaging de facto in QE, despite numerous denials that it is not, is also in direct violation of the treaty ratification which established the ECB and it has lead to the resignation of Bundesbank president Axel Weber who was seen by some as an eventual successor to Jean Claude Trichet. Angela Merkel is really not to be envied for the position she occupies now with regard to this matter and probably has plenty of paracetamol nearby to help her through the coming months.

The question that really needs to be confronted by Trichet and his successor is – given that the ECB is now expanding its balance sheet and incurring obligations on behalf of the citizens of the EZ’s member states - who stands behind the debt of the ECB?

Does the principle of several liability realistically apply there? I see this as somewhat similar to the situation that the US faced with Fannie Mae and Freddie Mac in which here was not an explicit US guarantee until the whole edifice came tumbling down at which point the holders of GSE bonds needed an answer right away – are these things federally guaranteed or not? The US decided that the public safety net would be put in place to cover them and another possible trigger for a systemic meltdown was averted. The simple rule of thumb that the US government has taken since the financial crisis of 2008 has been, to return to the main motif, we’re all in this together and the debt holders will be protected by the full faith and credit of the US government.

If a truly Darwinian outcome was to befall the Eurozone and capital flight from the banks of nationals was to gravitate towards the center would Germany stand tall and agree that we’re all in this together 100% - and not just pro rata ? This is the really hard question for which the only sane answer might be that it is better for Germany to get out of this commitment sooner while the going is good, rather than later when the entanglement is so great that there is no way out.

This explains why Merkel has been talking about haircuts, why the German parliament has been talking about the fact that the changes being contemplated by a revised EU treaty calling for more fiscal integration will require a 2/3 majority in their legislature and in a more general sense a rapidly evaporating consensus amongst German policy makers that protecting the euro should be undertaken at all cost.
The Germans are effectively snookered on this issue. Unless they agree that they are totally committed to supporting the euro – with all of the nasty political consequences that would flow from that, including even the possibility for German civil unrest – then the euro’s next crisis may be its final one as, to paraphrase W.B Yeat's classic line from The Second Coming, the center may not hold.

Whatever language is put into new documents that will replace or supplement the EFSF will try to obfuscate this issue. In their own inimitable way the EZ technocrats will devise ever more arcane credit enhancement features - labyrinths of repo channels - to try to disguise the fact that this issue has not been addressed. But if the sovereign dominoes start falling, or even if enough EZ government bond buyers think they might start falling, this question will move to center stage.

Why not issue Eurozone Bonds?

Some have suggested that the best way around the difficulties of designing a new architecture for the EFSF or its successor would be to grant the ECB the power to issue new E-bonds, but as indicated above this may have the unintended consequence of highlighting the legal flaw and bringing about the more vitriolic attacks from some member states. It would also certainly require plebiscites in many states with highly uncertain outcomes, not something favored by EZ bond investors.

Interestingly one of the main critics of E- bonds is the current ECB president as this article makes clear.

BRUSSELS (MNI) - The European Central Bank maintains its position that eurobonds with a "joint and several" guarantee would not be appropriate given the present circumstances in the European economies, ECB president Jean-Claude Trichet said Monday.

"In the ECB, as you know, we are not in favour of European bonds in which the European countries would be joint and several. We don't consider it is something that would be appropriate in the present circumstances," Trichet told the European Parliament's Economic and Monetary Affairs Committee on Monday.

Just to be totally clear and unambiguous on the matter – never something that a central banker should really do – the following direct quotations from M. Trichet are also on the record of the European Parliament:

"We are not ourselves in favour of issuing securities, treasuries that will be joint and several," Trichet told the European Parliament.
"We consider it is good that each particular state, each particular treasury has its own refinancing and has its own way of being on the market."

If E-bonds are a non-starter, and if the Germans are only committed to a pro-rated liability for anything that can go wrong within the EZ states, is it right for the CRA’s to continue to rate the securities issued by any new facility as AAA? While Moody’s and S&P analysts may possibly ponder that question, the capital markets may well be moving towards another test of the issue. But again there is a danger in thinking that they are only testing the size of the facility… more seriously they may be ultimately testing the nature of the legal guarantee behind the facility.

The final word on this dilemma will go to Han Werner-Sinn, who is Professor of Economics and Public Finance at the University of Munich, President of Ifo Institute for Economic Research and Director of CES.
The influential policy adviser wrote recently as follows:

One idea being voiced in Brussels is that the Luxembourg special purpose vehicle should buy up existing debts, as the ECB is already doing. It would be even more attractive for the debtor countries if they received additional loans from the special purpose vehicle so that they could buy back their outstanding debts themselves.

This would be an opportune time since 10-year Greek and Irish bonds are now only worth about 70% of their nominal value. This would amount to a valuation adjustment (“haircut”) for private creditors – as even members of the German government are claiming – without really hurting anyone.

But this sort of magic cannot work. Taxpayers of the countries with a good credit standing would in that case be liable also for the existing debts of the affected countries. If the loans granted as a substitute are not serviced, the taxpayers would have to meet the claims of the special purpose vehicle.

Under no circumstances should Germany accept this approach. It amounts to making the debts the responsibility of the Community via eurobonds – a policy that the German federal government has strictly refused, and rightfully so. This is a cunning way of introducing eurobonds, using incorrect figures and new semantics.

I would suggest that the writer of the above has hit the nail on the head in his last paragraph. The only real question is not one regarding whether the German government would be prudent to step away from the forces of encroaching fiscal unification and complete financial integration of the EZ, which would result in the ultimate consequence that Germany could effectively end up providing a safety net under the whole EZ project, but simply when they will want to step away.

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