Sunday, 17 July 2011

Will Germany take the Mister Creosote option?

In a nutshell the hard problem which has to be resolved in the Eurozone crisis can be reduced to this simple question: "Will Germany backstop the entire obligations of the EFSF, or whatever mechanism is put in its place to "assist" those EZ states that are insolvent, or not?

The head of the Bundesbank Jens Weidman was quoted recently as follows

"Nothing would destroy the motivation for solid budgetary policies faster than joint liability for (EZ) state debts" [emphasis added]

There is a huge difference between a backstop up to a limit - which for Germany at present under the current EFSF framework is approximately 27% or, to use the inimitable words from Mr Creosote, when faced with a menu of many options, choose to backstop "the lot". It comes down to the difference between a joint guarantee or a several guarantee. While Germany insists on the latter - which is the position of the German central bank chief and Angela Merkel, the legal framework of the EFSF would not provide suitably enduring underpinnings for the issuance of Eurobonds with a bulletproof AAA rating.

As others have argued there may well be contamination already within the capital structure or tranches of the CDO which is the framework of the EFSF. For Germany to agree to a joint guarantee of all of the obligations of the facility - which in effect would mean that in a worst case scenario it could end up on the hook for the lot would impair Germany's credit rating - and according to one very insightful analyst that process may currently be under way.

The existential risk for the German government - and the electorate - can be simply expressed in the analogy of a group of mountain climbers who are all inextricably linked together; if the most vulnerable was to fall it has the potential for "the lot" to fall into the abyss.

Expressed even more grotesquely it is worth remembering what happened to Mister Creosote when he elected to go for the lot.

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