March 27, 2011

Euro bailout explained

As It appears that Portugal will have to be saved by the EFSF, let us see what is the EFSF and how it works:

The EFSF practically does the following, it takes bad loans, and by putting them together, turns them into good loans. It uses a financial instrument similar to that used by institutions in the run-up to the 2008 financial meltdown - whereby subprime mortgages were bundled together with other loans and sold as one good loan. These instruments are known as collateralised debt obligations or CDO.
In February 2011 the Financial Times explained that, technically, the EFSF is not a collateralised debt obligation ‘but a special purpose vehicle that essentially pools guarantees and loans from stronger euro members to give it a top triple A credit rating.’
The economist Nouriel Roubini wrote in January 2011 that the EFSF was an instrument whereby ‘you take a bunch of dodgy less than AAA sovereigns (& some semi-insolvent) and try to package a vehicle that gets [an] AAA rating’. And it is this process of bundling bad debt into bonds which are guaranteed by good lenders which makes it akin to the ‘financial weapons of mass destruction’ which almost brought down the US and European banking systems.
The loans are still bad, the sovereign states are still distressed - it is only the guarantee that has changed. The bonds are valued not so much on the loans themselves, but on the guarantee which comes with them.
The risk has not gone away. It has merely shifted from one place to another, from bad lenders to good lenders as Germany. The main effect of this shift is to spread the cancer affecting one country to all the other countries of the EU. The reasons why the sovereign states find themselves distressed in the first place are not addressed in any shape or form.
If Portugal is forced to leave the money markets, as has happened to Greece and Ireland, ’the EFSF would then have to issue new debt on behalf of the remaining eurozone countries, to help Portugal’. In other words, 14 countries rasing money for three, until another defaults, then it’s 13 countries raising for four, and so on ‘until the bank of nations within the EFSF is so small that they cannot bear the burden of total debt on their shoulders.’
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