02 October 2011

Wolfgang Münchau: Eurozone fix a con trick for the desperate

To illustrate the danger of the CDOs as a solution to the eurozone crisis, it is important to recall a few facts about what happened during the credit bubble. CDOs lured investors to put money into mortgages. The CDOs themselves had triple-A credit ratings, even though they invested in bad assets. What at first appeared to be a violation of the laws of economics, physics and logic, ultimately had a simple explanation. The overall risk of the CDO was lower than the sum of its parts. When the bubble burst, governments stepped in and prevented a catastrophe.

So why use such a toxic instrument to construct a product to save the eurozone? The current lending size of the European Financial Stability Facility (EFSF) is €440 billion, which is equal to the guarantees given by the 17 eurozone Member States. If you want to leverage the CDO without increasing the liabilities of governments, then this €440 billion would become the equity tranche of the new CDO. The equity holders in the CDO are supposed to be the ultimate risk-bearers. You can leverage the structure by creating more senior tranches of bonds that would be open to outside investors. You could expand the structure further through a mezzanine layer – which carries less risk than that of the equity tranche but more than that of the senior bonds. You could look at those senior tranches as eurozone bonds.

The big difference between a eurozone CDO and a subprime CDO is the the nature of the backstop. When the eurozone CDO fails, there are no governments that can bail it out because the governments themselves are already the equity holders of the system. This leaves the European Central Bank as the last man standing.

But the whole idea of setting up a eurozone CDO is to avoid this outcome. If you wanted an ECB-backed solution, you could simply grant a banking licence to the EFSF, which would make it eligible as an official central bank counterparty. I also like George Soros’ idea to focus the eurozone rescue fund solely on bank recapitalisation, in addition to a mechanism that allows eurozone countries to issue short-dated discount bonds at low interest rates. Both solutions rely heavily on active cooperation by the ECB. Unfortunately, Europe’s central bank may not accept such a role because of the way it interprets its mandate, as described by the Maastricht Treaty and its own statutes.

The real reason why European officials are pursuing the CDO option is to get round this technical obstacle. Remember that one of the main reasons why banks created CDOs in the first place was “regulatory arbitrage”, as it was euphemistically known at the time. In that case, the idea was to circumvent capital adequacy rules. CDOs allowed banks to push risky assets off their balance sheet, which gave more room to make further loans.

In the case of eurobonds, the idea is also to circumvent Article 123 of the European Treaties (which says that the ECB must not monetise debt); the ECB’s governing council; the German Constitutional Court; as well as the Bundestag and other national parliaments. What better instrument than an opaque CDO to get round those inconvenient obstacles of democratic opposition, constitutional law and international treaties.

Do not get me wrong: I am in favour of an enhanced EFSF. The current mechanism is not big enough to protect Italy and Spain, and inject fresh capital into eurozone banks. That would require a lending ceiling three of four times the current size. But we cannot get there through dirty financing tricks that have demonstrably failed in the past. If this CDO were to collapse, the eurozone might face an imminent break-up that could trigger a global financial crash.

If you accept the political and legal constraints as a given, there are no easy policy options left. There exist only two categories of solutions to the crisis: a fiscal solution or a monetary one. Politics blocks the first; European law blocks the latter. The CDO is an alluring idea from the perspective of a technocrat who has to come up with something that satisfies current political preferences and that respects perceived or actual legal constraints. On the surface, it appears as if a CDO was a third category in itself. But that is not the case because it ultimately dumps the burden on the ECB, just as the subprime mortgage CDOs became a liability for governments.

As I have argued previously, European laws and current political preference are inconsistent with the survival of the eurozone. Something will have to give. A CDO is not a solution to the crisis. It is the last confidence trick in the toolbox of the truly desperate. The eurozone is about to kick the can a final time.

Original article (FT subscription required)

© Wolfgang Münchau