13 October 2011

Achleitner: Insurance, not leverage, is way to stabilise eurozone

By concentrating on the new issuance and not the existing stock of debt, the EFSF’s task would be significantly less daunting. Allowing peripheral eurozone governments to address their current liquidity crisis should be the ultimate goal of any such mechanism. Structural reform and eventual growth must deal with the solvency aspect, both of which will have time to occur if enough breathing space is given.

The EFSF would partly guarantee eligible sovereign bonds, or, in other words, insure them against potential haircuts. It would not guarantee the whole contractual terms but only a loss piece of say 40 per cent for Greece and if necessary 20 per cent for Spain, as an example. Investors would evaluate the trade-off between risk protection versus interest paid and, if satisfied, fund the entire issuance. Given that the EFSF need guarantee only a portion of those bonds, it could help raise significantly more funds than if it had to fund the loan itself. At 40 per cent risk cover, a guarantee of €1 helps to raise €2.5 in funding. At 20 per cent risk cover you can raise €5. Better yet, given that the EFSF would need only to issue guarantees rather than raising funds at this point, it could potentially mobilise more than the €440 billion AAA capacity and get closer to the €726 billion guarantee amount.

Assume for a moment a risk coverage of 40 per cent for Greek, Irish and Portuguese bonds and 20 per cent for Spanish and Italian issues: one could fund 4.5 times the guarantees, leading to a theoretical funding power of up to €3,000 billion, which should definitely silence market criticism about lack of firepower and end speculation. All of that would be on a purely unfunded and contingent basis, without increasing guarantees beyond what has already been decided. Indeed, with a bit of luck, not a cent would need to be spent.

EFSF bond insurance seems highly effective. By providing some security for the most speculative exposure, it would decrease capital costs for needy Member States, allowing them to return to capital markets more quickly.

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