THE EUROZONE´S BEST SOLUTION IS THE LEAST LIKELY / THE FINANCIAL TIMES COMMENTARY & ANALYSIS (HIGHLY RECOMMENDED READING )

The eurozone’s best solution is the least likely

By Wolfgang Münchau

Published: January 23 2011 19:51

Last week we got a glimpse of what a “permanent” crisis resolution strategy for the eurozone might look like: a bond repurchase programme for Greek debt. The reaction to reports that European Union officials were considering this option reminded me of the heydays of using structured finance to spread risk. The markets were euphoric.


Such a package would involve a big increase in the existing €440bn ($599bn) bail-out fund, the European financial stability facility. The EFSF needs more headroom to lend to Portugal, and even to Spain if needed. It may also need funds for other bond repurchases besides any large Greek programme.


There are various ways such a programme might work. The EFSF could lend money to the Greek government, which could then buy back its own bonds. An intriguing alternative is for the EFSF to buy Greek bonds (either on secondary markets or from the European Central Bank), then swap them for new bonds issued by Athens. Either way, the ECB would thus be relieved from its securities market programme, which has so far bought €76.5bn in bonds from eurozone peripheral countries.


The economic benefit of an EFSF bond swap programme would be to reduce interest rates on Greek debt, while also in effect rescheduling debt repayments. It would be market driven, too. No one would be forced into a “haircut”, in which some bond holders take involuntary losses. The risks to the EFSF are also moderate because secondary market prices are very low and already reflect a certain default probability.


But there are two problems. If you buy only from the secondary markets and from the ECB, you may end up with a crisis resolution programme that is too small. The vast majority of these bonds are not in the secondary market but held by banks that use them as collateral in ECB refinance operations. And these bonds are not for sale.


The second problem is German politics. The Germans are not opposed to a structured finance solution to this crisis. Quite the contrary. But Angela Merkel, German chancellor, will not allow the ceiling of the EFSF to be raised beyond €440bn – though she is apparently ready to agree that this ceiling can actually be reached, which it now cannot.


Ms Merkel’s difficulties stem from the Free Democratic party, the increasingly unpopular liberal party with which she is in coalition. As a sign of its desperation, the FDP has picked on the eurozone crisis fund as a casus belli to attract support from europhobic voters. Worse for the chancellor, the proposed deadline for a comprehensive crisis resolution package is March 24, only days before important state elections.


I have some sympathy with Germany’s desire to limit its liability, although not with the insistence on a rather arbitrary number as a ceiling. What I just do not understand is why conservative Germans have become so cavalier about dumping the credit risk problem on to the ECB. The bank’s securities market programme clearly threatens its independence, unless the programme is soon to be wound down. I wonder where all those German inflation hawks are now. Could some of my German friends explain that conundrum?


It is conceivable that Germany and the EU will try to solve this political problem through an obfuscatory structured finance solution. The goal here would be for the EFSF to undertake a bond buying programme but without the need to raise the official ceiling.


We should recall, however, that the purpose of structured finance is to circumvent something, often market friction or regulatory barriers. In this case, the purpose would be to circumvent the opinion of parliament and the public. German parliamentarians may refuse to raise a transparent ceiling – but who in the Bundestag is going to admit that they do not fully understand the risks associated with a complex debt swap?


The idea of a simple bond purchase and swap programme is transparent and sound. But to get around the €440bn ceiling, the structure would have to become quite complex. At the weekend I heard a couple of proposals of the kind that require flow charts to be made fully understandable.


My hunch is that there will be some sort of agreement – there always is. It will probably respect Germany’s €440bn line in the sand. In terms of its effect, the programme will be either small and insignificant or large and toxic. If German politics goes wrong, we end up with the former. And if it goes right, we may still end up with the latter.


The best solution, as ever, is the least probable: a large but limited increase in the EFSF’s lending ceiling; and a large bond purchase programme accompanied by the restructuring of the financial sector. That would be a step towards crisis resolution that everybody would understand.


The political problem consists of squaring two incompatible goals: Germany’s desire for limited liability; and debt relief that is effective. This is going to be hard to resolve; much harder than investors realise.


Copyright The Financial Times Limited 2011