COULD ANY COUNTRY RISK A EUROZONE BAIL-OUT ? / THE FINANCIAL TMES COMMENTARY & ANALYSIS ( HIGHLY RECOMMENDED READING )

Could any country risk a eurozone bail-out?

By Wolfgang Münchau

Published: September 26 2010 22:25

I spent the best part of last week trying to figure out the mechanics of the eurozone’s €440bn bail-out fund. The exercise reminded me of my research into the credit market, with its promises of credit enhancement and other logic-defying concepts. The European Financial Stability Facility is in many respects like a gigantic collateralised debt obligation and uses much of the machinery of modern finance.


But there is one important difference. In the days of the credit bubble, there was some ultra-cheap credit at the other end of a long CDO cash flow chain – subprime mortgages, for example. In the case of the EFSF, the situation could not be more different. Greece was very lucky to get into trouble before the EFSF was set up and was able to obtain its first €20bn loan tranche at an interest rate of about 5 per cent. This was calculated on the basis of a cheap money market rate, plus a small administration fee and a lending margin.


I cannot see how the EFSF can offer similarly attractive rates. We are not yet in a position where it would make sense for any country, not even Ireland or Portugal, to borrow from the EFSF.


When that changes, what happens then? My numbers are extremely rough, with lots of rounding errors – and probably other errors as well. But they give an approximate order of magnitude. The EFSF last week obtained a triple A rating, which will help it raise cash in the bond markets at good rates. To obtain the rating, the EFSF had to agree to an over-collateralisation. In this specific case it means that the EFSF needs to obtain government guarantees of €1.2bn for each €1bn in bonds it wants to issue.


Once it raises the funds, the EFSF will not be able to lend on all of the €1bn, but only the portion backed by the collateral of those countries that themselves have a triple A rating. That reduces the amount available to the borrower to €700m. What about the €300m gap? This is where it gets really complicated, and I am going to spare you the gory detail. A substantial part of this gap serves as a cash buffer, ready to be used if the borrower defaults.


So what is the interest rate? The borrower essentially pays the sum of the EFSF’s funding costs, an administration margin and a lending margin. The triple A rating should ensure that the funding costs for the EFSF are not extremely high, but I doubt that the EFSF could obtain a funding rate as cheap as that available to the European Investment Bank. The EFSF is not a sovereign investment bank, but a rather complicated and not very transparent structure, right out of the textbook of modern finance. One of the reasons the EIB was not eager to run the bail-out fund itself was precisely because it did not want its own credit rating tainted. I would thus assume that the EFSF’s funding costs exceed those of the EIB by a good margin.


Let us assume the EFSF raises the €1bn at an interest rate of 4 per cent. With administration charges and lending margins of 350 basis points, the effective interest rate to the borrower would be 7.5 per cent. What about the cash buffer? The EFSF must reinvest the buffer in the best triple A rated securities in the market. So if its own funding costs are 4 per cent, and if it invests the cash buffer into German bonds at a hypothetical yield of 2 per cent, there is a loss of 2 percentage points. This also has to be paid for by the borrower. This comes on top of the 7.5 per cent interest. It is not all that hard to conceive of a situation in which the borrower would end up paying a total interest rate of 8 per cent. Of course, the actual interest rates will depend on several factors: the EFSF’s own funding costs, the size of the lending margin, the gap between funding costs and reinvestment proceeds and probably several more factors. But no matter how you twist this, it is hard to construct a cheap loan out of this.


Three issues arise from this set-up. The first is that no country would ever want to borrow from the EFSF, unless it was absolutely unavoidable. The typical situation where an EFSF loan would be useful would be a case of egregious market failure. If the borrower is insolvent, the EFSF cannot help.


The second is that the overall amount for lending is significantly reduced. The headline figure of €440bn is misleading. First, one should deduct the shares of Greece, Ireland and Portugal, then the effect of the over-collateralisation and then the share of countries without a triple A rating. A more realistic ceiling is thus €250bn on my calculations, and that is still probably way too high. This may be enough to help a couple of small countries but would be inadequate if a large country should get into trouble.


And finally, the whole edifice would collapse if France was downgraded. This is a non-zero probability event, to put it mildly. Without France, Germany would be the sole pillar of the system, a role Germany would probably not accept.


Having looked at this in some detail, I find it hard to conceive of a situation where a country would both borrow from the EFSF and live happily ever after.