EU Agree on 500 Billion Permanent Bailout Fund

Personally I can’t see why a permanent bailout fund should be considered a positive thing. Wouldn’t it be much better to fix the economy so we didn’t have to bailout anything anymore – neither banks nor nations? Yeah, yeah, I know…that’s just ignorant non-economist talk. Stupid question!

“This is a serious blow for EU taxpayers.”

Sony Kapoor

EU finance ministers in Luxembourg managed to put the finishing touches on the euro zone‘s massive permanent bailout fund, yesterday, giving it an effective lending capacity of €500 billion.

One thing is; that if the EU have to bail out Spain, Italy and perhaps also France, 500 billion euro is far from enough.

The other thing is that the EU member states is supposed to reach the full pot gradually, in five stages, from 2012 to 2017.

I thought this crisis was somewhat acute?

Does this mean that no one is allowed to default until after 2017?

It also means that the total lending capacity of the fund will increase from 440 to 500 billon euro.

60 billion more than the existing facility – okay, maybe we can squeeze in a medium sized Spanish bank, or two…

Still, I really think we should be able to find a solution that not include more   bailouts of any kind.

But that’s obviously too much to ask for.

And – of course – European taxpayers will have to pick up the bill in the end.

“This is a serious blow for EU taxpayers,” says Sony Kapoor, the head of Re-Define, an international economic think tank, based in Oslo, Norway.

The former Lehman banker, now advisor for several governments and regulators, believes that the new stabilizing mechanism, in fact, does imply even greater risk for the states involved.

The ministers have also agreed that the bonds issued by the new fund will not have a so-called “preferred creditor status.”

“Without a preferred creditor status, creditor governments will be much less willing to lend through the ESM. This will make it less effective and result in higher contagion and financial instability throughout the euro area,” he says in a commentary.

The new European Stability Mechanism (ESM), is to replace the temporary €440 billion European Financial Stability Fund (EFSF) created last year.

The EU member states will offer €620 billion in credit guarantees, and a full €80 billion in cash, according to the EUobserver.com.

A Plan B?

Sony Kappor and Re-define have provided a series of suggestions on how to deal with the financial crisis in general, and the European debt crisis in particular.

Last week Mr. Kapoor called for a “Plan B” in the struggle to manage the Greek problem.

The following post was recently published at the think tank’s web page – www.re-define.org:

EU leaders are getting their knickers in a twist over Greece, again. The facts are well-known:  

A debt spiralling up to 170% GDP, a stubborn double-digit deficit, the collapse of private investment and a shrinking economy.

Plan A – liquidity support and structural reform under an EU-IMF program- has run aground. 

Europe needs a credible Plan B for Greece.

Greece cannot repay its debt in full but a situation where EU taxpayers share the burden through a write-off is politically toxic.

Another possibility of simply restructuring debt owed to the private sector will, as the ECB rightly points out, bankrupt the Greek banking system and trigger contagion.

Other options such as increasing the size of public support to Greece make little economic sense and remain politically fraught even as Greece runs out of cash.

The constraints imposed by what is economically sensible and politically feasible mean this is what Plan B must do.

First; recognize that haircuts on Greek government bonds are arithmetically unavoidable unless EU taxpayers are willing to give almost Euro 100 billion to Greece in aid, not loans.

The timing of these haircuts is flexible with now or July 2013, when the European Stabilization Mechanism is activated, being the two dates that make most sense. 

While restructuring now will minimise uncertainty and reduce the debt overhang, July 2013 may be more realistic politically, in particular because the ESM will make the process legally and operationally simpler.

Banks can also build additional buffers.

Second: differentiate between various groups of creditors.

Though the loans provided by Member states are legally ‘pari passu’ with debt to the private sector, EU loans and ECB support provided after Greece got into trouble must be treated preferentially.

Private holders of GGBs would have been worse off without public support, so the EU/IMF and ECB debt of around Euro 100 billion should not be restructured.

In 2013 this can simply be transferred to the ESM, which will have preferred creditor status.

Another category of creditors, Greek banks that hold more than Euro 50 billion of GGBs, will also need to be protected.

Not because of fairness or political expediency but because they have no loss absorption capacity.

A haircut to their holdings will bankrupt all Greek banks imposing enormous economic costs on Greece and its foreign creditors alike and triggering contagion.

Third: swap Greek bonds held by the ECB and Greek banks for new par bonds that are excluded from restructuring.

The ECB should pass on the nearly Euro 10 billion difference between what it paid for the bonds and their face value to Greece to help reduce the debt stock.

Clear statements that these new bonds will not be haircut will maintain public faith in Greek banks and prevent the large-scale deposit flight that would otherwise occur.

Fourth: change the Greek domestic law to smoothen restructuring and target a debt stock of just below the psychologically important 100% threshold.

The burden would fall mostly on private external holders of Greek debt of which German and French banks are the biggest.

Well-capitalized French banks, such as BNP Paribas, can comfortably absorb the 50% haircut needed.

Between the poorly capitalized but publicly supported German Landesbanken, the SoFFin bad bank and the stronger private banks such as Deutsche, German banks can also handle the haircuts.

The balance of Greek bonds, held mostly by institutional investors including hedge funds and distressed debt specialists, has already been marked down by close to 50%.

Contrary to what the ECB is self-interestedly saying, the direct contagion impact of Greek restructuring will be very limited.

The main concern is that of psychological contagion to Ireland, Portugal and to a lesser extent Spain. We address this issue at the end.

Delaying restructuring till July 2013 is possible but implies that a 75% haircut will be needed to compensate for the Euro 40 billion of repayments due to non-public external bondholders by then.

However, it may be the only political compromise possible between the fiscal and the monetary authorities in the EU.

While the re-profiling being discussed will keep this Euro 40 billion in play and reduce the need for public funds, it has much of the downside of an immediate restructuring without the upside.

It will not improve the debt sustainability, nor remove the uncertainty or debt overhang. Yet, as seen from the latest downgrade of Greece to CCC by S&P, even a re-profiling will trigger ratings action and be considered to be a default.

Any significant ‘voluntary’ roll-over could only be achieved through self-defeating credit enhancements such as providing collateral, using higher coupons or issuing the new securities under UK law that will only worsen the sustainability of Greek debt. 

Both re-profiling and roll-overs will merely postpone restructuring, not avoid it.

They may allow politicians to claim that there has been private sector involvement but it will mean little as there is no effective burden sharing.

Finally: contagion to Ireland and Portugal, which is a real risk, can be minimized through the introduction of an ESM clause that allows debt restructuring only when the Debt/GDP ratio and Debt Servicing/GDP ratios exceed 120% and 6% respectively, levels that neither Ireland nor Portugal are expected to breach.

The markets recognize that Greece is in a significantly worse situation.

Greece will need to work hard to restore growth – the number one priority and a debt restructuring will at least give it a fighting chance. It also needs to cut deficits urgently.

For the hard work that Greece needs to put in, there is no Plan B though making the debt stock manageable will at least give it a fighting chance of success.

Sony Kapoor is managing director of Re-Define, an international think-tank with offices in Berlin and Brussels.

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