The Circular Logic That Dooms Euro TARP From The Start

ΠΗΓΗ: Business Insider


The Eurozone bailout, now being referred to as Euro TARP, is doomed to fail.  While nothing has been officially announced the markets are rallying broadly on the back of a news article published by CNBC on Monday. The details are lacking as to the actual structure but speculation is already running rampant across the financial markets as to what it might look like.  

What is presumed is that Euro TARP will follow the proposal originally proffered by Tim Geithner on his European trip recently. That proposal had been widely dismissed by the G20 as they couldn't come to terms on any type of structure. The current idea outlined by CNBC will bypass the G20 entirely and allow the European Investment Bank (EIB), a bank owned by the member states of the European Union, to take money from the European Financial Stability Facility (EFSF) and capitalize a special purpose vehicle (SPV) that it will create.  

The SPV will then issue bonds to investors and use the proceeds to purchase sovereign debt of distressed European states, which will hopefully alleviate the pressure on the distressed states (PIIGS) and the European banks that already own their sovereign debt.     

If alarm bells aren't already going off they will be in just moment as you get the gist of the rest of this disastrous plan. 

The special purpose vehicle could then be used as collateral for borrowing from the European Central Bank (ECB), allowing the central bank to make loans to banks faced with liquidity shortages.  Let me be clear on this.  The European banks which are already undercapitalized and on the brink of failure will buy bonds issued by the SPV that is full of bonds issued by broke countries.  The banks will then used these bonds as collateral to borrow money from the ECB.  The ECB winds up with loans to broke banks and holding bonds backed by debt issued by broke countries as collateral. This is worse than circular logic, its circular borrowing akin to the Credit Default Swap (CDS) markets that helped sink Bear Stearns and Lehman Brothers, just with a European flair.

Are you getting the picture yet?   It get's better.  Let's throw in some leverage.

The EFSF fund has already committed to providing emergency loans to Ireland, Portugal and Greece – the worst bets on the table. It is expected to provide over 100 million euros ($134.9 million) in additional funding for a Greek bailout.  According to some estimates after those loans, the fund will be down to about 295 billion euros ($400 billion),  So we assume they take roughly $200 billion or so from the European Financial Stability Facility to fund the special purpose vehicle.

$400 billion is not NEARLY enough to solve the problems that Europe faces so the SPV will likely, as suggested by Tim Geithner, be levered up to 9x its capital giving the this vehicle about $1.8 trillion to work with. The SPV, as stated will take the PIIGS debt in and the banks will get EIB paper which they can then use as collateral to get liquidity from the ECB. Doesn’t this sound a lot like the “good bank/bad bank” solution that Lehman tried to sell?

Yes, the EIB paper is of stronger credit – barely - than the PIIGS paper but you are still left with the fact that broke countries are taking in debt from countries that cannot pay their debts, issuing a SPV to sell to other broke banks so that they can use it as collateral to borrow money after it has been leveraged 9x.   9x times a problem doesn’t make the problem smaller does it? What could possibly go wrong?

There is no doubt that the banks and the financial markets want a solution but the reality of the situation is that this is not really a solution to the problem -- which is the fact that the PIIGS are broke and they need an orderly default process to clear the excesses from the system.   However, this leveraged solution will inevitably "kick the can" and shift a massive level of toxic debt to France and Germanywhich are not in a tremendously strong position to handle it.  

The other problem is whether or not the German government can actually get this solution passed.   This out of Germany this morning "Andreas Vosskuhle, head of the constitutional court, said politicians do not have the legal authority to sign away the birthright of the German people without their explicit consent.  He stated that 'The sovereignty of the German state is inviolate and anchored in perpetuity by basic law. It may not be abandoned by the legislature (even with its powers to amend the constitution),'  There is little leeway left for giving up core powers to the EU. If one wants to go beyond this limit – which might be politically legitimate and desirable – then Germany must give itself a new constitution. A referendum would be necessary. This cannot be done without the people, he told newspaper Frankfurter Allgemeine."

Therefore, if the expansion of the EFSF, including the SPV, isn't legal from a German perspective without a formal vote of the people, then this deal is most likely dead before it starts.  If that is the case then the markets are in for a lot of trouble and most likely soon.  Again, this sounds a LOT like what the UK government said to Barclay’s when they wanted to buy Lehmann. Is this sounding more and more familiar? Are you getting as worried as I am?

However, if Europe is going all in with leveraged bets that will water down the credit quality of both France and Germany -- which leaves no strong credits in the Eurozone --then there will be further complications down the road as borrowing costs for Germany and France push higher dropping the Eurozone into a deeper recession. 

Of course, SPV's have a dubious and disastrous history to start with and it is highly likely that this whole process will end badly.  The reality is that PIIGS need an orderly mechanism to default, figure out what banks to save and which ones can be let go and start the process of clearing the years of bad debt and excesses from the system.   The only question is not whether this "clearing process" will occur it is only a function of when and under what terms.