Satayajit Das is at it again

Debt shuffling will be a self-defeating exercise


By Satyajit Das


Published: July 12 2010 16:10
Last updated: July 12 2010 16:10

George Bernard Shaw observed that “Hegel was right when he said that we learn from history that man can never learn anything from history”. Emerging details of the European Financial Stability Facility (EFSF) bear testament to this.

The structure echoes the ill-fated collateralised debt obligations (CDOs) and structured investment vehicles (SIVs). The head of the EFSF also had a brief stint at Moore Capital, a macro-hedge fund, entirely consistent with the fact the new body will be placing a historical macro-economic bet.

In order to raise money to lend to finance member countries as needed, the EFSF will seek the highest possible credit rating – triple A. But the EFSF’s structure raises significant doubts about its creditworthiness and funding arrangements. In turn, this creates uncertainty about its support for financially challenged eurozone members with significant implications for markets.

The €440bn ($520bn) rescue package establishes a special purpose vehicle, backed by individual guarantees provided by all 19 member countries. Significantly, the guarantees are not joint and several, reflecting the political necessity, especially for Germany, of avoiding joint liability.

The risk that an individual guarantor fails to supply its share of funds is covered by a surplus “cushion”, requiring countries to guarantee an extra 20 per cent above their ECB contributions. An unspecified cash reserve will provide additional support.

Given the well-publicised financial problems of some eurozone members, the effectiveness of the 20 per cent cushion is crucial. The arrangement is similar to the over-collateralisation used in CDOs to protect investors in higher quality triple A rated senior securities. Investors in subordinated securities, ranking below the senior investors, absorb the first losses up to a specified point (the attachment point). Losses are considered statistically unlikely to reach this attachment point, allowing the senior securities to be rated triple A. The same logic is to be utilised in rating EFSF bonds.

If 16.7 per cent of guarantors (20 per cent divided by 120 per cent) are unable to fund the EFSF, lenders to the structure will be exposed to losses. Coincidentally, Greece, Portugal, Spain and Ireland happened to represent around this proportion of the guaranteed amount. If a larger eurozone member, such as Italy, also encountered financial problems, then the viability of the EFSF would be in serious jeopardy.

There are difficulties in determining the adequacy of the 20 per cent cushion. There is the potential risk that if one peripheral eurozone member has a problem then others will have similar problems. The structure faces a high risk of rating migration (a fall in security ratings). If the cushion is reduced by problems of one eurozone member, the EFSF securities may be downgraded. Any such ratings downgrade would result in mark-to-market losses to investors.

Unfortunately, the global financial crisis illustrated that modelling techniques for rating such structures are imperfect. Rapid changes in market conditions, increases in default risks or changes in default correlations can result in losses to investors in triple A rated structured securities, ostensibly protected from this eventuality. Given the precarious position of some guarantors and their negative ratings outlook, at a minimum, the risk of ratings volatility is significant.

This means that investors may be cautious about investing in EFSF bonds and, at a minimum, may seek a significant yield premium. The ability of the EFSF to raise funds at the assumed low cost is not assured.


Major economies have over the last decades transferred debt from companies to consumers and finally onto public balance sheets. A huge amount of securities and risk now is held by central banks and governments, which are not designed for such long-term ownership of these assets. There are now no more balance sheets that can be leveraged to support the current levels of debt. The effect of the EFSF is that stronger countries’ balance sheets are being contaminated by the bail-out. Like sharing dirty needles, the risk of infection for all has drastically increased.

The reality is that a problem of too much debt is being solved with even more debt. Deeply troubled members of the eurozone cannot bail out each other as the significant levels of existing debt limit the ability to borrow additional amounts and finance any bail-out.

The EFSF is primarily a debt shuffling exercise which may be self defeating and unworkable. The resort to discredited financial engineering highlights the inability to learn from history and the paucity of ideas and willingness to deal with the real issues.

Satyajit Das is the author of the recently released “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives”