The European Council on Foreign Relations

€ view: Why the EFSF solution won’t work

Date: 25th October 2011  |  Author: Sebastian Dullien,

Categories: € View, Euro Crisis, Germany in Europe,
Tags: , eurozone, eurozone , germany, greece, efsf, crisis

On Wednesday, EU leaders are going to finally present their compromise from the marathon summit that lasted almost a week. Without any doubt, they will try to sell their compromise as a big step forward in the rescue of the euro area.

A central element of this compromise will be a leveraging of the EFSF which supposedly will increase its lending capability. After German chancellor Angela Merkel got her way and the EFSF will not get direct ECB access to borrow more to leverage the support loans for crisis countries, the idea now is the so-called “insurance” solution: The EFSF will insure the first loss of perhaps 20 percent or so on government bonds. So, should a sovereign country default, the EFSF will carry the loss of guaranteed bonds as long as it is below or equal to 20 percent of the original loan. Only beyond this share, the creditors will have to pitch in and bear the rest of any haircut. The hope is that given this insurance, investors will again consider bonds from countries such as Spain, Portugal, Ireland or Italy as safe assets and demand lower interest rates.

Unfortunately, this solution will most likely just fail to calm the markets. The problem of the past year or so is that the government bonds of many euro countries have transformed in the perception of financial markets participants from safe assets into risky ones. All those investors who primarily want safety (such as central banks, sovereign wealth funds, pension funds etc.) are thus dumping Italian, Spanish and even French bonds by the billions.

Insuring the first 20 percent of a potential loss is not going to make the Spanish or Italian bonds safe again. It just limits the downside. Governments bonds from the crisis countries might now have a little less downside attached to them should the worst (a sovereign default) happen, but the likelihood of loss persists.

What is worse, a 20 percent insurance is probably not worth a lot in the world of sovereign defaults. If a country just needs a 20 percent haircut on its debt to become solvent again, most likely there will be no default, but the country will try to continue muddling through even though the debt level is high. Given the negative stigma connected with and the chaos caused by a sovereign default, it is hard to imagine any European government going into a default with only a haircut of 20 percent in the cards. Instead, if we go by the example of Greece, if a default really happens, necessary write-downs on bonds are more likely in the magnitude of 50 or even 75 percent.

To put it in other words: The distribution of likely returns on sovereign bonds has very thick tails, with very little probabilities of small losses, but higher probabilities of large losses. The insurance approach now tries to take away the fear of the low-probability-low-loss events, while the higher-probability-high-loss events remain possible and largely uninsured. It is difficult to see how this should really bring down interest rates for crisis countries over an extended period of time.

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