Is a Leveraged EFSF a “Pipe Dream,” “Pure Poison,” or Both?

In recent weeks financial markets across Europe have rebounded in part due to hopes that European policymakers may “leverage” the European Financial Stability Fund (EFSF) in order to increase the amount of financial assistance available to troubled banks and/or euro zone nations.  Such a measure would involve borrowing money from the European Central Bank on top of the €440 billion currently allocated toward the EFSF.

Although speculation over how and when policymakers in Europe will implement further bailout measures continues to change on a daily basis, many market pundits and economists have clung to the idea that leveraging the EFSF could be an effective way to combat the sovereign debt crisis.  Unfortunately for these individuals, that is unlikely to be the case, as Dr. John Hussman explained earlier this month.

In his Weekly Market Comment dated October 3, the former economics professor and founder of The Hussman Funds explained why adding a meaningful amount of leverage to the EFSF is a “pipe dream.”  Hussman’s commentary is below:

One of the perplexing aspects of the discussion on European stabilization is the idea of “leveraging” the European Financial Stability Fund (EFSF) with funds from the European Central Bank (ECB). More than a few analysts have suggested that this sort of structure would help to avoid a Greek default. My impression is that this is wishful thinking.

As background, the EFSF represents a fiscal commitment of European countries to a fund intended to stabilize the European financial system. It is not, however, money that these governments have eagerly decided to simply flush down the toilet – the intent is to use it for stabilization, but also to get most of it back, as the overall commitment represents about 6% of the GDP of the European union. Notably, the total amount of Greek debt alone represents nearly 80% of the size of the EFSF, which would leave only 20% of the commitment available to other states if the EFSF was to buy it up, as some have suggested.

But for the sake of argument, let’s assume that European nations are willing to blow the whole amount on bailouts, and even to lose it all. Now comes the idea of turbo-charging the EFSF by “leveraging” it with funds from the ECB in order to allow it to purchase European debt in amounts 7-to-10 times the size of the true fiscal commitment. The key problem is this – in the event that there were losses on the purchased debt, any losses exceeding the true fiscal commitment of the EFSF would amount to money printing. The ECB will have none of it. Hence the resistance from ECB officials about this idea (not to mention that the original promise that the ECB would never be used to buy the debt of distressed countries has already been broken).

Given that Greece would have a primary deficit even if its debt service was cut to zero, and there is no hope of closing that deficit with further austerity (which continues to plunge Greece into deeper depression), it’s already clear that the recovery rate on Greek debt is likely to be less than 50%. So including Greece in the “ring fence” essentially wipes out at least 40% of the EFSF capital as a starting point.

The resulting math is straightforward, but skip this paragraph if it makes your eyes glaze over. In order to avoid a situation where the ECB actually prints money to cover sovereign losses, the maximum leverage of the EFSF would be 60%/(1-R), where R is the worst-case expected recovery rate for non-Greek countries. More plausibly, since buying up Greek debt would eat up about 80% of the notional size of the EFSF, any lending against the remaining capital would probably be against the remaining 20% of the fiscal commitment, allowing leverage of no more than 20%/(1-R).

The bottom line is this. It is misguided to believe that Europe can save Greece from default and also contain contagion from Europe’s other distressed countries. If Greece is included in the ring-fence, then even if we assume a worst-case recovery rate of 90% on distressed non-Greek European debt, the maximum leverage of the EFSF would still only be 2-to-1. The idea of 7-to-1 or 10-to-1 leverage is a pipe dream that assumes the ECB will be complicit in destroying the euro through currency creation.

The only real option for Europe is to allow peripheral defaults; to allow distressed and insolvent countries to exit the euro; and then for those countries to redenominate their own national currencies and peg them to the euro at a gradually depreciated level (which would be best for their citizens and could plausibly improve their competitiveness enough to close their primary deficits). At the same time, the proper way to avoid European contagion is to restrict the “ring fence” to Europe’s more solvent and fiscally stable member countries.

This morning Ambrose Evans-Pritchard of The Telegraph offered his own analysis on why a leveraged EFSF is a particularly bad idea for the euro zone.  Although his explanation was far shorter than that of Hussman, he came to a similar conclusion – that a leveraged EFSF is “pure poison.”

“If Europe’s leaders do indeed leverage their €440bn bail-out fund (EFSF) to €2 trillion or €3 trillion through some form of “first loss” insurance on Club Med bonds – as markets now seem to assume – the consequences will be swift and brutal,” Evans-Pritchard wrote.

He subsequently quoted Professor Ansgar Belke, from Berlin’s DIW Institute.  Belke contended that “any leveraging of the EFSF would be ‘poisonous’ for France’s AAA rating and would set off an uncontrollable chain of events.”

“It counteracts all efforts made so far to stabilize the eurozone debt crisis, which are premised on the AAA rating of a sufficiently large number of strong economies. In extremis, it would probably cause the break-up of the eurozone”, Belke stated to German newspaper Handlesblatt.