How do you turn uncertainty into safety? The euro was supposed to replace the uncertainty of doing business between multiple countries with a single economic entity, so safe that its members could borrow money close to the price paid by the strongest, Germany.
One good thing about financial markets is that they put a price on uncertainty. In hindsight, the multiple currencies and interest rates of pre-single currency Europe had an advantage because they forced people to do their homework; market governance was better than political governance, which is why many politicians hate financial markets.
Prior to the advent of the euro in 1999, the market’s verdict on countries like Italy and Greece was that they had to pay interest rates in the low teens – the price of their perceived profligacy compared to northern Europe. In my first book, Inventing Money, I wrote about how Italian officials brought in Wall Street banks and the hedge fund Long-Term Capital Management to contrive a squeeze in Italy’s bonds, driving up prices and turning convergence with Germany into a self-fulfilling prophecy.
Former LTCM partner Eric Rosenfeld later told me that he was so dubious about Italy being accepted into the Eurozone that he bought credit default swap protection against Italy going bust (LTCM ended up going bust instead). Once the euro was up and running, this kind of healthy scepticism got replaced with blind faith that the deficit and GDP rules crafted in Maastricht would prevent the new low interest rates from going to peoples’ heads. Those rules soon became a formality that Eurozone countries could ignore with the right paperwork.
That was the essence of the swap deal that Goldman Sachs did for Greece, concealing debt using a derivative that exploited a loophole in the accounting rules. Writing about this deal in 2003, I was struck by how Greece’s breaches of the rules were insulated from market scrutiny by the feel-good politics of the Eurozone. Unimpressed, Goldman secretly hedged its risk by buying CDS protection on Greece, making the Greeks pay for it.
Today, the politics of the Eurozone is itself a source of uncertainty. The market scrutiny that has been missing from the Eurozone since 1999 has returned with a vengeance, blocking the peripheral nations from access to funding and threatening Italy, Spain and even France. The bloated banking groups that grew during the euro’s heyday are also losing funding access, and need to be recapitalised.
With their system’s internal governance discredited, the Eurozone’s leaders have no choice but to create financial mechanisms that provide markets with a transparent substitute for that faith in single-currency politics they once had. These mechanisms, such as the European Financial Stability Facility, are supposed to fund the weakest members of the Eurozone without looking like a bailout – a simple transfer of money from strong to weak — which would be politically impossible.
The EFSF has been described as a collateralized debt obligation, which it has not been up to now because it doesn’t tranche or layer its risks. Recent proposals for a leveraged EFSF talk about it as a bank or insurance company, or even giving it formal CDO status. All these financial mechanisms share in common the concept that leverage applied to loss-absorbing capital delivers low-cost funding for a pool of risky assets. The EFSF’s hundreds of billions in capital are not enough on their own to lower funding costs for Italy and Spain, and backstop the Eurozone’s banks, but if they absorbed the first 20 percent of losses on these trillions of liabilities, that might do the trick.
This will turn strong-country taxpayers into equity holders in a portfolio of weaker Eurozone countries and banks. That’s the place the private sector doesn’t want to be (although there is talk of inviting Asian sovereign wealth funds to participate – good luck). If the leveraged EFSF comes to fruition, it may be because Eurozone taxpayers don’t have the tools to price the risks that their political leaders are taking in the way that financial markets can.