Why the EFSF will fail

How The EFSF Works:

The European Financial Stability Facility (EFSF) was set up in order to provide relief to countries that are in difficulties. It has no money, but borrows money on the market when needed, so that it can lend that money to a country in distress. The country cannot borrow on the market itself, because the interest rate it will be charged is too high. All euro zone countries participate in the EFSF, but most important are the highest rated countries. The idea is that the EFSF will be able to borrow for a lower rate, because of guarantees by the AAA-countries: Germany, France, The Netherlands, Austria, Finland and Luxemburg. Without such guarantees the EFSF would have to pay a high rate itself, and would not be able to lend out money at a low rate.

So far there have been 3 phases of the EFSF:

1. As of May 2010: guarantees by participating countries up to 440 billion euro, expected lending capacity 250 billion euro, because not all participating countries have the highest rating (AAA). As soon as the EFSF lends out more than is guaranteed by AAA-countries, the rating of EFSF cannot be AAA anymore, and the interest requested of it will go up, thereby rendering it useless.
2. As of July/October 2011: guarantees have been raised to 780 billion, resulting in a lending capacity of 440 billion.
3. End of October 2011: a plan has been announced to increase EFSF’s lending capacity to 1 trillion, supposedly by “leveraging”: EFSF won’t guarantee 100% anymore but only some, e.g. 20%.

Will Leveraging Do The Trick?

Suppose the guarantee is indeed 20%. This means that the first 20% loss to the EFSF-bond will be absorbed by the AAA-countries. An example: a bond bought for 100 goes down to 85: there is no loss to the bond holder, as this falls within the 20% margin. Now the bond loses more value, and it is worth only 79. This time the bond holder does suffer a loss, albeit of only 1. Of course, the bond could go down much further, especially in case of a default by a country in distress.

So given a 20% guarantee, then with only 100 billion guaranteed by the AAA-countries, 500 billion could be lent out. Or at least in theory, because it may very well be that the EFSF will not succeed in collecting 500 billion from the market for a reasonable interest rate. After all, 20% is far from 100%, so it’s unlikely the EFSF will get a AAA rating under such a scheme.

The 20% is not fixed yet and is subject to change. Bit by bit it is being raised by the proponents of the EFSF. Originally it was 20%, then “4 to 5 times leveraging”, which means a guarantee of 20-25%, and shortly after that was raised to 3 to 4 times leverage, i.e. 25-33% guaranteed. So the leverage factor is not clear yet, just as all other details have not been filled in.

With all this uncertainty, it will probably be hard for the EFSF to raise money. But there are parties that may be convinced in other ways than conventional loan conditions like interest rate and term. Examples are trade agreements or diplomatic support. Hence the plea to non-EU countries to participate, like India, Brazil, China, Japan. Although phase 3 has so far only been a vague idea, those in charge have undertaken a trip to China in order to raise money for the fund. The Chinese haven’t fallen for it; neither have the Indians or the Brazilians. The Japanese have, but only for a meager 300 million.

So much for the leveraging idea. I’ll continue with the analysis on the assumption of a 100% guarantee.

Can The EFSF Be Increased Enough?

To be effective, the EFSF has to have sufficient money. However, the EFSF cannot be increased indefinitely. There are 2 limiting factors (that are ofcourse interrelated):

1. The money has to be borrowed on the financial markets, which means that it depends on sufficient supply.
2. The higher the EFSF, the higher the amount guaranteed by the participating countries. This again puts pressure on their rating, thereby creating the very problem that was supposed to be solved in the first place.

To put a fund of 1 trillion in perspective, let’s compare it to some numbers:

• The total GDP of the euro zone is €12.5 trillion
• The total debt of the euro-countries is €7.8 trillion
• The total debt of the AAA-countries is €4.3 trillion

So raising the EFSF to 1 trillion means (supposing a proportional increase of current guarantees):

• Raising an amount equal to 8% of total GDP.
• At a 100% guarantee by the AAA-countries, their collective debt would increase by almost 1/4, in case they would have to live up to that guarantee.
• For The Netherlands, the guarantee would reach 100 billion. That is 27% of its public debt, and 17% of its GDP.
• For France, the guarantee would reach 360 billion. That is 22% of its public debt, and 18% of its GDP. France is not in a position to undertake such an extra debt, as it has now already had to cut government spending in order not to lose its AAA status.

All in all, raising the EFSF to 1 trillion with a 100% guarantee seems next to impossible. Hence the plan with the 20% guarantee. But as outlined above, that is most likely not to work either. It is much riskier, so the market will require a higher interest rate, thereby defeating the original intent of the EFSF.

Contributions by Non-AAA Countries To The EFSF?

So far the non-AAA countries have not been taken into account, as their guarantees cannot lead to an AAA status for the EFSF. But let’s take a closer look at those countries.

In descending order of the size of their guarantees, both currently and when the EFSF would be increased to a trillion on a 100% basis, the six biggest non-AAA countries are:

1. Italy: 139 billion, would become 316 billion.
2. Spain: 93 billion, would become 211 billion.
3. Belgium: 27 billion, would become 61 billion.
4. Greece: 22 billion, would become 50 billion.
5. Portugal: 20 billion, would become 45 billion.
6. Ireland: 12 billion, would become 27 billion.

It’s clear no help can be expected from them. They are the very countries for which the EFSF has been erected. Ireland, Portugal and Greece are already on life support. Italy and Spain are next in line. Belgium is probably the one in best shape, which rather says it all.

The rest of the non-AAA countries are all smaller than Ireland, and amount only to a few percent of the total EFSF fund. Conclusion: it really comes down to the 6 AAA-countries.

Ok, But What IF We Do Have A Trillion?

Now suppose somehow, somewhere, the trillion will be scraped together. Will it be enough? Some has already been promised to Ireland and Portugal, so let’s say there is 800 billion left. That might, or might not, be just enough for Spain. For Italy at least 50% more will be needed.

So in short, the EFSF is fantasy. If it is continued anyway, then the only effect will be to increase the risk of contagion – especially for France. After all, countries are financially linked even tighter, so they are more likely to be contaminated.

Meanwhile the interest rate on Italian bonds is increasing, in spite of daily intervention by the ECB. Italy will need more than a trillion to be saved, and as the above analysis shows: that’s unlikely to be available. This means soon there will be another crisis, bigger than the one with Greece, and with only 2 options: Italy goes bankrupt and leaves the Euro, or the printing presses at the ECB will do overtime to come up with the missing trillion.

Given Draghi’s short track record and his nationality, I have a suspicion what his preference will be. Let’s see if the Germans will wake up in time.