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    « Upcoming Nobel Peace Ceremony: UN High Commissioner Too Busy To Attend | Main | The People Vs. WikiLeaks »
    Monday
    Dec062010

    Inside The EU Bailouts

    Given that the EU is on the hook again for yet another multi-billion euro bailout - this time for Ireland - it would be interesting to learn how exactly the EU funds these massive bailouts. The answer it appears is - just borrow more to save those who have already borrowed too much. 

    Following the Greek debacle, as an effort to ready itself for future fiscal train wrecks, in June 2010 the EU set up what is called the European Financial Stability Facility (EFSF). The EFSF is a specialized financial vehicle created within the framework of the Ecofin Council (the EU agency that comprises of finance ministers of member states and is responsible for the EU's economic policies). Altogether 16 Euro Area Member States, that use euro as their official currency, are part of the EFSF. Poland and Sweden, two countries which do not use the euro, have reportedly voluntarily offered to contribute financial resources to the EFSF in future on an as needed basis. 

    The EFSF is based in Luxembourg, and is headed by Klaus Regling (former Director-General for economic and financial affairs at the European Commission). The EFSF identifies it's objective as: "to preserve financial stability of Europe’s monetary union by providing temporary financial assistance to euro area Member States in difficulty". The EFSF was set up in such a way, that it would really exist only if need be. It was automatically set to close on June 30, 2013, if it never had to bail any state out. If the EFSF ends up making financial commitments during it's temporary three year operation period (like the one it's about to do for Ireland), then it's lifespan would extend until such time that the loans were fully paid and the financial obligations were satisfied. 

    The EFSF offers a safety net of €750 billion (that's close to a trillion USD) to it's member states in times of need, which includes up to €250 billion from the IMF (International Monetary Fund). Does that mean the EFSF actually has all this (or even part of this ) money stashed somewhere in a bank account? No. It in fact has no money at present. The €750 billion is more 'aspirational' than reality.

    The way this system was set up, the EFSF becomes operational only if a member state makes a request for bailout. Once the state's finances have been officially and thoroughly examined and a decision has been reached to rescue the sinking ship, then the EFSF kicks in gear and starts raising money in the market by issuing new bonds. So, it starts to raise money only after a need is established and approved. It's almost like applying for water permit, after you have made sure that you house is indeed on fire. 

    As I have already explained when I wrote about the Irish bailout, issuing bonds is pretty much how all governments raise cash. And when investors lose confidence in a country's ability to meet it's financial obligations, the price of it's bonds goes down and the yield (aka the interest rate on the bond) simultaneously goes up. In the long run no state can sustain borrowing more and more money at high interest rates.

    Also as the investor confidence goes down, a country's credit rating is adversely affected. Lower the credit rating, again higher the interest rate (much like consumer loans). If a country's credit rating drops below BBB-, then no new money can be borrowed in the market at any interest rate. At that point you're pretty much shut out of the market.

    So the idea behind the EFSF is that once a state in financial ruins has reached a point where it can no longer borrow money on it's own from the market, it will then go back to the market but this time with it's comrades who have better financial standing. Despite the presence of struggling European economies like Ireland, Spain and Portugal in the EFSF, because the EFSF also has states like Germany and others which are on much better financial ground, their credit rating together as a group is excellent. The EFSF, in fact has a credit rating of AAA from S & P, Aaa from Moody's and a AAA from Fitch, which are the three major credit rating agencies.

    The bonds issued by the EFSF are guaranteed by the 16 member states together, therefore the EFSF bonds in theory would enjoy higher investor confidence. The inclusion of more fiscally stable economies in the mix increases the possibility that EFSF as a group will be able to meet it's financial obligations - of paying promised interest while the bond is held by the investor and repaying the principal upon maturity or sale of the bond by the investor. 

    But the bottomline is that there is no money right now in the EFSF. Now that the Irish bailout is an official certainty, the EFSF will go to the market next month to issue bonds, so as to start raising money in order to pay Ireland. The scheme is not without it's critics. There are experts who are skeptical about this whole set up.

    Alex Blumberg and Chana Joffe-Walt of NPR's Planet Money recently talked with Satyajit Das (an author and a financial risk consultant) and Scott Mather (Managing Director, PIMCO) about the EFSF. While discussing the fact that Ireland which cannot borrow money on it's own in the market, will be lent money by the same market (via the EFSF bonds), and this transaction in turn is guaranteed by struggling economies like Portugal and Spain, Mr. Das raised the question, "Portugal, who can't borrow is guaranteeing this (referring to the EFSF bonds). So you've got basically, people who are being lent to who can't pay you back, and the guarantors aren't solvent either. So exactly, what are you doing?"

    Mather points out in the same discussion that, "To the extent that countries like Ireland and Portugal draw on the program, and countries like Spain and Italy are required to guarantee some amount of debt, there's no question that's deteriorating their own credit-worthiness." What he is arguing here is that this set up may increase the possibility of eventually more and more states needing to be rescued, as those who are on the edge of fiscal collapse now are having to prop up those which have already collapsed. 

    Then there's the issue of who is actually going to finance this bailout, since the money is not coming directly from the coffers of any European state? It's essentially whoever buys the EFSF bonds, is who is going to rescue Ireland. So who buys bonds? Pretty much anybody and everybody. Bonds are an integral part of a well balanced portfolio. Even if you yourself didn't purchase bonds, chances are high that if you're part of any retirement program, pension system, or if you own mutual funds in your portfolio, you are a likely owner of bonds. In NPR's discussion, this point is poignantly highlighted:

    "BLUMBERG: Which are the exact investors the Stabilization Fund (EFSF) now needs to make that aspirational $1 trillion materialize.

    Mr. DAS: Pension funds and other investors who buy normally highly-rated, which is triple-A rated bonds...

    BLUMBERG: So the people who are bailing out Ireland are teachers and postal workers? The people who are actually buying the triple-A...

    Mr. DAS: Absolutely, you and me."

    ~ Gauri

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