James’s Musings

thoughts, photography, and geeky stuff
from an unrelentingly curious Silicon Valley entrepreneur

Germany is the new AIG (and what Justin Bieber has to do with it)

by James G. Beldock on December 5, 2010

I’ve got a great new in­vest­ment for you. You’ll love it. We’re go­ing to bundle up a bunch of bad debt from BBB- bor­row­ers who ba­si­cal­ly can’t bor­row an­oth­er cent, mix it up with some in­sur­ance guar­an­tees, and then present it to Standard & Poor’s and Moody’s. The rat­ing agen­cies will give the bonds a AAA rat­ing. We’re go­ing to do a tril­lion dol­lars of this, and the in­sur­ers will be per­fect­ly fine in­sur­ing all this. It’s a no-brain­er in­vest­ment. How much will you give me?

If this sounds like I’m talk­ing about 2008, CDO syn­di­ca­tion of sub-prime debt, and AIG and oth­ers of­fer­ing Credit Default Swaps, or CDSs, as de­rivates used to hedge again­st CDO loss­es1, you have a good mem­o­ry, but I’m not. I’m ac­tu­al­ly talk­ing about the new European Bailout Fund which was much-hyped to­wards the end of last week. 2 Maybe the EU fi­nance min­is­ters missed the whole 2008 cri­sis, but even if they did, it’s hard to be­lieve they ex­pect the rest of us to buy their bonds based on the ex­act same false premis­es.  Fool me on­ce, shame on you; fool me twice—oh, nev­er mind. Here’s the prob­lem:

The Irish gov­ern­ment needs a bailout. They can’t bor­row at any­thing but a junk bond rate. So the EU an­nounces to much fan­fare that the big Trillion Dollar Bailout fund will come to the res­cue. But wait, it’s not a fund. It’s a “fa­cil­i­ty,” and it doesn’t cur­rent­ly have a sin­gle cent in it. 3 Instead, it’s a fa­cil­i­ty that will is­sue bonds it­self to oth­er in­vestors. So the Irish debt has a lousy rat­ing, but mag­i­cal­ly the bonds the Bailout fa­cil­i­ty is­sues turn in­to AAA se­cu­ri­ties. How? Because the re­main­ing EU mem­ber states (those not re­cip­i­ent of bailout funds) put their “full faith and cred­it” be­hind the fa­cil­i­ty and guar­an­tee it. Heard that one be­fore? Yes, that’s the phrase every­one thought ap­plied to the US government’s sup­port Fanny and Freddie, but didn’t (and that worked out well, didn’t it?), but it’s al­so di­rect­ly anal­o­gous to the com­mit­ment AIG made in the form of its CDSs be­fore the melt­down. AIG pro­vid­ed de­riv­a­tives worth tril­lions of dol­lars of CDOs with­out much re­gard to whether, if those bundles of CDOs even­tu­al­ly de­fault­ed at high­er rates than pro­ject­ed, they would have the cap­i­tal to post as the col­lat­er­al re­quired to sup­port those CDS poli­cies4

Here’s why this European fa­cil­i­ty looks just like the CDS cri­sis: the guar­an­tee­ing coun­tries guar­an­tee the debts of the bailed out coun­tries. But some of those guar­an­tee­ing coun­tries (Spain, Portugal, Italy, etc.) are al­ready tee­ter­ing on the brink. Which means they may de­fault. And need bailouts them­selves, guar­an­teed by the re­main­ing coun­tries. The col­lat­er­al re­quire­ment bal­loons far big­ger than the orig­i­nal Irish cri­sis: now it in­cludes fail­ures in Spain and Italy and Portugual as de­rivate prob­lems of the core cri­sis. Just as AIG’s de­riv­a­tives poli­cies forced AIG to post col­lat­er­al far greater than the un­der­ly­ing CDOs. So who ends up hold­ing the bag? AIG—I mean Germany. For ex­act­ly how long do you think the Germans will guar­an­tee the debts of the mis­man­aged Mediterranean (and Irish) economies? This isn’t just coun­ter­par­ty risk, it’s po­lit­i­cal risk. The fu­ture of the EU it­self hangs in the bal­ance. If the Germans pull out, pre­cise­ly who would guar­an­tee the­se debts?

Like any oth­er na­tive New Yorker, the the­ater-go­ing part of me used to dread the an­nounce­ment that was oc­ca­sion­al­ly heard just as the house lights went down: “In this evening’s per­for­mance, the role of King Lear, nor­mal­ly played by Sir Anthony Hopkins, will be played by Justin Bieber.” Everybody in the au­di­ence groans. A few leave. I’m hav­ing that same re­ac­tion to today’s per­for­mance of the European Bailout Fund. “In today’s per­for­mance, the role of the Guarantor usu­al­ly played by AIG will be played by Germany.” We all groan. You can see the bond fund man­agers leav­ing for the doors al­ready. Oh, look, there goes Alliance Bernstein. And there goes CALPERS. I won­der whether PIMCO will stay for the sec­ond act….

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  1. There was al­so straight out in­sur­ance again­st CDO loss­es, of­fered by such firms as FSA; for more de­tails, read Michael Lewis’s ex­cel­lent The Big Short: Inside the Doomsday Machine []
  2. The fa­cil­i­ty has ac­tu­al­ly ex­ist­ed since May of this year; last week’s an­nounce­ment marks the first de­ploy­ment of the fa­cil­i­ty. It be­comes a per­ma­nent fea­ture of the EU in 2013—if the EU makes it that long! []
  3. For a some great back­ground in­for­ma­tion on the European Bailout fa­cil­i­ty, lis­ten to Friday’s NPR Planet Money pod­cast. I can’t rec­om­mend Planet Money enough. []
  4. The prob­lem for AIG was not pay­ing out on the­se in­sur­ance poli­cies, since that was the job of FSA and MBIA. Instead, it was the huge­ly in­flat­ed re­quire­ments of AIG to post col­lat­er­al as a re­quire­ment of the CDS agree­ments which it­self was too much for AIG to han­dle. []

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