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 policies. 4
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….
- 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 [↩]
- 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! [↩]
- 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. [↩]
- 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. [↩]