Monday, 26 September 2011

Eurozone Debt Crisis Part Three: Has the penny cent dropped?

Following the outline of a potential solution to the debt crisis which we had been mulling, the weekend news was significantly brightened by a piece in Saturday's Telegraph suggesting that a workable looking solution may be quietly emerging from the recent G20 summit in Washington.

Encouragingly, it has all the features which we already listed as consistent with a credible solution. Namely: financial firepower, ECB coordination and a realisitic assessment of sovereign prospects.

The suggestion is that by using the European Financial Stability Fund (EFSF) as equity, the ECB would be able to raise a fund of between one and two trillion euros to be used to recapitalise those banks that are losing investors' confidence.

This type of proposal is appealing. The ECB is a strong institution with share capital which will soon total €10 bn euros. However by adding the EFSF as an equity tranche of the recapitalization fund, the ECB is well insulated from any loss. In reality the funds might not even be used - with the authorities underwriting any capital raising, private shareholders are unlikely to want to be diluted at current lowly valuations.

The other important suggestion is that the German delegation is insisting upon a managed default by Greece as a condition of the deal. Perversely this acceptance of reality should give investors confidence, provided it forms part of an orderly process.

Just to put things in perspective, if the new, geared version of the EFSF were able to deploy capital then they would appear to be able to raise capital ratios to 8.5% for a potential liability of just €130bn euros. If this were done in conjunction with a Greek debt write-down to zero (only 50% is rumoured) a further €80bn would be required. A complete default by Portugal would cost a further €30bn. The total loss on defaults would be €110bn – suffered by the EFSF with total deployed funds of €240bn. This is clearly manageable within the EFSF’s budget.

Could it be worse? Without the contingent liabilities of their banking systems Spain and Italy (the elephants in the zone) would inspire a lot more confidence from the bond markets. But the appeal of having such a large funds would be that capital ratios could be raised much higher – even if it were only the lower figure of €1 trillion.

What if there were low take-up from private investors? Well if the authorities were able to deploy up to a trillion euros in contingent convertible capital securities with interest rates of, say, 10% the income alone would almost cover the majority of Greece and Portugal’s losses.

If this proposal really exists it is positive however there is plenty of work to be done – not least to assess the impact of debt reconstruction on other institutions (pension funds, insurance companies etc). It is however an encouraging sign that the penny cent might have dropped.

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