It is time to prepare for the unthinkable: there is now a significant probability the euro will not survive in its current form. This is not because I am predicting the failure by European leaders to agree a deal. In fact, I believe they will. My concern is not about failure to agree, but the consequences of an agreement. I am writing this column before the results of Sunday’s European summit were known. It appeared that a final agreement would not be reached until Wednesday. Under consideration has been a leveraged European financial stability facility, perhaps accompanied by new instruments from the International Monetary Fund.
A leveraged EFSF is attractive to politicians for the same reason that subprime mortgages once appeared attractive to borrowers. Leverage can have different economic functions, but in these cases it simply disguises a lack of money. The idea is to turn the EFSF into a monoline insurer for sovereign bonds. It is worth recalling that the role of those monolines during the bubble was to insure toxic credit products. They ended up as a crisis amplifier.
Technically, the EFSF monoline insurer would provide a first-loss tranche insurance for government bonds up to an agreed percentage. It sounds like a neat idea, until the recipients of the insurance realise their sovereign bonds have turned into hard-to-value structured products. One of the factors that will make them hard to value is the incalculable probability that France might lose its triple A rating. In that case, the EFSF would automatically lose its own triple A rating – which is derived from that of its guarantors. The EFSF’s yields would then rise, and the value of the insurance would be greatly reduced. The construction could ultimately collapse.