Oct 21 2011

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EU Fiddles While Athens Burns

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…Couldn’t Put Europe Together Again

So, having given themselves six days to sort out the Continent’s debt problems, what was the latest announcement from the EU?

That they need three extra days.

This is neither surprising nor encouraging for the realists among us.

Along with that timing announcement, came scraps of news of what EU leaders are actually planning to unveil.

This news is neither surprising nor encouraging.

According to reports, the EU has agreed to use the recently expanded $550 billion European Financial Stability Fund (EFSF) to provide a “first-loss” guarantee of up to 20 precent on new sovereign debt issued by “at-risk” countries in the EU.

In practice, as these “at-risk” countries seek additional debt funding, they will also “purchase” the guaranteed funds from the EFSF, that are intended to make the risky government debt more attractive to investors, and at least in theory, keep premiums on those new bonds at reasonable levels.

The result would buy “at-risk” countries more time to tackle their spending challenges and, with stability, return to growth that would enhance government balance sheets.

But the plan is self defeating and  insufficient.

Consider, are rational investors going to provide the equivalent of a AAA interest rate on a bond issue for an “at risk” country, where, upon default, only 20 percent of the debt is assured of repayment?

Worse, the European governments have yet to agree whether private investors or the EFSF governments are first in line for repayment.  Incredibly, the new EFSF initiative could, be designed solely to pay back the government fund, undermining the entire purpose of the new initiative, which is to attract competitive, private market financing.

In addition, by making “at-risk” countries  purchase the insurance, the EU is adding to the unstable debt load these countries are already carrying, compounding the debt problem.

According to the Wall Street Journal, Italy and Spain, two “at-risk” EU countries, will need to borrow $1.24 trillion by mid 2013 to keep their governments operating. If the new EFSF plan is implemented, these countries will need to borrow an additional $240 billion, in the form of EFSF insurance, just to assure the hope of reasonable interest rates.

But the true failure of this initiative is that it is insufficient in size.

EU financial analysts have concluded that it would take a staggering $2.7 trillion to provide the reassurance necessary for bond investors regarding new issues of sovereign debt by “at risk” countries – almost four times the size of the existing EFSF.

And though there is little if any political support for such a massive expansion of the EFSF, the size of the backstop required exposes yet another, core structural problem with any approach for EU debt relief.

Any additional funding of an expanded EFSF – political considerations aside – would fall heavily on France and Germany, the two largest countries.

In the case of France, any additional financial burden to support the EFSF could threaten the country’s AAA bond rating – already under pressure from rating agencies – and thus exposing France to the contagion that has consumed Greece and threatening the PIIGS.

The simple fact remains that nothing short of a comprehensive guarantee (a la TARP) can prevent additional financial unraveling in Europe. And there is not enough money in Europe to provide that guarantee.

All the rest of the activity is static, as we will all soon see.

Despite the grim forbodings, as of this writing, the DOW has soared over 200 points on flat US earnings news and promises of EU miracles.

Denial isn’t a good strategy either, as we will soon see.

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