Can the European Union avoid a financial market meltdown? (Part 3)

For the past cou­ple of weeks we have exam­ined the crit­i­cal issues fac­ing some mem­bers of the EU. The need to prop­erly address the unfold­ing cri­sis can­not be over­stated, with a fail­ure to calm devel­op­ing mar­ket fears poten­tially impact­ing every other major econ­omy around the world, includ­ing the United States.

While final deci­sions regard­ing the mech­a­nisms to be used to fore­stall the impend­ing default of Greece (were no addi­tional aid to be pro­vided), the poten­tial insol­vency of EU banks, and the “tapped out” nature of the EFSF remain extremely murky, the few details that have emerged could sug­gest a num­ber of prob­lems as time pro­gresses. At least a few under­ly­ing (and poten­tially unre­solved) issues seem rea­son­ably clear at this point.

First, should the EU decide to increase the finan­cial fire­power of the Euro­pean Finan­cial Sta­bil­ity Facil­ity (EFSF) through a lever­ag­ing effort, the 10-to-25 per­cent loss guar­an­tee becomes extremely prob­lem­atic in both design and imple­men­ta­tion. Regard­ing the design, is this loss guar­an­tee for all pur­chases of the debt instru­ments in both pri­mary and sec­ondary (resale) mar­kets? If it applies to only orig­i­nal (pri­mary) pur­chasers, would this limit sec­ondary mar­ket activ­ity as time pro­gresses, and thereby reduce demand and price (and thereby caus­ing the loss guar­an­tee to “per­form” if the pur­chaser wishes to sell the sov­er­eign debt instrument)?

In terms of the imple­men­ta­tion of the loss guar­an­tee, would there be some time limit placed upon the buyer’s abil­ity to uti­lize the loss pro­vi­sion. Does it only apply to those who hold the sov­er­eign debt instru­ments to matu­rity? If so, wouldn’t this pro­duce an investor mind­set to avoid long-term debt instru­ments in favor of short term instru­ments? In the case of the long-term instru­ments, would a pro­vi­sion to pro­vide loss cov­er­age only at matu­rity cause a drop in demand for long-term instru­ments, with result­ing higher long-term inter­est rates? And can coun­tries such as Greece, Spain, Italy, Por­tu­gal, and Ire­land afford the higher inter­est rates that would come with such a pol­icy imple­men­ta­tion? And if it applies to all matu­ri­ties at all times, might this not cause spec­u­la­tion in the mar­ket for such secu­ri­ties, pro­duce wild price (and inter­est rate) gyra­tions, which might then allow the loss guar­an­tee pro­vi­sion to bleed the EFSF of its funds?

And what hap­pens if the losses far exceed the abil­ity of the EFSF to repay its oblig­a­tions to pro­vide a 10-to-25 per­cent loss guar­an­tee? Such a sce­nario is not all that improb­a­ble, par­tic­u­lar given the 50 per­cent “vol­un­tary” reduc­tion finan­cial insti­tu­tions are now being asked to absorb to keep Greece from default­ing on its oblig­a­tions. What hap­pens if future investors in pri­mary or sec­ondary mar­kets ignore the call for more “vol­un­tary” reductions?

Other issues in the bailout effort of Greece (or any other coun­try receiv­ing some sort of aid via the EFSF efforts) involve “asym­met­ric infor­ma­tion” issues. One pos­si­bil­ity is the emer­gence of a “moral haz­ard” on the part of gov­ern­ments receiv­ing assis­tance, that is, once aid is pro­vided (in what­ever form), gov­ern­ments change their behav­ior and become less dili­gent in solv­ing their under­ly­ing finan­cial imbal­ances, under the belief that should prob­lems develop in the future, another bailout will result.

A sec­ond prob­lem might ensue in the form of an “adverse selec­tion” of par­ties inter­ested in pur­chas­ing the sov­er­eign debt instru­ments of nations with finan­cial dif­fi­cul­ties. Since a loss guar­an­tee would be pro­vided by the EFSF, those pur­chas­ing the sov­er­eign debt instru­ments (or even those help­ing to recap­i­tal­ize EU banks) may include investors with lit­tle expe­ri­ence in eval­u­at­ing the risks involved in such mar­ket trans­ac­tions. Should this occur, the ini­tial inter­est rates asso­ci­ated with the sov­er­eign debt instru­ments of Greece, Italy, and the like might be held down, and cause (over time) a greater oppor­tu­nity for losses as inter­est rates rise to more appro­pri­ate lev­els. This might then deplete funds from the EFSF and endan­ger the entire stabilization/bailout effort.

Of course, I could be exag­ger­at­ing these (and other) poten­tial prob­lems with the EU bailout. Should this hap­pen to be true — with final deci­sions regard­ing the imple­men­ta­tion of the EFSF prov­ing effec­tive — a great deal of time will likely be required for plan­ning and imple­men­ta­tion of EFSF actions. In the mean­time, finan­cial mar­kets will undoubt­edly remain highly agi­tated as mar­kets attempt to antic­i­pate out­comes. This uncer­tainty could pro­duce wild swings in U.S. (and world­wide) stock mar­kets and keep many investors on the side­lines via U.S. Trea­sury (and Ger­man sov­er­eign debt) securities.

Dr. James New­ton serves as Chief Eco­nomic Advi­sor to Com­merce National Bank and is an aux­il­iary fac­ulty mem­ber in eco­nom­ics and sta­tis­tics at OSU-Marion and OSU-Newark. Dr. Newton’s views do not nec­es­sar­ily reflect those of Com­merce National Bank or OSU-Marion/Newark.

Posted by Jim Newton on Nov 15 2011. You can follow any responses to this entry through the RSS Feed. Comments can be made below.