European Financial Stability Facility

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EFSF is designed like a CDO

"... Europe is following a similar path. The EFSF, created to assist countries facing “illiquidity,” is designed exactly like a CDO. The EFSF buys the bonds of the countries which find it difficult to finance themselves in the marketplace (for example, Ireland) and issues bonds that are AAA rated. How is this alchemy possible? Once again, it relies on overcollateralization, an assumption on the joint distribution of possible outcomes, and the inevitable seal of approval of the three major credit rating agencies.

With the EFSF, the overcollateralization takes the form of guarantees by other eurozone countries. Among the major countries, however, only France and Germany have an AAA rating. How can a bond guaranteed in large part by countries such as Italy and Spain (likely candidates for a fiscal crisis) provide AAA status to Irish bonds? According to Standard and Poor’s, for example, “The rating on EFSF reflects our view that guarantees by ‘AAA’ rated sovereigns and freely available liquidity reserves invested in ‘AAA’ securities will, between them, cover all of EFSF’s liabilities.”

But the value of the guarantees depends on the situation. As long as the only country to be rescued is Ireland, there is no problem. But if the EFSF has to guarantee Spain, would Germany really be willing to step in and use its taxpayers’ money to cover Spanish banks’ losses? And how compromised might French and German banks become – and thus how much more fiscal strain is in store for France and Germany?

Here, too, no mathematical formula can help, because what we need to test is the reasonableness of our assumptions. This is why rating agencies’ opinions are so valuable. Unfortunately, one must wonder to what extent these ratings are distorted by the eurozone countries’ political power.

Since the crisis, rating agencies have been under attack, and major regulation, which could severely affect their business, has been discussed on both sides of the Atlantic. Given this, how free are credit rating agencies to express their opinion on the very institutions that will regulate them? We will have to await the pricing of the credit-default swaps on EFSF debt, which will be issued in January, to see whether markets believe the ratings..."


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