It actually resembles the U.S. bank bailout, but it may not work out as well
After a brutal week, the U.S. markets had a pretty decent Monday, with the Dow and S&P 500 indices up more than 2%. This activity came despite a couple of weak U.S. economic reports, including a decline in new home sales. While we hate to rely on media reports for what's pushed the market up or down, many reasonably state that news of a new euro zone deal might have been responsible. Will the apparent new proposal actually help?
I say "apparent" new proposal, because reports indicate that officials in Europe are still discussing the approach. So what we've got so far is not final. But it's still worth discussing, since it does represent a new way to potentially solve the region's problems. So this explanation is based on reports out there, not a finalized plan released by European officials.
The European Investment Bank, owned by the European Union, will create a special purpose vehicle ("SPV"). It will put some cash into that SPV from its European Financial Stability Facility ("EFSF"). The SPV would also get funding by selling bonds to investors. With those cash proceeds, it will buy the sovereign debt of troubled nations (think: Greece). Those bonds the SPV issues can also be used by banks as collateral to borrow from the European Central Bank ("ECB"). Those banks may be having issues due to their euro zone sovereign debt holdings.
Got it? Basically, euro zone officials would create a toxic sovereign debt fund. Banks would effectively trade their toxic sovereign debt for ECB loans, with an SPV acting as the middleman.
Oh, and leverage will somehow be involved, probably so that more loans can be provided to banks. That means that losses will be magnified.
Does this sound familiar? It's similar to how the U.S. intended to first bail out its banks. It sought to acquire toxic mortgage securities. By providing money to banks for those securities, the banks would be rid of the risk that was scaring off investors. And the government could better stomach that risk because they could hold the securities to maturity.
Of course, that's not what happened. Instead, the government ended up just throwing wads of cash at banks, because the logistics of the original plan turned out to be unworkable.
But Here's the Problem
But the euro zone's plan is different in another important way: its SPV wouldn't be purchasing toxic mortgage-backed securities. Instead, it would purchase toxic sovereign debt. This is a big difference because those mortgage-backed securities were thought to be significantly undervalued by the market due to uncertainty. In the case of toxic sovereign debt, significant structural problems are threatening nations near default.
During the U.S. financial crisis, banks had a liquidity problem: losses weren't going to overwhelm their assets, but they couldn't roll over their debt due to uncertainty. But at least a few of the troubled nations in Europe appear to have a true solvency problem: their losses will overwhelm their assets. It's not a simple short-term funding issue.
The U.S. version of TARP could have worked, because the government would be willing to take, maybe, tens of billions in losses if it meant restoring confidence. But in the case of Europe, those losses are likely to be more significant. Unlike the U.S. banks, those sovereign nations might not be able to pay back the SPV. If those economies have significant structural issues, then short-term certainty can't fix the long-term problem.
So I'm skeptical. This sounds like more smoke and mirrors. It may amount to a complicated way for the ECB to bail out the troubled nations. Ultimately through this plan, it looks like someone will have to pay once the SPV experiences losses. Presumably the same nations would have to pay as would if a more straightforward bailout was provided. So what's the point? Let's hope European officials come to explain some subtly that the above analysis misses that makes this plan a significant step forward, instead of a shuffle sideways.
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