Financial Times
October 2, 2011
We are now in the stage of the crisis where people get truly desperate. The latest crazy idea, which is being pursued by officials, is to turn the eurozone’s rescue fund into an insurance company, or worse, a collateralised debt obligation, the financial instrument of choice during the credit bubble. This is the equivalent of putting explosives into a can, before kicking it down the road.
To illustrate the danger of the CDOs as a solution to the eurozone crisis, it is important to recall a few facts about what happened during the credit bubble. CDOs lured investors to put money into mortgages. The CDOs themselves had triple-A credit ratings, even though they invested in bad assets. What at first appeared to be a violation of the laws of economics, physics and logic, ultimately had a simple explanation. The overall risk of the CDO was lower than the sum of its parts. When the bubble burst, governments stepped in and prevented a catastrophe.
So why use such a toxic instrument to construct a product to save the eurozone? The current lending size of the European financial stability facility (EFSF) is €440bn, which is equal to the guarantees given by the 17 eurozone member states. If you want to leverage the CDO without increasing the liabilities of governments, then this €440bn would become the equity tranche of the new CDO. The equity holders in the CDO are supposed to be the ultimate risk-bearers. You can leverage the structure by creating more senior tranches of bonds that would be open to outside investors. You could expand the structure further through a mezzanine layer – which carries less risk than that of the equity tranche but more than that of the senior bonds. You could look at those senior tranches as eurozone bonds.
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