The Latest Plan for Resolving the European Sovereign Debt Crisis

• Reduce Greece’s debt to a sustainable level.

• • Current Greek debt holders are asked to voluntarily take a 50% write-down in the value of their bonds. There was a fear that any write-down in the value of Greek debt would constitute a default event. However, the International Swaps and Derivatives Association (ISDA) ruled that because the write-down is voluntary, it does not technically constitute a default event.

• • In exchange, the current Greek debt holders are to receive safer bonds.

• Recapitalization of Europe’s banks so that the tier 1 capital ratio is 9%.

• • Europe’s banks need to raise €106 billion in order to meet this obligation.

• • The banks have nine months to comply.

• • The €106 billion price tag may be too low as the models that derive the figure do not assume a “stressed” scenario.

• Creation of a €1 trillion firewall.

• • The firewall is intended to prevent a run on European banks if there should be a default event.

• • After bailouts of Portugal, Ireland, and Greece are factored in, the European Financial Stability Facility (EFSF) has approximately €200 billion of spare bailout capacity.

• • The €1 trillion will be raised in one of two ways, both of which leverage the EFSF by roughly 5x.

• • • Method 1: The EFSF will effectively issue credit default swaps on European sovereign debt by insuring the first 20% of losses.

• • • Method 2: The EFSF will create special purpose vehicles (SPVs) to attract private investors and/or sovereign wealth funds, such as China and Japan. The SPVs would offer to take the first 20% of losses that these investors might suffer. Effectively, this method is like a collateralized debt obligation (CDO).

• Closer monitoring of national budgets and economic policies.

• Possible changes to the European Union or eurozone charters to allow for greater economic and taxation integration.

Potential Problems

• The EFSF does not actually contain sovereign cash. Instead, its sovereign backers provide guarantees that are used to attract monies from private bond markets. Monies will only be paid out in the event of default. Yet, these defaults might actually restrict a state’s ability to fulfill its obligations under the EFSF.

• German legislators voted on 26 October 2011 that their country will not contribute more money to the EFSF.

• On the same day, German legislators also voted in opposition to the European Central Bank (ECB) purchasing the debts of European sovereigns. The funds for these purchases rely upon the ECB’s singular European power of printing money to monetize European sovereign debt. The Bundestag’s vote effectively serves as a statement of opinion.

• The funders of the EFSF have their economic fortunes intimately tied in with the fortunes of those that they are insuring. This correlation means that any sovereign debt loss event that needs to be absorbed by the EFSF mechanism simultaneously weakens the EFSF and the backers of the EFSF.

• It is uncertain how European banks will raise €106 billion in additional capital in the next nine months. Traditionally, European banks have increased their capital not through attaining deposits but by issuing their own debt or equity. Unfortunately, the market for bank capital has dried up.

Originally published on CFA Institute’s  Enterprising Investor.