Behind the headlines: smoke and mirrors

The headlines from last night's EU summit are positive, as are reactions in the equity and currency markets, but a careful reading of the EU summit statement gives a more sobering picture.

The 50% figure for private sector involvement (PSI) is large, involuntary, and comes with no greater guarantee of finality than did the 21% figure announced fourteen weeks ago. The structure of the bond exchange has yet to be determined, and we don't know the extent to which various parties will participate. (The presumption is that this level of PSI won't trigger CDS, but I wouldn't be surprised if this view was challenged at some point.)

We're told that credit enhancement will be provided so that Greek collateral will remain eligible for Eurosystem liquidity operations, but we don't know the form this enhancement will take.

We're told that eurozone member states "solemnly reaffirm their inflexible determination to honour fully their own individual sovereign signature." But we're given no reason to expect investors will be treated any better in the future than they're being treated in the case of Greece.

The enhancements to the EFSF "will be done without extending the guarantees underpinning the facility." No additional financial resources are being provided. They're simply spreading existing resources more thinly.

With respect to the new insurance aspect of the EFSF, leaders state, "Purchasing this risk insurance would be offered to private investors as an option when buying bonds in the primary market." This raises a host of questions. How much do they intend to charge for the insurance? How will this price be determined.? More important, why should investors expect that the EU will perform on these insurance agreements? After all, who is taking first losses in the case of Greece?

The EU hopes to cajole "private and public financial institutions and investors" to enlarge the resources of the EFSF by co-investing in special purpose vehicles. How would these vehicles be structured, and what sweeteners, if any, would be provided to entice investors to participate?

Along these lines, EFSF head, Klaus Regling, is traveling to Beijing later this week to entice additional investment, and reports suggest Sarkozy is planning to call Hu Jintao today in hopes of eliciting support. But when thinking of Chinese involvement, it's useful to note comments made by Gao Xiching, President of the China Investment Corporation at an IMF meeting on 24-Sep-11. "A lot of people blame the Chinese for saving too much money and not spending so that made it possible for the European friends and the American friends to borrow. Yeah -- that's true. So we are going to spend more. But when we spend more, we're going to pull money out of your system." These sorts of comments do little to raise hopes for significant Chinese involvement.

The EU summit statement also indicates,  "Legislative work on the Commission proposals for a Common Consolidated Corporate Tax Base and for a Financial Transaction Tax is ongoing." The issue of corporate tax is no less contentious now than it has been for the past few years, with Ireland expressing particular objections. And while the financial transactions tax may be less contentious, at least within Europe, it would be harmful to European banks and more generally to the European economy, which needs the financial system to function more efficiently rather than less efficiently.

The EU and the European Banking Authority (EBA) state the need for guarantees on bank liabilities to support the term funding of banks and, in particular, to prevent banks from deleveraging as existing term funding arrangements mature. But banks are having difficulties because of the risks of sovereign insolvency. Are we to believe that sovereign guarantees of bank liabilities are going to improve the creditworthiness of banks at this point? And of course we're told this is an issue that the Commission "should urgently explore," with no further information available.

Banks will be required to have tier 1 capital ratios of 9%, but we're told that any plan for achieving this "must ensure that banks’ plans to strengthen capital do not lead to excessive deleveraging." How are regulators going to prevent deleveraging, short of nationalization? (Speaking of nationalization, reports suggest Greece will need to nationalize a number of its banks as a result of these measures.) 

The EBA refers to the expectation that banks will withhold dividend and bonus payments, to reach these capital targets. Will every problem in Europe be met with a call to withhold bank bonuses? Is there a view that banks can reach 9% capital ratios by lowering employee compensation? In what other industry would this constitute a reasonable microeconomic analysis?

The bottom line is that the EFSF is not getting more resources, and it's existing resources will be spread more thinly, via two vague approaches involving an insurance scheme and/or special purpose vehicles. Bank shareholders are being raided while the EU demands that banks raise additional capital. And banks are expected to respond without deleveraging.

I believe the measures announced overnight in the EU summit statement do very little to help the situation and quite possibly will serve to exacerbate the crisis. The reaction in financial markets appears to be considerably more favorable, but my sense is that this response is likely to follow the previous pattern, with initial relief and optimism giving way to concern  and skepticism as the details of the announcements are analyzed in coming days and weeks.