Leverage to the Rescue!

Location Date: 
September 28, 2011

As Yogi Berra aptly put it, “It’s like déjà-vu, all over again.”  ‘If leverage got us into this problem, then more leverage will get us out of it,’ seems to be the logic of U.S. Treasury Secretary Tim Geitner and others with ‘iBank’ experience.

The latest idea to save Europe is to take the properly sanctioned EFSF asset base of roughly €440 BN and leverage it to over  €2 TN to effectively recapitalize European banks and bailout the entire Garlic Belt plus Ireland.  While I studied finance at university, I did not stick around to get a Ph.D., but perhaps I should have when it comes to how this would actually be “effected.”  One version involves the European Investment Bank (“EIB”) - when you need a lot of leverage and a lot of really smart people to do it, who better to call than the structured products dudes at an ‘iBank’?  Unfortunately, this effort is doomed because the 4 biggest backers are Germany, France, Italy and the UK.  The Italians, I suppose, might go for a CDO squared punt, but the UK would certainly not put its AAA rating on the line for this project.  So forget the EIB idea. 

A terrific blog post by Macro Man, has put forward another version of the same idea as shown in this complicated chart below:


He goes on to state:

“The trouble is, that the Bundeathstar really don't want to do this, and the Panzer tanks are firmly blocking the ECB lending to such an SPV. But, as mentioned yesterday, TMM get the impression that the Germans have overplayed their hand (for example, they don't have any friends at the G20), and unless they really are about to leave Europe, they are going to be forced to accept some such plan. The key thing with the above is that it maintains the cloak of complexity for the public, while showing markets where the money comes from, thus avoiding the need to put the plan to electorates”  (emphasis is mine). 

While it is clearly possible to “fool some of the people all of the time”, it is unlikely that you can fool all of the Germans.  Their outspoken Finance Minister Schauble (all FMs are outspoken these days!), branded any such idea as “silly.”  In reality, it’s very likely that the situation will become ever more volatile going forward.  And the solutions ever more “creative.”

As State Street’s Lee Ferridge points out, markets and investors are suffering from “pessimism fatigue” and so any positive news on Europe would trigger a big rally in risk assets like we have seen over this week.  I agree with him in that this is a nice lift to prune your portfolio and generally further reduce risk.

Jim McGovern