The Corner

CD Oh No

Writing in the Financial Times, Wolfgang Munchau makes short work of the idea that financial engineering offers a way to avoid Eurogeddon. Some key extracts follow:

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….

Do not get me wrong: I am in favour of an enhanced EFSF. The current mechanism is not big enough to protect Italy and Spain, and inject fresh capital into eurozone banks. That would require a lending ceiling three of four times the current size. But we cannot get there through dirty financing tricks that have demonstrably failed in the past. If this CDO were to collapse, the eurozone might face an imminent break-up that could trigger a global financial crash.

If you accept the political and legal constraints as a given, there are no easy policy options left. There exist only two categories of solutions to the crisis: a fiscal solution or a monetary one. Politics blocks the first, European law blocks the latter. The CDO is an alluring idea from the perspective of a technocrat who has to come up with something that satisfies current political preferences and that respects perceived or actual legal constraints. On the surface, it appears as if a CDO was a third category in itself. But that is not the case because it ultimately dumps the burden on the ECB, just as the subprime mortgage CDOs became a liability for governments.

As I have argued previously, European laws and current political preference are inconsistent with the survival of the eurozone. Something will have to give. A CDO is not a solution to the crisis. It is the last confidence trick in the toolbox of the truly desperate. The eurozone is about to kick the can a final time.

Let’s hope not.

The nation-states of the Eurozone need to step in to restore the order that the broken, unfinished machinery of the common currency union has wrecked but cannot repair. As a first stage, they need to recapitalize their own banks and if that has to mean (temporary) nationalization, so be it. Based on their experience in the early 1990s, the sensible folk at the Riksbank, Sweden’s central bank, can give some pointers on how this could be done. Easy, no, pretty, no, but if plan B is a dream that a cunning CDO will set matters to rights, it certainly beats the alternative.

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