While equity markets have sailed blithely on this autumn so far, indicators of sovereign credit risk are flashing red.
The Markit iTraxx SovX Western Europe index, an unweighted average of the credit default swap spreads of 15 Western European governments, yesterday moved to a new high since its launch in September last year.
The index has risen 40 basis points in a month, while yesterday CDS spreads for Ireland, Portugal and Spain all hit record highs.
Ireland’s ten-year interest costs for bond market funding now exceed 9%. Strangely enough, as Professor Morgan Kelly of University College, Dublin, pointed out in a widely read Irish Times article earlier this week, Irish banks are still offering mortgages to their own customers at around 5% interest rates, even if their own borrowing costs are now approaching double figures (assuming that they have to seek finance at a "sovereign-plus" credit spread). That’s not a sustainable business model, to put it mildly.
Kelly forecasts a second leg of the financial crisis in Ireland, this time involving mass mortgage defaults, since he expects home loan rates to increase, while many homeowners' mortgages are now much larger than the value of their properties.
But will the European sovereign debt crisis stay confined to the periphery? Europe’s Financial Stability Fund, the EFSF, which was set up in May to provide a funding backstop to member countries in difficulty, may in fact have increased overall systemic risk. As Satyajit Das wrote in September, before the latest phase of deterioration:
“Ironically, the actual structure of the EFSF (it’s set up like a CDO, with so-called ‘credit enhancement’ built into the structure – IU.eu comment) encourages troubled countries to access the facility early to ensure its availability. The structure embodies an accelerating ‘negative feedback loop’. As market conditions deteriorate, market access becomes limited and countries draw on the EFSF facility (eliminating them from the guarantee pool), increased financial pressure will be exerted on the AAA-rated Eurozone countries. The need to maintain adequate coverage to preserve the EFSF’s AAA rating on existing debt will mean that the buffer will increase and the capacity of the EFSF to lend may become impaired.”
The buffer is funded by those issuance receipts from the EFSF's own AAA-rated bond issues that are not lent on to those sovereigns seeking help. In other words, the more countries seeking help, the greater the buffer and the quicker the EFSF runs into self-imposed lending limits. And so, by implication, if you're going to seek financial assistance, get there first.
Putting this in layman’s terms, imagine a shipwreck in which 15 survivors have been cast into a stormy sea. Some (Germany, France, the Netherlands) are strong swimmers, others (Ireland, Portugal, Greece, Spain, Italy) are barely able to keep their heads above water. Someone (the EFSF) comes along and decides that, for the sake of the weaker swimmers, the best solution is to tie all fifteen together by one arm and one leg. The buffer then functions as a kind of additional lead weight on the ankles of surviving swimmers once one or two of the weaker start to lose strength.
Does this structure increase or decrease the chances of the whole group drowning?