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Monday, November 28, 2011

Why the Eurozone is (was) like a CDO

Eva and I flew into Goa on Saturday morning, so I'm just coming up to speed on the state of the world. Unfortunately, the state of the world (i.e., the Eurozone as far as I am concerned) is showing no signs of coming to its senses. Merkel is still blaming the other member governments for fiscal irresponsibility (not low German wages), and thinks a last minute installation of central fiscal administration, should this even be possible, will accomplish anything except make the situation worse (that is, as long as austerity is the call to arms). The ECB is still sitting on the fence and washing its hands of the affair, as if it were the central bank of a different planet. So the expedition to Mt. Euro has gone astray and looks like the heroic tomfoolery of Scott's expedition to the South Pole.

In the meantime, after moving into our superior cottage up the hill, in among the palm trees, I had a minor satori that the Euro was the currency-zone equivalent of a CDO (collateralized debt obligation, of subprime mortgage notoriety). Why that? The Euro, like a multi-tranche CDO, combines assets of different creditworthiness into a pooled asset which, by dint of financial engineering, has a higher creditworthiness than the weighted average of its components. The Euro amalgamated different countries with varying creditworthiness, from the marginal like Greece to the gold-standard like Germany, and, despite the no-bailout-clause of the Maastricht treaty, allowed them all to enjoy near-German creditworthiness. Spreads over German Bunds began to disappear and everyone could now borrow on near-German terms. This was even better than if, like in a normal currency union, the risks of the constituent parts were simply pooled by a Federal government (like in the US), with a bonus due to the gains of diversification. Countries like Greece were now benefiting from borrowing rates well below anything they deserved as independent countries, and even better than the weighted-average creditworthiness of the entire Eurozone, had sovereign debt been entirely mutualized in Eurobonds from the beginning. A CDO, in other words, distilling triple-A status from the dross of subprime mortgages.

The reason? As far as I can see, the 'senior tranche' of the Eurozone - the AAA-rated countries like Germany, France, the Netherlands, Austria - was assumed to be ready to pluck the chestnuts out of the fire should the EZ ever get into difficulties. Thus, the 'senior tranche' bootstrapped the creditworthiness of the group through implicit CDO-like financial engineering above the average of its underlying assets. But after the 2008 world crisis, and even more, after the haircut on Greek debt, the curtain was jerked from the emperor's new clothes and, just as in the subprime mortgage crisis, the structured asset was revealed to be naked. The irony is that the creditworthiness of the EZ member countries, due to the competitiveness straightjacket of the common currency, is now lower than if they had remained independent, and plummeting fast.

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