The EU gets serious about its sovereign debt crisis

Morris Segall      European banking systems, European debt restructuring, European Financial Stability Facility, European sovereign debt, European Union, Greek debt crisis

European leaders today agreed to a plan brokered by French President Sarkozy and German Chancellor Merkel to provide a second and more comprehensive “bailout” of Greece and avoid that country’s imminent debt default. The new agreement is noteworthy in that for the first time, it calls on private debt holders to be part of the solution.

In addition, the EU is not just giving Greece a new tranche of money from its European Financial Stability Facility (EFSF), it is restructuring the Greek debt by extending maturities and lowering interest rates and expanding the scope of the Facility to provide for financing stabilization for other EU countries in distress. In effect, the EFSF will fulfill the role the Federal Reserve System played in stabilizing the U.S. banking system in 2008 by becoming the lender of last resort.

We have long argued (See our blog article of July 1 and our website article of March 15), that this approach was long overdue by the European Union leadership if a continuum of sovereign debt defaults by its weaker members was to be avoided. The concession to Germany to include private debt holders in debt restructuring is a major and necessary development. These moves will avoid an imminent Greek default on its debt (although the debt restructuring will likely create a technical default of its credit terms) and will also alleviate the increasing pressure on Italian and Spanish finances for the time being.

Notwithstanding these new and bold moves by the EU, today’s agreement will need further expansion. First,  the EFSF must recapitalize the various EU banking systems for the losses incurred in the debt restructuring to keep them financially strong.  Second. the private creditors of Greek debt must all agree to the principal loss involved in the restructuring. Third, the EFSF must be greatly expanded if it is to effectively “backstop” Irish, Portuguese, Italian and Spanish debt. Third, private creditors must be convinced to go along with similar restructuring of the debt of those countries if a comprehensive solution is to be achieved. Fourth and most important, the voters of the other EU countries, whose credit is underwriting the EFSF facility, must continue to go along with this scheme. This has been the most difficult hurdle to overcome in the ongoing European debt crisis.

Until all of these factors are accomplished, we are of the opinion that substantive steps have been taken to avoid the crisis du jour in Europe for the time being. Until further and more expansive steps are taken to truly restructure more of Europe’s sovereign debt, we remain skeptical the EU has fully solved it sovereign debt issues. We will watch further developments unfold to see if the current crisis has been deferred once again or if long term solutions are truly being implemented.

Morris R. Segall