Eurozone's Credit Crisis Past Threatens to Haunt its Debt-Laden Future

A common definition of insanity is doing the same thing over and over again and expecting a different result.

Say what you will about the global financial crisis - now in its fourth year after having morphed from the credit markets to the world of government debt - but at the very least it offers up some rather delicious irony.

Europe, in an effort to rescue itself from the evil grip of "speculators", is opting for the same kind of complicated financial tactics that most of its elite felt were a large part of the current crisis in the first place: debt and leverage.

When did that ever cause any problems?

Germany's Der Spiegel got the ball re-rolling over the weekend with a report suggesting EU honchos were looking at ways in which they could amplify the lending capacity of the region's freshly-minted bailout fund, the European Stability Mechanism; at the moment it's capped at €500bn but officials would like to add "leverage" and up that capacity to around €2tn.

How does that work, you might ask?

Well, in some respects it rather easy to explain - you simply use "other people's money" - but there's a bit more to it than that.

Europe's essentially setting up the kind of complex derivative that it says helped torpedo the credit markets in 2007: a collateralized debt obligation, or CDO.

A CDO is exceedingly simple in construct. It's essentially a box into which a host of assets are poured. Collectively the sum strength of the CDO should exceed that of its parts. If it does, the CDO can then borrow from the outside world at low, competitive interest rates, using the assets inside as collateral.

That's what CDOs did: they stuffed mortgage bonds of all persuasions into a single box, secured a Triple-A credit rating on the dim theory that stronger home borrowers would easily offset the weaker ones and sold bonds based on that basis.

The ESM is no different: assets are poured in from the 17 Eurozone members whose debt ratings range from Triple-A (Germany, Finland and Austria) to Triple-B (Spain and Ireland) to junk (Portugal, Greece and Cyprus).

Collectively, the €80bn of "paid-in" capital alongside the various "capital subscriptions" based on GDP (Germany's will be the largest at €190bn, Malta's the lowest at €511m) will give the ESM its €500bn in firepower and, it is hoped, a Triple-A credit rating when it's fully operational on 8 October.

Now ... here's where it gets interesting.

By using a few simple techniques, Der Spigel says, the ESM can amp that €500bn by a factor of four. Firstly, the ESM could sell Triple-A bonds into the open market, raising hard cash.

It could take that cash and buy government debt (for example cheap Spanish government bonds). It could then (with a banking license) "repo" those bonds onto the European Central Bank (i.e. use them as collateral to borrow cheap money).

Presto! The ESM "lends" to Spain at 5.5 percent (its 10-year bond yield) and "borrows" from the ECB at 0.75 percent. The healthy "spread" would theoretically allow the ECB to repeat this process several times over, increasing the hard cash lending base quickly as a result. Maybe even as high as €2tn when other, more complicated techniques are added-in, including investments from private and sovereign wealth funds.

Astute readers will just as quickly latch onto the inherent fallacy this sort of leverage creates: the ESM is effectively "kiting" money from Spain *back* to Spain via the ECB in a shell game that simply keeps debts off the balances sheets of both and onto opaque ECB.

Impossible you say?

Nope - It's happening already.

The ESM's little brother, the soon-to-be departed European Financial Stability Facility (EFSF) has already issued around €131bn in bonds under similar 'sum-of-the-parts' circumstances, the majority (65 percent, according to a PIMCO research note) of which are effectively parked at the ECB. The EFSF bonds were sold to Spain and Greece for IOUs. Spain and Greece gave the EFSF bonds to their banks, which then used them as collateral to borrow money from the ECB.

A German Finance Ministry spokesperson dismissed the idea of €2tn in lending capacity as "illusory" but conceded leveraging the €500bn cap was a possibility.

It'll need to be.

As PIMCO notes, Spain and Italy will tap the markets for €300bn in new bonds this year alone, and the Southern Eurozone members has averaged at least €95bn in net new borrowing every year since 1989. Under that kind of arithmetic, €500bn won't last long - and getting new capital from Germany just got next to impossible thanks to the Constitutional Court's ruling in Karlsruhe earlier this month that capped Germany's commitment.

So now we have the two problems.

Firstly, the ESM is really only shifting cash around the various European institutions as opposed to generating new money. Secondly, more than a one third of its capital base comes from countries which have either already been rescued or are most likely to apply for formal assistance.

In other words, Spain and Italy are paying nearly 28 percent of the funds that will be used to rescue each other. With broke Greece and bailed out Portugal, Ireland and Cyprus kicking in another 8 percent.

And at the end of this complicated shell game, it's still unlikely to be big enough to fulfil its remit (especially now that ECB President Mario Draghi promised to use it to buy an unlimited amount of bonds via his Outright Monetary Transactions programme).

And none of this, of course, will persuade indebted governments to push through the economic and social reforms needed to avoid another financial meltdown. In fact, the Ponzi-like nature of the ESM will likely create the kind of moral hazard that will have the opposite effect.

Which takes us back to pre-crisis 2007, when money was created through layers of complicated, over-rated debt products that created no real assets but instead the delusion of wealth which made us feel richer than we really were.

What could possibly go wrong?