The End of Sovereigns

 | Dec 06, 2011 | 2:30 PM EST  | Comments
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Global capital markets have breathed a sigh of relief with the European Central Bank's announced support of the European Union, U.S. fiscal and monetary authorities, and the International Monetary Fund. Equities are rising as capital flows away from U.S. and German government debt. Sovereign yields in Italy, France and Spain have declined precipitously, while German yields have risen. This reflects optimism by traders that Europe will avoid a wave of defaults and contagion.

All this comes despite Standard and Poor's threat of downgrades to the creditworthiness of 15 EU members, including Germany, which would also cause the bailout fund, the European Financial Stability Facility (EFSF), to be downgraded. A downgrade of the sovereigns and the EFSF would almost certainly prevent the EFSF, a key portion of the bailout, from being funded and possibly from being completed. That would indicate the crisis is moving closer.

In response, the EU has announced plans to investigate the ratings agencies.

The entire process has become surreal. In a normal environment, these actions would frighten investors and traders, resulting in a flight to safety. But that isn't happening. Traders and investors seem to have concluded two things: one, that the decision by the world's monetary and fiscal authorities to do whatever is necessary to prevent defaults and contagion in Europe is absolute, and two, that these actions are in the best interest of investors. It's bizarre.

So what actions are being considered and what are the ramifications?

The U.S. Federal Reserve and the individual European sovereign central banks have announced plans to consider lending money to the IMF that it can then lend out to at-risk countries by way of buying sovereign bonds and capping yields.

In order to be successful, the IMF will have to leverage these borrowed funds, most likely through the issuance and sale of Special Drawing Rights, or SDRs, back to its members. These new leveraged funds can then be used to buy, or threaten to buy, sovereign debt from troubled countries with war chests large enough to scare away bond vigilantes and equity vultures.

There are other ideas being proffered by policymakers, but what I haven't heard anyone consider is this: What if it fails?

The IMF is an organization whose members are countries, not central banks. IMF funding is provided via fiscal policy, not monetary policy, as part of members' fiscal budgets. This funding is not loaned to the IMF, it is given.

If the IMF borrows money from central banks, then leverages and relends the money, it obligates itself, its members, and those members' taxpayers for the amount in excess of the IMF funding agreement. In this case, the IMF would be operating in supra-sovereign capacity. In order for this to happen, the U.S., the only member with veto power, would have to allow it.

Putting aside constitutional issues, what happens if the bailout fails? The member countries receiving funds will default and the obligation to service those debts will fall on the non-defaulting members, the largest of which is the U.S.

The Fed is prohibited from directly monetizing U.S. Treasuries, meaning it can't lend money directly to the U.S. Treasury. The Fed must operate through the banks and primary dealers of U.S. Treasury debt. Further, the Fed obviously can't borrow money on behalf of the Treasury.

But this is what's being considered by mixing global monetary and fiscal funding through the IMF.

A week ago, IMF Managing Director Christine Lagarde said that the G20 would provide unlimited resources to prevent defaults in Europe, two days after U.S. President Barack Obama said U.S. taxpayers would not be obligated.

IMF members potentially needing support are Greece, Italy, Portugal, Spain, Ireland, and perhaps France. Their fiscal funding of the IMF as a percentage of total annual funding is 0.46%, 3.31%, 0.43%, 1.69%, 0.53% and 4.51%, respectively, for a total of 10.93%.

The IMF adopted rules less than three weeks ago that allow members to borrow up to 1000% of their funding quota for up to two years through the creation of The Precautionary and Liquidity Line. If the threat was not successful at convincing bond vigilantes that it could prevent defaults and the plan had to be activated, it could bankrupt the IMF while obligating member countries to pay the bill.

The prudent question for investors to ask now is why haven't investors asked what happens if the IMF's plan fails.

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