Sunday, 7 December 2014

Juncker's CDO

The new President of the European Commission has recently unveiled his second attempt at increasing European investment without raising public debt levels. His first attempt, which envisaged leveraging the ESM, was shot down by the Germans. This version leverages both the EIB and the EU's own budget. By committing 16bn EUR from the EU's budget and 5bn from the EIB, Juncker reckons that upwards of 315bn of new investment could flow into EU-wide projects, increasing jobs and improving infrastructure. It sounds wonderful, doesn't it?

But how would it work, exactly? Here is an explanation from the European Commission's factsheet:
The role of the Fund is to mobilise extra private finance in specific sectors and areas. The Fund is estimated to reach a multiplier effect of 1:15 in real investment in the economy. This is the result of the Fund's initial risk bearing capacity and is an estimated average calculated as follows: For every initial one euro of protection by the Fund, three euro of financing could be provided to a certain project in the form of subordinated debt. Given that this creates a safety buffer in that particular project, private investors can be expected to invest in the senior tranches of that same project. EIB and European Commission experience indicates that 1 euro of subordinated debt catalyses 5 euro in total investment: €1 in subordinated debt and on top of that 4 euro in senior debt. This means that €1 of protection by the fund generates €15 of private investment in the real economy, that would not have happened otherwise. This 1:15 multiplier effect is a prudent average, based on historical experience from EU programmes and the EIB.
I've drawn this up as a leveraged structure:

Note that the actual investment would be Mezzanine + Senior Debt, i.e. EIB subordinated lending plus private sector investment. The Equity portion is described in the factsheet as "protection". There is no actual money involved. It consists of public guarantees, not real money. In effect, the EU and EIB combined are providing insurance to private sector investors - accepting "first losses" of up to 21bn Euros. The EU's portion would guarantee the first 16bn Euros of longer-term infrastructure investment: the EIB would guarantee the first 5bn of capital investment in SMEs.

In fact, let us be completely clear. NONE of this money exists. Not a single Euro of it. This is a synthetic structure based entirely upon insurance, not actual funds.

The key to this is in the footnote of this diagram:

The EU's guarantee of 16bn Euros is only backed 50% by actual funds. If losses exceed 8bn Euros, the EU will have to find new money from somewhere. But worse than that, every euro of the 8bn actually backing this guarantee is already committed to other initiatives. 3.3bn Euros comes from Connecting Europe Facility (which is developing pan-European digital technology and broadband), 2.7bn Euros comes from Horizon 2020 (the EC's framework programme for research & innovation) and the remaining 2bn Euros directly from the existing EU budget. The EU is providing no new money to this initiative whatsoever, apart from the leveraged lending it expects the EIB to provide. All it is doing is placing both its existing investment programmes and the future budgets of member states at risk in the hopes of encouraging increased private sector investment in European projects.

The risk mitigation for the EU lies in the "second pillar" of Juncker's proposal. There would be a new facility in which EU bureaucrats would pick projects for presentation to the private sector as investment opportunities and provide "technical assistance" to investors to help them choose which projects to adopt. According to the EC's press release, projects would be recommended by Member States according to the following criteria:
  • EU value-added projects in support of EU objectives
  • Economic viability and value – prioritising projects with high socio-economic returns
  • Projects that can start at latest within the next three years, i.e. a reasonable expectation for capital expenditure in the 2015-17 period.
Why on earth would the private sector want to invest in projects chosen according to these criteria? Since when have either high socio-economic returns or EU objectives been of interest to private investors? What attracts private investors is returns on their investment - but there is no mention of the need to generate real financial returns. Reducing private sector risk is not enough to encourage investment. After all, investors who don't want risk can buy German bunds.

And it gets worse. These are the sorts of project that the new proposal wishes to encourage:
The new Fund will support strategic investments in infrastructure, notably broadband and energy networks, transport in industrial centres, as well as education, R&D, renewable energy and energy efficiency.
Looks good, yes? But as I noted above, the EU already has initiatives addressing broadband networks and research &innovation, which it is proposing to rob in order to provide guarantees for this new scheme. And that's not all.

It already has numerous energy initiatives - indeed one criticism that could reasonably be levelled at the EU is that it has lots of initiatives but no coherent energy policy. Unless the new funding would go to the existing initiatives, which seems unlikely, this is simply going to create confusion and duplication - as well as creating a golden opportunity for bureaucrats both in member states and in the EU itself to promote their pet projects. Transport in industrial centres looks like a good investment - but if it is so inadequate at the moment, why do private sector investors need public guarantees to encourage them to invest? After all, we assume, the principal beneficiaries of transport in industrial centres are industries. And as for education, it is notoriously difficult to demonstrate tangible benefits from educational programmes. If the programmes directly benefit industries, in that they provide workers with the skills those industries need, surely it would be reasonable to expect the private sector to accept the risk of investment? And if the programmes don't directly benefit industry, why would the private sector invest at all, even with public sector guarantees?

In short, there is a huge amount of muddled thinking going on in this proposal.

On the face of it, the EIB's involvement seems more sensible. Channelling investment funds to SMEs is clearly a good idea, given the paucity of bank lending in much of the Eurozone at the moment. But hang on a minute. Isn't this what the EIB already does? This is what its website says:
Smaller businesses face particular difficulties in accessing finance, particularly since the crisis. Our support has increased substantially since 2008, boosting our already significant long-term commitment. Countries particularly badly affected have received additional assistance. Our support has added impact by encouraging other private banks to on-lend and pass on advantages to businesses.
And these are the forms the EIB's existing support takes:
All types of investment by smaller businesses are eligible for favourable EIB loans. Support is channelled through our partner network.
Innovative financing options
We use a range of financial techniques to increase the impact of funding from the EIB, the European Commission and others.
Research, development and innovation support
We help with access to debt financing for research, development and innovation projects.
Capital injection & development advice
We invest in venture capital or private equity funds which then help growth.
Microfinance in the EU
Micro-businesses in the EU receive financial and technical assistance from our microfinance programme.
Energy efficiency investment
Green Initiative: energy efficiency for SMEs in new Member States and pre-accession countries. Funded by EIB loans and European Commission grants.
So the 5bn Euros of capital from the EIB isn't quite what it seems, either. It's simply capital the EIB already uses as backing for SME lending. 

In fact the new fund is to be a trust fund within the EIB. But the EIB is getting no new capital to support it, just a bunch of EU guarantees partially backed by money already committed to other things, and it is expected to divert part of its existing capital to support the new fund - which will of course reduce its current lending capability. On the basis of this faux capital, it is supposed to provide 63bn Euros of new subordinated debt. So this, too, is not quite what it seems: it is partly a diversion of lending from the EIB's existing SME support facilities.

Juncker's scheme is a highly-leveraged, complex funding structure reminiscent of a synthetic CDO. And just like the synthetic CDOs that contributed to the financial crisis, it is a clever piece of smoke and mirrors. It is intended to fool people into believing that investments can be guaranteed by the public sector without cost. This is dangerous nonsense. The first losses would go to the EU and the EIB, which ultimately would mean sovereigns coughing up more money, although not at this stage a huge amount. But the next losses would ALSO fall to the EIB, creating further claims on EU sovereigns (since they are the EIB's shareholders). The combined EU sovereigns stand to lose a total of £84bn Euros before the private sector takes any losses at all. 

This strikes me as considerable public sector risk for very little return. Though to my mind the investment opportunity is nowhere near adequate anyway: the criteria make no sense from an investment point of view. I suspect the scheme may begin and end with leveraged lending from the EIB. This would be a viable approach - indeed a lot more EIB lending could be supported - if the EIB's subordinated loans could be packaged up and sold to the ECB. But no-one is going to agree to this, even to support pan-European projects. Monetary financing of all sovereigns is as bad as monetary financing of one, apparently. It's a weird take on "All for one, one for all".

Juncker's claim that this scheme will create at least 315bn Euros of new investment may or may not be true. But one thing is completely clear. Describing this scheme as funded with new investment capital from the EU is wrong. The EU's capital investment in this scheme is zero.

Related reading:

Austria's folly and Juncker's madness - Pieria
The Juncker fund will not revive the Eurozone - Wolfgang Munchau, FT


  1. If a private company tried to do this they would - quite rightly - need to consolidate the entire structure and all of the borrowing would count as debt. This is yet another sign that the European Commission's own accounting is not up to the same levels they require of the private sector (IFRS).

  2. Just another attempt to increase costs without any new credits ( to destroy us)
    The eurozone is the best in the world at going this.
    The city of Jean had a functional tram operational for two weeks but not enough tokens to run it.
    My experience of the euro is a drive to continually build more stuff that cannot be used...
    The function of the euro is simple : it must destroy societies so as to maintain wealth concentration

  3. Economists who believe it to represent reality sometimes wear suits, have fancy degrees, and jobs in the respected halls of academia.

  4. Another epic piece from you! I view this as a pathetic way to get around the stability- and growth pact limits, with little positive potential effects but possibly notable costs later on. Europe does not need financial engineering, but debt restructurings and easier monetary and fiscal policies.

  5. I'm beginning to feel very sorry for the ECB. The EU has kitchen sinked them with having to solve all the problems that the structure and fiscal problems of each member state are creating. The poor ECB are expected to administer aspirin to the obese smoker EU patient without the EU giving up any of their vices.

  6. There is an obvious trade here:

    1. get bridge loan of say €100m
    2. create SPV
    3. have SPV buy €100m worth of senior tranche of EIB project
    3. have SPV (alone or with mates) issue covered bond guaranteed on these (+ admin spread)
    4. sell covered bond to ECB
    5. goto 2 (you've just got your €100m back from the ECB)

    No risk for the trader here, she just makes the admin spread and uses zero long term capital (once the 300B are exhausted she gives back the €100m to the bridge lender). In that scenario it makes sense that it's the EIB that decides what project gets done as after all it's the ECB's money we're spending. Technically there's no monetary financing that a normal electorate can notice.

    Now I'd like to know is whether this trade is the very point of the scheme and who understands that... Note that even if it's not, it may still work out that way anyway.

    1. Observant. When I wrote my comment above about securitising EIB loans and selling them to the ECB, I wondered if the private sector would try to create an equivalent trade. I admit I hadn't appreciated the timing of the ECB's commencement of covered bond purchases, though. This is even more Machiavellian than I had appreciated. I detect Goldman influence, don't you?