Posted on Tue, Oct. 25, 2011
last updated: March 15, 2013 11:57:46 AM
WASHINGTON — European finance ministers on Tuesday scuttled a summit planned for Wednesday as they continued torturous negotiations in search of elusive consensus to address mounting debt woes. The longer they take to find a solution, experts said, the greater the risks grow for the U.S. and global economies.
Europe's finance chiefs had planned to meet Wednesday ahead of a European Union summit late in the day. The 27 ministers were to draft for the heads of state a detailed plan to recapitalize European banks, deal with an expected debt default by Greece and expand the bloc's bailout fund. All three steps are necessary to ensure that a new financial contagion doesn't spread globally as in late 2008.
Instead, their meeting was scrapped as the nations continued to haggle over everything from the size of the expanded bailout fund to how much austerity is expected from countries whose economies already are showing signs of a sharp slowdown.
The summit of elected EU leaders was pushed back to Wednesday night and that too was in doubt. Italian Prime Minister Silvio Berlusconi desperately tried to hold his coalition government together as anger grew over European demands that Italy undertake stronger austerity measures.
Meanwhile, Europe's problems crossed the Atlantic Ocean to send stock prices reeling and to pound a large U.S. financial firm. The Dow Jones blue chip average fell 207 points, or 1.74 percent, to close at 11,706.62. MF Global Holdings, a big boutique investment bank, saw its shares plunge as investors fretted over the amount of European debt it holds.
Here are answers to questions about the unraveling European economic order.
Q: Why did EU finance ministers cancel their meeting?
A: For many reasons, but one clear one was fighting between the 17 European Union members that use the euro as their currency and the 10 members that have their own currencies. These 10 members, most notably Great Britain, didn't want to agree to anything ahead of the meeting of heads of states.
Q: Why is that such a big deal?
A: Generally, finance chiefs hammer out of the details, do the heavy lifting and the heads of state then bask in the glory of announcing the deal. This time, however, the tough decisions will fall to the heads of state. Unlike finance ministers, they have to answer to voters, and they tend to see solutions through the prism of politics, not economics.
Q: What else is holding up a deal?
A: Leaders are divided on how much risk to assume when expanding the existing bailout fund and how to proceed with Greece, whose debt was the spark that ignited the crisis. It's now widely expected that Greece will take a structured default on its bonds, something that hasn't happened in a developed nation in modern times. The question EU leaders can't agree on is how much of a hit holders of Greek bonds should take: Fifty cents on the dollar? More?
The rapid deterioration of Greece's economy means that earlier bailout numbers can work only if bondholders take some losses. Published reports suggest that Germany — Europe's de facto leader, as its largest economy — wants these bondholders to take a 60 percent loss, while junior partner France wants a number closer to 40 percent. Original plans anticipated investor losses in the 20 percent range.
Q: Does that percentage gap matter?
A: Yes. Any loss above 50 percent makes it hard for bondholders to treat such a deal as a voluntary structured default, in which bondholders accept a new bond with better investment returns in exchange for agreeing to losses on the old one. The question of voluntary vs. involuntary matters because of outstanding speculative bets that were made about the possibility of debt defaults. These bets were made through credit-default swaps, the pernicious insurancelike financial instruments that amplified the U.S. financial crisis in 2008 and now threaten to do the same in Europe. A voluntary restructuring must be done in ways that financial markets don't consider to be a technical default.
Q: Why do credit-default swaps matter?
A: Swaps issued against bonds from the five biggest European economies have been estimated at about $93 billion. The 2010 revamp of financial regulation in the United States, known as the Dodd-Frank Act, sought to put a more orderly settlement mechanism in place after the government rescued financial giant American International Group. It had made billions of dollars worth of bets via the swaps — which act like default insurance — but it lacked the capital to honor its bets when markets tanked and there was no formal exchange on which bets could be settled. Today, credit-default swaps remain lightly regulated globally. They represent a storm cloud threatening European debt.
Q: Can't banks just be forced to take bond losses?
A: That could lead to the sort of credit crunch experienced in 2008, when financial institutions were unsure who owed what to whom and lending of every sort screeched to a halt. The U.S. Federal Reserve was able to thaw the frozen credit eventually by becoming a creative lender of last resort, moves that saved the U.S. economy from a depression but also drew the ire of Congress. It's not clear that the European Central Bank has the same authority to act, and the EU has 27 different finance ministries instead of a single Treasury Department.
The head of the influential Institute of International Finance, the global trade group for big banks, warned in a statement late Monday that there could be dire consequences from a disorderly default.
"It would most likely have severe contagion effects, which would cost the European and the world economy dearly in terms of employment and growth," said Charles Dallara, who's in Brussels, where negotiations continue with bondholders.
Q: What's President Barack Obama doing about this mess?
A: There's not much he can do beyond press the Europeans to strike a deal that will convince global markets they've acted sufficiently to stanch the crisis. European leaders acknowledge that they've acted too slowly. In congressional testimony Tuesday, Charles Collyns, the assistant treasury secretary for international finance, said the administration continued to press for solutions.
"We have worked hard to convey to European leaders our sense of the need for bold solutions and to provide constructive advice on how to move forward. Secretary Geithner has traveled to Europe three times in the last six weeks alone, and President Obama is frequently in contact with leaders across the region," Collyns said in prepared remarks.
Q: Why is MF Global in trouble?
A: Shares in MF Global Holdings were down by more than 47 percent in late-day trading. A day earlier, the credit-rating agency Moody's Investors Service downgraded MF Global to just one notch above junk-bond status. That action came in large part because MF Global holds lots of European government bonds, and it stands to lose greatly if there are defaults. The bank is run by Jon Corzine, a former Democratic senator and governor from New Jersey who was widely expected to be a future U.S. treasury secretary.
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