Europe’s Financial Alchemy by Luigi Zingales: It is universally recognized that a key factor underlying the 2007-2008 financial crisis was the diffusion of collateralized debt obligations (CDOs)... [T]he European Financial Stability Facility (EFSF), created by the eurozone countries last May, is the largest CDO ever created... the outcome could be similar: the entire banking system sent into a tailspin.
CDOs are a form of financial alchemy: special-purpose vehicles that buy the financial equivalent of lead (low-rated mortgaged-backed securities) and finance themselves mostly with the financial equivalent of gold (highly sought-after AAA bonds). This transformation is based on one sound principle and two shaky ones. The sound principle is excess collateral.... The first shaky principle is that if the return on these bonds is highly correlated... they all default at the same time.... The second shaky principle is that... issuers of CDOs relied on credit-rating agencies.... As a result, the CDO market did not so much spread risk as it shifted and hid it....
Europe is following a similar path. The EFSF, created to assist countries facing “illiquidity,” is designed exactly like a CDO. The EFSF buys the bonds of the countries which find it difficult to finance themselves in the marketplace (for example, Ireland) and issues bonds that are AAA rated. How is this alchemy possible? Once again... overcollateralization, an assumption on the joint distribution of possible outcomes, and the... approval of... credit rating agencies.
With the EFSF, the overcollateralization takes the form of guarantees by other eurozone countries. Among the major countries, however, only France and Germany have an AAA rating. How can a bond guaranteed in large part by countries such as Italy and Spain (likely candidates for a fiscal crisis) provide AAA status to Irish bonds?... [I]f the EFSF has to guarantee Spain, would Germany really be willing to step in and use its taxpayers’ money to cover Spanish banks’ losses?... [H]ow free are credit rating agencies to express their opinion on the very institutions that will regulate them?...
After the sub-prime mortgage crisis, politicians alleged that the market was short-sighted and irrational, and rushed to propose new regulations. While some of the criticism might have merit, what gives politicians the moral authority to criticize? After all, as the EFSF shows, their orientation can be more short term and irrational than the market’s, repeating the same mistakes because they seem not to have learned from them.
The market’s verdict is likely to be uncompromising. As Oscar Wilde said: “Fool me once, shame on you; fool me twice, shame on me.”
I think that the answers to Luigi's worries are pretty simple.
"How can a bond guaranteed in large part by countries such as Italy and Spain (likely candidates for a fiscal crisis) provide AAA status to Irish bonds?" The answer is that it cannot, and does not. The bond guarantee is offered by France and Germany: they are the countries that matter.
"If the EFSF has to guarantee Spain, would Germany really be willing to step in and use its taxpayers’ money to cover Spanish banks’ losses?" I agree that it is better for Germany not to offer a guarantee than for it to offer it and then to renege on it. But it is, of course, best of all for Germany to offer the guarantee and stand behind it.
"How free are credit rating agencies to express their opinion on the very institutions that will regulate them?" Not very. But why does this matter? The guarantee is AAA if Germany and France fulfill their pledges, and not if otherwise. You don't need a rating agency to tell you that.
"What gives politicians the moral authority to criticize [the markets]?" There is no rule saying that you have to have moral authority before you can criticize. Anybody can criticize. The important question to ask is never "does the critic have moral authority?" but rather "is the critic right?" In this case, the critics of the market are right.
If I understand Luigi's argument, it is that the EFSF should not have been started and should be wound up as soon as possible because the German government is making pledges that it will be unwilling to fulfill should push come to shove. It is not clear to me why he believes that to be the case--everything I have heard tells me that the German government does understand what its pledge to back the EFSF means, and does and will stand behind hit.