Introduction: U.S. Exposure to the European Sovereign Debt Crisis
As recently as July 2011, a number of financial measures have
been implemented by institutions and member states of the European
Union (the "EU") to address the current sovereign debt
crisis and ensure financial stability in the EU. These
measures include the extension of loans to the countries known
collectively as the "European periphery" —
Portugal, Ireland, Italy, Greece, and Spain — and the
establishment of inter-governmental facilities to repurchase
government bonds in the debt markets.
U.S. ownership of the European periphery's sovereign debt has
been estimated at $18 billion, although the actual figure may
actually be higher, since U.S. pension funds and other
institutional investors are not required to disclose these
holdings. Although this amount is relatively marginal
compared with the holdings of European institutions, the indirect
exposure of U.S. institutions to the EU sovereign debt crisis is
significantly larger than it first appears.
According to recent reports, U.S. ownership of securities in the
European periphery's private sector is approximately $70
billion. Ratings downgrades or insolvencies at any of these
companies could result in financial losses for U.S. funds and
investors. Most importantly, a default or deterioration of
the conditions in the European periphery would likely spark a
"systemic contagion," as the collapse of Lehman Brothers
in September 2008 and the volatility of financial markets in recent
days have clearly demonstrated.
Similarly, a vicious circle links sovereign risk, bank
creditworthiness and the real economy. Banks in the European
periphery (as well as banks in other EU countries with large
positions in the European periphery's sovereign debt) have in
recent weeks seen their funding costs and credit default swap
premiums increase exponentially, while their issuance of short-term
wholesale debt has fallen sharply.
This "collateral damage" is likely to spill over to U.S.
institutions as adversity hits the European banks to which these
U.S. institutions are creditors. For example, Moody's
recently put Crédit Agricole, BNP Paribas and
Société Générale on notice for a
possible downgrade because of their potential exposure to a Greek
default. According to JPMorgan estimates, U.S. money market
funds have loans outstanding to French banks of approximately $200
billion (or near 12% of the assets under management).
Furthermore, a recent report by Fitch Ratings revealed that the top
ten U.S. prime money-market funds have about half of their assets
invested in securities issued by European banks.
Another serious concern is the exposure that the U.S. might have to
the European periphery through credit default swaps
("CDSs") issued by U.S. banks and insurance companies to
provide insurance against default to the holders of government
bonds. These are the same contracts that brought down
insurance behemoth, AIG, in the wake of the 2008 credit
crunch. According to the Bank for International Settlements,
U.S. banks have approximately $150 billion in credit default swap
exposure to the European periphery, which represents the largest
portion of such exposure by any country alone. The terms of
restructuring of the sovereign debt that are currently being
negotiated may trigger a default event under the outstanding CDSs
and obligate the U.S. banks to make the payments provided
thereunder, with severe consequences for the U.S. financial
industry and overall economy.
In addition, as U.S. companies are increasingly exposed to
international markets, any conditions adversely affecting the
European periphery could have negative effects on their business
and financial results. Although the majority of U.S. publicly
traded companies do not break down their EU revenues on a
country-by-country basis in their securities disclosures, research
reveals that several U.S. private and public companies have
significant revenue exposure to the European periphery, especially
in the energy, pharmaceutical and industrial sectors. In
addition, the strains in bank funding markets described above could
cause the London Interbank Offered Rate ("LIBOR") to
spike, which would push up borrowing costs for many non-financial
businesses.
As a result, U.S. companies and financial institutions need to pay
great attention to the public and private finances in the European
countries in which they operate, and review their portfolios and
business plans to mitigate risks, as any worsening in sovereign
debt risk in these countries could affect their European
subsidiaries, with negative implications to the U.S. parent
company.
As negotiations regarding a restructuring of the European
periphery's debt enter into a decisive phase, what follows
below is a high-level summary of the most recent financial measures
and regulatory proposals designed to stabilize the EU financial
markets.
Background
Seventeen of the twenty-seven EU member states, known as the
"Eurozone," share an economic and monetary union and use
the euro as their common currency. Since 1999, Eurozone
member states have transferred monetary sovereignty to the European
Central Bank (the "ECB") and other EU governmental
entities with responsibility for monetary policy.
A body of regulatory requirements referred to as the
"Stability and Growth Pact" was passed in 1997 to enforce
fiscal responsibility and set certain national debt ceilings among
Eurozone member states. In particular, the ratio of each
member state's annual government deficit to GDP cannot exceed
3%, and gross government debt to GDP cannot exceed 60%.
However, these regulations have suffered from the lack of a
meaningful enforcement mechanism and have come under increasing
scrutiny during the current financial crisis.
In October 2008, as the EU entered its first official recession,
the heads of state of the Eurozone and the ECB, at an extraordinary
summit in Paris, agreed to a 14-point program to stabilize the
European economy. A critical point of this process was the
establishment of the European Financial Stabilization Mechanism
(the "EFSM") and the European Financial Stability
Facility (the "EFSF").
The EFSM is a regulation that gives the EU Commission the authority
to raise up to €60 billion in funds to provide loans or
other funds to Eurozone member states facing a "severe
financial disturbance," subject to the adoption of an
"economic and financial adjustment program," including
specific measures to restore financial stability. Once the
mechanism is activated, the EU Commission is authorized to grant
loans or lines of credit and to borrow in the financial markets on
behalf of the EU to then lend the proceeds to the beneficiary
member state. The EU budget guarantees the repayment of the
bonds in case of default by the borrower.
The EFSF is a Luxembourg entity funded by the Eurozone member
states and governed by an inter-government agreement. The
mission of the EFSF is to provide financial assistance to
financially distressed member states, by issuing bonds or other
debt instruments backed by guarantees from the Eurozone
countries. Issuances by the EFSF are executed by the German
Debt Management Office ("DMO") on behalf of the
EFSF. Although EFSF's total guarantee commitments
are equal to €440 billion, the facility currently has an
effective lending capacity of no more than €250 billion,
because bailout measures must be guaranteed by AAA-rated member
states. The guarantee commitments are made by member states
on a pro rata basis, with Germany (27%) and France (20%)
contributing the largest shares.
The EFSM and the EFSF can only be activated upon a member
state's request for financial assistance and the adoption of a
conditional macroeconomic adjustment program to be approved by the
EU Commission and the ECB. In July 2011, the lending
capabilities, scope of activities and maximum guaranty commitments
of the EFSF were further expanded.
The recent financial bailout measures for Greece, Ireland and
Portugal were the result of a concerted effort by EFSM, EFSF and
the International Monetary Fund (the "IMF").
However, with the EFSF due to expire in 2013, the regulatory field
is about to change again. On June 24, 2011, the EU Council
established a new crisis resolution mechanism, the European
Stability Mechanism ("ESM"), with the mission of
replacing the EFSM and the EFSF as a permanent inter-government
organization to provide financial aid to distressed Eurozone member
states.
In addition, at the March 24, 2011 summit of the EU Council, a
"Euro Plus Pact" was signed by each of the Eurozone
countries, as well as by Bulgaria, Latvia, Lithuania, Poland and
Romania, to adopt a comprehensive package of measures to
"strengthen the economic governance and competitiveness of the
euro area and of the European Union." The plan is a
successor to the "Competitiveness Pact" that was
advocated earlier in the year by the French and German governments
and is designed to become a more stringent successor to the
Stability and Growth Pact.
Recent Financial Stability Measures
Second Financial Assistance for Greece
A first €110 bailout package for Greece (subject to
the adoption of certain austerity measures) was approved in May
2010, including a €80 billion contribution from all
Eurozone members on a bilateral basis (subject to management
authority of the EU Commission) and a €30 billion funding
from the IMF. However, following a review of Greece's
financial conditions in March of this year, it became clear that
the rescue plan of Greece was not sufficient to enable the country
to restore its debt limits and boost an economic
recovery.
As a result, on July 21, 2011, a second three-year €109
billion bailout package for Greece was passed. The second
Greek loan facility will be co-funded by the EFSF and the IMF,
although an important contribution — in the amount of
approximately €50 billion — will come from the
private lending sector in the form of a credit enhancement through
the voluntary exchange of certain bonds maturing between 2011 and
2020. The assistance package will be used to cover
Greece's budgetary needs, a recapitalization of Greek banks and
a contribution to a debt buyback program for Greece.
The EFSF loans will have lower interest rates and extended maturity
dates (from the current 7.5 years to a minimum of 15 years and up
to 30 years with a 10-year grace period) than the comparable 2010
Eurozone loans. It is anticipated that the revised EFSF
lending rates and maturities will apply to all outstanding
financial instruments issued to assist Greece, Portugal and
Ireland.
Financial Assistance for Portugal and Ireland
Following a formal request for financial assistance made by
the Portuguese authorities, on May 17, 2011, the EU announced the
approval of a €78 billion financial assistance program,
which will be shared equally (€26 billion each) by the
EFSM, the EFSF and the IMF. The Portugal bailout package is
contingent upon the adoption of certain tax austerity measures, a
reform of the judicial, employment, and housing sectors and a
restructuring of the debt ratio and capital requirements of
banks. The first EFSF bonds issues in support of Portugal
were placed on June 15 and 22, 2011.
On November 28, 2010, Ireland received a €85 billion
financial assistance package, consisting of: (i)
€4.8 billion in bilateral loans from the United Kingdom,
Sweden and Denmark; (ii) €22.5 billion from the EFSM;
(iii) €17.7 billion from the EFSF; (iv) €22.6
billion from the IMF; and (v) €17.5 billion from certain
Irish government agencies. The Ireland bailout package is
contingent upon a reorganization of the banking sector, a fiscal
plan to reduce the national debt and certain growth-enhancing
legislative reforms. A first €5 billion EFSF bond
issue was placed on January 25, 2011 and was oversubscribed by
investors. The EFSF anticipates issuing additional bonds in
the amount of €10 billion by the end of 2011.
ECB Liquidity Measures and Bond-Buying Program
Since the inception of the Greek debt crisis, the ECB has
adopted a number of measures in the name of European financial
stability, including a May 6, 2010 decision to accept certain Greek
sovereign debt as collateral, and the adoption on May 10, 2010 of
certain "non-standard" measures primarily designed to
provide liquidity to Eurozone banks at a fixed rate. These
non-standard measures are still in effect and include: (i)
the establishment of temporary liquidity swap lines with the
Federal Reserve to provide short-term US dollar liquidity in
exchange for collateral or under repurchase agreements; (ii)
certain 3-month and 6-month longer-term refinancing operations
("LFTOs") at a fixed-rate tender or at a rate equal to
the average minimum bid rate of the main refinancing operations
("MROs") during the term of the LFTOs; and (iii) a
bond-buying program for the Eurozone's debt securities markets
known as Securities Market Programme ("SMP").
The ECB has actively implemented its bond-buying program and,
according to recent reports, it currently holds approximately
€74 billion worth of the European periphery's debt,
largely consisting of Greek, Irish and Portuguese government
bonds. At an emergency conference held on August 7, 2011, the
ECB indicated its intention to use its powers under the SMP to
purchase outstanding government bonds of Italy and Spain.
These measures appear pivotal to addressing the debt crisis at a
time when the ESFS' increased lending capacity and bond-buying
authority are not yet fully effective and operational.
Amendments to the European Financial Stability Facility
(EFSF)
At present, the EFSF has an effective lending capacity of no more
than €250 billion. It has been argued that at
€250 billion — and already committed to bailouts
of Greece, Ireland and Portugal — the facility is not
large enough to handle a bailout of Spain, and that, even at
€440 billion, the EFSF alone would not be enough for both
Italy and Spain for any significant length of time. Indeed,
the IMF has recently estimated that Italy's financing needs
will run between €340 and €380 billion annually
over the next 5 years.
For these reasons, on June 24, 2011, the EU Council approved an
amendment to the EFSF's Framework Agreement. The purpose
of the amendment was to (i) raise member states' guarantee
commitments to €780 billion, including an
"over-guarantee" by each member state of up to 165%, (ii)
increase the EFSF's effective lending capacity to €440
billion, and (iii) expand the scope of the EFSF, by allowing the
entity to purchase bonds on the primary debt markets under certain
circumstances.
On July 21, 2011, to further improve the effectiveness of the EFSF,
the Eurozone summit further expanded the EFSF's scope of
activity allowing it to (i) act on the basis of a precautionary
program, (ii) finance recapitalization of financial institutions
through loans to governments including in countries not covered by
existing programs, and (iii) intervene in the secondary markets on
the basis of an ECB analysis recognizing the existence of
exceptional financial market circumstances and risks to financial
stability and on the basis of a decision by mutual agreement of the
EFSF member states to avoid contagion.
The authority to act preemptively in countries that are not
recipients of an existing bailout measure is designed to give the
EFSF room to maneuver to prevent a crisis in Spain and Italy.
Furthermore, the EFSF — unlike in the past —
will have the power to buy government bonds and other bad assets
ailing Eurozone countries from private investors. However,
the amendments to the EFSF's Framework Agreement regarding
guarantee commitments (which will have the effect of increasing
EFSF's effective lending capacity up to €440 billion)
and preemptive actions, including on the primary and secondary debt
markets, will be required to be approved by the individual member
states in accordance with their ratification procedures. It
is expected that the amendments will not become effective until the
third quarter of 2011.
It is also anticipated that the interpretation of the rules
governing the expanded powers of the EFSF will be subject to
intense legal analysis. The EFSF's mission and its
inter-governmental programs have come under legal scrutiny since
the entity's formation, as Article 125 of the EU Treaty (the
"no bailout" clause) prohibits the EU and its member
states from assuming or discharging any other member state's
financial obligations (including through guarantees). On such
grounds, three cases have been filed and are still pending in
German Federal Constitutional Courts, claiming that Germany's
financial assistance to Greece and the guarantees provided under
the EFSF are in conflict with EU and German law. On July 5,
2011, a joint hearing on all three cases was held, but no final
decision appears to be close. It is possible that the German
courts will require a parliamentary vote on all future requests for
bailout funds.
EFSF's newly-created power to purchase bonds on the primary
and secondary markets may raise similar legal issues. The
purchase by the EFSF of bonds issued by member states to discharge
past obligations could be viewed as an "indirect"
assumption of such member state's financial obligation.
In addition, it remains to be seen how the requirements of
EFSF's "precautionary program" will be interpreted
and what conditions will be viewed as constituting
"exceptional market circumstances" to enable the EFSF to
purchase bonds on the secondary market. However, these
amendments are clearly a far-reaching step towards the pooling of
the debt of Eurozone member states, and have played an important
role in accelerating the establishment of ESM, EFSF's successor
entity.
The European Financial Mechanism (ESM)
As described above, on June 24, 2011, the EU Council decided to
establish a permanent crisis resolution mechanism, the European
Stability Mechanism ("ESM"). The ESM is
expected to replace the EFSF at the end of its term in 2013 and
will also result in the abolition of the EFSM. However, in
recent days, as the debt woes of Spain and Italy have continued to
escalate, some Eurozone governments have been discussing a new
phase-out strategy, pursuant to which both ESM and EFSF would be
kept in place and coexist. The two bailout funds together
would total nearly €1 trillion, which would leave more
than €700 billion to provide financial assistance for
Italy and Spain.
The process of establishment of the ESM is moving rapidly, as the
key EU member states in recent weeks signed a Treaty to set forth
the governance structure, powers and other key aspects of the
ESM. Like the EFSF and EFSM, the purpose of the ESM will be
to provide financial assistance to Eurozone member states, under
strict policy conditionality, when they are experiencing or are
threatened by severe financial problems. The ESM Treaty
authorizes financial assistance in the form of loans or, as an
exceptional measure, through the purchase of bonds on the primary
markets. It is contemplated that the ESM will offer loans at
funding costs plus 200 basis points for loans up to three years and
plus another 100 basis points for loans longer than three years,
with no service charge. Currently, EFSF's margin for
Ireland stands at 247 basis points, while the margin for Portugal
is 208 basis points.
The aggregate capitalization of the facility will be equal to
€700 billion, and its lending capacity will be set at
€500 billion. Unlike the EFSF, ESM's capital
structure will include not only individual guarantees but also
€80 billion in fully paid-in capital and €620
billion in additional callable capital. Therefore, the ESM
will not require the credit enhancements (including over-guarantee,
cash buffer and cash reserve) that the EFSF needs to have to secure
an AAA rating.
If the ESM is implemented, a legal issue that may arise is whether
the direct purchase of bonds on primary markets is consistent with
Article 125(1) of the EU Treaty. However, on March 25, 2011,
the EU Council adopted a decision to amend Article 136 of the EU
Treaty so that an EU legal basis can be created for the ESM.
The amendment will become effective following ratification by all
member states. It is anticipated that national approval
procedures will be completed by the end of 2011.
The "Euro Plus Pact" and the EU Financial
Regulatory Reform
As described above, the "Euro Plus Pact" is a recently
adopted plan pursuant to which the member states of the Eurozone,
Bulgaria, Latvia, Lithuania, Poland and Romania have made specific
commitments to a list of political reforms that are designed to
improve the fiscal strength and competitiveness of each
country. The plan is revolutionary because it represents the
first step towards establishing a common EU economic policy along
with the EU monetary policy.
The Euro Plus Pact requires each participating member state to
provide commitments on an annual basis with respect to four main
goals: (i) fostering competitiveness (by reducing wage costs,
especially in the public sector, and increasing productivity); (ii)
improving employment (by increasing long-term and unemployment
rates and lowering employment taxes); (iii) enhancing
sustainability of public finances (among other things, by limiting
early retirement and increasing the sustainability of pensions,
health care and social benefits); and (iv) reinforcing financial
stability.
An additional goal of the pact is tax policy coordination, as
participating member states are committed to adopting national
legislation to implement the EU fiscal rules set forth in the
SPG. According to the draft conclusions from the summit,
among other things, participating countries are expected to develop
a common corporate tax base as a "revenue neutral way forward
to ensure consistency among national tax systems." The
commitments made by each member state are subject to monitoring by
other Euro Plus Pact participants on the basis of a report
generated by the EU Commission. However, as the pact is
currently set out, there are no binding obligations and no
enforcement measures are currently contemplated.
As of January 1, 2011, the EU has also implemented a new framework
for financial supervision and the oversight of systemic risk, which
represents the first step towards the establishment of a EU
financial regulatory authority. The new financial supervisory
framework consists of a European Systemic Risk Board
("ESRB"), which has the responsibility to detect and
respond to systemic risks to the financial system and a European
System of Financial Supervisors, which consists of three European
Supervisory Authorities ("ESAs"), including the European
Securities and Markets Authority, the European Banking Authority,
and the European Insurance and Occupational Pensions Authority,
with responsibility for the oversight of micro-prudential
supervision of financial institutions within their respective
sectors.
The ESRB has an advisory role but is entrusted with the power to
issue recommendations which, if not complied with by the member
states, may be referred to the EU Council. The goals of the
ESAs include (i) monitoring the application of EU rules, (ii)
mediating between national supervisors, and (iii) providing advice
to the EU Commission in relation to the content of new legislation
and licensing credit rating.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.