While top bank fiddles, Europe burns

Mario Draghi's Friday speech at the European Banking Congress was the most depressing and frightening thing to come out of the European debt crisis since George Papandreou, then Greece's prime minister, said "referendum" and scuttled October's deal to rescue Greece.

In Frankfurt, Draghi -- the new president of the European Central Bank -- pushed back against eurozone politicians who have pleaded for the bank to become the bond buyer of last resort. He asked, "Where is the implementation of those long-standing decisions?" By that, he meant, why is the European Financial Stability Fund, the eurozone's bailout fund, still unable to intervene, 18 months after it was established and four months after eurozone leaders voted to expand its powers?

The European Central Bank wouldn't need to intervene in the bond markets, Draghi was saying, if eurozone politicians would get the European Financial Stability Facility running.

OK, good question. The delay is unconscionable in the midst of a crisis. But no one who knows how quickly the technocrats in Brussels move expected that the rescue facility would be in action by now. The best guess back in July was that it would take until October or November to get all 17 members of the eurozone to approve the changes, and then until sometime in early 2012 to write the rules that would govern the facility's new powers. And that's approximately where we are now.

But calling on the European Financial Stability Facility now is scarily out of date. Can't Draghi hear the dominoes falling? By the time the facility is up and running, it will be just about useless.

A fund that falls short

The European Financial Stability Facility might have been a good idea 18 months ago, but this crisis has left it far behind. It is no longer a serious player in the eurozone crisis. If Draghi doesn't realize this -- if his speech in Frankfurt was anything more than an attempt to get politicians off his back -- then the European Central Bank doesn't understand just how serious the current stage of the crisis is. And that would indeed be scary, since it would mean that the central bank doesn't understand that it is the only player left with the power to stop this crisis short of financial chaos.

Why is the European Financial Stability Facility irrelevant to this stage in the crisis? Most criticism of the facility has argued that the 440 billion euro ($600 billion) rescue fund is too small to do the job -- even if the fund were able to get on with the job.

But the real problem is in the structure of the fund as it was set up in May 2010 to address the first Greek crisis. Because eurozone governments were unwilling to put real money at risk in the facility, they built a row of risk dominoes. And once one domino falls, it only becomes more likely that the next will tumble, too.

You see, the facility was structured not as a pool of actual money but as a collection of guarantees from the 17 eurozone member governments. With those guarantees behind it, the facility would be able to raise real money by selling bonds. Because key guarantor countries such as Germany and France had AAA credit ratings, the European Financial Stability Facility got an AAA rating, too, from Standard & Poor's, Moody's Investors Service and Fitch Ratings. That meant that the facility could sell its bonds at a low interest rate and that financing the facility would be cheap for member governments.

Instead of transfers of actual cash from strong member governments, the facility transferred credit ratings from strong countries such as Germany to weaker countries such as Ireland and Portugal.

But with all the advantages of that arrangement for politicians -- who didn't want to tell taxpayers to take money out of their pockets to support the bonds of other eurozone members -- there were some potential problems. They would become apparent as the crisis spread to pull in other countries.

Now the dominoes fall

As the crisis has progressed -- and maybe really only now that it threatens Italy and Spain -- has it become clear that setting up the European Financial Stability Facility in this way was akin to setting up a row of dominoes. And once one domino tips, it threatens to take down the next and the next and -- maybe -- finally, all the dominoes.

In the initial structure of the facility, Italy provided 18% of the guarantees, Spain 12%, France 20.5% and Germany 27%. Ireland and Portugal also provided a share of the group guarantee behind the facility.

Or at least they did until they needed rescues. When a country needs a rescue from the facility, it can't provide part of the facility's guarantees, and other countries have to pick up the slack. When Portugal and Ireland dropped out of the pool of guarantors, Italy's share of the guarantee went up to 19%, Spain's to 13%, France's to 22% and Germany's to 29%.

Ireland and Portugal are small economies, and their troubles didn't create a huge surge in the guarantees from other eurozone members. Italy and Spain are much bigger economies, and if they need rescues, the effect on the guarantees from other members would be considerably greater. France's share of the guarantee would go up to 32% and Germany's to 43%.

And, of course, that's not the end of the dominoes. The bond markets are starting to worry about Belgium. Standard & Poor's has warned that France is getting overextended, and that its AAA rating might be in danger.