Now that the ESM has been officially inaugurated, to much pomp and fanfare out of Europe this morning, many are wondering not so much where the full debt backstop funding of the instrument will come from (it is clear that in a closed-loop Ponzi system, any joint and severally liable instrument will need to get funding from its joint and severally liable members), as much as where the equity "paid-in" capital will originate, since in Europe all but the AAA-rated countries are insolvent, and current recipients of equity-level bailouts from the "core."
As a reminder, as part of the ESM's synthetic structure, the 17 member countries have to fund €80 billion of paid-in capital (i.e. equity buffer) which in turn serves as a 11.4% first loss backstop for the remainder of the €620 billion callable capital (we have described the CDO-like nature of the ESM before on many occasions in the past). The callable capital is highly amusing: as part of the finalized structure, the capital call process is as follows: "ESM shareholders irrevocably and unconditionally have undertaken to pay on demand such capital within 7 days." The irony of a country like Greece precommiting to a €19.7 billion capital call, or Spain to €83.3 billion, or Italy to €125.4 billion, is simply beyond commentary. Obviously by the time the situation gets to the point where the Greek subscription of €20 billion is the marginal European rescue cash, it will be game over. The hope is that it never gets to that point.
There is, however, some capital that inevitably has to be funded, which even if nominal, may prove to be a headache for the "subscriber" countries. The payment schedule of that capital "invoicing" has been transformed from the original ESM document, and instead of 5 equal pro rata annual payments has been accelerated to a 40%, 40%, 20% schedule. And more importantly, "The first two instalments (€32 billion) will be paid in within 15 days of ESM inauguration." In other words, October 23 is the deadline by which an already cash-strapped Spain, has to pay-in the 40% of its €9.5 billion, or €3.8 billion, contribution, or else.
Spain will then have 2 years in which to fund the balance of its remaining €5.7 billion equity subscription commitment.
What happens, at least on paper, if Spain is ever "equity" deficient? Here is what the ESM Treaty has to say on this particular matter:
If any ESM Member fails to pay any part of the amount due in respect of its obligations in relation to paid-in shares or calls of capital under Articles 8, 9 and 10, or in relation to the reimbursement of the financial assistance under Article 16 or 17, such ESM Member shall be unable, for so long as such failure continues, to exercise any of its voting rights. The voting thresholds shall be recalculated accordingly.
If an ESM Member fails to meet the required payment under a capital call made pursuant to Article 9(2) or (3), a revised increased capital call shall be made to all ESM Members with a view to ensuring that the ESM receives the total amount of paid-in capital needed. The Board of Governors shall decide an appropriate course of action for ensuring that the ESM Member concerned settles its debt to the ESM within a reasonable period of time. The Board of Governors shall be entitled to require the payment of default interest on the overdue amount.
Source: ESM Treaty
In other words, should a worst case scenario materailize and Europe's insolvent countries are unable to even prefund their portion of the €80 billion in equity needs (forget 8x bigger capital calls), it will be up to Germany (and/or any other viable AAA-rated countries) once again to fill the hole, and at that point "The Board of Governors shall decide an appropriate course of action for ensuring that the ESM Member concerned settles its debt to the ESM within a reasonable period of time." The same board of Governors comprising of the same insolvent countries whose primary duty is to stuff Germany with as much of the costs as possible. We can't wait to see what punishment they dole out for Europe's insolvent (i.e., most of them) countries.
Now the problem for Spain, as has been frequently reported here in the past month, is that due to the major debt maturity hurdle in October, the country is in danger of running out of cash in the next few weeks. Adding the burden of funding an otherwise token amount of cash such as the €3.8 billion paid in capital requirement, and one can see why everyone from Mario Draghi, to Goldman, to Italy and France (but oddly enough not Germany - why? Recall that Germany needs a low EURUSD which benefits its export industry, and needs the periphery constantly on the verge of collapse - Germany does not want a strong periphery as that does not help the European mercantilist construct nor its leverage as Europe's ultimate paymaster) has been asking that Spain promptly demand a bailout, and get the implicit ECB secondary market support, so that Spain can then in turn not be a threat to the primary market monetization scheme which is the ESM.
And here is where the glory of the European close-loop ponzi truly shines:
Spain needs to request a bailout in order to have the explicit (as merely implicit will no longer do) ECB backstop, to be able to issue the debt at modest rates, to raise the cash needed to fund the ESM payment and other general "sovereign purposes", which in turn is needed to make sure future Spanish debt obligations are funded in the primary market (at least until the ESM's dry powder runs out), in order to allow Spain to continue to do nothing to fix its soaring budget deficit due to rising spending and contracting revenues, for which the market merely looks away with Draghi's blessing, until the crisis reaches the next plateau, as fundamentally the lack of cash is due to insolvency, not lack of liquidity, and breaks through it, requiring even more cash, and even more pledgeable collateral, which Europe no longer has (which then activates "Operation Obama rescue us in exchange for our implicit votes" in play" but that's a different story). And of course, for all of the above to happen, Mariano Rajoy has to be prepared for the social and political fallout when he officially cedes sovereignty of the country to the IMF, the Troika, and naturally to Merkel. Fast forward to 2014 when a Merkel visit in Madrid requires the protection of 70,000 policemen (not just the 7,000 planned for her visit to Athens tomorrow).
Finally, the reason why all of the above is actually very much moot, is as follows. In the ESM presentation, we also get a glimpse of the combined residual ESM capacity:
In other words, with up to €292 billion already pledged out of a total €700 billion, there is just over €400 billion left for incidentals. Such as the sovereign funding cliff needs in 2013 driven primarily by Spain and Italy. How big are said needs? For that answer we go back to Ray Dalio, and Bridgewater, who recently spelled out the crux of the European situation in one simple chart:
In other words, everything Europe has "done" so far is completely meaningless. Any questions?
Full ESM presentation can be found here.