There is a scene in The Big Short, the film about the global financial crisis, in which Selena Gomez explains the subprime scam through a Blackjack game in a casino. On a winning streak, she bets $10 million on her hand. Someone watching is impressed and places a side bet on her winning the next game. And then someone places a bet on that bet. In this way, an initial bet of a few million dollars turned into a sequence of bets of hundreds of millions. It\u2019s an attempt to explain the domino effect of a CDO \u2014 the collateralised debt obligation, which collapsed the subprime housing market. Inevitably, she busts. Cue a cascade of losses.<\/p>\n
In real life, though, it was so much worse. The highly leveraged bets placed were in the billions, not millions, and the banks turned them into products which they would then sell on to naive investors. From the outside, these products looked just like a safe government bond. But, in reality, they were toxic \u2014 just like the three-day-old seafood stew metaphor that Anthony Bourdain cooks up in another scene from the movie.<\/p>\n
If there is one thing that everybody should remember about the global financial crisis, it is this: complex financial products, especially the three-letter acronym ones, serve one purpose \u2014 to defraud. The only financial advice I ever dished out during my previous career as a financial journalist was that when you meet a three-letter acronym, run fast.<\/p>\n
You might have thought that the calamity of that relatively recent crisis would have put an end to these scams. And in one respect it did: banks no longer use them. The problem is, governments do. And the three-letter acronyms are back. We saw this only last week, in Brussels, where EU leaders were on the brink of agreeing on a \u20ac150bn loan to Ukraine. That the plan fell through was because Bart De Wever, the Belgian Prime Minister, looked at the small print of the agreement. When he discovered that his country would be most exposed by the loan, he asked the others to share the risk. They said \u201cNo\u201d. So he said \u201cNo\u201d.<\/p>\n
I am sure the EU will find a way to change De Wever\u2019s mind. And if it is good at one thing, it is at getting people to agree to something they don\u2019t want to agree to. Certain readers might think this would be a good outcome: Ukraine needs the money to defend itself against an evil aggressor. But let\u2019s first take a closer look at the small print of this special purpose vehicle \u2014 also known by the three-letter acronym SPV \u2014 or \u201creparations loan\u201d.<\/p>\n
After Russia\u2019s invasion of Ukraine, the EU froze some \u20ac200bn worth of its assets. Most of that money is sitting in Belgium, with a financial company called Euroclear. This is not an ordinary bank, but a depository, where governments and central banks around the world hold their assets.<\/p>\n
Originally, some member states wanted the EU to sequester the Russian money outright \u2014 to literary take the money and give it to Ukraine. But this would have been a big legal and financial risk. Foreign courts would have declared the confiscation illegal and forced Euroclear, which has offices around the world, to compensate Russia. And since Euroclear is headquartered in Belgium, the Belgian government would have been the ultimate guarantor. So the EU devised a scheme very similar to the subprime scam 20 years ago \u2014 a scheme with the sole purpose of hiding the risk, to make it impossible for foreign law courts to get their fingers on the money. No wonder De Weever was antsy.<\/p>\n
Here\u2019s the small print. Step one, the EU creates an SPV \u2014 a special purpose vehicle \u2014 essentially a reparations loan to Ukraine based on the Russian assets. This means that the frozen Russian money is not physically moved; it stays in the frozen bank account at Euroclear. But the SPV holds a claim on those funds. In step two, the European Commission would issue the debt, which would be guaranteed by the member states. This money is then put into the SPV. In step three, the SPV then gives out a loan with this European money to Ukraine.<\/p>\n
Ukraine gets the money. But can\u2019t afford to pay it back. Everyone knows this. A bank would call this bad-faith lending. It is exactly what happened during the subprime crisis, which started with teaser rates on mortgages. The banks knew that once those rates reset, people could no longer afford them. Under the cover of the SPV, the idea is that Ukraine would repay the loan after receiving war reparations from Russia, which, as we know, is never going to happen.<\/p>\n
Let\u2019s return to our movie scene and consider the people in the audience who placed their side bets on Gomez winning her game of Blackjack. In the jargon of finance, their side bets would be called a derivative \u2014 something which derives its value from an underlying bet \u2014 in this case a Blackjack game. Back in the real world, Europe\u2019s gamble with the Ukraine loan is just as risky. Essentially, the success of the EU\u2019s bet lies on the outcome of a future legal case \u2014 that an international court will commit Russia to war reparations, while also declaring our SPV scheme to be legal. So we are betting on the outcome of a legally unprecedented case at an uncertain point in the future. It\u2019s no different from placing money on the outcome of a Blackjack game. Remember all these expert opinions that told us the subprime mortgages were safe? Beware!<\/p>\n
But in many respects, this is much worse than the subprime crisis. When Lehman Brothers collapsed in 2008, governments bailed out the banking system, and central banks printed vast quantities of money to keep the world economy afloat. This time, though, it\u2019s the governments themselves who are engaging in these dodgy transactions. They want to dish out a loan of some \u20ac150 billion without having to get approval from anybody. And if it fails, who is going to bail them out?<\/p>\n
Inevitably, if the EU loses the legal bet, they will have to pay out themselves \u2014 with member states first in line. They are the guarantors of the loan. As a result, when the Russians \u201cdefault\u201d and fail to pay war damages, the losses will fall to the European taxpayer \u2014 another parallel with the subprime crisis. But back then, the banks concealed the risk from the investors. Here, the politicians are attempting to conceal the risk from the voters.<\/p>\n
They are doing so because they have run out of political support at home. The former German Chancellor Olaf Scholz said German voters would never finance Ukraine if it meant they had to sacrifice domestic spending. I think this is probably true of France and the UK as well \u2014 not that they would admit it.<\/p>\n
\u201cIf the EU loses the legal bet, they will have to pay out themselves \u2014 with member states first in line.\u201d<\/p>\n