Three key issues dealt in the EFSF are:
1. Lever EFSF to Increase its fire power
2. Greek debt Haircuts (10% vs 50%)
3. Recapitalisation of European banks
We look at each of these in some level of detail on what it holds for bond markets, the only true barometer of what lies ahead.
1. EFSF Leverage:
The EFSF was not granted a banking license which would have given it an ability to raise capital off ECB balance sheet and hence resolve the whole matter. This was anyways impossible without A FISCAL UNION. So am not sure why the markets were even talking about it. The EFSF as it stands will increasingly phase out ECB bond buys.
There are two important options via which EFSF will deal with the issue of bond purchase:
- A peripheral country issues bonds with a partial insurance certificate to be covered by EFSF bonds, which the peripheral has bought using an EFSF loan and deposited with a fiduciary. If the peripheral defaults, the fiduciary will deliver the EFSF bonds to investors in compensation. From an economic vantage point, the EFSF will provide partial insurance against a default of the peripheral bonds. It is important that EFSF maintain its AAA rating at all times for this to work. It is also important to understand on how the EFSF will deal with losses exceeding 20% like in the case of Greece.
- An SPV(special purpose vehicle) buys existing or new peripheral bonds. The EFSF will make a financial contribution to this special purpose vehicle by participating in the most risky tranche, which would be the first to shoulder the losses in case of a default on the peripheral bonds bought by the vehicle. Other investors would buy the less risky tranches. Just as under the first option, the EFSF would ultimately insure the repayment of the peripherals against default up to an amount that is still to be defined.
According to the statement, both options might be used to insure bonds up to the four or fivefold volume of the EFSF assets. The EFSF may lend € 440 bn at most. Taking into account the already committed funds (€ 133 bn) and the funds needed for other purposes (such as banking recapitalisation), the EFSF might have € 200 – 250 bn at its disposal. If it insures 20 – 25% of
the repayments of the peripheral bonds, it could provide insurance for bonds with a total volume of about € 1,000 bn. That would certainly be enough to cover Spain’s and Italy’s financial needs until the end of 2014. We expect that Spain and Italy will require a total of € 710 bn; usually, the IMF takes on one-third of that amount. However, the key question is whether investors will be willing to buy large volumes of insured bonds and thus put an end to the government debt crisis. This will be tricky for the following reasons:
- The very fact that Government needs to provide insurance will spook bond investors who will perceive that these bonds are not at all secure. Bond investors close to EU markets may deal with this contradiction differently from Bond investors in US or Asia who will be far skeptical of such a mechanism
- Many investors may doubt the credibility of this partial insurance. If the governments state that a haircut for a peripheral country is “voluntary” as in the case of Greece, investors might think that the EFSF as insurance provider may not pay in the case of future haircuts.
It is also to be seen on how EFSF is able to leverage its existing pool of equity. Given China reluctance, it may ultimately be left to private investors who will be far more demanding and hence threatening the whole leverage story itself.
2. Haircut is significant but insufficient
Even with haircut of 50% for Greece debt (more than 12% agreed on July 21), the country still has a debt/gbp ratio in excess of 100% and hence future defaults cannot be ruled out. The community of states would contribute another €30bn, presumably in order to enhance the new bonds with collateral and thereby provide a bigger incentive for private sector creditors to participate in a debt exchange.
According to the community’s plans, Greek debt would decline by an amount which is estimated
to correspond to 50% of Greece’s GDP.
3. Bank recapitalisation
As expected, the heads of government agreed that European banks shall have a core capital ratio of 9% in the future even if the government bonds they hold are accounted for at market valuations. According to the statement, banks shall reach this target by mid-2012. In order to do this, banks shall primarily raise funds themselves. The EFSF shall take action only if neither the banks themselves nor the national governments have enough funds to recapitalise the banks. But as we reported from Reuters that the Bank recap is a political problem more than an economic one and hence we will back the EU politicians to throw their weights around to solve the problem of bank recap.
The shortfall created by a tougher stress test is certainly large. Take the 90 banks that participated in the European Banking Authority’s now-discredited exam in July. If banks were forced to mark their sovereign debt to market and achieve a core Tier 1 capital ratio of at least 7 percent under a stressed scenario, they would need 93 billion euros. Raise the pass mark to 9 percent, and the hole is 260 billion euros.
That’s a giant leap from the gap of 2.5 billion euros identified by the EBA in July. However, when judged against the economies of the 21 countries whose banks sat the test, it’s still manageable. A 93 billion euro capital injection is equivalent to only 0.7 percent of the countries’ expected GDP for 2011. Even with a 9 percent pass mark, the bill is still just 2 percent of GDP.
While the partial insurance scheme should provide stability to debt problem and cover Spain and Italy needs well into 2013, we are not bought into the story given lack of details. Italian auctions after the launch of EFSF did not comfort investors as yields hit the roof again at 6%, a level which will not be sustainable for Italy weak cash balance sheet.
Euro zone is developing from a monetary union characterized by the Maastricht Treaty towards a transfer and liability union. If the current EFSF mechanism fails to please the bond investors, the governments may request their parliaments at the end of the day to increase their guarantees for the EFSF another time so as to enable the EFSF to cover the funding costs even of the large peripherals Italy and Spain for three years. Further leverage may be difficult to get approval and if they do get approval, EFSF itself may lose its rating and hence risking the entire structure. This alone is enough for us to suggest that crisis worsen far more before before ebbing off.