Although there are no definite details of how and when
the EFSF would be leveraged there are some hints that allow us to make some
initial points (EFSF website, EU statement). In a strange quirk of fate, the EU
is now seriously contemplating using almost exactly identical financial
gimmicks and structures that it accused of bringing the world economy to the
brink of extinction. i.e. SPV’s, CDS’s, CDO’s, leveraging toxic mortgages and
credit slicing. Instead of mortgages, we now have peripheral debt and instead
of CDS we have EFSF certificates, and EFSF controlled SPV’s.
EFSF Pool of money
The initial pool of money allocated to the EFSF was
440bln. However, as more countries are raised to the pig status this has come
down. Current estimates are around 250-290bln. The uncertainty comes from the
fact that the EFSF would be called to recapitalise Banks if the respective Bank
and country fails to raise it.
EFSF leverage
According to the not so clear EU communiqué the EFSF
would be allowed to leverage the remaining amount of cash 4 to 5 times and this
is how the 1trl figure is achieved. This leverage is going to be achieved using
two different options:
Option 1. Credit Certificate
This is how we presume it is supposed to work (see
EFSF website). Investors would have the option when buying a NEW issue to ask
for an EFSF guarantee certificate to be attached to it. This certificate would
offer a 20% (the exact amount has not been fixed) protection given default.
This would be the EFSF guarantee. Subsequently, one could detach the
certificate from the body and sell it thus creating a new parallel to the CDS
insurance market. We do not know whether one could, for example, buy in the
open market 5 of these and claim full insurance against the bonds but it seems
that these certificates are going to be country specific.
The idea behind the proposal is that investor would
lower their demands for yield once they know that they are partially protected.
It is not known whether Eurostat would use this fact to lower the debt of a
country or increase the one to the selling county. As the markets are efficient,
this drop in the yield presumably would be compensated by an equivalent
increase in yield of those we sell the protection, namely the EFSF countries.
This brings us to the next few points.
Correlation Risk. Since the
EFSF is composed by all countries including the ones that the protection is
aimed at, it would be very hard to price it. This is also known as correlation
risk. Simply put, it is imprudent to buy protection insurance against someone
from that someone. We therefore conjecture that the market is going to price it
solely as German risk.
Concentration
Risk. Greece, Eire and Portugal
already have their share of the bailout from EFSF and hence this is aimed at
Italy and possibly Spain and Belgium. However, the sheer size of Italian debt
would make it a purely German risk. In other words, there is a single point
failure in the whole scheme and that is called Italy (some may call it
Berlusconi).
Credit Event. The EFSF
website tells us that the certificate would be paid if ISDA determines that
there is a credit event. I don’t see how this can be reassuring to prospective
investors given the lengths the EU has gone the past few months in order to
avoid calling the Greek bankruptcy a Credit event worth triggering the CDS.
Could the EU engineer something similar in the case of Italy in order not to
pay the insurance as it has done for Greece? Would voluntary restructurings
become credit events?
CDS. One cannot help being
cynical when it comes to the CDS market. The EU leaders did their best to badmouth
the CDS market and now they are trying to create a parallel one themselves. Is
this a way to corner or even manipulate the sovereign CDS market? We do not
know. Why not buy CDS outright instead of the complex certificate process. EFSF
claims that since it is a 3-A entity it would offer superior protection to
investors (see points above on correlation and concentration risk). Is there
going to be an arbitrage between the certificate and the CDS? Maybe, but the
devil is in the documentation and pricing risks properly.
Negative Pledge. A rather
minor point but one that should not be overlooked is the issue of negative
pledge. As was the case of Greece with Finland, many Italian and other
periphery bonds have a prohibition on giving security unless it is done to
everyone. We believe that this would be dealt with effectively (given the right
amount of legal fees to lawyers).
Option2.
The SPV approach
The SPV approach aims to create a vehicle that
investors from across the world would be able to invest in. It would be
structured so as to be attractive to SWF and other international investors.
Although they have not mentioned it, they could also be one suitable for
Islamic banking. There would be one SPV per country and its purpose would be to
buy in the Primary or Secondary market bonds of the country in need. So, how
are the investors in this SPV would be protected? The idea is that there would
be a 3-tier capital structure with the EFSF taking the first loss.
Senior
Tranche. There would be a Senior tranche that would pay a fixed
coupon. This would be a freely tradable bond.
Participation
Capital Instrument.
This would be junior to the Senior tranche but rank higher than the EFSF
investment. It would carry a small coupon and it would take a cut from the
appreciation or full redemption of a bond. For example, if a Greek bond now
trading at 50% is bought and is redeemed in full, there would be a 50% of the
nominal gain. This would be distributed (we don’t know how much) to the holders
of this participation instrument.
EFSF Investment. This money would be used as a cushion against any
losses given default. The exact amount has not being revealed.
It would be interested to see if the SPV would be able
to buy not just new issues but already existing ones, as these are precisely
the ones that would give the Participation trance its biggest gains. If that is
the case, then we have another possibility of a grand Free Rider alongside the
ECB. According to the EFSF website, the setting up of these SPV could only take
few weeks and this may coincide with the PSI.
EU Politics
The sole purpose of both
options is to attract investment from the private sector to the rescue of the
periphery. This however, has to be done in accordance to the fortress Europe
principle which does not allow foreigners laying their hands on real assets in
Europe. Only Europeans (Germans) have that privilege. In other words, Europe is
not only trying to raise cash but also to control the amount and where it is
going. On the other hand, it would be very hard to play that sleight of hand to
the most likely investors to this scheme, the Chinese. We would therefore
expect them to be less enthusiastic or to demand in parallel other more
“physical” concessions.
