IF YOU ARE IN TROUBLE – DOUBLE…

By Martin, Macronomics

“What investors should never forget about credit risk is that it is an event risk!” – Credit Crises: From Tainted Loans to a Global Economic Meltdown by Jochen Felsenheimer and Philip Gisdakis

For a change, it is going to be a shorter post than usual. In this post we will review the extension of the EFSF and the risk it entails.

I have already touched on the EFSF and its similarity with CPDO products which were the craze during the halcyon days of structured credit in the post – “Much ado about nothing“: “in our levereraged EFSF play, the lower volatility in interest rates, the lower likelihood of default. But in a CPDO/Leveraged EFSF, there is a risk of failure of repayment of full principal at maturity.”

I discussed this very subject with my good credit friend today, and here is what he had to say about the EFSF following our conversation:

“To summarize, European states only guarantee each bond issued by the EFSF in accordance to the percentage of their contribution. Each time a country needs the funding of the EFSF, that country cannot guarantee anymore the future bonds to be issued … so the remaining countries have to share the cost of guaranteeing the future bonds. Initially, Portugal was a guarantor for the bond issued to help Ireland. Once Portugal asked for help, the EFSF lent money and Portugal could not guarantee any new bonds issued by the fund, while still guaranteeing the one issued before to help Greece and Ireland. So each time a country suffer a rating downgrade, the pressure increase on the other contributors.

That explains the subordination of the EFSF bonds to the sovereign bonds of its contributors … and why leveraging the fund is not the right solution !

Here below is a chart where you can see the correlation of the EFSF bonds with the French 10 years OAT bonds … versus the German 10 years Bund. The correlation between the EFSF 10 years and the French OAT 10 years is 1.

As French spreads keep on widening, so does the EFSF spreads. This is frightening and explain why a France downgrade will jeopardize the all scheme.”

And to illustrate our conversation we came up with the nice illustration below:

In white… EFSF 10 years bond
In yellow … French 10 years OAT
In orange … German 10 years Bund

What’s wrong with this picture? You probably know by now.

EFSF existing bonds:

EFSF 10 year bond versus German Bund

And my good credit friend to add:

“Main talks were about E.U. combining the EFSF and the ESM by mid 2012 to create 1 Fund with 940 billion euro (1.3 trillion US $) firepower.”

Well, obviously there is a number of issues about such a conclusion….

The 500 billion Euro ‘permanent” bailout fund (ESM) was slated to replace the 440 billion “Temporary” European Financial Stability Facility (EFSF) fund. Well, the latest proposal that has the stock markets excited is to merge the two funds …. But there is a bias, it double counting the money.”

Bloomberg reports:

“European governments may unleash as much as 940 billion euros ($1.3 trillion) to fight the debt crisis by combining the temporary and planned permanent rescue funds, two people familiar with the discussions said.

Negotiations over pairing the two funds as of mid-2012 accelerated this week after efforts to leverage the temporary fund ran into European Central Bank opposition and provoked a clash between Germany and France, said the people, who declined to be identified because a decision rests with political leaders.

Disclosure of the dual-use option helped reverse declines in U.S. stocks and the euro on speculation it could help break the deadlock among European leaders. Their wrangling led to the scheduling of a summit three days after an Oct. 23 gathering.

The 440 billion-euro European Financial Stability Facility has already spent or committed about 160 billion euros, including loans to Greece that will run for up to 30 years. It is slated to be replaced by the European Stability Mechanism, which will hold 500 billion euros, in mid-2013.

A consensus is emerging to start the permanent fund in mid-2012, the people said. During the transition between the two funds, euro-area governments originally agreed to cap overall lending at 500 billion euros, a figure deemed sufficient when Greece, Ireland and Portugal were the primary victims of the debt crisis.”

On this very subject my good credit friend commented:

“Now …. Have a look: The total overall cap is 500 billion euros, of which 160 billion have already been committed or spend to help Greece. Therefore there is only 340 billion left! So how can you get 940 billion euros? This would raise the permanent fund above the agreed upon amount…. And the German Supreme Court has stated this cannot be done without a popular vote (referendum) !!! Also bear in mind that the German Supreme Court has ruled there should not be a permanent bailout fund at all…. Which add to the already constitutional issue. I do not see a popular vote in Germany having a positive outcome!”

Please find here after the link to the ESM term sheet as of March 21st 2011:
http://www.vm.fi/vm/fi/04_julkaisut_ja_asiakirjat/03_muut_asiakirjat/20110322Laajen/ESM_Term_Sheet_21.3.2011.pdf

Page 10 of the term sheet :

“As originally foreseen, the EFSF will remain in place after June 2013 so as to administer the outstanding bonds. It will remain operational until it has received full payment of the financing granted to the Member States and has repaid its liabilities under the financial instruments issued and any obligations to reimburse guarantors. Undisbursed and unfunded portions of existing loan facilities should be transferred to the ESM (e.g. payment and financing of installments that would become due only after the entry into force of ESM). The consolidated EFSF and ESM lending shall not exceed € 500 bn.”

So, please fasten your set belt as the weeks ahead might be quite volatile indeed.

“When written in Chinese, the word “crisis” is composed of two characters. One represents danger and the other represents opportunity.” – John F. Kennedy

Stay tuned!

*Martin is a credit expert at a London based bank.  

Martin T., Macronomics

Martin T. is a credit specialist with a London based bank. During his career he's had different roles within various banks, covering everything from FX to High Grade Bonds. He has always been passionate about markets and particularly on Macro trends.

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  • Rick

    When written in Chinese, the word “crisis” is composed of two characters. One represents danger and the other represents opportunity.” – John F. Kennedy

    Popular fallacy. It means “the crucial point of danger” in Chinese. No opportunity present.

    http://en.wikipedia.org/wiki/Chinese_word_for_%22crisis%22

  • http://pragmaticcapitalism Michael Schofield

    You could buy puts- hoping the guy who sold them doesn’t go bust!

  • http://macronomy.blogspot.com Martin

    ;-)