The CDO At The Heart Of The Eurozone

Tyler Durden's picture

A few days ago, we demonstrated that the latest Greek bailout package is nothing more than recycled MLEC special purpose vehicle designed to cover up toxic assets off balance sheet, like that one that was supposed to wrap up the subprime toxic mess. Luckily that did not happen as all it would do is make the credit crash even more acute when it finally did hit. In the meantime, the other Frankenstein contraption proposed by Wall Street to contain the fallout of the PIIGS bankruptcy, is the EFSF, which also got a facelift a few weeks back, and which is effectively a CDO: the same instrument which caused European banks to now be insolvent after buying up all tranches offered them by Goldman et al in the 2005-2007 period, once US banks realized just how toxic the less than AAA tranches were. It is poetically ironic that the instrument that led to Europe's insolvency is now what is supposed to prevent (temporarily) its plunge into outright default. For all who are wondering what the details of the new and improved CDO at the heart of the Eurozone are, here is Nomura's Nikan Firoozye.

The CDO at the Heart of the Eurozone

The announcement of the expansion of the loan capacity of the European Financial Stability Facility was accompanied by an update to the entity structure. The new structure includes a greater level of guarantees allowing for the removal of the cash collateral requirement, a previous requirement to ensure an AAA rating on the issued bonds even when issued in the midst of a crisis. The removal of this cash element moves the loan to issuance ratio to 1:1 from the previous ~0.7:1. The new structure offers many advantages in our view, not the least of which is the fact that, by offering further credit enhancement, it should trade tighter. We analyse the model-based spread between the new and old structures using CDO valuation methods.1

Some of the main differential aspects between the structures include:

  • Removal of cash buffer. Increase of guarantee from 120% to 165%.
  • The AAA element is essentially unchanged (for EUR100mn issuance, it moves from EUR100mn to EUR102mn in our example of EFSF ex-Greece/Ireland/Portugal), but the AA and lower guarantee is increased. And the total loan size is increased.


We are effectively analysing a super-senior tranche of a CDO. For a given EUR100mn bond, the old structure has a pool of EUR120mn in guarantees (of which EUR75mn are AAA and EUR45mn are AA and lower ratings), and the proceeds of the bond issue are invested in EUR75mn of loans (directly corresponding to AAA guarantees) and EUR25mn of AAA collateral to ensure the rating. The total pool is then EUR220mn and the super-senior principal is protected as long as defaults remain below EUR120mn.

Correspondingly we see the new structure has EUR165mn in guarantees, of which EUR102mn are AAA (just slightly more than the AAA guarantees and AAA cash buffer in the original). What offers far greater protection against losses is the EUR63mn of AA and lower rating guarantees together with the larger loan size of EUR100mn. With a total pool of EUR260mn, the super-senior principal will remain intact unless defaults exceed EUR160mn.

We value this super-senior tranche using a simple CDO evaluator, with a gamma copula (and gamma=200% to emulate Normal copulas) in Figure 2. We can then value each structure under various default correlations. In the example we consider the guarantee pool ex-Greece/Ireland/Portugal and consider a loan to Portugal as backing the bond issue. CDO models typically are applied to lower default correlations, but we can only assume relatively high correlations across eurozone sovereigns. We note that the minimum fair-value spread between the two is about 2bp in the 5yr and 6bp in 10yr, but that this decreases to flat in 5yr and 2-3bp in the 10yr when default correlations are reduced to as low as 80%. We note that fair value, according to the CDO valuation methods is between 30-40bp tighter than current spreads, but that given liquidity considerations and the overall complexity of the structure, we do not think that this is particularly relevant to levels of EFSF in general.

While the valuation of the EFSF is not the most pressing issue in the eurozone, due to the ongoing debate on issues of sustainability, the politics of austerity measures and private sector burden sharing, the EFSF remains a key element in the eurozone’s ability to support itself. CDO-evaluation methods do give insight into the variation in the guarantee structure underlying the EFSF. As a result of the above, we believe the new structure will trade some 2-4bp tighter than the old structure, once parliaments have ratified the increases in guarantees.

And just because this time it is different, this particular CDO will work. We promise.

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Dick Darlington's picture

This monster really turns your stomach upside down so after taking a puke i think i'll have a drink too.

moldygoat's picture

I have started drinking more heavily since reading ZH. I am long small batch bourbon.

NotApplicable's picture

One has to keep their mind (and body) flexible during these increasingly uncertain times. Otherwise the bowels lock up and you aren't worth a shit.

Or so I'm told.

spekulatn's picture

And just because this time it is different, this particular CDO will work. We promise.


It better!  :)

Greyhat's picture

The funniest Hyperinfective Invest Vehicle is the TARGET2 account of the Bundesbank. €340bn of credits to other bankrupt EURO-CBs secured by europes finest paper trash collateral. Gravity bomb, implosive on fail, too big to survive. :-)

SWRichmond's picture

Caption contest!

"Leverage, bitches!"

"Scotty, move leverage to the shields!"

"At warp 9, we're going nowhere mighty fast."

InvalidID's picture

For the Caption Contest:


 Lets write the details of this one in Portugese. The Chinese don't speak Portugese right?

 Hey guys, I bet the Fed will buy it if we...



ThirdCoastSurfer's picture

Belarus is in big trouble with news of rioting after the electricity was cut off for lack of payment and the Bank of Russia just tapped a $5.4b loan from the the Russian Central Bank.  

uranian's picture

In true Orwellian style, Europe's last dictator, Alexander Lukashenko, ordered the arrest of hundreds of protesters for clapping and organized a rock concert of mini-skirted girl bands to try to entice them away from demonstrating.

the tragi-comedy of planet earth grows by the day.

Milstar's picture

"Belarus is in big trouble with news" just with Russia now owning them there is nothing new.  Sometimes a state default is the best option.  

elOso's picture

would love to see a cds market develop on the EFSF. let the market price the risk and total fck with the european kleptocrats.. although if someone was brave enough to sell protection on the super senior tranche not sure I would feel that great about having a counterparty around down the road to collect from...

Global Hunter's picture

Admittedly I had a pint for lunch, but things just get more bizarre.

carbonmutant's picture

There seems to be a shortage of cash in the new structure...

This like Debt backed by Debt...


AcidRastaHead's picture

Are you ageist?  Got a problem with super-seniors?  They're super you know.  That's like way better than deluxe-seniors.

AcidRastaHead's picture

Are you ageist?  Got a problem with super-seniors?  They're super you know.  That's like way better than deluxe-seniors.

AcidRastaHead's picture

Damn that double minus advanced mathematics.

augie's picture

The new structure includes a greater level of guarantees allowing for the removal of the cash collateral requirement...

How does that make anything more safe? 

NotApplicable's picture

Because it's greater. It goes to eleven.

centerline's picture

+1.  Head banger nod to Spinal Tap.  Classic.

centerline's picture

Sounds to me like nothing more than removing barriers to "technical insolvency," so that when this  particular turd detonates it will lead to immediate and irreversible failure.  All the chips have been pushed into the center of the table.    

augie's picture

Yikes, I think i'd rather prefer a spinal tap aphorism.

Cole Younger's picture

" once parliaments have ratified the increases in guarantees."..............enough said

centerline's picture

... and it's gone!    hahahahahaha...

Ghordius's picture

Damn are the smart! I had no idea they used copulas! On whole contries

slewie the pi-rat's picture

long liver;  short lungs.

weed, BiCheZ!

fukin groundhog day, or what?

Milstar's picture

Short kidney's go long term livers!.  Every 1st yr med student knows that. 

chump666's picture

yes a rioting contagion...EZ is done.

I am done with EZ, till the next implosion (1week and counting) till then, China, PMI, liquidity, inflation

midnight's picture

Zero Hedge, quit fooling the forum members with that PIIGS crap, just because it makes you look macho.


1) Show PROOF (from other source besides your ass) that Spain and Italy are broke

2) Greece, Ireland and Portugal are the side of _small_ U.S. states.


You don't have a clue about Europe. Get one

Milstar's picture

WTF do you need??!!!? CDs Spreads have blown out, rates are up in the 5's or higher. debt to GDP is rising.  Spain has massive undisclosed debt and insolvement regional banks, Italy has a sky high debt to GDP that makes even Greece look restained.  What more do you need?? 

zevon investments llc's picture

This link has the same content but formatted:

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hamurobby's picture

Interesting statement...

The U.S. economy is about to enter a state of recession within nine months (Europe has time in the bank for the same reason we did with QE about 3 years).


Peter K's picture

You got to wonder how much longer the Soviet Union could have survived if it had access to the the EU braintrust?

johnnysize's picture

Here is the joke... you go short all the Sov debt in the pseudo develped world and buy "emerging market debt" ...add a little Green Mountain Coffe short and you are George Soroz. But guess what? It wont work. After the mountain seems to big to climb, we will shift the fear to another global economy. We cant short everything? CAN WE? Oh wait, maybe we can. Maybe we can simplfy the world's woes by simply stop buyiong and selling equities and bonds, but BUY GOLD. In the end its GOLD and AMMO. Get used to have money, no matter whwre you live, you better have gold and ammo. PERIOD. Have fun long /shorting your wangs into rasberry root heaven.