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.