Still confused about why nobody is calling the EFSF expansion Europe's TARP, aside from the fact that this latest European bailout is exactly Europe's TARP? Need a one page summary tearsheet on the European Council Decision as pertains to Greece now and all the other European countries later? Have no fear, because Goldman's Francesco Garzarelli is here again, explaining all you need to know about the ongoing taxpayer-to-insolvent nation-to-bank capital transfer.
European Views: The European Council Decisions - A First Take
1. A common fiscal strategy gradually taking shape
The European Council announced a series of new policy measures for Greece and for the safeguard of financial stability in the Euro area. In earlier notes, we articulated the broader context and the criteria on which we would have assessed these measures. Below we provide our first take, based on the broad information so far available, on the main items. A more in-depth analysis will be possible when technical details become available in coming weeks.
Overall, the package for Greece (large PV transfers on the loans, mobilization of funds to support growth and ongoing technical assistance and oversight) is stronger than expectations, underlying a strong commitment to avoid support the country and avoid what could have been a disruptive unilateral ‘haircut’ at this juncture. Lower funding terms for Ireland and Portugal, to match Greece’s, materially improve the debt sustainability of these countries. Some private sector involvement will be conducted through a set of options financial institutions can voluntarily chose from, including a bond buyback. The IIF has posted a ‘financing offer’ on its website but bonds eligible and term sheet itself will need to be clarified. The ECB has compromised on collateral eligibility for ‘Selective Default’ rating in the case of Greece, apparently in exchange for guarantees from the fiscal authorities.
Appropriately targeted – and carrying high political significance, in our opinion – are the measures introduced to stem contagion: the EFSF can intervene in secondary bond markets and support banks in non-program countries. Both have long been on our ‘wish list’ of ways to tackle the crisis. The fact that the size of the EFSF has not been increased admittedly takes some of the shine away from the announcement, as its financial resources no longer match its enlarged scope. The authorities have already said that bigger capital commitments to the EFSF would be considered if needed, but doing it now would have increased its effectiveness as a deterrent. The ECB is probably now in a more comfortable position to conduct open market operations in the broader Eurozone bond markets if deemed necessary, before the fiscal institutions are finalized.
It would have been naïve to expect technical details to be spelled out at this point, and these will be needed to form judgement, and lead to improvements. Nonetheless, together with implementation uncertainties and risks (including parliamentary approvals), the last night’s announcements will still leave investors cautious to take sovereign spreads in the larger non-AAA issuers much tighter than where they were ahead of the Moody’s downgrade of Portugal. This remains our markets view, as expressed in previous notes, and we await flows from outside the common currency area to realign attractively valued bonds in the likes of Italy and Spain to underlying credit fundamentals. Bond prices in the program countries, instead, should be supported by the cheaper funding terms from new loans, representing a value transfer to existing bondholders.
All in all, the Eurozone has in our opinion taken a step forward towards forms of ex ante risk sharing which are less conditional, and the ECB assigned a central role in deciding when financial stability is threatened and bond purchases are necessary and fiscal responsibilities need to be shared. Together with a deeper governance structure (on which the statement remarks more work remains to be done), and a fairer terms when providing intra EMU financial support, the fiscal architecture of EMU is progressively taking shape. Note that from 2013, and possibly before, government bonds issued in the Euroarea will be issued under homogeneous legal terms, and will include collective action clauses.
In reviewing the main measures, we start with the ones that we believe are most important for the entire area.
2. Stemming contagion
Considering that sovereign tensions had engulfed Spain and Italy heading into the summit, measures to avoid contagion were in our view the main benchmark against which to judge the announcements. We have been surprised positively in this area, although the size of the EFSF may need to be revisited in the future if its greater scope and deterrent function can be put to work in practice.
This tendency to ‘under-size’ otherwise good policy initiatives has been a recurrent feature of European policies (the negative reaction to the EUR240bn effective lending capacity of the EFSF, which subsequently became EUR 440bn, comes to mind). But probably after such a large package for Greece, this was all that could be expected at this point. The mechanics of these policies will need to be articulated at upcoming Eurogroup meetings, starting with one scheduled for next week.
- Both the EFSF and its successor from mid-2013, the ESM, will be allowed to intervene in the secondary bond markets of all EMU countries if the ECB judges that ‘exceptional financial market circumstances’ pose a threat to financial stability. So the ECB takes a central role here in deciding when to act and what to buy, on a case by case basis. The central bank’s accountability in these matters is to Parliament. Member states would need also to endorse the decision, but the financial inter-linkages are so deep that incentives should be aligned when activating the facility. Had the latter been in place, the escalation of pressures on Italy and Spain could have been contrasted, or may not have come about in the first place. It is unclear at this point if the EFSF would buy the SMP portfolio from the ECB (or swap it with its own bonds); we would see this fit, but it brings back to the issue of size of the EFSF. The latter could become binding once the share of AAA-rated backed available funds is eroded (subtracting the funds committed for the program countries, these amount to around EUR 150bn). The arrangements fall short of the creation of a common debt management office, but institutionally represent a big step forward. Issues which need to be clarified are of technical nature: can the ECB buy on behalf of the EFSF, does the latter need to pre-fund (probably yes), etc.
- The EFSF can be used to finance the recapitalization of financial institutions in EMU countries through loans to governments. Where the credit risk ultimately resides will need to be clarified, what terms will be applied, what are the competition implications, etc. However, this policy should help reduce the correlation of sovereign and financial risk still so present in numerous countries (Spain and Italy are good examples), because the market assumes that undercapitalized institutions will ultimately fall back onto the public sector’s balance sheet. Our bank research colleagues will be commenting more on these aspects. The ECB has said that a plan to address funding dependency in the program countries is also under study. The greater latitude of the EFSF could offer room for coordinated solutions in this important area. We stress that, relative to where policymakers stood just three months ago on these matters, this represents an important breakthrough.
3. A big transfer of resources to Greece and program countries
The over-arching narrative fits in the dynamics we have dubbed ‘managed deleveraging’ in our research. An advanced club of countries, with highly interconnected banking systems ‘takes over’ using a joint balance sheet the liabilities of smaller countries in exchange for greater control over its cash flows. A doubling of the funds committed to Greece (now amounting to around 100% of GDP, not including the interest subsidies) and the much more generous terms also granted to Ireland and Portugal represents a sizeable transfer of resources to these countries, which improves their debt sustainability. Technical support and the disbursement of funds earmarked to economic activity go in the same direction. Private sector participation is achieved voluntarily along a set of choices. The ECB has compromised on the SD issue for collateral eligibility.
- iA second package for Greece has been agreed, amounting to ‘an estimated’ EUR 109bn (the figure includes PSI, and privatization receipts, which are uncertain ex ante). The IMF has been called to co-sponsor again the deal (and PSI offer is conditional on this happening) and we expect a 70-30 split (with roughly EUR 45-50bn provided by Greece’s EMU peers and the rest from PSI and privatizations – see below). Total committed official sector contingent aid to Greece over 2010-2014 now adds up to EUR 190bn (EUR 110bn ‘Greece 1’ plus around another EUR 80bn ‘Greece 2’. The overall IMF portion could be as much as EUR 65bn (of which EUR 18bn have been disbursed) while the share provided by Eurozone countries could amount to around EUR 125bn (EUR 47 disbursed). The funds will cover medium-long term GGB redemptions through mid 2014 and finance the (declining) deficit over this period.
- New loans to Greece from EMU countries will be funded through the EFSF (http://www.efsf.europa.eu), which will also replace bilateral arrangements in the first package. Including the EUR 26bn for Portugal and the EUR 18bn for Ireland and a cumulative EUR 70bn for Greece, the stock of EFSF bonds could amount to around EUR 100-120bn over the next two years just for the support provided to the three program countries. The EFSF has a lending capacity of EUR 440bn (over-collateralized to maintain AAA rating). The share backed by the AAA-rated EMU sovereigns amounts to EUR 255bn.
- Lending terms have been drastically reduced, increasing debt sustainability. New loans will have maturities between 15 and 30-years, with a ‘grace period’ of 10-years. The loans will be priced at the cost of funds for the EFSF, which is close to Libor. For example, up to now Greece could access a 7.5-year loan at around 6%. Now it will be able to enter a 30-year loan at around 3.6%. This is what already takes place for the Balance of Payment Facility in support of eastern European countries, and represents an important change, as we suggested in our January issue of the Fixed Income Monthly. The existing loans (currently with maturity of 7.5-years) will also be modified and extended, although details are yet to be provided.
- A comprehensive strategy for growth and investment will be spearheaded by a EU Commission-Greece Task Force, mobilizing structural funds available in the EU budget (co-investment rates had already been lowered to 15%). The EIB will participate in supporting the economy. A progress report will be available in October. Stronger growth goes along way to improve debt sustainability, as sensitivity analysis in the IMF’s latest review illustrates. Even if the headline deficit targets for Greece remain ambitious, the combination of lower interest payments (at cost, and much below Greece’s ‘exit yield’) and support to domestic activity make them somewhat more realistic to achieve.
4. A menu of options for voluntary private sector involvement
Part of the package will be supported by Private Sector Involvement, or PSI, as some countries (Germany most vocally) had been asking for. This had been our baseline case since the start of the year. The statement explicitly says that PSI pertains only to Greece, indirectly taking issue with the CRAs’ downgrading of Portugal and Ireland on the basis that PSI would be a pre-condition for further aid. We doubt that the promise that PSI would not be extended is ‘time consistent’ (as readers may recall, the earlier promise was of no PSI at all until 2013). Nonetheless, we do not expect Ireland or Portugal to be in need of additional support.
To keep with the ‘voluntary’ flavour of the initiative, the Institute of International Finance has put forth a Greece financing offer, with a menu of instruments. The information is not exhaustive to provide a final assessment. To our understanding, the expected notional amount of bonds involved will be in the region of EUR 13.5bn. Additionally, the official sector will engage in a buyback program that could target another EUR 25bn notional of debt, according to our initial interpretation of the somewhat sibylline statements. If this holds true, then the funding provided to Greece by the private sector would be in the region of EUR 30-35bn, broadly in line with what the IMF had earmarked.
Financial institutions can elect to exchange their bonds with four different long-term debt instruments (discount or par bonds) carrying step-up coupons and principal protection; alternatively, they can opt to participate in a debt buyback run by the official sector through the EFSF. The optimal choice will be influenced by accounting constraints. The calculations provided by the IIF suggest that the ‘PV transfer’ to Greece (assuming exit yields in the region of 8-9%) would amount to around 20%. Overall, PSI appears to be contained, and the fact that it is conducted in coordination with financial institutions (30 bank and insurance companies have already endorsed it) means that participation will likely be high. As expected, PSI does not change debt sustainability trajectory materially, and the more meaningful restructuring is the one piloted by the official sector.